Fundamental Analytics [Revised] 18 September 2018 2ContentsPharma Back to Basics .......... 4How the industry makes money ....... 4The industry as a set of project lifecycles ...... 6The start of the lifecycle: How new drugs are created .......... 8Eroom's Law and falling returns on R&D .... 13R&D skill versus R&D luck, lottery economics, and therapy area strategy .... 17How drugs are priced once they are approved ....... 19The profitability of approved drugs27How IP protection is won and lost . 29Pharma and biotech business models and the project lifecycle ....... 34Mapping between the project lifecycle and accounting statements37From lifecycles to drugs, diseases, and companies .. 41The rarity of new drugs for common diseases ........ 45Overcrowding in hot specialty niches ... 49Regional and global market growth rates .. 52Industry consolidation and fragmentation .. 54Financial reporting issues in pharma ........ 60Don’t panic: It’s only accounting: an introduction to earnings quality .... 60Accounting choices and estimates: a double-edged sword61How do we define earnings quality .......... 62EQ: areas to monitor .......... 63Overstated revenue63Understated expenses ........ 64Overstated assets ... 64Understated liabilities ......... 65EBBS or “Earnings Before Bad Stuff”: a closer look at the use ofnon-GAAP measures in pharma .... 66Non-GAAP measures: why ........... 67Pharma Non-GAAP measures: deep-dive ... 67Non-GAAP adjustments have been increasing of late ......... 68Recent rise in non-GAAP adjustments has been having a bigger impact onvaluations .. 80Appendix .... 85What do pharma financials look like ...... 86Geoff Robinson, CA FCAAnalystgeoff.robinson@ubs+44-20-7567 1706Guy WeynsAnalystguy.weyns@ubs+65-6495 3507Renier SwanepoelAnalystrenier.swanepoel@ubs+44-20-7568 9025Jack ScannellAnalystjack.scannell@ubs+44-20-7568 6717Michael LeuchtenAnalystmichael-a.leuchten@ubs+44-20-7568 8843Petrina-Oana CarcotaAnalystpetrina-oana.carcota@ubs+44-20-7567 7335 Fundamental Analytics [Revised] 18 September 2018 3Structure of pharma financials ....... 87Typical pharma income statement . 87Typical pharma balance sheet ........ 95Typical pharma cash flow statement ........ 106Critical accounting issues in pharma ...... 116Revenue recognition issues in pharma ..... 116Licensing .. 128Externalisation revenue .... 133R&D cost capitalisation .... 135Patent protection . 145Stock versus asset deals ... 147Assets swaps........ 151Acquiring pharma intangibles ...... 154Acquisition of a single compound154Acquired in-process R&D (IPR&D) . 155Contingent consideration payments (incl CVRs) ... 158Amortisation of pharma intangibles ......... 166Pharma asset impairment . 168Funding R&D ....... 180Public funding for R&D (IFRS) ....... 180Interest cost capitalisation183Inventory valuation .......... 189Pharma PPE .......... 191This note replaces an earlier version, in which some corrections have been made:(a) page 1 – we corrected a typo (patents changed to patients); (b) page 36 –we included an additional source for Figure 30; (c) page 59 – we amended thenames of two of the acquired companies in the following updated text: Therecent acquisition of AveXis and its gene therapy capabilities by Novartis is a goodexample here, as are Roche's acquisition of Flatiron Health (real world cancer data),and Sanofi's acquisition of Ablynx (protein engineering). Fundamental Analytics [Revised] 18 September 2018 4Pharma Back to BasicsHow the industry makes moneyThe drug industry primarily makes money by investing in research anddevelopment (R&D) to produce new drugs that qualify for intellectual property (IP)protection of one kind or another: patents and/or other kinds of regulatoryexclusivity. This usually involves inventing new drugs, and sometimes involvesselling new diseases as well. Many successful drugs have created their ownmarkets by crystalizing a patient group, and encouraging diagnosis and treatment1. The industry then uses the legal monopolistic power that IP provides to maximiseits profits on drugs – generally charging what the market will bear – until the IPprotection expires. At this point, the drugs can usually be copied by others andprices fall substantially; sometimes by 95% or more, to the marginal cost ofproduction. By the time the IP expires and profits collapse, companies hope tohave discovered, patented, and developed more new drugs to sell. Because today'svaluable patent-protected drug is tomorrow's patent-expired drug, or generic,over time, more and more prescriptions are for generics. Today, genericprescriptions make up around 90% of thevolumeof drugs prescribed in the US,but patent-protected drugs make up around 75% of thevalueof drugs prescribedin the US.Therefore, the value of the drug industry depends on the market's expectations of: The cost of R&D and its success rate;The revenue and profit trajectories of new IP-protected drugs (which, in turn,depend strongly on pricing expectations);The rate at which IP protection expires, and prices and profits fall in the face ofcompetition. So, the investment performance of the sector tends to be very sensitive to: The degree of optimism or pessimism that exists on R&D productivity (Figure 1,Figure 2); Expectations around like-for-like price inflation and mix inflation. This, in turn,is sensitive to the likelihood of drug price reforms in the US (Figure 1, Figure 2).The US is a global outlier in terms of drug industry economics, with rapidadoption of new drugs, high drug prices, and a profit pool that isdisproportionate to its population size. 1Drugs, to a surprisingly large extent, create and/or grow diagnoses. First, there is little pointin diagnosing a disease that cannot be treated. Once there is decent drug therapy, diagnosisrates tend to go up. Second, response to drug therapy often helps define and clarifydiagnostic categories. It also provides clinical and economic incentives to improve the matchbetween diagnostic categories and therapies. Generic prescriptions make uparound 90% of the volume ofdrugs prescribed in the US… …but patent-protected drugsmake up around 75% of the valueof drugs prescribed in the US。。。。。。