VOLUME III: ISSUE XII

MARCH 2013

BEYOND THE PATENT CLIFF

By Charles Bagley
While much concern in 2012 was paid to the fiscal cliff, another looming change approached unnoticed: the patent cliff. Large pharmaceutical companies have used patents on their blockbuster drugs to ensure recession-beating growth during the worst stretches of the economy. Patents in the pharmaceutical sector prevent competitors from imitating the product and provide a quasi-monopolistic control over the market for the drug. The term for patents in the United States is 20 years. However, because many companies file for patents before they even begin clinical trials, the effective term of the patent is much shorter. Due to the FDAs standards for medicine, typically a pharmaceutical company will only have eight years to sell the drug before generics are made. The patent cliff, then, isnt a single day or month. Over the past eighteen months, 27 patent expirations cost individual companies just over $33 billion in sales. The largest patent expirations include Lipitor, which provided $9.5 billion in sales, Plavix, which provided $8.4 billion in sales, and Seroquel, which provided $6.6 billion in sales. As generic drugs are made to compete with brand-name drugs, companies report huge losses in sales. Last year, Pfizer reported an 8.6% drop in sales. The drop in sales that resulted from Lipitors patent expiration accounted for over sixty percent of Pfizers entire loss that year. The introduction of generic drugs resulted in losses for major brands through the first half of 2012. That was the only year since 2008 that the industry experienced losses. Most companies claimed that patent expiration alone caused drops in sales, but Michael Kleinrock, director of research at the IMS Institute for Healthcare Informatics, says there were more causes: The environment in which pharma companies operate has really taken a knock this year at the same time that the big expiries happened. The combination of factors is something that makes a lot of numbers look pretty bad. Todd Evans, director of Pharmaceuticals and Life Sciences at PricewaterhouseCoopers adds that not only the economic state but also unfruitful research and development and health care reform have ushered major drug companies to partnerships with insurers, patient advocacy groups, and nontraditional partners like information technology. One of the most important bellwether events of the last year was the Supreme Court ruling that the Affordable Care Act is constitutional, says Evans. The advance in the health care system marked an important change for major drug companies: they now must make sure that insurers offer their medication. After Obamas reelection, many companies could no longer put off necessary adaptations to their drug research and development. After uncertainty, major firms now know what to expect in the future. And the future looks bright. Most big pharmaceutical companies were affected by major patent expirations over the past 18 months but have also spent a very long time preparing for that eventuality, says Glen Giovannetti, Life Sciences Leader at Ernst and Young. Sure enough, revenues are down, Giovannetti says, but ironically, stock prices of most of the big companies are up. Wall Street is attuned to the fact that, next year, the big companies will again look like growth stocks. One reason for this is that large pharmaceutical companies have altered their strategy. With no new blockbuster drugs to replace old ones, companies are establishing relationships and licensing deals to acquire therapies that will target relatively small populations. In the new age of personalized medicine, there is promise in this approach. These large companies are also poised to move into China and Latin America, markets that used to be unable to offer the same protection to their patents. Still others believe that patent expiries will lead large drug companies to invest in truly innovative science. Analysts at the annual J.P. Morgan Healthcare Conference indicated many examples of recent investment, such as BMSs acquisition of Hepatitis-C drug

Story continued on page 3, Patent Cliff TRADE OF THE MONTH (BBRY) Kevin Goldfarb
Page 4

