Business Risks in the Pharmaceutical Industry based on AstraZeneca - Case Study Example

Business Risks in the Pharmaceutical Industry Introduction Imagine working in a business that is 50% riskier than any other (KPMG, 2005), where government regulations threaten to wipe out $32-42b of potential industry revenues in the next few years (Rhodes and Mulder, 2005), more class action suits will be filed against companies in the same industry (Griffith, 2004), and worst of all, animal rights and environmental activists are becoming more aggressive (BBC, 2005). These indeed are trying times for the pharmaceutical industry, of which AstraZeneca is a part. Part A: Business Risks of AstraZeneca and the Pharmaceutical Industry AstraZeneca (2005, pp. 155-157) identified the company's business risks: 1. Loss or expiration of patents, marketing exclusivity or trademarks negatively affect the company's pricing and sales. For example, sales of best-selling drugs Losec/Prilosec, Zestril, and Nolvadex fell significantly in 2004 due to patent expiration (drugs developed by the company) and anticipated loss of marketing exclusivity (drugs developed by other laboratories but marketed by AstraZeneca). Manufacturers of generic pharmaceutical products in countries like Asia and Latin America are challenging the company's patents and trademark protection. 2. Exchange rate fluctuations are a major concern for a company with headquarters in the U.K., operations in 45 countries, 64,200 employees of whom 60% are based in Europe (AstraZeneca, 2005, p. 16), 49% of sales from the U.S. and Canada, and 30 manufacturing sites in 20 countries buying and selling raw materials from different sources using a variety of currencies (AstraZeneca, 2005, p. 14), although they are minimizing this to avoid currency fluctuation effects. The company reports in U.S. dollars, so a stronger dollar will have a negative effect on its bottom line due to lower dollar revenues on sales in foreign currencies. Although AstraZeneca mitigates currency risk, it does not "seek to remove all such risks (AstraZeneca, 2005, p. 155)." The company, with a $1.1b fixed interest rate debt, is exposed to interest rate risk due to fluctuations in market interest rates. By converting fixed interest debt to floating rate (AstraZeneca, 2005, p. 91), every one hundred basis point (one percent) rise in interest rates means the company pays $11m more. 3. Uncertainties of developing new products from the Research and Development (R&D) pipeline affects not only AstraZeneca but the whole pharmaceutical industry, which spends an estimated $1 billion over at least ten years to launch a new drug (KPMG, 2005, p.6), which includes losses incurred in developing drugs that do not even reach the market. Companies need to launch new drugs to replace those with expiring patents, marketing exclusivity or trademarks (Bate, 1997, p. 230-231). 4. AstraZeneca is the 9th largest pharmaceutical company in the world (Fortune, 2005) and competes with bigger companies with more resources for R&D and marketing. It also competes with biotechnology companies developing similar products. Increasing regulations in Europe, the Americas, and Asia (Clifford and Flochel, 2005) that put caps on drug prices directly or indirectly lead to low revenues and margins. 5. The company is at risk of paying higher taxes if existing U.K.-recognized double tax treaties are revoked for any reason. Fortunately, these treaties are holding but the risk of being taxed more than once for the same revenue is real. 6. AstraZeneca had a product liability scare in 2004 with Crestor, an anti-cholesterol drug. As the recent experience of Merck with Vioxx has shown, adverse publicity depresses the stock price and wipes out a portion of potential revenues (Bate, 1997, p. 287-288). 7. AstraZeneca's reliance on other companies for raw materials and services expose it to supply chain risks. If these third parties do not deliver, the company suffers stoppages in production, late deliveries, and lost revenues as the market switches to similar drugs. 8. The pharmaceutical industry is highly regulated by strict controls on labeling, manufacturing, distribution, and marketing (AstraZeneca, 2005, p. 157). Regulatory approvals at several levels cause new product launching delays, as AstraZeneca experienced with Crestor, which reached the U.S. market one year late. A delayed product means one year less of revenues and one year more of expenses. Complicating the process further is that regulations prior to approval vary in the company's major markets, and once the drug is approved, it continues to be subject to wide-ranging oversight requirements that, if not meticulously complied with, can lead to a withdrawal of the drug's approval. 9. Just because a drug makes it to market does not mean it will do what it was designed to do. Sometimes, the drug fails to perform, as AstraZeneca experienced in late 2004 with its lung cancer drug Iressa (Cervenka, 2005). 10. AstraZeneca has environmental liabilities at some currently or formerly owned, leased, and third party sites in the U.S. (AstraZeneca, 2005, p. 111), but the company does not see material adverse effects on its financial position (AstraZeneca, 2005, p. 157). However, animal rights and environmental activists, most especially in the U.K., are becoming aggressive in targeting pharmaceutical companies, so the risk factor of environmental liabilities is rising (BBC, 2005). 