Industry Audit & Companies of the Year

The Enron/Arthur Andersen debacle has been a painful warning that there is more to analyzing corporate performance than the smoke and mirrors that often pass for accounting and financial scrutiny. Indicators such as brand value, new product revenue, presence and percentage of business conducted in the US market, and sales growth provide more reliable criteria for companies' short and long-term prospects. But what accounts for superior performance? Is it company size, R&D spend, marketing muscle, or all three together?

This article looks at performance measures beyond those revealed by standard accounting and financial reports to take into account new marketing metrics such as sales per representative, intellectual capital, and percentage of revenue from products that were not on the market until five years ago or less. That shift represents a return to the focus on product quality and satisfying consumers rather than Enron's and Worldcom's "pump and dump" methods that allowed executives to cash out without regard for consumers-or employees.

2001 Performance Markers

One challenge in conducting a cross sectional analysis of any industry is finding appropriate benchmarks to use as a basis for comparison. For pharma, the most readily available source of such information is financial statements. They and their accompanying notes contain a wealth of information about a company's financial position as well as insight into how the company competes strategically.

This analysis examines financial statements along with more intangible market metrics to assess what determines successful economic performance in the pharmaceutical industry. (See "Acknowledgments," page 90.) It focuses on the "Sweet Sixteen" pharma companies for 2001: those with the highest sales revenue and for which there was access to financial information. Thus, most of them are US-based, adhere to generally accepted accounting principles (GAAP) and file 10-K forms for tax purposes. Among the 16 are also four non-US-based companies (Aventis, AstraZeneca, GlaxoSmithKline, and Novartis), which made the cut because their stock is traded through American Depository Receipts. ADRs trade on US stock exchanges, report to the Securities and Exchange Commission, state their earnings in GAAP, and file Form 20-F with the Treasury Department. Thus, this audit examines all 16 companies according to the following criteria:

Sales-2001

Sales. Pfizer, with its enormous size, deep R&D pockets, extensive pipeline, and powerful marketing machine, is tops in this category. (See "Sales-2001.") Forest Labs ranks 16th, possibly because it has only two blockbuster products.

Market capitalization. Pfizer hits the top level in market cap as well, with a total of $251.2 billion. (See "Market Capitalization-2001.")

Market Capitalization-2001

Market cap measured against sales. Amgen tops out with a ratio of 18. (See "Market Cap to Sales-2001.") Merck's low market cap to sales ratio of 2.7 is a function of its ownership of Medco, a pharmacy benefit manager with lower profit margins. It will be interesting to see what happens to that ratio if and when Merck sheds Medco. The low ratios of GSK, AZ, Bristol-Myers Squibb, Aventis, and Pharmacia reflect low valuations from a market perspective.

The ratio of market cap to sales is very important. In absolute terms, size certainly matters. One would expect Pfizer, at $25 billion-plus in sales revenue, to be valued higher than Forest at $1.2 billion. But the ratio is the great equalizer. It is analogous to comparing strength between an elephant and an ant. The elephant can lift substantially more than an ant in absolute terms. But accounting for body mass, the ant, gram for gram, is stronger. So the market cap to sales ratio shows that a smaller company can do more with less, such as grow faster, increase earnings faster, and so forth.

Market Cap to Sales-2001

Market value added (MVA) and economic value added (EVA). Developed by the consulting company Stern Stewart, MVA and EVA are relatively recent additions to the business lexicon, but they may be the most important factors in assessing a company's economic performance. (See "Market Value Added-2001" and "Economic Value Added-2000,")

The MVA concept is fairly simple: Add up all the capital that investors put into a company-stock, debt, and retained earnings. Then see how the market determines the company's stock value, adding back debt. If the company's market value is greater than all the capital invested in it, then MVA is positive. Management has done its job:

Market value added-2001 and Economic Value added-2000

It has created wealth. If the market value is less than the capital invested, MVA is negative and management has destroyed wealth.

Economic value added is after-tax net operating profit (NOPAT) minus the cost of capital. EVA measures a company's success during the past year; MVA looks to the future, reflecting the market's assessment of a company's prospects. (See "America's Best Wealth Creators," Fortune, December 1993.) In the table on economic value added, Wyeth registers a negative EVA of $2.1 billion. But of the major pharma companies, Wyeth comes in seventh with an MVA of $62.5 billion in wealth added.

