Returns to R&D spending are below costs of capital and deteriorating further; despite this the average large pharmaceutical company has increased R&D:sales ratios over the last decade. This implies that managements have faced little if any pressure to return cash to shareholders rather than funding non-productive R&D. We believe this is changing
With costs of debt very low and R&D (and SG&A) to sales ratios very high, it is both theoretically and practically feasible for activists to fund a company’s acquisition simply by correcting the target company’s inefficiencies. For example lowering R&D and SG&A ratios to feasible levels (8% and 29%, respectively) would free cash flows sufficient to service debt equal to 1.8x the current market value of AZN, and 1.2x the current market value of LLY
This points to two simple conclusions:
On the bright side, AZN and LLY are undervalued – managements either capture efficiencies and return more cash to shareholders on their own initiative, or risk having to do so under activist pressure. Either way, share prices go up
On the less cheerful side, average R&D:sales ratios are likely to fall which, given weak (+/- 4%) expectations for longer-term pharmaceuticals sales growth points to outright declines in R&D spending. This is negative for the broader Research Tools & Services sector, where consensus calls for longer-term revenue growth of 11%
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