11. Forward-looking statements became a sensitive issue even before the passage of the Sarbanes-Oxley Act of 2002, especially Section 404, which requires stronger financial reporting controls. Like any other company dependent on high-risk R&D activities, Astra-Zeneca's prospects are uncertain. Using forward-looking statements may be misconstrued as an attempt to mislead stockholders and potential investors (AstraZeneca, 2005, p. 157). Several papers (KPMG, 2005; Griffith, 2004; Clifford and Flochel, 2005) identified similar sets of business risks. In addition, KPMG (2005, p. 3) concluded the following: 1. The pharmaceuticals industry is 50 percent riskier than the overall S&P 500 on the basis of cash flow and net income scaled by assets despite steady sales over a 13-year period. The industry's return on investment is highly volatile: pharmaceutical companies earn huge profits on some years and then, as patents expire or a drug fails, profits plunge or dry up. 2. Risks in the industry changed dramatically in the last five years due to regulation (drug approvals) and legislation (price caps and health care cost control). The industry expects setbacks as the Medicare Modernization Act of 2003 takes effect in early 2006 in the United States. 3. Pharmaceutical companies' senior management teams are getting more involved in risk management. AstraZeneca is cited (KPMG, 2005, p. 8) for putting in place a Risk Advisory Group, a separate body that reports to the board on issues of industry and corporate risks and threats. KPMG (p. 6) singled out the Chief Financial Officer and the internal audit team as the ones best positioned to play an active role in risk management. The reason is that financial information flow from different departments in the organization are a good source of early warning signs of root troubles in the business environment. Part B: Use of interest rate swaps and forward foreign exchange contracts In explaining foreign currency fluctuations as a risk factor, AstraZeneca (2005, p.155) mentioned that "the notional principal amount of financial instruments used to hedge these exposures, principally forward foreign exchange contracts and purchased currency options, at 31 December 2004 was $31m." Details of these financial instruments and its fair value are explained (AstraZeneca, 2005, pp. 91-94). The financial instruments used are derivatives, so called because they derive their value from some underlying asset (stock, bond, or currency), reference rate (such as a 90-day Treasury bond rate), or index (the Standard and Poor's (S&P) 500 or Financial Times London Stock Exchange Index (FTSE) 100). The most popular types of derivatives are swaps, forwards, futures, and options (Shapiro, 1996, p. 154). A swap is a financial transaction in which two counterparties agree to exchange streams of payments over time (Shapiro, 1996, pp.702-703). Swaps allow borrowers to raise money in one market and to swap one interest rate structure for another, for example, from fixed to floating, or to go further and to swap principal and interest from one currency to another. These swaps allow the contracting parties to arbitrage their relative access to different currency markets. A borrower whose paper is in demand in one currency can obtain a cost saving in another currency sector by raising money in the former and swapping the funds into the latter currency. Interest rate and currency swaps are the most common types (Shapiro, 1996, pp. 726-727). AstraZeneca (2005, p. 92) used an interest rate swap to convert a $750b US dollar fixed rate bond into a floating rate bond until maturity in 2014. Companies use swaps if it predicts interest rates to fall, resulting in lower interest payments on floating rate debt. However, if rates rise, the company will lose instead of gain from the hedge. Although no details are indicated aside from the mention of an interest rate cross-currency swap, what the company probably did was to exchange dollar payments for a fixed interest rate dollar debt with the payment for a floating rate debt in sterling or euro with a notional principal value of $32m (AstraZeneca, 2005, p. 93). The interest rate swap protects the company from a potential dollar interest rate fall (should rates rise, there will be no need to swap a fixed interest rate bond, since the company would be happy holding on to its fixed rate debt) and a predicted strengthening of the dollar, which allows the company to exchange more euros or sterling for the same dollar amount to pay off the euro or sterling floating rate debt. The counter party to the transaction was most likely a bank with a client in Europe looking for a fixed interest rate dollar debt to reduce interest rate risk on a high floating interest rate loan. The bank, acting as financial intermediary to AstraZeneca and another client, earns the difference in interest rates multiplied by the notional principal. The Appendix illustrates a classic interest swap transaction. AstraZeneca (2005, p. 92) also has a forward foreign exchange contract, a derivative to hedge 100% of working capital transactions and 95% of future foreign currency exposures, notably $4.0b of payables in sterling and Swedish kronor and $1.9b of receivables in euros. A forward contract calls for delivery at a future date of a specified amount of one currency against a dollar payment, at an exchange rate that is