The company has had its share of problems-Phen-Fen, among others-but the market seems to have put that behind it and is looking to a future in which Wyeth's prospects seem bright. Think of MVA as the value the market places on the future stream of annual EVAs. (See "The Real Key to Creating Wealth," Fortune, September, 1993.)

In Stern Stewart's view, the cost of debt is obvious from interest expenses paid. But the cost of equity or common stock is not so obvious. And equity is an expensive way to finance assets to generate revenue. The real cost of equity is what shareholders could be getting in price appreciation and dividends if they invested in a portfolio of companies with comparable risk.

What is a general number for the cost of equity? Over time, stocks return, on average, six percentage points higher than long-term government bonds. So, the total cost of capital is a weighted average of debt plus stock.

One way to get higher returns on capital is leverage: Use more debt in the capital structure. In the early 1980s, Coca Cola-like Forest Labs today-was virtually debt free. Instead of floating more stock to finance growth, the company used less expensive debt, lowering its weighted average cost of capital (WACC) from 16 percent to 12 percent. (See "The Real Key to Creating Wealth," Fortune, September, 1993.) That has implications for pharma, which is notorious for having little debt in the capital structure.

Lilly and Pharmacia have comparable sales, but Lilly's market cap is almost 60 percent higher. Its MVA is two-and-a-half times greater, and its EVA is twice as large, indicating Lilly was better managed and produced greater wealth for shareholders in 2001. Thus, last year's MVA represents the difference between the total capital investors put into a company and the money they could take out as of October 31, 2001. Pfizer, J&J, Merck, BMS, Lilly, and Abbott have shown superior performance in this critical measure.

R&D to sales-2001

Strategically, companies can increase shareholder value in the following ways:

• Increase profit by lowering operating costs. This suggests that companies begin to focus on operating expenses on the income statement in addition to increasing top-line revenue.

• Invest in high-return opportunities. Hence, Merck's decision to exit the lower-margin pharmacy benefit manager (PBM) business and focus solely on the higher-margin pharma business.

• Lower WACC by taking on more debt in the capital structure.

• Own fewer assets. Companies are not in business to own assets; they are in business to use assets to generate wealth for shareholders.

Ratio of R&D to sales. Pfizer is at the top with $4.8 billion in total R&D spend, and Forest is last with $106 million. (See "R&D to Sales-2001.") On a percentage basis, however, Genentech comes out first, spending 30 percent of sales on R&D, followed by Amgen and Abbott. The interesting question is whether R&D investment is related to performance. That will become clear later in the article.

R&D Spend-2001

Growth Factors

An Arthur D. Little study estimates that the pharma industry as a whole is expected to grow 7-8 percent annually during the next five years. Hence, growth above that rate-even into double digits-is impressive as an indicator of solid performance. (See "Growth 2000-2001.") Abbott came in first in 2001 with 40 percent growth, followed by Forest at 34 percent. Coming off a huge sales base, Pfizer's 13 percent growth is very impressive, as is GSK's at 12 percent. Schering-Plough had no growth and Merck reported an anemic 5 percent.

J&J is an interesting story. It came in third in this metric with a 19 percent growth rate in its pharma division from a huge revenue base. It begs the question of whether a big company can continue to grow at above-average rates. J&J's stable of diverse businesses makes it less vulnerable than others to a slowdown. It may be difficult for a $25 billion company to grow as it did when it was much smaller. But given J&J's structure as a kind of holding company for more than 100 entrepreneurial divisions, it may be relatively feasible for each of its smaller entities to grow at 10-15 percent rates. What's even more impressive is that J&J has had 69 consecutive years of sales growth.

Growth 2000-2001

Nevertheless, how a company grows is as important as whether it grows. Even J&J's impressive growth is partly a result of its Alza purchase. Abbott's growth, too, is partly from its purchase of BASF's pharma division Knoll. A red flag should go up when sales growth comes mainly from the purchase of other businesses. There will be a new respect for increasing top-line growth, because growth will be harder to come by. The US economy is growing about 3-5 percent and the pharma industry is predicted to grow at less robust rates than it did during the last few heady years.

