Description

Company Overview

Viatris (VTRS) is the new corporate name of the global healthcare company recently formed by the combination of Mylan and Upjohn (a division of Pfizer).  With Mylan’s generic portfolio of more than 1,400 molecules and Upjohn’s trusted brands such as Lipitor, Celebrex, Lyrica, and Viagra, the merger assembles first-rate R&D, legal expertise, a global manufacturing and logistics footprint, and an international salesforce and marketing team able to deliver healthcare to 60,000 customers in more than 165 countries.

As of late 2020, the upcoming merger was expected to generate $19.5 billion in revenues, $7.5 billion in EBITDA, $4 billion in free cash flows, $1 billion of cost and operational synergies over four years, and net debt of nearly $25 billion.  Management guided that a portion of free cash flow would be used to pay down debt to hit net debt/EBITDA of 2.5x by end of 2021.  Dividends were to start in Q1 and would represent 25% of annual free cash flows.  Prior to the merger, 75% of Mylan’s revenue came from North America and Western Europe with Asia Pacific and Emerging Markets accounting for 10% and 15% respectively.  After the merger, North America and Western Europe will fall to about 60% of revenues with Asia Pacific growing to 30% (China ~11%).  As part of its restructuring, Viatris will close, divest, or downsize to 35 manufacturing facilities from its current size of 50 with 9,000 of its 45,000 employees being impacted.  The upfront cost to reorganize the company will be around $1.5 billion, consisting mostly of severance expenses. 

By February 2021, Viatris’ new management lowered its full-year guidance in all categories:  Revenue was reduced to $17.5 billion, EBITDA to $6.2 billion, free cash flow was cut in half to $2 billion, the $1 billion in synergies was accelerated to 3 years vs. 4 years, and dividends delayed until Q2.  The $2 billion in free cash flows reflect the $1.5 billion of restructuring costs which will be expensed in 2021.  The reduced revenues were partly because of the unexpected decline in Lyrica sales in Japan (Japan’s Ministry of Health is allowing generic competition to Lyrica sooner than expected, even though Viatris claims it still has exclusivity), and China applying increased pressure on drug pricing from foreign drug companies.  The other contributing factor to the reduced guidance was Viatris’ optimistic outlook when the merger was first announced.  The projections put forth were achievable but at the high end of expectations and were never adjusted so to keep the merger on track.  Now that the merger is completed and considering the headwinds from Japan and China, management is taking this opportunity to reset the table, reduce expectations for 2021, and lower future hurdles.  That is not to say that the company will not have to face continued headwinds in the years to come.

Industry Overview

Worldwide pharmaceutical sales have grown into a $1.2 trillion a year business.  North America represents nearly 50% of the world’s sales, Europe and AMEA&A (Asia, Middle East, Africa, and Australia) at 25% and 17% respectively, with Latin America underrepresented at 3%.  As total spending on healthcare as a percentage of GDP continues to rise globally from mid-single digits in 1990 to low teens by 2019 (During the same period the US has gone from 10% to over 18%), generics continue to play a role in helping lower healthcare costs.  The FDA, by streamlining the generic approval process, has actively increased the number of low cost drugs which was intended to help make healthcare more accessible and at a lower cost.  Because of the FDA actions, 90% of all prescriptions filled in the US are generics helping save the healthcare system over $2.2 trillion over the past decade.  Even though branded drugs only represent 1 out of 10 filled prescriptions, they still account for nearly 80% of prescription spending.  That trend is only expected to increase as branded drug prices get more expensive.

Small molecule generic drugs are bioequivalent versions of their branded counterparts whose exclusivity has expired.  They are essentially identical in terms of their active pharmaceutical ingredient (API), quality, strength, and impact.  In today’s market, it takes on average over $1 billion and 12-14 years for a branded drug to go from patent application to pharmacovigilance (drug safety or stage IV).  Once an application is approved, a drug remains on patent for 20 years, which gives the branded drug exclusivity once it hits the market for about 5-7 years.  During that window of opportunity, branded drug companies must work quickly to build up demand, recoup their R&D expenses, and generate profits before the generics enter the market.  Historically, only around 1 in 10 branded drugs released become profitable when including the R&D and development costs of drugs that never made it to market.

