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Free Cash Profiles: The Pharmacos

Lack of revenue at small biotechs drags down the industry's ability to generate cash.
David M. Katz, CFO.com | US
April 6, 2012

When it comes to pharmaceutical companies' ability to spawn free cash flow as they grow, the key is in the R&D.

But maybe not in the way you think. True, smaller companies' larger proportions of research and development spending surely lead to steeper long-term growth trends. But a snapshot of 267 pharmacos ranging from early-phase biotechs to drug-industry giants shows that their large relative amounts of R&D spending makes them less efficient cash generators than the big players.

That's because spending on R&D eats away at a companies' operating cushion, a key component of a company or an industry's Free Cash Profile (FCP), a metric designed by Charles Mulford, a professor of accounting at Georgia Tech. The metric is designed to forecast the ability of a company or an industry to produce cash as it grows. (See "How the Free Cash Profile Works," below.)

Basing his research on data for the 12 months ended with the fourth quarter on or nearest to December 31, 2011, Mulford finds that the pharmaceutical industry as a whole has a dreadful median FCP: -9.10%.  In comparison, the median FCP for all nonfinancials (with revenues exceeding $100 million and including 44 industries) for the year ended 2011 is 3.88%. (The data is supplied by Cash Flow Analytics, a firm at which Mulford is research director.)

Leading the pack of the industry, middle-market firms — those with revenues of between $300 million and $800 million — have a median FCP of 17.65%.  Counterintuitively, the biggest companies in the business (annual revenues of more than $5 billion) trailed slightly with a median FCP of 15.88%. 

In most other industries, size matters. That's because the biggest companies are in general best equipped to demand quick and full payment from their customers and bargain for the best prices and terms from their suppliers. And good working capital performance, which depends on a company's ability to manage accounts receivable, accounts payable, and inventory, fuels a company's capacity to generate free cash flow as it grows.

Still, the negative operating cushions of the smallest drug firms are indeed the biggest weight pulling down the industry' FCP, according to Mulford. (Operating cushion is operating profit excluding depreciation and amortization, divided by revenue from core operation.) Thus, the middle market and largest pharmacos have median operating cushions of 28.34% and 18.15%, compared with -32.96% for the industry as a whole.

R&D spending is the primary reason for the huge abyss between top and bottom in terms of operating cushions, according to Mulford. While the middle-market firms and biggest companies are spending medians of just 17.54% and 15.66% of their revenue dollars on R&D, research spending by the industry as a whole is 57.35% of revenue.

What are the reasons for the whopping R&D expenditure recorded at the industry's low end? One is that "so many firms in the overall industry have very low revenues that any spending results in a significant percentage of revenue," according to the professor.  Further "these smaller companies need to spend on R&D to develop a product pipeline needed to grow revenues."




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