FIVE QUESTIONS WITH RAY MCDANIEL Matt Evans

Page 2

HOW SERIOUS IS BRAZIL? Jeon Kang

Page 3

INSIDE THIS ISSUE

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mArCH 2013

FIVE quEsTIONs wITH rAY mCDANIEL

CEO, Moodys Corporation
By Matt Evans
Moodys Investors Service is a key player in the global bonds market as a leading provider of credit ratings, research, and risk analysis across 110 countries, Moodys rates the creditworthiness of debt securities on a ratings scale from AAA (highest quality investment grade) to C (lowest quality speculative grade). This scale ranks bonds based on an investors expected loss given default. In 2007, Moodys Analytics was established as a separate entity, offering expertise and experience in non-rating activities such as financial risk management and quantitative analysis through proprietary research and software. I spoke with Ray McDaniel, CEO of Moodys Corporation, who provided us with his insight on what is happening today. Has there been a trend in ratings upgrades for issuers in the U.S. as we move out of the recession? If, so has there been a more positive trend in certain sectors? Our credit ratings analysts issue regular reports that track trends in credit quality, including the ratio of upgrades to downgrades, in the various sectors we rate. Most recently, among U.S. corporate ratings, downgrades have continued to outpace upgrades despite the end of the recession due, in part, to anticipated tightening in fiscal and monetary policy over the medium-term and a corresponding increase in borrowing costs. Thats also been the case in our Public Finance sector, where we have seen more downgrades over the past year, as many issuers deal with challenging conditions. Are ratings affected by presidential elections, and if so, were there increased ratings movements, negative or positive, postelection in November? As CEO, I am not directly part of the ratings process. All of our credit ratings are assigned by a committee of analysts who are responsible for a particular sector. But in terms of understanding how our analysts might approach this process, the results of an election are often one of the many factors our rating committees might consider in evaluating the creditworthiness of a particular credit. In the case of the U.S., our Sovereign ratings team has issued commentary that discusses how political developments related to the financial system, such as the debate over tax rates and spending, could impact their views on credit quality. The implementation of Basel III is designed to increase the stability of the banking system but will conceivably have a negative effect on bank ratings until banks adjust to meet new requirements. Will Moody's adjust its rating methodology to accommodate this transition? How do you feel about the new standards? [...] analysts from our Financial Institutions team have commented a number of times on the credit implications of the Basel III guidelines, and it is part of what they look at when assessing banks credit quality. Our analysts general view is that Basel III can be credit positive to the extent that banks will be required to set up greater capital and liquidity buffers that will result in extra layers of protection, which is positive for most bondholders. However, other elements of the regulations can complicate the picture. For example, banks may need additional support from governments to comply, or have trouble successfully implementing the regulations. Because these factors can be different for various institutions, our analysts examine their impact individually when they rate a particular credit. In addition, Moodys Analytics, a separate division of Moodys that helps companies address financial risk, has developed a number of software programs that help banks examine and adjust their portfolios to prepare to comply with the new rules. On January 23rd Moody's reported a negative outlook for higher education in the U.S. Can you comment on why the action was taken? How, if at all, may students be affected under current university trends or under the actions universities will need to take in order to move toward a positive outlook? Our U.S. Public Finance Group published a report in January in which we Moodys warned that the higher education sector faces challenges from rising costs and tuition price sensitivity, as well as other factors such as lower government spending on research as a result of budget cuts. Its important to note that as a ratings agency, Moodys does not recommend specific actions that institutions need to take. Our analysts noted that universities will need to find ways to cope with changes in the higher education sector as it evolves. For students interested in a career in finance, what was the educational and career path that led you to your position today? What were your interests and ambitions? My path to a career in finance is good evidence that there is no one path. My academic training is as a lawyer, yet I have spent my entire career in business first in the insurance sector and now, for over 25 years, with Moodys. Its probably already obvious to your readers, but generally speaking, arent the most successful people the ones not only with aptitude, but passion? If those criteria are satisfied, the skills and experience they accumulate along the way in many different endeavors will prove valuable in finance. In my case, I studied Political Science as an undergraduate and then, as I said, went on to law school. Along the way, I wrote and even had published several pieces of fiction. So, use me as a case study for many possible paths!

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mArCH 2013

wHArTON uNDErGrADuATE FINANCE CLuB

HOw sErIOus Is BrAzIL?