fixed at the time the contract is entered into. In combination with options, the company can protect its cash flow from a dollar depreciation that increases the company's dollar expenses for payables in sterling and Swedish kronor. However, dollar depreciation will be beneficial for its euro receivables currently worth $1.9b, since dollar income will increase. There is no need to hedge euro receivables against dollar depreciation. It can, however, choose to hedge euro receivables against a dollar appreciation that will have the opposite effect on its payables. How does a foreign exchange forward contract work This contract is between the company and any number of parties (one or several banks, financial institutions, companies, or even with a company subsidiary). This transaction's risk is that either party may default on the terms of the agreement, which happens if the exchange rate fluctuation is such that one party will be bankrupted by honoring the contract. During the 1997-1998 Asian financial crises, several Southeast Asian companies holding forward contracts were bankrupted when their local currencies depreciated by almost 100%, making it impossible to deliver the dollars promised (Brandt21, 2004). As Stiglitz (2000, pp. 94-96) says, this was a common effect of the globalization of financial markets as derivatives were used for currency speculation. In order not to hedge all of its currency risk with forward contracts, AstraZeneca also uses options, a derivative that gives the holder the right, but not the obligation, to sell (put) or buy (call) another financial instrument at a set price and expiration date. The seller of the put option or call option must fulfill the contract if the buyer so desires it. Because the option not to buy or sell has value, the buyer must pay the seller of the option some premium for this privilege (Shapiro, 1996, p. 160). Applied to foreign currencies, call options give the customer the right to buy, and put options the right to sell, the contracted currencies at the due date. This allows the company using options to limit its potential loss from currency fluctuations to the actual cost of the option, which is small compared to the total value of currencies it wants to hedge. We can illustrate this with an example (Shapiro, 1996, p. 161). Suppose AstraZeneca wants to hedge a 100,000 payment due in 60 days to a supplier in Germany. It will buy a call option to have Euros () delivered at a specific exchange rate (the strike price) on the due date. Options are priced (using the Black-Scholes options pricing formula) to have a premium, say, of $0.02/, and an exercise price of $1.17. The company pays $2,000 (100,000 x $0.02) for a call option that gives it a right to buy 100,000 at $1.17 in 60 days, just in time to pay its German supplier. If at the time of the payment the Euro rises to $1.20, the option would be in the money by $0.03. AstraZeneca exercises the call option and buys Euros for $1.17, earning a profit of $3,000 (100,000 x 0.03) that covers the $2,000 cost of the option. If the rate in 60 days were $1.15 instead, the option would be out of the money, and AstraZeneca would let the option expire and purchase the Euros in the spot market. It spent $2,000 for the option but its savings of $2,000 (100,000 x 0.02) by buying the currency in the spot market makes the company even on the transaction. This is how currency options protect the company against exchange risk compared to forward contracts. Part C: Alternative risk management strategies Aside from interest rate swaps and forward currency contracts and options, AstraZeneca has other alternatives to manage its interest rate and currency risk profile. Swaptions and other non-plain vanilla derivatives. The company can design, on its own or with the help of financial intermediaries, complex derivatives that combine swaps, options, or convertible bonds whose values are derived from treasury bonds in the countries where the company operates, stocks in other companies or industries totally unrelated to the pharmaceutical industry (as a hedge against the latter's performance), or commodities. The objective is to spread the risk attached to currency and interest rate fluctuations and avoid negative effects on the bottom line (Micklethwait and Wooldridge, 2000, p. 315). Hedging Translation Exposure. A company like AstraZeneca with assets and liabilities, revenues and expenses in floating currencies can use a basic strategy to hedge translation exposure (or the conversion of transactions from different currencies to the dollar). As Shapiro (1996, p. 265) summarizes, the company can increase hard currency (likely to appreciate) assets and soft currency (likely to depreciate) liabilities and decrease hard currency liabilities and soft currency assets. For example, if Euro devaluation is likely, the company can reduce its Euro cash holdings, tighten credit terms to decrease accounts receivables, increase borrowings, delay accounts payable, and sell the currency forward. This can help the company if it is ahead of the market in anticipating exchange rate fluctuations. Otherwise, markets can develop financial instruments that will include the potential effects of currency appreciation or depreciation. Commodity hedging. Companies dependent on raw material inputs or commodities are sensitive to price changes that affect gross and operating margins. To protect itself from