Opinion Intangible fixed asset investment for future growth Business Characteristics of Pharmaceutical Companies

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Tomoyuki Shibuguchi, Senior Researcher, Pharmaceutical Industry Policy Institute
Shinichiro Iida, Senior Research Fellow

Introduction

The pharmaceutical industry is well known as an intellectually-intensive industry with a high R&D cost to sales ratio among manufacturing industries, while profit margins tend to be high due to low manufacturing costs per ^product1). While this may seem to indicate that the industry has the capacity to allocate more resources to R&D, the drug discovery environment is undergoing significant changes, including the diversification of modalities, and companies need to invest for future growth by making acquisitions and introducing products developed by other companies in parallel with their own R&D investments. The actual status of such investments cannot be seen simply by tracking "expenses" on the income statement, such as R&D expenses. In this report, we focus on "assets" on the balance sheet and investigate the status of investment for future growth of Japanese pharmaceutical companies by comparing them with European and US pharmaceutical companies and other industries in Japan.

Research Methods

We obtained financial data on Japanese and U.S. and European pharmaceutical companies from SPEEDA (User Base, Inc.), as well as from each company's annual securities reports, financial statements, and financial summaries. The fiscal year is the fiscal year of each company, and the fiscal periods do not necessarily coincide. Some companies have changed their accounting standards from Japanese GAAP to IFRS since FY2013, but the data were combined without distinguishing between them. Data on acquisitions and introductions were obtained from Evaluate Pharma.

Assets of Japanese Pharmaceutical Companies

When a company is acquired or merged in order to introduce a new technology or product from outside, the target company's trademarks, patents, exclusive sales rights, in-process R&D expenses, etc. are recorded as "intangible fixed assets" within the assets on the balance sheet. We began our survey with the idea that by looking at changes in these intangible fixed assets, we might be able to examine the investment status and attitude of the companies and their industries.

Figure 1 (left) shows asset trends in the balance sheets of 15 Japanese pharmaceutical ^companies2) every five years from FY2009 to FY2019. Over the past 10 years, the assets of pharmaceutical companies increased from 12.9 trillion yen to 28.3 trillion yen. Among asset items, intangible fixed assets increased the most, from approximately 2 trillion yen (15.2% of assets) in FY2009 to 12.0 trillion yen (42.4% of assets) in FY2019, accounting for the largest share of assets.

The 10-year compound annual growth rate (CAGR) for intangible fixed assets was 19.9% from FY09 and 26.0% for the 5-year period from FY14, with particularly strong growth in the last few years. Over the past five years, the growth rate of intangible fixed assets has been remarkably high: 0.9% for cash and deposits, one of the current assets; -0.3% for investments and other assets, including shares in affiliates; 8.5% for tangible fixed assets, including land and buildings; and 10.8% for total intangible fixed assets.

The left side of Figure 1 shows the total value of 15 companies, but the value of their assets increased significantly due to Takeda's acquisition of Shire in FY2018. In FY09, intangible assets were about 1.3 trillion yen (13.1% of assets), but increased to 3.8 trillion yen (24.7%) in FY09. The CAGR for intangible fixed assets is 11.2% over 10 years and 13.6% over 5 years from FY2014, and like the 15-company total, has been particularly increasing over the past few years. This higher growth rate compared to other items (cash and deposits: 3.8%, investments and other assets: -2.9%, property, plant and equipment: 3.1%, and total: 4.1%) over the past five years suggests that the pharmaceutical industry as a whole is aggressively investing in intangible assets for future growth.

Examples of corporate acquisitions

In this section, we will introduce some examples of acquisitions made during the above period. Table 1 summarizes acquisitions of R&D-oriented companies by major Japanese pharmaceutical companies (since 2010). Even excluding the large acquisition by Takeda of over 1 trillion yen, acquisitions in the range of tens to hundreds of billions of yen can be seen. Among them, there are many cases of acquisitions of companies that do not have products, drug applications, or Phase 3 development products, and there are also cases of huge investments of more than 300 billion yen in R&D prior to Phase 1/Phase 2. When an R&D-oriented company is acquired, most of the acquisition value is allocated to intangible assets and goodwill (Table 1, right). These assets are generally calculated as intangible assets, taking into account the probability of success and time value (e.g., 8% discount rate) of the value that the acquired company's R&D product or drug discovery technology could generate in the future. Given the characteristics of the pharmaceutical business, where the time from entry into clinical trials to commercialization is approximately 10 years and the probability of success is 10-14%, it was assumed that the company was taking significant risks and investing in acquiring pipeline and new drug discovery technologies in the early stages of development.

