Making Money More Efficiently

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Pharmaceutical companies have never been known for their efficiency. The high margins on their drugs have probably made them lackadaisical about slimming down. But with many blockbuster compounds slated to lose patent protection in the years ahead, all that's changed.

Listen to recent pharmaceutical-earnings conference calls, and you'll hear as many updates on efficiency programs as on drug pipelines. Some companies are slimming down by cutting workers, while others are buying up competitors to capitalize on advantages of scale.

Now that major drugmakers have reported their third-quarter results to the SEC, let's examine their performance via a couple of different metrics.

First up: gross margins

Company	2005	2006	2007	2008	YTD
AstraZeneca	78%	79%	79.7%	80.8%	83.4%
Bristol-Myers Squibb (NYSE: BMY)	69.7%	67.6%	68.7%	70.2%	72.6%
Eli Lilly (NYSE: LLY)	76.3%	77.4%	77.2%	78.8%	82.3%
GlaxoSmithKline (NYSE: GSK)	78%	78.4%	76.8%	77.1%	75.4%
Merck (NYSE: MRK)	77.4%	76.7%	76.6%	76.8%	76.8%
Pfizer (NYSE: PFE)	85%	85%	84%	85.1%	85.6%
sanofi-aventis (NYSE: SNY)	74.8%	74.3%	74.1%	74.5%	75.6%

Source: Capital IQ, a division of Standard & Poor's. YTD = Year to date.

Merck and Sanofi have lower gross margins because they have joint ventures -- with each other, among others -- that don't show up in the revenue for the company. Merck, for instance, manufactures the product, which is then sold to the joint venture, presumably at a much lower gross margin. Glaxo's net margin is lower because it has plenty of over-the-counter products -- Tums, Aquafresh, and the like -- which can't compete with the high margins of branded drugs.

It's more important to look for trends. In this regard, Lilly appears to be the clear winner, improving 600 basis points over almost four years. AstraZeneca isn't doing too badly here, either.

Next up: Revenue per selling, general, & administrative dollar
You can measure this as a percent of revenue that goes toward these expenses, but I like inverting the fraction. That gives a much better feel for the company's efforts, by answering one simple question: For every dollar spent on marketing and such, how many dollars in revenue can we expect to get?

Company	2005	2006	2007	2008	YTD
AstraZeneca	$2.69	$2.70	$2.77	$2.82	$3.25
Bristol-Myers	$2.88	$2.81	$3.07	$3.30	$3.74
Eli Lilly	$3.26	$3.21	$3.06	$3.08	$3.22
Glaxo	$3.18	$3.35	$3.46	$3.62	$3.26
Merck	$3.08	$3.04	$3.13	$3.28	$3.54
Pfizer	$3.13	$3.15	$3.19	$3.42	$3.53
Sanofi	$3.46	$3.68	$3.87	$4.02	$4.32

Source: Capital IQ, a division of Standard & Poor's. YTD = Year to date.

Again, because of idiosyncrasies of reporting revenue, it's best to focus on trends within a company, rather than the differences between the companies. Still, you can't help but notice what a bang-up job Sanofi is doing in this category.

Note also that nearly every drugmaker has improved substantially in this category. That's not too surprising; sales forces have slimmed down as companies figure out better ways to hawk their products.

The only number that really matters
While we can measure how efficiently drug companies are doing in the individual categories, their bottom-line earnings matter most. Here's how the companies' net margins have fared over the last few years:

Company	2005	2006	2007	2008	YTD
AstraZeneca	19.6%	22.8%	18.9%	19.3%	25%
Bristol-Myers	16.1%	9.8%	11.9%	25.5%	16.3%
Eli Lilly	13.5%	17%	15.8%	(10.2%)	21.5%
Glaxo	21.6%	23.2%	23%	18.9%	19.2%
Merck	21%	19.6%	13.5%	32.7%	37%
Pfizer	17.1%	40%	16.8%	16.8%	23.5%
Sanofi	7.9%	13.6%	18%	13.4%	29%

Source: Capital IQ, a division of Standard & Poor's. YTD = Year to date.

As you can see, there's a lot of variability. In addition, large one-time events, like Pfizer's 2006 sale of its consumer-health division to Johnson & Johnson (NYSE: JNJ), or Eli Lilly's 2008 acquisition of ImClone Systems, can throw off net margins considerably.

In general though, pharmaceutical companies seem to be doing well this year -- although I'd caution that one year doesn't make a trend.

I lied
While many investors think earnings are the most important measure of a company's health, Fools are much fonder of free cash flow. Earnings can be easily manipulated, but meddling with cash flow is more difficult. For pharmaceutical companies, which add to their pipeline by licensing drugs, it's essential to keep an eye on the company's ability to increase its coffers.

Here's a look at how the companies are faring as a measure of free cash flow/revenue:

Company	2005	2006	2007	2008	YTD
AstraZeneca	24.8%	26.1%	21.6%	24.2%	29.4%
Bristol-Myers	5.9%	8%	12.7%	13.4%	13.8%
Eli Lilly	4.2%	18.5%	21.9%	31.2%	11.4%
Glaxo	23.3%	12.9%	20.4%	23.7%	22.7%
Merck	28.2%	25.6%	24.7%	22.1%	1.4%
Pfizer	26.6%	32.1%	23.7%	34.2%	32.8%
Sanofi	18.4%	17.5%	18.8%	24%	N/A*

*Sanofi doesn't release quarterly cash flows.

There's no clear winner here. It's possible that all those severance packages haven't worked their way through the system yet, and that we'll see things pick up in the future.

Doing the same with less
Keep in mind that all measurements of margins are based on the company's revenue. Efficiency measurements are nice, but investors still have to make sure that they're keeping an eye on the net result. If revenue is decreasing substantially, it doesn't really matter if the company is getting a little more efficient.

And besides, cutting costs can only get you so far; eventually the company must develop (or acquire) new drugs to keep the money flowing and investors happy.