Sunday, May 6, 2007

The case for debt



Sorry for not posting last week...just finished the finals....phew!

A few days back Pharmagossip had an interesting post regarding Big Pharma moving into debt. The post referenced the following Reuters item which talks about Astra Zeneca's decision to go into permanent debt following the chunk of change they plunked down for MedImmune. The move was praised by many financial types such as David Beadle, analyst at UBS who said:
"Astra are partly responding to what they are being told by the investment community, that you need to be progressively geared". The same article also quotes GSK CEO Jean-Pierre Garnier saying "Yes, some investors would like us to gear up our balance sheet."

The case for levering/gearing: The case for leverage is clear to anyone who has flipped a condo before the recent bust. You borrow at low rates, buy real-estate and flip it in a couple of months for a substantial gain. Use part of the proceeds to pay your debt and keep the rest for yourself...all for a very low initial investment of your own money.

For Big Pharma majors like GSK, J&J, Merck, Pfizer etc, the case for more leverage is clear. If you take a company like GSK, the return on average assets was 20.84% in 2006 according to Google finance. For Merck & Co, this figure was 9.92% in 2006. Both GSK and Merck have a debt rating of AA. Only in recent months has Pfizer's rating been cut from AAA to AA. With an AA rating, Big Pharma can borrow at extremely low rates (around 0.68% higher than Uncle Sam according to this article on Bloomberg). So debt makes sense for Big Pharma. They can borrow at 6%, invest the money in their own business, and earn anywhere from 9% to 20%.

Of course the fact that Big Pharma can borrow doesn't necessarily make it good for investors. Investors could achieve the same effects of leverage by borrowing themselves and using the borrowed money to invest in the unlevered shares of Big Pharma (to make the same returns). The reason that it makes sense for Big Pharma, rather than the investor to borrow is taxation (interest paid by Big Pharma on debt is tax-deductible. For investors, only mortgage interest is tax-deductible...and only in some countries like the US). More academic stuff on capital structure here.

How much to lever: Exactly how much to lever is harder to determine. As the company borrows more, its tax benefits become greater due to greater interest payment deductions. However more borrowing will cause Pharma's debt ratings to be downgraded and will raise interest rates on debt. At higher debt levels, there are also other costs of financial distress that make borrowing unattractive. Given that there is a trade-off between positive and negative effects of debt, there is an optimal debt to equity ratio for a firm. Exactly determining this is more art than science.

That being said, based on the book value (in practice one should look at the market value), it does appear that the current levels of debt at Big Pharma are too low. According to Reuters, the average Long-Term Debt to Equity ratio at a Big Pharma company is only 0.27 compared to 0.59 for the S&P 500 companies. So it does appear that Big Pharma should lever up from current levels, if they want to maximize returns for shareholders.

Why Big Pharma doesn't like debt: Despite people like GSK's Garnier making the right statements, why has Big Pharma resisted this so far? As anyone with a student loan (or other kind of debt) already knows, debt puts tremendous pressure. Given the strong cash flows, Big Pharma managers are not really forced to take on more debt. Their thinking seems to be something like "Why take on more debt for shareholder's benefit when we can get by without debt and a lot less pressure on us?"(see here for a slightly related New Yorker cartoon).

AZ's Statement on Debt: While in general more debt is in order, Pharmalyst is not really sure about AZ. Ideally they should have increased their leverage while in a position of strength (where they really didn't need the money but were increasing debt to maximize shareholder returns). With the MedImmune acquisition though, they are being forced to take on more debt. This probably will increase the cost of debt and make it less attractive for their shareholders.





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