Since IFRS amortizes both intangible assets and goodwill only after commercialization (market value is established), the R&D phase has the advantage of not affecting the income statement in a single year. The changeover from Japanese GAAP to IFRS since 2013 may have encouraged pharmaceutical companies to take advantage of this accounting characteristic and actively acquire R&D-oriented companies. On the other hand, it also entails the risk of large impairment losses at the stage of value abandonment such as discontinuation of developed products during the R&D phase. In the recent past, Dainippon Sumitomo Pharma and Astellas posted impairment losses of 17.4 billion yen and 27.0 billion yen, respectively, for the discontinuation of Phase 2 and Phase 3 products (Boston Medical) and 58.8 billion yen for the revision of Astellas' Phase 1/2 product (Audentes Therapeutics) plan, This is a factor that has a negative impact on the operating margin for the single fiscal year.

Trends in Introduction of R&D Products

As with acquisitions, the value of in-licensed R&D products is recorded as an intangible asset. Figure 2 shows the number of R&D product introductions by Japanese companies. Over the past 10 years, there were 425 in-licensing of R&D products targeting global markets. The annual trend shows that the number of cases doubled from 2012 to 2018, from less than 30 cases to nearly 60 cases.

The increase was accounted for by pre-clinical and research projects (both defined as Evaluate Pharma), with Japanese companies increasingly in-licensing earlier, more uncertain pipelines and drug discovery technologies. ^Keyi3) reported that acquisitions and in-licensing are becoming earlier and earlier globally, and the same was confirmed for Japanese firms. Although the transaction value of these in-licensing deals was not disclosed, it is believed to have contributed to the growth of intangible assets of domestic firms.

Similar to corporate acquisitions, the recording of intangible assets from the introduction of R&D products also has the potential for impairment losses due to the discontinuation of development or a decline in future value, factors that could negatively impact operating income in a single year.

We observed a trend of a decrease in the number of installations over 2019/2020, possibly due to COVID19, but also possibly due to less disclosure by the companies, etc.

Comparison with U.S. and European pharmaceutical companies

We then examined the transition of intangible fixed assets among U.S. and European pharmaceutical companies (Figure 3). Both the U.S. and European pharmaceutical companies have increased their total assets over the past decade, with the eight U.S. pharmaceutical ^companies4) increasing from $527.7 billion (FY2009) to $789.4 billion (FY2019), and the eight European pharmaceutical ^companies5) increasing from $514.4 billion to $705.5 billion over the same period. Intangible assets accounted for more than 40% of total assets, at $233.9 billion (44.3% of total assets) and $181.2 billion (35.2% of total assets), respectively, in FY2009, but in FY2019, both the amount and the ratio of intangible assets to total assets increased over the 10 years, to $380.1 billion (48.1%) and $345.7 billion (49.0%), respectively. In FY 2019, both the amount and the percentage of assets in the portfolio grew over the 10-year period. In the U.S. pharmaceutical industry, intangible assets temporarily increased in FY2009 with Pfizer's acquisition of Wyeth and Merck's merger with Schering-Plough, but the amounts were amortized through FY2014 and showed a downward trend. However, intangible assets increased through Johnson & Johnson's acquisition of Actelion in FY2017 and Bristol-Myers Squibb's acquisition of Celgene in FY2019. The CAGR of intangible assets was 4.1% (FY 2009-2019) and 11.5% (FY 2014-2019) for U.S. pharmaceutical companies.

For European pharmaceutical companies, intangible assets increased through Novartis' acquisition of Alcon in FY2010, Bayer's acquisition of Monsanto in FY2018, and Novartis' acquisition of Avexis, with CAGRs of 6.7% (FY2009-2019) and 7.2% ( In terms of CAGR, even the 14 pharmaceutical companies excluding Takeda Pharmaceuticals showed higher CAGRs (11.2% and 13.6%) than European and US pharmaceutical companies during the same period, suggesting that Japanese pharmaceutical companies are aggressively investing in intangible assets.