Since small molecule generics drugs are easy to synthesize and do not require years of R&D and testing, the path to market takes on average 2 years costing around $10 million.  Whereas the price of branded drugs will have an upward trajectory, especially as it gets close to losing its exclusivity, over the past five years the average manufactures price (AMP) of a generic drug, has fallen approximately 7% annually.  That number is highly influenced by the number of competing manufactures.  A single generic producer is likely to sell their generic drug at an AMP that is 25% lower than their branded counterpart.  When six generic manufactures produce a copy of the same branded drug, the generic AMP can be 95% lower than the branded AMP.  On average, between three and five manufacturers apply to produce the generic version of a branded drug.  Additional pricing pressure is applied to the US generic drugs by a consortium of wholesale drug buyers (Red Oak Sourcing, Walgreens Boots, and McKesson).  Together, these three companies represented 85% of all direct US generic drug purchases.  The overall generic market is highly bifurcated with the top three companies (Viatris, Sandoz (a subsidiary of Novartis), and Teva) representing 50% of all worldwide generics sold and the bottom half fragmented among smaller, foreign players with low-cost operations.  With continued headwinds facing the generic industry, further consolidation should be expected.

Over the past decade, established generic manufacturers mostly fell into one of two different business models:  1) Manufacturer of aging commodity portfolios that produce stable but diminishing cash flows, or 2) Manufacturer that continues to strive to be first-to-file (FTF) and first-to-market (FTM) for generic drugs which require a constant cash investment.  The Viatris merger represents a hybrid within the generic industry by combining both business models mentioned above while leveraging the newly formed company’s scale, scope, and resources (intellectual and access to capital) to continue to pivot into biosimilars.

Biosimilars is a biologic drug created from an organism that is similar to a branded drug already on the market and represents a growth opportunity for Viatris.  Unlike small molecule generics, which are synthesized using the same API as the branded drug, biosimilars key ingredient is developed by modifying a living cell to create the necessary protein structure.  The development process usually takes 7-9 years, and cost hundreds of millions of dollars.  Manufacturing a biosimilar can be just as challenging as the development stage, requiring operational expertise and over 250 in-process tests to ensure quality and purity standards.  Any change in temperature, production timing, or variation in the ratio of molecules can lead to failure and a costly restart to the production line.  Because the development and manufacturing process will not be an exact copy as the original biological branded drug, biosimilars need to prove that their final product is similar in safety, purity, molecular structure, potency, and efficacy.  Biologics and Biosimilars are the fastest growing segment of the pharmaceutical industry, representing over $300 billion in sales and expected to grow at a 12% CAGR.  Since biologics are relatively new to the market (especially in the US) and many still have exclusivity, biosimilars represent less than 10% of combined sales but over time their percentages will continue to grow.   In the next five years, biologics and biosimilars are expected to represent 32% of the estimated $1.65 trillion in pharmaceutical sales worldwide.

Future Growth and Profitability

Viatris has branded 2021 a “trough year,” refocusing investors’ attention away from earnings and on to their global restructuring program they expect will produce operation leverage and lead to future profits.  By reducing its manufacturing footprint from 50 down to 35 facilities, the company will need to eliminate redundancy, cut waste, and improve operational efficiency.  Improving operational leverage and future profits will also include pruning its portfolio of over 7,500 products including generics, over-the-counter medication, and branded drugs.  With an increase in the number of branded blockbuster drugs coming off patent (including biologics) starting in the next few years, the freed-up capital from unprofitable or marginally profitable product lines can be reinvested to ensure Viatris is FTF and FTM on new generic and biosimilar drugs.  For the small molecule generics that remain in the portfolio, they will be drugs with less market competition, under less pricing pressures, or will benefit from growth in new markets.

Reducing expenses and improving margins is a good first step, but for management to truly turn the company around it needs to find a way to grow its topline revenues.  The growth of its generics business will come from expansion into emerging markets like India, Brazil, and China where the growing middle class is gaining more access to available healthcare.  By leveraging Upjohn’s in-house salesforce (including in-country reps and marketers), Viatris expects to get better penetration into international markets which in turn will improve its revenue and margin mix while deemphasizing its North American exposure.

However, Viatris’ long-term growth and profitability will come from the company’s ability to continue to expand its biosimilar footprint.  The barriers to entry for the development and manufacturing of biosimilars are more meaningful than generic production and favors large, well-capitalized companies with a competitive edge in R&D, manufacturing, marketing, and distribution.  By teaming up with a diversified group of R&D partners, Viatris has over 17 biosimilars on market or in different stages of development.  With the focus of being FTM, these collaborations share the development costs, inherent risks, and seek to exploit each companies’ competitive strengths.  Humira is the most successful and best-known biologics on the market today.  Costing around $7,000 a month, those suffering from rheumatoid arthritis are left with few options, although with good insurance plans and additional discounts, a yearly treatment can be reduced to just under $40,000.  In 2020, Humira generated over $20 billion in worldwide sales.  Even with a discount to branded biologic drug sales, biosimilars still offer a very compelling profit margin.  Viatris’ biosimilar products are currently available in over 75 countries and over the next few years, 66% of Viatris products launched are expected to be biosimilar drugs.  Currently, the US trails the EU in the number of biosimilar authorizations as the EU began approving biosimilars 9 years earlier than the US (2006 vs. 2015).  To date, the FDA has only approved less than 30 biosimilars of which only 17 are on market, half that of its EU counterpart.  Both markets are expected to grow much faster than the branded small molecule drugs.