price fluctuations of these raw materials ($650m inventory in 2004), the company diversified its raw material sources following a global purchasing policy that mitigates the adverse effects of price volatility (AstraZeneca, 2005, p. 89). Intracompany financial transactions. AstraZeneca can use different techniques like transfer pricing, intercompany loans, and optimising the use of the cash flow generated by subsidiaries in different countries to manage interest rate risk, saving on interest expenses by allowing cash-rich subsidiaries to lend at market rates to cash-hungry subsidiaries, saving the loan spreads collected by banks and other financial intermediaries. Global companies in the same industry (Bayer, 2005) and in other industries (Gczy, Minton, and Schrand, 1997) use these techniques. For AstraZeneca, high in margins and rich in cash in several currencies and thinking of returning some of the cash to shareholders (Symonds 2005), increasing these intracompany transactions may be a good way to hedge against interest and currency risk. Conclusions At a time when AstraZeneca faces tremendous business risks, it is in the midst of a management transition as a new Chief Executive Officer (CEO) takes over in January 2006. Although CEO-designate David Brennan rose through the sales and marketing side of the business, he has to learn to manage the risks the company will face in the coming years. With revenues battered by regulations and legislation, economics affected by global economies reacting to public clamor to keep health care costs down, and the industry reeling from huge lawsuits, the company is facing increased stockholder pressure to deliver consistently better results. The financial management team is at the forefront of improving cost performance (Symonds, 2005). Managing interest and currency risk profiles with derivatives is one way. It will continue to do well by keeping its financial reporting integrity, and by looking for innovative ways to utilize the cash generated worldwide. Maintaining financial soundness is AstraZeneca's best strategy to avoid its stock price going down and making it a target for other companies in the industry looking for a good company to devour. Bibliography: AstraZeneca (2004) Thinking Performance: Annual Report 2004. London: AstraZeneca PLC. [online] Available from http://www.astrazeneca.com [Accessed 5 December 2005]. Bate, R. (Ed.) (1997) What risk Science, politics, and public health. Oxford: Butterworth-Heinemann. Bayer AG (2005) Risk Management. 2004 Annual Report. [online] 15 March 2005 Available from http://www.bayer.com/management_report/overview/bayer risk_management.htm [Accessed 9 December 2005]. BBC News (2005) Animal-rights blow for drugs firm. June 23, 2005. London: BBC. [online] Available from http://www.animalliberationpressoffice.org/media_coverage/2005-06-24_phytopharm_shares_tank_bbc.html [Accessed 6 December 2005]. Brandt21 Forum (2004) Foreign Investment and the Second Debt Crisis: Southeast Asia. Brandt21 Forum. [online] Available from http://www.brandt21forum.info/index.htm) [Accessed 7 December 2005]. Cervenka, A. (2005) AstraZeneca Needs Pain Relief. Fortune Magazine. 21 March 2005. [online] Available from http://www.fortune.com/fortune/information/Magarchive/ 0,16011,magarchive-03-21-05,00.html) [Accessed 6 December 2005]. Clifford, L. and Flochel, P. (2005) Global Pharmaceutical Issues and Insights. Ernst & Young: Progressions 2005. Available from www.ey.com/progressions [Accessed 6 December 2005]. Fortune (2005) World's 500 largest corporations. Fortune Magazine. [online] Available from www.fortune.com [Accessed 7 December 2005]. Gczy, C., Minton, B., Schrand, C. (1997) Why firms use currency derivatives. Journal of Finance, 52, pp. 1323-1354. Griffith, E. (2004) Risk Management for the Pharmaceutical Industry. March 2004. Fujitsu Consulting, pp. 88-90. [online] Available from www.pharmpro.com [Accessed 6 December 2005]. Harper, D. (2005) Corporate Use of Derivatives for Hedging. Investopedia. [online] Available from http://www.investopedia.com/article/ [Accessed 7 December 2005]. KPMG (2005) Pressure Points: Risk Management in the Pharmaceuticals Industry. Advisory from KPMG International. [online] Available from www.kpmg.com [Accessed 5 December 2005]. Micklethwait, J. and Wooldridge, A. (2000) A future perfect: the challenge and hidden promise of globalization. New York: Crown. Rhodes, J. and Mulder, J. (2005) Challenges and Opportunities Converge in Today's Pharmaceutical Industry. Med Ad News/Deloitte LLC. [online] Available from www.deloitte.com/us/lifesciences [Accessed 7 December 2005]. Shapiro, A. C. (1996) Multinational Financial Management. 5th ed. London: Prentice Hall. Stiglitz, J. (2002) Globalisation and its discontents. London: Allen Lane. Symonds, J. (2005) Interview with AstraZeneca CFO on 28 July 2005. [online] Available from http://www.astrazeneca.com [Accessed 5 December 2005]. Appendix: A Sample Classic Interest Rate Swap Payables Portfolio $50m portfolio $50 million portfolio Loan Portfolio 6.25% LIBOR + 0.75% U.S. Company 5.35% LIBOR Bank Intermediary 5.25% LIBOR European Company LIBOR + 0.5% 5.00% Floating Rate Lender $50m loan 5-year maturity $50m bond 5-year maturity Eurobond Legend: Payment Streams Outflow Inflow The Bank Intermediary nets the following: Interest Rates Receipts 5.35% Pays 5.25% Receives LIBOR Pays LIBOR Net 10 basis points Read More