Following are the criteria for evaluating companies' growth:

Price to earnings ratio. P/E is the stock price divided by earnings per share. (See "Earnings Per Share-2001"and "Price to Earnings-2001.") Genentech is number one with a P/E of 83.3. Abbott, Amgen, and Forest place second, third, and fourth, respectively. Merck is at the bottom, influenced by its tie to Medco, which produces lower margins. Because Medco's sales are growing faster than Merck's pharma sales, Merck's profit margins and P/E are in decline.

Earnings per share-2001 and Price to earnings-2001

Price to sales ratio. Price to sales is calculated as the stock price divided by revenue per share. (See "Price to Sales-2001.") Some analysts prefer this ratio because it is more difficult to manipulate sales than earnings-for which there are dozens of accounting tricks, from methods of depreciation to counting pension fund interest as income.

Price to earnings to growth ratio (PEG). The PEG rate is calculated by taking the P/E ratio and comparing it with an estimated growth rate over time-typically five years. From the shareholder's perspective, the lower the rate the better. All of the pharma companies' PEG rates in this report are greater than 1.00. (See "Price/Earnings to Growth-2001.") That means that none are relatively undervalued. A one-to-one ratio means that P/E is in line with the estimated growth of long-term earnings. Given those terms, Forest is the best buy at 1.01. AZ, in PEG parlance, is substantially overvalued as a stock buy at 3.33.

Price to sales-2001

Gross margin. Each company's income statement includes this very important measure of profitability, calculated by subtracting the cost of goods sold from sales. Gross margin reveals how good a company is at pricing and how efficient it is in buying the goods it needs to manufacture products. For pharma companies, the cost of goods sold is not that crucial a line item because the cost of ingredients and raw materials is relatively low. So gross margin tends to reflect a company's pricing. The higher the GM, the higher the prices a company commands.

Price/earnings to growth-2001

The hands-down winner for 2001 is Amgen, with a GM of 95.3 percent. (See "Gross Margin-2001.") Amgen gets top prices for its two basic pharma products. Generics have not yet spoiled its party. Equally impressive is Pfizer with 84.4 percent. Schering-Plough and Lilly are also in the 80 percent plus range. Merck's 39 percent is misleading because it is dragged down by Medco's strong sales growth from lower-margin products. Similarly, J&J's relatively low GM at 71.1 percent is affected by its substantial consumer business, which brings lower profit margins than prescription pharmaceuticals. The relatively low margins for GSK, Aventis, and Novartis may be a result of generating the bulk of their sales outside the more profitable US market.

Gross Margin-2001

Profit to sales. This ratio is calculated from the income statement by subtracting operating expenses from gross margin before taxes. It's not surprising that Amgen is number one with a P/S of 39.4 percent, undoubtedly helped by its stratospheric GM of 95.3 percent. (See "Profit to Sales-2001," page 78.) And Pfizer is strong at number two with 34.9 percent. Given J&J's strong consumer franchise, its P/S of 24.7 percent is very impressive. Merck is deceptively low at 21.8 percent, again, because of Medco's influence. But BMS, Pharmacia, Wyeth, Abbott, Genentech, and Forest are below average when compared with their peers.

Profit to sales-2001

Sales to assets ratio. This very important ratio is calculated by taking the top-line-sales-from the income statement and dividing it by total assets, which are found on the balance sheet. It is a measure of asset productivity or asset turn-over. In general, the higher the ratio, the better. The industry average is .85, which means it takes one dollar invested in assets to produce 85 cents in sales, an indication of a capital-intensive industry. Merck ranks highest at 1.08, but that is somewhat inflated because of the high turnover of Medco's fast-moving inventory. AZ is number two at .92; Genentech, at .29, comes in last.

Sales to assets-2001 and Profit to assets-2001

Assets to net worth ratio. This is a measure of how much of the company is owned by shareholders and how much is owned by creditors. Total assets minus total liabilities equals net worth. The ratio is calculated by using total assets as the numerator and net worth as the denominator. The more debt a company has, the more "leveraged" it is, which kicks up return on net worth.

Most analysts set a 50 percent or lower debt to capital rate as safe. None of the 16 pharma companies come close to that (See "Assets to Net Worth-2001," page 80.) Wyeth is the most highly leveraged company at 4.62 to 1. The most conservative company is Forest at 1.18 to 1.