By Jeon Kang
In the 60s, Charles de Gaulle said of Brazil, le Brsil nest pas un pays srieux or Brazil is not a serious country. A few decades later, another Frenchman, Jerome Valcke, the General Secretary of FIFA, publicly proclaimed that Brazil needs a kick up the backside, unimpressed by the nations progress in preparations for one of the biggest sport festivals in the globe the 2014 World Cup. So really, how serious is Brazil now, less than 500 days left in its countdown clock? Brazil is planning to host the games in twelve cities, widely distributed across the nation, a notable transformation from a heavy southeast and south concentration in 1950 when it hosted its first World Cup. Spreading the venues is an economically strategic first move, considering that more revenue will be generated from the half-million soccer fans around the planet who will be visiting these cities. Many of Brazils airports need significant modernizations to avoid giving bad first impressions to the hundred thousands of enthused soccer fans, many of whom will be visiting the nation for the first time. The transportation infrastructures linking these twelve cities also need a lot of work; it is vital to note the importance of airports and airline networks in Brazil due to the nations vast physical size and the fact that it doesnt have well-established railroad systems. Brazil needs serious capital, manpower, and determination to meet the demand. In monetary terms, the country has recently announced that it will need an extra USD1.7 billion in addition to its initial projections. The Brazilian Audit Court announced that it estimates a hefty price tag of USD13.28 billion to renovate and build stadiums, airports, and other infrastructures to thrill the fans of the Beautiful Game around the world. This is a fifteen percent increase from the initial plan of USD11.58 billion. The increase is due to higher-than-expected price of renovations and accelerating preparation processes. So, business-wise, Brazil is a little surprised but the fifteen percent increase is not enough to daunt the proud Brazilians. The question is how serious are they in terms of meeting deadlines? It is no secret that FIFA, soccers international governing body, and the Brazilian government clashed several times over the issue. Ricardo Tarde, operations director for the 2014 World Cup local organizing committee, is confident that Brazil is moving along at a promising pace and will satisfactorily meet the timeline for the 2013 FIFA Confederations Cup, which is to be held on June as a rehearsal for the World Cup, and the 2014 World Cup. Although FIFA officials are much more relieved assessing Brazils progress now than they were at the 1000-days mark, they are still a bit skeptical. For one thing, FIFA has already twice postponed the handover date for four of the six stadiums to be used in the Confederations Cup and sternly warned that there will be no delays. But, the magnificent Maracan Stadium, which will host both final games of the World Cup and Confederations Cup, cannot meet the deadline given by FIFA, April 15th. The city government of Rio, which has the owneryour one-stop shop for finance

ship of the historic and venerated stadium, said it would not be ready until May. Maracan Stadium is one of the oldest and largest stadiums in the world, and sat 200,000 soccer enthusiasts during the final game of 1950 World Cup. Maracan initially planned to reopen in February 2013, unveiling a 450 million USD makeover. But FIFA secretary Valcke, upon visiting the Arena Castelao, the first 2014 World Cup stadium to be completed, pointed out that he could not make phone calls due to the lack of wireless infrastructure in the region FIFA was assured by the nations communications ministry that it would increase the number of antennas and other wireless network devices around the twelve stadiums. Mr. Tarde and Brazil are hopeful for the financial stimulus that the sixty-four Beautiful Games will generate. Mr. Tarde estimated that the festival would generate USD54 billion for the Brazilian economy. Then the nation will march again to host the 2016 Olympic games the economic figures these two giant events will produce may very well serve as the biggest facilitator of Brazils inclusion in the developed nations club. Without a doubt, there is still a formidable amount of work to be done in order for the passionate Brazilians to boast their prowess not only as the best soccer players but also as a successful host of the sports biggest celebration. An unfortunate nightclub fire that killed 230 citizens on the 500-day mark has diverted the nations attention from the World Cup, prompting millions to show their condolences to the victims and their families. Alarmed by the internationally rising concerns about safety issues, FIFA and Brazil have proclaimed that they are training staff so that stadiums can be safely evacuated within minutes in unexpected situations. Soon, all eyes and ears of excited sports fans around the globe will be on Brazil. The question remains of whether or not Brazil will follow through.