Comparison with Other Domestic Industries (Manufacturing)

Having looked at domestic and international trends in the pharmaceutical industry, we now compare these trends with those of other industries in Japan. Figure 4 summarizes the annual trends of major companies in each industry, focusing on Japan's representative manufacturing industries such as automobiles, electrical machinery and equipment, general chemicals, and precision machinery and ^equipment6). The left panel of Figure 4 shows the ratio of intangible fixed assets within the assets of each industry, and the right panel shows the annual changes in the total value of intangible fixed assets. The pharmaceutical industry already accounted for the largest share (15.2%) of the manufacturing industry. As the fiscal year progresses, the pharmaceutical industry increases in both ratio and value, and in FY2020 it has the highest intangible fixed assets in terms of value (12.0 trillion yen, including Takeda Pharmaceuticals). Excluding Takeda, the intangible fixed assets of the pharmaceuticals industry increased consistently over the 10-year period, although the size of the industry will be smaller, at 3.83 trillion yen in FY2020. Among the industries compared in this report, intangible fixed assets increased in the chemicals industry through acquisitions of overseas companies as in the pharmaceutical industry, but remained generally flat in the automobile, electrical machinery and equipment, and precision machinery and equipment industries, while the pharmaceutical industry showed a characteristic of continuously increasing intangible fixed assets.

Summary

We have focused on changes in intangible fixed assets within the assets of domestic pharmaceutical companies. Not only is the amount of intangible assets increasing year by year, but the growth rate is also remarkable, indicating that the industry is aggressive in introducing new technologies, drug discovery seeds, and products through corporate acquisitions and other means. In addition to products, there was also a trend toward the introduction of early-stage R&D projects, suggesting that the contribution of startup companies to early drug discovery is also growing among Japanese pharmaceutical companies. Compared to other manufacturing industries, pharmaceutical companies tend to continuously increase their investment in intangible fixed assets, suggesting that drug discovery through open innovation is occurring not as a business strategy of individual companies but as a trend in the pharmaceutical industry as a whole, where pharmaceutical companies introduce drug discovery seeds generated by startup companies and academia, and also take on R&D for product commercialization. This is not a business strategy for individual companies, but a trend in the pharmaceutical industry as a whole. It appears that the domestic pharmaceutical industry is changing into an industry that creates maximum business value through both single-year in-house R&D investment and R&D investment as an asset.

The U.S. and European pharmaceutical companies are larger than the domestic pharmaceutical companies in terms of both size and the ratio of R&D investment in assets, and they are investing more aggressively in intangible fixed assets. Figure 5 shows the operating profit margin and R&D ratio of the major Japanese, U.S., and European pharmaceutical companies. The R&D ratios of the Japanese, U.S., and European firms all hovered around 17%, indicating that the Japanese firms are aggressively investing in R&D. On the other hand, from the perspective of operating profit margins, the Japanese firms are investing more aggressively in intangible fixed assets. On the other hand, in terms of operating profit ratio, the ratio of operating profit ratio of European and U.S. companies is higher than 20%, compared to around 13% for Japanese companies. Although a more detailed study of the means of procurement for the acquisition of intangible fixed assets is needed, it is believed that European and U.S. companies, which have higher profit margins than Japanese companies, are more likely to reinvest profits in intangible fixed assets.

In Japan, it has been pointed out that among manufacturing industries, pharmaceutical companies have higher operating profit margins. As mentioned above, the fact that operating profit margins are lower than those of European and U.S. pharmaceutical companies must be taken into account, but there are also some accounting points that should be kept in mind. Under IFRS, which has been adopted mainly by major pharmaceutical companies, acquired intangible assets in the research and development stage are not amortized until they are commercialized, and therefore do not affect the income statement for a single fiscal year. Therefore, when intangible assets in the R&D stage are expanded, operating income is more likely to increase than when the company conducts R&D in-house rather than through acquisitions. When discussing the operating profit margin, it is necessary to take into account not only R&D expenses on the income statement but also intangible fixed asset investments in assets.

The mission of the pharmaceutical industry is to continue to develop and launch innovative drugs that satisfy unmet medical needs while maintaining its function as a stable supply of pharmaceuticals as part of society's infrastructure. In order to fulfill this mission and continue to grow in the global market, it is essential to respond flexibly to the rapidly changing environment surrounding drug discovery and to introduce technologies and drug seeds not only from in-house R&D investments but also from external sources. We look forward to deeper discussions on industrial promotion and industrial policy based on an awareness of the business characteristics of the pharmaceutical industry.

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