Assets to net worth-2001

How Well They Compete

Dupont's long-term return-on-investment model enables analysis of how a company competes by examining two equations:

• profit to sales (P/S) x sales to assets (S/A) = profit to assets (P/A), an important profit measure in its own right-return on assets.

• multiplying P/A x assets to net worth (A/NW) = profit to net worth (P/NW).

The model indicates that there are three ways to make money:

Margin management. Measuring profit against sales, companies can price more effectively, do a better job of purchasing, and achieve better control of operating expenses.

Asset management. Companies turn assets over faster and do more with fewer assets, increasing sales faster than assets increase and reducing sales, but reducing assets even faster.

Financial management or leverage. When companies take on more debt, that leverages the profit to net worth ratio.

An important measure of return on investment (ROI) is P/NW. (See "Profit to Net Worth-2001,") Wyeth is number one because of its relatively high A/NW ratio at 74 percent P/NW. Lilly is number two at 54. Using the Dupont model, the following shows how well the "Sweet Sixteen" companies compete:

Profit to net worth-2001

Pfizer: P/S (34.9 percent) x S/A (.82)=P/A (28.6 percent) x A/NW (2.14) = P/NW (61.2 percent). Pfizer's high profit margin indicates it does very well on top-line pricing; its S/A is about average. Its assets/NW is at the higher end of the pharma industry, resulting in a very high P/NW. If Pfizer can raise its S/A and take on a modest amount of debt, it can increase P/NW substantially. The table, "Debt to Capital-2001," below shows that Pfizer has only 9.7 percent of its capital structure in debt. Its strength is on the income statement, which would include expenses for marketing.

GlaxoSmithKline: P/S (30.1) x S/A (.81)=P/A (24.4 percent). A/NW was not available for GSK, but the company's P/A is a bit below Pfizer's. With average S/A, GSK competes mainly on operations and pricing on its income statement.

Debt to capital-2001

Merck: P/S (21.8 percent) x S/A (1.08)=P/A (23.5 percent) x A/NW (1.59)=P/NW (37.4 percent). As pres-ently constituted, Merck competes in volume, as its relatively low P/S indicates, but it has the highest asset turnover and a modest amount of debt that result in a relatively high return on net worth.

AstraZeneca: P/S (25.9 percent) x S/A (.92)=P/A (23.8 percent) x A/NW (1.84)=P/NW (43.8 percent). AZ has a slightly below-average P/S, with a modestly higher than average S/A and a modest amount of debt that results in a relatively high return on net worth.

Bristol-Myers Squibb: P/S (33.8 percent) x S/A (.80)=P/A (27.0 percent) x A/NW (1.66)=P/NW (44.9 percent). BMS competes primarily on its income statement, although it is doubtful that it gets high prices with such a relatively low gross margin, with a lower-than-average S/A and a modest amount of debt.

Aventis: P/S (19.9 percent) x S/A (.58)=P/A (11.5 percent) x A/NW (2.92)=P/NW (33.7 percent). Aventis is relatively low on P/S and S/A, below average on both ratios. But it has the second highest asset to net worth ratio and that lifts P/NW to a respectable number.

Johnson & Johnson: P/S (24.7 percent) x S/A (.86)=P/A (21.2 percent) x A/NW (1.55)=P/NW (32.9 percent). J&J is average in all three measures. If it can improve one or more of these three drivers, its return on net worth will improve.

Novartis: P/S (26.5 percent) x S/A (.49)=P/A (13.0 percent) x A/NW (1.57)=P/NW (20.4 percent). Novartis is below average in P/S, well below average in S/A, and about average in leverage, resulting in a less-than-spectacular P/NW of 20.4 percent.

Pharmacia: P/S (16.3 percent) x S/A (.86)=P/A (14.0 percent) x A/NW (1.81)=P/NW (25.4 percent). Pharmacia has a P/S that is 25 percent below average combined with an average asset turn-over and fairly conservative debt.

Wyeth: P/S (20.3 percent) x S/A (.79)=P/A (16.0 percent) x A/NW (4.62)=P/NW (74.1 percent). Wyeth is below average in profit margin and asset turn-over, but it more than makes up for those shortfalls with the highest debt to net worth ratio, making it number one in profit to net worth.