Patent Cliff, story continued from front page

developer Inhibitex and Gilead Sciences purchase of HIV drugmaker Pharmasset. Many believe that large drug companies are likely to continue to build their pipelines via acquisitions and partnerships. Still, the patent cliff has proven to be a challenge for large pharmaceutical companies. While there is an opportunity for growth in the future, whether or not companies will ever be able to reach those opportunities depends on whether or not they can survive the current market. To this end, companies need to restructure their research and development strategies to become more efficient. For instance, AstraZeneca disclosed that 7,300 positions are to be eliminated in the coming year, many from research and development. The move reflects an industry-wide shift from in-house research to contracting research to small labs. Companies that can do so successfully can significantly develop in this changing market.

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mArCH 2013

TrADE OF THE mONTH: sHOrT BBrY

(RIMMor whatever they choose to call it)
By KevinGoldfarb
As you may have heard, Research In Motion is now called BlackBerry, which basically makes them an entirely new company. On top of that, they have come out with two new phones Q10 and Z10 based off of their new mobile OS, BlackBerry 10. After a dwindling of their smartphone market share to a miniscule 2%, a series of product flops, and the perpetual delay of the BlackBerry 10 operating system, it looks like BlackBerry finally has an answer to those forecasting its fall. Why BlackBerry is Misguided: Do not read this article and think I am saying that BlackBerry does not produce good product. Some of their phones are great, specifically, the ones with a full QWERTY keyboard. The takeaway from this should be the following: BlackBerry will fail as long as they continue to keep their focus on the consumer. They need to focus on the corporate and business markets for their phones. Their supposed saving grace is the BB 10 operating system. Upon rollout, however, the company announced that the only phone that can currently run the software is the full touch-screen Z10, with the keyboard-endowed Q10 delayed at least 10 weeks. This means that BlackBerry currently does not sell a currentmodel phone with a keyboard. Sure, you could buy a one- or twoyear old model, but, as they sound, they are one- and two-year old phones that were never as good as one- or two-year old iPhones and Androids. Why did BlackBerry ever think it was a good idea to not sell a phone with a keyboard? People dont buy BlackBerrys because of the amazing apps, sleek design, or super-fast web browsers; they buy them for the keyboard. It is absolutely ridiculous that they would move that far away from their core-competency and operate a full fiscal quarter without selling a keyboarded-phone. They are throwing away their corporate bread-and-butter to go for a consumer that is already being ambushed by Apple and Samsung. It just doesnt make sense. The Risks: The risk to this short is that BlackBerry could be an attractive acquisition target. The risk in this is that the company may be worth much more as part of another company than it is worth as a standalone. Possible tie-ups could include Microsoft, Google, or another tech giant who would be interested in their corporate contracts, BlackBerry Enterprise Server (one of the few bright spots of their performance, which serves as a mobile solutions suite for large companies), and for easier access to the corporate smartphone market. This would obviously have a negative impact on its shares and could result in a substantial downside to this trade. The Trade: This trade is not based on the fact that they dont sell a phone with a keyboard, it is based on the fact that their comeback from dismal performance is dependent on poorly conceived product. I would look for slow sales and sluggish adoption of the BB 10 operating system for confirmation of this thesis and hold for a 3- to 6-month period. This article was written on February 13, 2013, when: BBRY traded at $15.32 Disclosure: I may or may not take a position in this trade in the near future. All data is sourced from Bloomberg or Yahoo! Finance.

[CrEDITs]
Kevin Goldfarb Editor-in-Chief
Vice President of Financial Analysis

shruti shah
Managing Editor

Jasmine Azizi & Alejandro Villero

Assistant Editors

Guilherme Baiardi, Tony murphy, matt Parmett & Teddy Xiong

Senior Financial Analysts

Charles Bagley, JeonKang,Karan Parekh &matt Evans

Financial Analysts

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