David Sage

Better management of working capital could help firms get a better return rather than just driving top-line growth.

Pharmaceutical companies have long been the envy of other industries, given their strong balance sheets, high operating margins, and access to cash. As a result of these competitive advantages, members of the industry have historically paid little attention to releasing cash from their working capital, which is commonly defined as the difference between a company’s current assets and its current liabilities.

In the past, pharmaceutical companies were willing to operate with high levels of inventory and readily dealt with the related costs, as they did not want to run the risk of disrupting the delivery of medicines and missing a profitable sale. As a result, companies placed little emphasis on pursuing best practices in forecasting or other ways to wring greater returns from assets and investments that could free up cash.  

As followers of the pharmaceutical industry know, times are quickly changing. The industry faces significant challenges in different areas related to patent expirations, pricing and regulatory pressures, thin late-stage pipelines, shifting demographics, and efficacy issues.   

Faced with these challenges, members of the industry are now seeking to preserve the value they have created while at the same time executing new transformational strategies to create value. Although much of the focus in recent years has been on the industry’s cost-cutting measures, the active management of working capital is increasingly becoming a key element of this transformative effort.

Evaluation of the 16 Largest Firms by Sales

Cash on the prescription!, Ernst & Young’s new report on pharmaceutical companies and working capital management, provides an analysis of the performance of the 16 largest U.S. and European pharmaceutical companies by sales, based on their publicly available financial statements. While the report does not disclose the performance of individual pharmaceutical companies, it found that these players have an aggregate total of between $22 billion and $47 billion in cash unnecessarily tied up in working capital. Even for an industry as cash-rich as pharma this is a significant amount of capital, equivalent to between 4% and 9% of annual sales in the industry.

The industry has made some progress in reducing levels of working capital in recent years. Since 2000 pharmaceutical companies have managed to reduce their level of working capital by 2.4%, from 84.4 days to 82.3 days. Within the last year the number of initiatives launched by companies in the sector to free up cash has risen sharply.

Unfortunately, the top-end estimate of available cash that could be released from working capital industry wide has actually increased over the past year by approximately $12 billion. This is primarily due to further deterioration among the worst-performing companies in terms of management focus on cash and process efficiency and was also exacerbated by the impact of currency movements that benefited U.S. companies and negatively affected foreign-based entities.  

Tips for Improving Management of Working Capital

The opportunities for companies to release cash are distributed across all traditional components of working capital, with 35–40% each coming from payables and inventories and 25–30% coming from receivables.
 As companies work to identify further opportunities for improving their management of working capital, they should begin by examining the practices of other industries such as consumer products that do not enjoy such high levels of operating margins and cash generation but which have much lower working capital requirements. Strategies that have been used successfully by these industries include incentivizing cash performance; tightening management of payment terms for customers and suppliers; improving credit, billing, and collection processes; establishing leading demand forecasting processes; and building greater linkage and closer coordination across the entire supply chain. These are some of the most effective avenues for the pharmaceutical industry to pursue for improved working capital management.

While the industry is in a period of profound change, there are several clear trends on the horizon that will further increase the pressure on companies to achieve higher levels of excellence on their working capital efforts and in certain cases help to drive positive returns.

Industry Consolidation

There have been several high-profile mergers and acquisitions in the pharmaceutical sector in the last year. There are expectations for further consolidation given revenue challenges and the need for greater returns on R&D efforts. This consolidation could advance companies’ efforts to improve their working capital management by helping the merged entity leverage relationships with customers and suppliers and implement best practices.

History has shown, however, that mergers present significant challenges. These can relate to implementation costs, the alignment of business processes and information systems, and failure by managements to commit fully to change. All of these aspects can hamper efforts to bring new competencies and efficiencies to the enlarged organization.
Global Manufacturing and Supply Chain Networks

Pharmaceutical companies in recent years have increasingly sought to standardize and rationalize their global supply chain and manufacturing networks. Steps taken by the industry include outsourcing noncore operations, globalizing procurement activities, and rescaling business processes.

In the supply chain area, redesigned distribution networks, increased collaboration with wholesalers, and the increased prevalence of inventory management agreements with U.S. wholesalers have provided additional means to rationalize the global supply chain. These and other measures are expected to continue expanding opportunities to drive cash and cost out of working capital.     

Impact of the Financial Crisis

The impact of the current economic and financial crisis was not fully reflected in the industry’s operating and financial performance in 2008, so its impact could not be fully identified in the Cash on the prescription! report. The continuation of current economic conditions, however, will undoubtedly have a greater impact on the industry in 2009, with early indications already pointing to some softening in sales growth.

Factors such as reduced demand, late or nonpayment by major customers, failure of drug store chains, and reduced health insurance due to unemployment each could create further pressure to improve working capital performance in 2009. This also raises the potential for disruptions in the supply chain, leading to increased tensions between all participants in the working-capital value chain.

At a time when most in the industry agree that the blockbuster business model, which has driven the industry for decades, is nearing an end, building a sustainable cost advantage will be a business imperative for the successful pharmaceutical company of tomorrow and an essential part of delivering value to shareholders.

To be successful in this effort pharmaceutical companies should establish an environment where the finance function, in particular the CFO, is empowered to drive the types of transformational strategies required to move the organization from simply driving top-line revenue growth to managing for return. A comprehensive approach to working capital management, which can bring about significant cash and cost benefits within 12–24 months after initiation, should be viewed as a key pillar of any such strategy.

David Sage is a partner, transaction advisory services, Ernst & Young. The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young. “Cash on the prescription!”  relied on publically available data of the 16 largest U.S. and European pharmaceutical companies by sales, which includes Abbott Laboratories, Amgen, AstraZeneca, Bayer, Bristol-Myers Squibb, Eli Lilly, GlaxoSmithKline, Johnson & Johnson, Merck & Co., Merck KGaA, Novartis, Pfizer, Roche, sanofi-aventis, Schering-Plough, and Wyeth.

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