Valuation

With Viatris’ stock trading at less than 4x expected 2022 earnings, the market remains skeptical that the new management can right the ship, especially with several headwinds continuing to negatively impact the company and industry:  foreign competition, pricing pressure from regulators and wholesale distributors, no guarantee that the current pipeline of drugs (especially biosimilars) will be successful, and a balance sheet with $25 billion in net debt. 

As the pharmaceutical industry enters an upcycle of branded drugs coming off patent starting over the next couple of years, Viatris is well-positioned to take advantage of that and other tailwinds while it integrates and restructures the Mylan/Upjohn combination.  It will take time for Viatris’ key growth strategies to have a positive impact on both revenues and margins.  In the short run, the company’s success will be measured by how quickly it can integrate platforms, reduce expenses, and improve operational efficiency.

The markets’ low expectation for Viatris works in the company’s favor as the hurdles for future success are very low.  It will not take a lot of improvement to demonstrate that Viatris is both a stable and profitable enterprise, which in turn will increase both earnings and the multiple investors are willing to pay.  Conversely, if the company cannot quickly demonstrate its ability to cut costs and improve operational efficiencies, then investors will have a clear indication of whether management can execute its future strategies.

Risk

Investing in Viatris comes with its share of risks:

• High level of net debt on the balance sheet

• Inability to successfully expand generics into international markets and deemphasize NA impact

• Continued pricing pressure from regulators and wholesale distributors

• Success in Biosimilars is muted

• Litigation – besides its ongoing disputes, regulatory and government inquiries/investigations, and class actions suits that include EpiPen and drug pricing, Viatris has also assumed liability for any Upjohn legal matters

Summary

There is no hiding the fact that Mylan’s old management had a history of impulsive acquisitions to quickly build its generic market share.  Those past acquisitions continued to concentrate Mylan’s North American presence just as US generic drug pricing peaked and was beginning a downward cycle.  Mylan’s management was, at best, destroyers of value during that period as they leverage the company’s balance sheet for future revenue and profits that never materialized.  The recent merger between Mylan and Upjohn may seem like old behavior under a new company name, but the combination of the two firms focuses on deemphasizing the company’s reliance on single molecule generics and the North American market by expanding their focus into biosimilars while leveraging their international footprint to expand into growing markets.  Investors who owned shares of Mylan before the merger were mistreated as the terms of the deal greatly favored Pfizer. 

With several industry headwinds and the added challenge of integrating and restructuring the new entity, the market remains doubtful that Viatris can show stability and execute its business model.  The company’s future revenue growth and profitability will depend initially on its ability to integrate and reduce expenses in the merger between Mylan and Upjohn while increasing the profitability of its generic and branded drugs segment, and successfully develop/manufacture and be FTM with its pipeline of biosimilars.

In the past, Viatris (Mylan) and its competitors solved their problems by focusing on gaining market share and that led to bad corporate and industry-wide behavior.  Today, consolidation is once again a topic of conversation but this time it is less about market share and more about having the scale, scope, and infrastructure to develop and manufacture complex drugs on a global platform.  The generic drug industry’s ongoing consolidation is no different from what happened over time to the airline, automobile, or semi-conductor industries.  In those examples, the surviving companies emerged much more focused on operational efficiency and profitability and that led to more disciplined behavior.

For Viatris to be one of the surviving companies in the generic industry, they need to execute a multipronged strategy to restructure operations and reduce expenses, bring its pipeline of generics and biosimilars successfully to market, and improve its balance sheet.  Improvements in these areas will lead to better revenues and margins, underpinning both the company and its stock price.  The market is not looking for perfection, just progress and clear signs that management will create value and not destroy it.

Catalyst

• Aging population
• Growth from emerging markets and a growing middle class

• Upcoming cycle of blockbuster branded drugs coming off patent

• Growth in biosimilars worldwide

• Consolidation leading to more discipline industry behavior