Pharmalot: There seems to be a lot of excitement about Pfizer splitting up. Evans: My feeling is that, if you look at the share price performance - from the high teens to low 20s - it’s mostly attributable to anticipation that Pfizer will take some kind of action...They’ll do something with animal health or whatever. But people are really expecting is that they’ll shake things up and wind up with a growth company.
Pharmalot: But you don’t think splitting Pfizer into established and core businesses is not such a hot idea. Or at least will accomplish the needed goals. Why? Evans: Two things. First, there is the question of whether splitting a company achieves the presumed objective of creating growth. The subtext is that by divesting slower growing parts of the company, they will be left with a core that has greater potential. The difficulty is twofold. When you look at the growth potential of what would become the core business, it more likely than not looks to be a business in decline. Objectively, it’s fairly clear the company leftover would not be a growth company. Problem two is that if you haven’t achieved growth, then you’ve got to consider the costs incurred by breaking the company up. And there are number of those beyond investment banking and distractions to management.
Two primary concerns is asset utilization in manufacturing. As Pfizer has become bigger over the years, it has become more efficient, in part, because those mergers allowed it to reduce shifts in the manufacturing base. As you break the company up, unless you make some possible but novel arrangements, then you’re going to lose those efficiencies. And those efficiencies are significant. The second is revisiting the notion that, if you want a growth company you want a small sales base. If the sales base is $20 billion or $30 billion, then $1 billion in new product creates more growth. I get that and agree with that.
If you’re going to launch more products than you lose to patent expirations or simple obsolescence, it makes sense to do that with a smaller company. But the opposite is also true. If you’re going to lose more products to patent expirations than you’re going to launch, then it makes sense to have a larger company. And the reason is that if you lose a $10 billion product and sales are $100 billion, that’s a 10 percent loss. But if the sales base is $50 billion, then it’s a 20 percent loss. It’s simple math on growth and risk as it relates to company size.
Pharmalot: You mention sales weighted average is an issue. Can you explain that? Evans: In terms of near-term growth, the rule of thumb is how old are the products. A company with old products is likely to be later along in its life cycle and growth is declining. A company with a young set of products is more likely to be growing. So you would look at how long ago a product was launched and multiply the number of years times that product’s share of total sales. And so we used a sales-weighted average to look at this...We found that Pfizer’s present sales-weighted average is 10.9 versus an industry average of 11.4 percent. If we removed the established products, Pfizer’s sales-weighted average falls to 10.4 years, which is still better than the industry average but is only a six-month reduction that moves Pfizer only one spot in ranking. On the life cycle curve, it doesn’t make a lot of difference.
And this is an important distinction and it really is the heart of the argument. If you had this extreme difference between established and core businesses – one growing at 20 percent and another falling 20 percent – and the ceo is frustrated and wants to spin out and all of the sudden you’d have some sizzle and better valuation, then it could make sense. But if the premise was to be left with a core growing fast enough to be interesting, they clearly haven’t succeeded in that regard… They’re not sufficiently different. We’re comfortable saying that their core is not a growth company. It could be the established products fall a lot faster than they say they will, but that would not change the fact. We forecast the core top-line growth rate at negative 2 percent versus established negative 3.4 percent long-term.
Pharmalot: You also make the point that the number of Phase III and filed products per dollar of sales for the core unit isn’t much better than for Pfizer overall. What does this suggest? Evans: We want to know what they have in the pipeline to add to sales mix. We divided the number nme’s (new molecular entities) filed or in Phase III by current sales. We’re just counting the number of filings and Phase III; we’re not trying to estimate which are better or worse…Anyway, we found the core business would decline more slowly than total, but that’s hardly the objective…It’s easy to frame in binary terms, but doesn’t create a growth company at the end of the day…So you could argue it’s just a step on the road, reducing the size of the business to open the door to growth. But then what are the next steps? And they have to include R&D returns above the cost of capital. They have to do enough R&D to be able to expect growth and right now, neither of those things is true…The returns on R&D are below of the cost of capital…
Pharmalot: What would you tell Read? Evans: What will you do about manufacturing efficiencies? If investors contemplate a break up, manufacturing efficiency will be a primary question and they need to have an answer to that. There’s a shrunken sales base, but not doing enough R&D to create growth and so they have a problem. Patent expirations come more frequently than product launches… So what comes next? How do they make the core a growth company? If they spin out products from established, you have a company not reinvesting in sustainability, so you’ve got to pay out earnings as dividends. …And you’ve got to pay a lot of money. They will have to repatriate out-of-country cash, and pay taxes…It looks like a very inefficient transaction. This problem of where the money comes from reemerges