Lilly: P/S (33.5 percent) x S/A (.70)=P/A (23.4 percent) x A/NW (2.31)=P/NW (54.1 percent). Lilly is well above average in P/S, combined with a high gross margin, indicating that it does not compete on price as much as it focuses on high-margin, high-value products for which the company can get a premium price. Its S/A is about 15 percent below average, but the A/NW ratio comes in fourth and results in a very high P/NW.

Schering-Plough: P/S (25.7 percent) x S/A (.81)=P/A ( 20.8 percent) x A/NW (1.71)=P/NW (35.6 percent). S-P has average numbers across the board, resulting in an average profit to net worth.

Abbott: P/S (11.6 percent) x S/A (.7)=P/A (8.1 percent) x A/NW (2.56)=P/NW (20.8 percent). Abbott has a very low P/S because of its low gross margin and a below-average S/A, but it has the third highest debt to net worth ratio, giving it a decent return on net worth.

Amgen: P/S (39.4 percent) x S/A (.62)=P/A (24.4 percent) x A/NW (1.23)=P/NW (30.0 percent). Amgen has the highest profit margin, following its highest gross margin, but a low asset turn-over and very conservative leverage place it in the bottom third for return on net worth.

Genentech: P/S (12.8 percent) x S/A (.29)=P/A (3.7 percent) x A/NW (1.20)=P/NW (4.4 percent). Combined with an ultra-conservative debt ratio, the resulting profit to net worth is not what one would expect from Genentech, because of the lucrative therapeutic area in which it specializes, oncology.

Forest: P/S (22.8 percent) x S/A (.8)=P/A (18.2 percent) x A/NW (1.18)=P/NW (21.5 percent). The relatively low profit margin and average gross margin suggest that Forest prices Celexa (citalopram) competitively. Its S/A is a bit below average and its debt ratio is conservative, resulting in a very modest return on net worth.

More Than Money

Non-finance accounting factors come into play as well. Marketing metrics are chief among them:

US presence. Companies that do most of their sales in the US market-the most profitable in the world-perform better than average in key measures. (See "US Presence-2001.") Two-thirds of the new drugs introduced in the past five years originated in US labs. (See "How Europe Could Cure Its Ailing Drugmakers," Business Week, March, 2002.)

US Presence-2001

Domestic sales per rep. The basis for this calculation is total dollar sales for pharma adjusted for the percentage sold in the United States. Sources for this information were Pharmaceutical Execu-tive, company annual reports, and 10-K forms filed with the US Treasury Department. It seemed inappropriate to compare US reps with detailers who must function in Japan, Italy, France, Pakistan, or China, where the economic setting is different. The number of reps came from figures in Business Week and the Wall Street Journal.

As "Domestic Sales Per Rep-2001" shows, the number-one pharma company in reps' sales productivity is Genentech, reflecting high-value revenue from anti-cancer drugs and relatively few reps needed to target a small base of specialists. Number two is Lilly, another company that focuses on complex therapies that are generally delivered in hospital settings. Tied for third are J&J and Merck, and number five is Wyeth, which also is reputed to have the highest rep retention rate in the industry.

Domestic sales per rep-2001

As noted earlier, market cap in the long run should equal expected future profits, discounted for

• the time it will take to achieve those profits

• risk that profit will never materialize

• opportunity cost foregone.

For companies with higher valuations, the market is saying that it expects the payback to occur in a relatively short time, that profit will materialize, and that the return expected far exceeds any opportunity not taken. In the early 1980s, a company's stock value more or less equaled its book value.

Today, stock value is more than two times book value. (See "High Turnover, High Risk," Business Week, spring 2002.) That difference is seen in the price companies pay to acquire brand name products, such as in BMS' purchase of Dupont's brands. Baruch Lev, accounting professor at the New York University's Stern School of Business, says brands can have value that greatly exceed the book value of a company's hard assets. One example is Coca-Cola, valued at about $80 billion, with the company's property, plant, and equipment valued at about $10 billion. The remainder, $70 billion, is attributed to the value placed on the brand.

"Brand Power" knowledge capital earnings-2001

Using Lev's methodology, "Brand Power Knowledge Capital Earnings-2001" indicates the "smartest" pharma companies according to the term he coined, "knowledge capital." (See "Accounting Gets Radical," Fortune, April, 2001.) The report's common thread reflects the three companies that do the best job of developing knowledge capital: Pfizer, Merck, and J&J.

