Pfizer Worried About Blockbuster Drugs Coming Off Patent

Case Type: finance & economics; operations strategy.
Consulting Firm: KPMG Advisory first round full time job interview.
Industry Coverage: healthcare: pharmaceutical, biotech, life sciences.

Case Interview Question #01043: The client Pfizer Inc. (NYSE: PFE) is an American pharmaceutical company headquartered in New York City, with its research headquarters in Groton, Connecticut. It is among the world’s largest pharmaceutical companies. Pfizer develops and produces medicines and vaccines for a wide range of medical disciplines. Their products include the blockbuster drug Lipitor (atorvastatin), used to lower LDL blood cholesterol; Diflucan (fluconazole), an oral antifungal medication; Zithromax (azithromycin), an antibiotic; Viagra (sildenafil) for erectile dysfunction; and Celebrex/Celebra (celecoxib), an anti-inflammatory drug.

The client Pfizer has a market capitalization (market cap) of $200 billion. They have about 4% market share and are currently enjoying a 34 price-to-earnings (P/E) ratio. The pharmaceutical industry’s average P/E is about 29. Over the next five years they are looking at a healthy growth in their EBIT (earnings before interest and taxes) margins. However, for three years thereafter (from year 6 to year 8), the EBIT margin growth is likely to stagnate when three of their blockbuster drugs come off patent. Subsequently, blockbusters currently in the pipeline will hit the market and their EBIT margins are expected to return to healthy growth levels. The new CFO of Pfizer wants us to help her figure out if the three-year plateau five years out is an issue she should be worried about. If so, what external options can she pursue to fix it?

Possible Answers:

1. Suggested Structure

* Clarify the client’s position in the industry
* Explore competitive developments and projected trends
* Explore some possible external options

2. Detailed Analysis

(1) Client Financials:
* $48 billion in revenues
* EBIT at $12 billion
* Gross margins of 80%
* Totally debt-free

(2) Client History:
* Typically taken the OTC approach when blockbuster drugs have come out of a patent
* Price will drop to 20% of pre-OTC price.

(3) Competitive Developments:
* Consolidation is common, but not frequent in the industry.

(4) External Options:

* The new CFO has no experience with either mergers or acquisitions, so M&A is out of question.
* Licensing drugs from other companies
– This is a fairly common practice in pharmaceutical industry
– License potential blockbusters that much smaller firms or firms without their clout are currently developing and that will hit the market during the three years in question.
– Generate sales to grow their EBIT margins.

Sample Interview Transcript

Candidate: (I had no real idea how to proceed. I didn’t have a particularly good idea about the pharma industry. So there was no particular framework that came to mind. I was going for the “groping in the dark” approach!)

Interesting. Broadly, I’d like to better understand our client’s position in the industry, then explore competitive developments and projected trends and finally explore some possible external options.

But let me first try to get a better sense for our client and their strengths particularly financial. Can you offer some details?

Interviewer: Sure. Our client Pfizer has about $48 billion in revenues, EBIT runs at about $12 billion. Gross margins are quite high at 80% and they are totally debt-free.

Candidate: I see. What has the client typically done when blockbuster drugs have come out of patent? I believe over-the-counter (OTC) versions are one route.

Interviewer: Quite right. They have taken the OTC approach and probably will with these blockbusters as well. But this is not a financially attractive option. As soon as the blockbuster drug goes off patent, its price drops to 20% of its pre-OTC price. Margins are consequently totally squeezed. Anyway, is this EBIT margin plateau an issue?

Candidate: Oh, I most certainly believe so. You indicated that the client enjoys an above average P/E. So clearly they are doing something right. I’d expect that the market is also aware of this projected trend in EBIT margins and the price of the stock probably reflects an expectation that management will do something about the trend. I would therefore strongly caution against doing nothing.

Interviewer: So what would you recommend?

Candidate: You mentioned external options. Can you clarify what that means? Mergers, acquisitions, and so forth?

Interviewer: Yes.

Candidate: I see. Can you tell me more about the pharmaceutical industry? Is there any consolidation happening? Are there potential merger or acquisition candidates that the client has in mind?

Interviewer: Well, consolidation is something that is always happening at different levels. What do you think of a merger of equals?

Candidate: I’d say this is something we can explore if in fact there are similar trends in the industry and there is a threat of us being left behind or “overpowered”. If not, then there is the anticompetitive aspect to worry about. Also I’d be concerned about post-merger integration issues. Does the client have experience with mergers and managing post-merger issues?

Interviewer: Let’s assume that they don’t. What types of things would advise the client to look out for?

Candidate: There are a few things they should absolutely ensure they do. First, they have to make sure that any target will offer operational efficiencies that can be exploited. Then, they have to ensure that they retain and reward management talent appropriately. This talent will be key from an execution perspective and if the client wants to extract all the efficiencies of the merger, retention of management is key. Rewarding management and key officers and tying incentives to performance is therefore critical. Finally, there has to be a very clear vision articulated and tangible, measurable goals established. This is also critical.

Interviewer: That’s good. What other external options come to mind?

Candidate: I’m not very familiar with the pharmaceutical industry and I am not sure if there is something unique to this industry. There is nothing in particular that jumps out in my mind.

Interviewer: Are you familiar with the software industry?

Candidate: Yes, sort of.

Interviewer: Are you aware of the notion of licensing?

Candidate: Oh yes!

Interviewer: Licensing is something that is fairly common in the pharma industry. The client can take advantage of their marketing prowess and brand image in the market to license potential blockbuster drugs that much smaller firms or firms without their clout are currently developing and that will hit the market during the three years in question. This way they can generate sales to grow their EBIT margins.

Candidate: Got it.

Leaving this case interview, I felt as though I had blown the interview for not having come up with the licensing option. In retrospect I probably did a reasonable job. My biggest take-away is that I should have sought clarity on what the interviewer meant by “external options.” He wasn’t particularly forthcoming with information throughout the interview and preferred to let me talk and think out loud. I should have pressed him for a laundry list of what would constitute “external options.” I think it’s perfectly alright to ask such a question and then analyze the relative merits and demerits of each option before making a recommendation.