At its May ‘Meet the management’ event in Basel, Sandoz was represented by Richard Francis, the MD of the business unit, Peter Goldschmidt, the regional manager for the US and Carol Lynch, head of the biosimilars business. According to Mr Francis, the choice of team was driven by his expectations of where analysts would focus their questions, but we see it being as much an indication of where Sandoz’s own priorities lie. After all, the US is its most profitable market and is also the place where it expects to make the bulk of its revenue from biosimilars. Even so, it is a pity that the company didn’t also showcase its operations elsewhere in the world, particularly in Asia where it is one of the few western generic companies to have a significant market presence.
Sandoz has sadly stopped reporting its sales of biosimilars, preferring a number that bundles in both Glatopa, its generic version of Copaxone (which is reasonable enough) and contract manufacturing (which should really be elsewhere). This conveniently makes sales appear larger while obscuring how the company is really doing but even so, it is clear that biosimilars still account for considerably less than 10% of turnover, leaving over 90% of revenue arising from the traditional small molecule business.
From a profit perspective the situation is somewhat different, but not in the way that you might think. Biosimilars certainly have very high margins – 90% + in the case of the monoclonal antibodies – but Sandoz is currently incurring enormous costs. In Q&A, the team estimated that 50% of Sandoz’s entire R&D spend goes on biosimilars, which implies a bill of several hundred million euros annually. On top of this, Sandoz has had to create a marketing and pharmacovigilance infrastructure in Europe and the US to sell its existing biosimilars and will have to expand this significantly (particularly in the US) to cope with the products that it has in its pipeline. As a result, biosimilars, far from being earnings enhancing, are currently a major drag on the profitability of the division.
Apart from driving forward the biosimilars project, one of Richard Francis’s key objectives when he took over the helm at Sandoz two years ago was to improve margins. The defenestration of his predecessor, Jeff George, a few weeks before the Basel event was a reminder (if one were needed) of the risk of not delivering on targets, but improving profitability at the same time as stepping up investments presents a major challenge to management. In Q1 2014, just before Mr Francis arrived at Novartis, Sandoz’s EBIT margin was 12.2%. In Q2 2016, it was 14.7%. ‘Core operating income’ (i.e. EBIT with amortisation of intangibles and extraordinary items excluded) as a percentage of sales was up from 16.7% to 20.8% over the same period. This looks pretty impressive but a fairer reflection of management’s achievement is to look at the figures up to Q4 2015, prior to the consolidation of a large block of Novartis tail-end products. These brands added anywhere up to 270 basis points of margin to the division but even without them, the core margin would probably still be above 18%, which is a decent uplift under the circumstances. So, how has it been achieved?
Increasing the percentage of sales coming from more differentiated products is part of the answer but not the main one, we believe. For a company as large as Sandoz, shifting the sales mix is a slow business and certainly not something that can be achieved in a couple of quarters without the benefit of M&A. In pharmaceuticals, as in other industries, the quickest way to deliver margin enhancement is to get costs down. And since there is no way of getting costs down in biosimilars, Sandoz has been putting pressure on costs in the rest of its business. One of the biggest things that it has done is to shift a large part of its small-molecule R&D into the hands of third party developers. In the past Sandoz, like all the other major generics companies, attempted to develop almost every pipeline project in house, only turning to dossier developers where its internal developments failed or where it required technology that it didn’t have available. Now it is focusing internal resources on the more complex projects and handing off the remainder to partners. In the main, Sandoz seems to have opted for co-development, which means that it continues to keep a close eye on how developments are progressing and also gets to hang on to the IP, but this new policy also has the highly beneficial side-effect of removing a major cost item from the P&L.
The other big item on the agenda is manufacturing costs. An initiative announced by the Novartis top management to coincide with the investor meeting was the combination of the production assets of the pharma and generics divisions, which have hitherto been run completely separately. On the face of it, this is an obvious thing to do, since a tablet is a tablet, whether it is on or off patent. However, in order to actually make savings, the manufacturing footprint of the total business has to shrink, which means moving products between sites and closing plants, neither of which is very easy to do. Falling demand for some of Novartis’s innovative products as they come off patent, plus tech transfers following the sale of tail end brands, will do some of the work, but the rest is going to have to be mandated.
Managing this without supply disruptions will be a challenge, as will maintaining the production flexibility and cost focus that is so crucial to a generic supply chain. Tablets may all be alike but generic and innovative products nevertheless have different characteristics when it comes to manufacturing. While on patent, the demand for an innovator product is generally quite predictable, making it easy to schedule the factory. Demand for generics, on the other hand, can be very volatile, particularly where Sandoz is bidding in tenders such as in Germany. In addition, the margins on innovator drugs are so high that the manufacturing costs become an irrelevance, whereas COGS is an absolutely crucial competitive advantage (or disadvantage) for a generics company. According to Richard Francis, he has been asking his plant managers to deliver 10% lower production costs each year, which they are unlikely to have achieved, but at least it gives them something to aim for. Along with the R&D initiative detailed above, this also explains just how the company has added over a percentage point to its operating margins in 24 months, even in the face of strong price pressure in most markets. We doubt, however, that the (recently ex-) head of the Pharma Division has been delivering the same message to his own manufacturing units, if he has had any contact with them at all.
Of course, if the Novartis production network gets a dose of generic cost control across the board, it could be a winning result for both divisions. The real world being what it is, though, the more likely outcome is a total mess, with the added risk for Sandoz that its products will be de-prioritised vs drugs from the Pharma division because their profitability is so much lower.
Which brings us back to Sandoz’s margins. The good news for the company is that biosimilars finally seem to be reaching an inflexion point. Once Sandoz has one or two biosimilars on the market in the US as well as in Europe, it should finally generate enough sales to cover the massive overheads associated with these products, at which point Richard Francis can sit back and watch his division’s profitability soar. We haven’t quite got there yet, though, and the next 12-24 months will actually be the hardest part since the quick wins on cost have presumably all been achieved and the pricing environment remains very tough. If Sandoz can continue to ratchet up profitability under these circumstances, then Mr Francis will deserve congratulations. If not, he had better hope that he is still in post next time the Novartis cavalcade swings into town.