Reputation Also Matters

In an inaugural public opinion study of corporate image conducted by the Reputation Institute and Harris Interactive, a nationwide survey of 10,830 people in August 1999, J&J came out on top. (See "The Best Corporate Reputations in America," the Wall Street Journal, September 1999.) The company placed first in emotion (admired and respected), products and services (high quality, innovation, and value), and workplace environment; third in social responsibility (a good corporate citizen); and fourth in financial performance.

In the second annual survey, J&J remained the number-one rated corporation while Merck came in at 28. (See "Survey Rates Companies' Reputations," the Wall Street Journal, February 2001.) Companies whose reputation scores had fallen experienced an average 28 percent drop in market capitalization after the study, and those with higher scores posted an average gain of 8 percent in market capitalization.

Based on similar reputation attributes, Jeffrey Resnick of Ratings Research confirms that the usual suspects consistently reach the upper echelon of corporate reputation, with Johnson & Johnson, Merck, and Pfizer in the top fifth. (See "A Matter of Reputation," Pharmaceutical Executive, June 2002.)

Problems on the Horizon

During the next four years, the industry stands to lose more than $40 billion in collective revenue to generics. (See "Drug Makers' Stocks Are Battered by Looming Patent Expiration," the Wall Street Jour-nal, December 2001.) "Patent Expiration Vulnerability" shows the percentage of 1999 pharmaceutical sales derived from products going off patent from 2000 through 2003.

Patent Expiration Vulnerability

Generics competition is problematic for several reasons. First, of course, companies must replace lost sales. So the key variables of growth and new product development become critical. And new products tend to be associated with higher prices, which begets increased profits.

Black & Decker is responsible for another interesting marketing metric. In the 1970s, B&D brought in new management to turn around what had become a stagnant company. The new team calculated that revenue from new products that were not on the market five years ago amounted to a paltry 10 percent. Realizing that innovation and new product development are crucial and that new products usually result in higher prices and profit margins, the team set about to change the ratios. Today, B&D generates about 60 percent of its revenue from products that were not on the market five years ago.

New products revenue-2001

According to the happy talk in the trade press, nearly every pharma company is an innovator with a pipeline ready to explode and plans to introduce at least three blockbuster products a year. The reality is far less dramatic. Based on FDA information about new product approvals and reported 2001 revenues for products introduced in 1997, Big Pharma's percentage of revenues from new products not on the market more than five years ago is unimpressive. (See "New Products Revenue-2001.") But not all companies are suffering equally.

The Fabulous Four

Taking a look at the overall picture, and weighting the various performance measures according to their importance (see "Measuring Up," page 88) PE's "Sweet Sixteen" devolve into the "Fab Four" : Pfizer, Johnson & Johnson, Eli Lilly, and Merck. (See "Pharma's Top Performers: The Big Picture,")

Pharma's top performers: the big Picture

Although Pfizer does not top every category, it is clearly the overall winner for 2001, leading in sales, growth, and strongly weighted measures such as market value added. Otherwise, it consistently comes in second or third. J&J, the quintessential hybrid, is an impressive second or third in most categories.

Lilly is really a niche player. It has less than half the sales of Pfizer, yet it is more profitable in terms of profit to net worth.

Merck is the consummate innovator, with 15 new therapies in five years through 2000. Its scientists have been more innovative than its competitors. Since 1996, Merck researchers have patented 1,933 new compounds, 400 more than second place Pharmacia. (See "Will R&D Make Merck Hot Again?," Fortune, July 2002.)

Consider the following:

• Investors place high value on Pfizer, J&J, and Merck for market capitalization, reflecting consistent performance and returns over time.

• Pfizer and J&J are first and second in market value added, reinforcing their high market cap rankings.

• J&J and Eli Lilly place third and fourth in economic value added.

• Lilly and Pfizer are effective at getting good prices, as evidenced by their superior performance on gross margin.

• Pfizer and J&J place high in asset turnover, with efficient use of assets.

• Although the industry's debt in the capital structure is low, Pfizer and Lilly leverage debt better than their peers, kicking up profit to net worth in the Dupont ROI model.

• Pfizer, J&J, and Lilly all earn more than 55 percent of their total pharma revenue in the profitable US market.

