Is R&D Spending A Good Predictor Of Pharma Industry Performance?

by Trefis Team
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Research and development (R&D) efforts are practically the lifeline of big pharmaceutical firms. Big pharma companies often spend billions of dollars on what eventually may not turn even out to be marketable products. Therefore, the pharma business comes with significant risk, which is mitigated by strong pricing power that these firms enjoy during their products’ patent protection period. So what insights can we extract from the level of R&D spending? Can R&D spending be taken as a reasonable predictor of a company’s sales and value? We did a quick analysis on the last 10 years of data for Johnson & Johnson (NYSE:JNJ), Pfizer (NYSE:PFE), Merck (NYSE:MRK), Bristol-Myers Squibb (NYSE:BMY) and Roche (NASDAQ:RHHBY). While all of these companies have highly successful R&D programs, the actual amount spent on R&D does not appear to be a reliable predictor of sales, at least in the context of the recent landscape shift in the pharma industry. However, there is reasonable evidence of R&D spending impacting how investors view a company’s value relative to its sales. However, even this evidence does not hold true for all companies under our coverage, which suggests that R&D productivity has become increasingly hard to assess as companies shift their focus from small molecules to biologics.

Pharma R&D Spending _ 5 Firms

R&D Not A Predictor Of Sales In The Last Decade

Our correlation analysis suggests that R&D spending is not reliable as a predictor of revenues. Assuming that the majority of R&D spending is comprised of phase 3 trials, we believe it is reasonable to assume that it would take 2 to 4 years for the impact on sales to show up. Accounting for this time lag, we see correlation coefficients drop significantly across the board. For instance, accounting for a lag of 2 years between R&D spending and relevant sales, we find that correlation coefficients for Bristol-Myers Squibb and Roche are negative, and those for Pfizer, J&J and Merck are less than 0.4, suggesting weak correlation. All coefficients turn negative if the time lag is increased to 3 years. We believe that this behavior is primarily because of two reasons. First, the last 5-10 years have seen major a patent cliff hitting the pharmaceutical industry. Therefore, any increase in sales attributable to R&D efforts has been overshadowed by sharp declines in the sales of off-patent products. Second, there is some evidence that R&D productivity has declined and big pharma firms are now shifting to areas such as cancer and Alzheimer’s. The research focus has shifted from small molecule drugs to large molecule biologics, which are more complex and represent a relatively new area for some of these firms.

Reasonable Predictor Of P/S Ratio For Companies Promising Newer Horizons

We observe a strong positive correlation between J&J’s R&D spending and price-to-sales ratio (a measure of how expensive the stock is) for a lag period of 2 years. This suggests that change in R&D spending today could fairly predict the change in J&J’s P/S ratio 2 years from now. However, it must be noted that this relationship has existed in the last decade and may not continue going forward. The company has had a successful run focusing on its pharmaceutical segment, and has stepped up its R&D spending in the last 5 years. This has translated into significant growth in market cap despite a limited increase in sales, reflecting investor confidence in J&J’s future. We see similarly strong relationships between Merck’s and Bristol-Myers Squibb’s R&D spending and their respective P/S ratios, but for a lag period of 3 years. In the case of Pfizer and Roche, the relationship remains weak. Roche’s P/S ratio has increased over the past few years but R&D spending hasn’t shown a similar trend.

How do you view R&D efforts of pharma companies? Please let us know your views by commenting in the box below.

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