Sep 2004

LONG ONLY JAPANESE EQUITIES

The Fund owns two pharmaceutical companies, Takeda Chemical, Japan’s largest, and Yamanouchi Pharmaceutical.

The Fund owns two pharmaceutical companies, Takeda Chemical, Japan’s largest, and Yamanouchi Pharmaceutical. Yamanouchi is in the process of merging with Fujisawa Pharmaceutical, which will make it Japans second largest drugs company with a domestic sales force second only to Pfizer. Compared to their international rivals they remain minnows. In terms of sales Takeda and Astellas, which is to be the new name for the merged company, rank 14th and 17th respectively with sales just one sixth of the largest global company, Pfizer.

Most quoted pharmaceutical businesses have generated consistently high returns on capital for investors and have proven to be great investments over the last 10 years. For example Pfizer’s operating profits have risen 8.7 times whilst generating an average return on equity (‘ROE’) of 27%. Its shares have advanced 4.9 times versus a comparative rise of 1.1 times in the S&P Composite Index. Takeda has increased operating profits 3.9 times, generated an average ROE of 11% and advanced 2.4 times versus a 40% fall in the TOPIX index.

Pharmaceutical businesses possess a number of characteristics that make them so good. The most important is the priority and emphasis that consumers place on health over most other expenditures. Health, together with education and security, can be considered as essential services and are thus typically subject to much less pricing scrutiny. Drugs have an additional advantage as patents protect them for significant periods of time allowing for monopolistic pricing until the patent lapses. At the same time inventing such product requires significant resource not only in terms of research and development but also only in regulatory approval costs which only few companies can afford making the barriers to entry for new competitors material. Another advantageous feature of most pharmaceutical businesses is the practice of charging all research and development costs as expenses. Other businesses might, with some justification, capitalise them. The practice of not doing so makes the businesses refreshingly transparent. Other costs include production and raw materials, which are relatively low for a business producing pills and solutions, and distribution. Even here the cost of establishing distribution should be simpler and less costly than for other goods partly because the customers are easily identifiable and small in number (doctors, surgeries and hospitals) and partly because a product with proven efficacy has the advantage of advertising itself and the patent protection acts to restrict choice. Capital expenditure rarely exceeds depreciation and anyway these amounts are generally less than 25% of net profits keeping the capital intensity low.

Over the last five years the industry has been consolidating. One of the benefits of consolidation is the lead a larger company is perceived to have from a higher research and development (‘R&D’) budget. Pfizer with 6 times the sales of Takeda has 7 times the R&D expenses, surely a massive competitive advantage. That may be, but recently large drug companies with the biggest R&D budgets have had great difficulty in generating new innovative drugs that command a big enough end market to replace drugs coming off patent let alone to grow the sales line. Of late there have been an increasing number of examples of product withdrawals not only prior to release but also afterwards as well, which brings the added risk of litigation if the unanticipated side affects are severe. Merck’s recent withdrawal of Vioxx is a case in point. Clearly the failure to innovate questions the reliability of future returns even if historically they have been spectacular. Takeda Chemical is not immune to these problems. Its recent success has been partly attributable to an anti-ulcer drug Prevacid, which is due to come off patent in 2008. It is not obvious that the company has products with a similar sales capacity in current development.

Ironically, just as industry consolidation accelerated apace, some of the best performing drugs companies in recent years were those that developed specialist product for relatively small end markets. These companies tend to exploit an expertise in a particular diagnostic area that often helps avoid competition from the larger companies. This worked for Fujisawa, Yamanouchi’s merger partner. Prograf, which helps prevent the rejection of new organs and tissues after transplant, has been a huge success for it and at the same time serves a market whose size is, arguably, too small for the majors to exploit. However, seeing these successes against the recent failure of large companies to develop new big selling drugs may force them to compete in a variety of specialist markets, reversing the policies of the past.

These recent high profile failures and the increased competition they engender will likely act to moderate the exceptional returns or increase barriers to entry, or both, and have already questioned the extent to which returns on capital are sustainable. We judge that, although some of the highest returns may be impossible to maintain, the general attractions of the business outlined above still pertain and as society ages the headwind that this demographic event provides for most businesses, gifts the pharmaceutical industry a following wind.

Determining whether a business is good is one thing, buying it as an investment at the right price is another. It is for this reason we would find it difficult to be enthusiastic owners of many western pharmaceutical companies such as Pfizer and Merck trading on 5.4x, and 5.0x EV/sales with exceptionally high margins of 35-40% but were happy buyers of Yamanouchi and Takeda earlier this year on under 2x EV/sales and free cash flow ratios in excess of 7%. Like with some other businesses we own a cash flow yield 4.5% above the risk free rate (the current 30 year JGB yield of 2.5%), for no assumed growth (but with the potential for it) from a balance sheet groaning with cash (cash for both companies is approximately 30% market capitalisation), which could be, and is in the case of Yamanouchi, redeployed to improve internal rates of return, looks like a good investment to us.

14 Oct 2004 LTL 000-024-7