• Pfizer, J&J, and Lilly place in the top third in sales revenue per rep.

• Pfizer, J&J, and Merck are in the highest echelons for knowledge capital earnings.

• Lilly is in the upper quartile for revenue from products that were not on the market five years ago.

Pfizer's greatest strength is its ability to market. It has tended to grow by acquisition, striking a balance between revenue growth and R&D. Its impending acquisition of Pharmacia has provided much grist for the analysts' mill. Some believe Pfizer is paying too much, perhaps a premium of 40 percent. Yet, using the preliminary numbers in an all-stock deal, a $60 billion purchase of a company that did about $12 billion in sales revenue in 2001 results in a multiple or ratio ratio of five to one, just a tad above the going rate for acquisitions.

Even though Pharmacia's 2001 performance in this industry audit was lukewarm, it is important to recall that, after Merck, Pharmacia is second in patent registrations. And after Genentech and Forest Labs, Pharmacia places third in the "Sweet Sixteen" in that increasingly important marketing metric, percentage of revenues from new products. So, will Pfizer overpay for Pharmacia? The answer depends on whether one sees the glass as half full or half empty.

Does R&D Pay Off?

The pharma industry relies on the claim that price controls would adversely affect research in the same way people used to rely on a crucifix to ward off Dracula. The industry argues that high profits are necessary to attract investment into a high-risk industry. The table, "R&D/Sales to Percentage of New Product Revenue-2001" on page 83, sheds light on that contention. In sum, the relationship between R&D and key performance measures appears to be tenuous at best.

R&D/Sales to percentage of New Product revenue-2001

The reality is that there is little correlation between the ratio of R&D to sales and other performance measures. Again, as with market cap to sales, R&D to sales is the equalizer. Pfizer spends about $5 billion on R&D while Amgen spends about $1 billion. The ratio of R&D to sales gives a better picture of the intensity of a company's investment.

Aventis is fourth in R&D to sales but 15th in market cap to sales. J&J is last in R&D to sales but third in market cap to sales, though some of that is diminished by lumping J&J's consumer sales into the denominator. Pharmacia is seventh in R&D to sales but 13th in market cap to sales, and ranks an impressive third in revenue from new products. Forest is 15th in R&D to sales but fourth in market cap to sales. The correlations or lack thereof are even more pronounced when compared to MVA.

Return on stock equity-2001

Wyeth is first in profit to net worth but 11th in R&D to sales. Genentech is fifteen in return on net worth but first in R&D to sales. The table "R&D to Sales-2001" on page 75 attempts to ascertain if there is a positive relationship between R&D investment and increasing new products revenue. The metrics show where pharma companies rank for R&D to sales and the corresponding rank for new product revenue. Pfizer ranks fifth in R&D to sales but 11th in revenue from products that were not on the market five years ago.

The Bottom Line

Is it best to be big? Is it best to develop, produce, and market only pharma products as Merck and Pfizer do or to function as a hybrid like J&J, GSK, and Wyeth? Or is it best to be a specialized "boutique" operation like Genentech in oncology?

The superiority of the top-gun performers does not come from observing any one set of protocols. Mega companies like Pfizer perform very well, as do smaller-scale operations like Lilly, a "pure play" pharma company thatachieves high performance.

So what can analysts and investors conclude? To the extent that there are common denominators across the different models of competition, the following points are relevant:

High investment is required to generate sales. Low sales to assets ratios suggest that in the pharma industry this is so. Hence, companies should pay more attention to improving asset turnover and productivity.

The companies in this report face similar conditions. They sell similar types of products to the same customers and face the same negative industry conditions: a high level of regulation, low R&D productivity, looming patent expirations, and competition from generics.

The income statement (gross margin, operating expenses, profit to sales before taxes) is critical. More effective pricing at the top-line and control of operating expenses will be increasingly crucial to achieving above-average returns. Better control of operating expenses is necessary. For example, marketing expenses, including detailing spend, needs to be scrutinized. If it becomes more difficult to maintain high prices and generics are on the rise, the day of the 80 percent gross margin may soon be pass Control of operating expenses is also reflected in a higher ratio of sales per rep. Given the high expense for detailing, that is a very important productivity measure.

Lower assets are required. Higher sales to asset turnover results in a lower asset base required to generate a certain level of sales and lower costs of debt, floating stock, and allocating earnings to finance the purchase of assets. It follows logically that, if more sales can be achieved with the same level of assets or if sales drop but assets drop more, fewer assets will be required, with less need to finance assets.

The industry is projected to grow significantly faster than the US economy as a whole. Thus, there will be a need for new investment. Sooner or later those 80-percent-plus gross margins will begin to deteriorate, and there will be lower internally generated earnings to fund the growth in asset investment. The industry will need to take another look at the debt to capital ratio and leverage it as an important source of funds. If the industry on average grows the top line by $850 million, it will require an additional $1 billion in asset investment.

Market capitalization and brand equity will become more important. That will be true, particularly as growth increases through mergers and acquisitions. How much, for instance, would a company have paid for BMS two years ago compared with today's bargain price? What would the price of either Vioxx (rofecoxib) or Celebrex (celecoxib) have been two years ago compared with the diminished value of those brands today?

Gains come through margin management. The Dupont ROI model suggests that most pharma companies make their gains through margin management (P/S). There are two other ways to make money: S/A and A/NW. Therefore, the industry will need to pay more attention to improving asset and financial management.

Good Management Matters

What words of wisdom will highlight the competition levelers among disparate models to foretell who will win and who will lose? At the risk of oversimplification, top gun pharmas are simply companies that are well managed. And it is difficult to say what "good management" is. Without being privy to the inner sanctum of strategic planning, one can only observe performance and assume that the best and most consistent performers are being well-managed.

Business Week started its "Nifty Fifty" performers list six years ago. Only one company, Merck, has made the list every year. Pfizer has made the list three times. (See "The Business Week 50," Business Week, spring 2002.) All 16 companies made the magazine's Global 1000 for the last two years. (See "Business Week Global 1000-Market Value as of May 31, 2002,")

Business week global 1000-market value as of May 31, 2002

Strategically, the vast majority of major pharma companies still compete on the blockbuster model: Find a new drug, get a patent on it, milk the dwindling years of exclusivity, panic in the year before patent expiration, then unleash the lawyers to play legal games.

Toward a New Strategy

When Merck realized that Vioxx's sales would be less than targeted, it moved quickly to cut expenses. That was a hint of pharma's dilemma to come: being unable to raise prices and having to move, ever so grudgingly, to control expenses, especially out-of-control marketing costs. Dr. Judy Lewent, Merck's astute CFO, hinted as much in an August 2002 New York Times article, "Out of the Merger Rush, Merck's Out on a Limb." She said, "This is not cost cutting. This is taking a fresh look at all the fundamental processes at Merck."

One can look to the high-tech industry that not long ago sported gross margins of 70 percent and up, not unlike the pharma industry today. IBM and Compaq were sailing along, making easy profits, until an aggressive price competitor, Dell, changed the rules of the game. So what if the industry strategically backed away from pricing high and started with more aggressive pricing and learned to profit by bringing the product in under targeted gross margins and operating expense ratios.

Measuring Up (on a scale of 1-7)

Consider the following hypothetical scenario: The ROI model shows that Pharmacia produced a below-average profit to sales ratio (16.3 percent), had an average asset turnover (.86), and employed relatively little debt in its capital structure (1.81) in 2001, resulting in a lackluster profit to net worth of 25.4 percent.

Suppose Pharmacia could have made small, incremental changes in more than 30 line items in its profit-and-loss statement and balance sheet. Suppose it raised prices by, say, .1 percent; lowered the cost of goods sold by .5 percent; increased sales by 1 percent; lowered operating expenses, especially the profligate marketing expenses, by 1 percent, lowered bad debt by .5 percent; lowered administration/overhead by 1 percent; increased inventory turnover slightly; increased sales to assets slightly; got into debt just a bit more, and so on. That kind of modeling might have

• bumped profit to sales up from 16.3 percent to 17 percent

• moved sales to assets up from .86 to .90

• increased assets to net worth from 1.81 to 1.9, still very conservative.

The result would be a profit to net worth of 29.02 percent or a 16 percent increase in profit to net worth. It would have done so without having to merge or acquire, double sales, or cut operating expenses in half. It just would have made very modest incremental changes in about 30 accounting statement lines.

Acknowledgments

So, could there be another way to compete strategically? Stay tuned.