Master Thesis

THE AARHUS SCHOOL OF BUSINESS
MSc in Finance and International Business
Authors: Alfredo Galletti Carsten Wong Iversen
Academic Advisor: Tom Aabo
THE VALUE OF MANAGERIAL FLEXIBILITY IN PROJECT APPRAISAL

_________
A CASE STUDY ABOUT THE EXPANSION OF NOVO NORDISK IN LATIN AMERICA
AARHUS, September 2004
ABSTRACT
The objective of the present case study has been the evaluation of the
planned expansion of Novo Nordisk in Latin America for the production and commercialization of human DNA recombinant insulin obtained through a US$ 200 million investment for a production facility in Montes Claros, Brazil, basing on the authors estimations and markets analysis. The evaluation of the investment has been performed through the implementation of the extended Net Present Value methodology, which incorporates the analysis and the evaluation of some Real Options embedded in the investment into the more traditional Discounted Cash Flow approach. While the traditional DCF approach appeared to give a negative NPV to the project; its extension, applying a Real Option approach, gave a positive one. The extra value added by the Real Options examined is then shown to be the value given by the possibility of adjusting the investments base strategy through the implementation of path-dependent tactical decisions (the managerial flexibility). The explicit valuation has been performed on the investment considered on a stand-alone basis, calculated on the authors estimations and hypothesis. Nevertheless, a qualitative approach has been implemented for the value of the project from a groups point of view, analyzing some of the strategic options (strategic flexibility) available by enterprising the project.
The prophet stared at his crystal ball There's no vision there at all The prophet looked and he laughed at me He said you're blind too blind to see [Harris S., Dickinson B.]
TABLE OF CONTENTS
I. II. INTRODUCTION.......................................................................................... I OBJECTIVE .................................................................................................. II
III. SCOPE AND LIMITATIONS .....................................................................III IV. METHODOLOGY....................................................................................... IV 1 THEORETICAL BACKGROUND ................................................................ 1
1.1 1.2 THE NET PRESENT VALUE AND DCF METHODOLOGY .................................. 2
1.1.1 1.1.2 1.2.1 1.2.2 The Basic Methodology.............................................................................................................2 Including Uncertainty in Projects Valuation.............................................................................4 The Basic Financial Option Theory ..........................................................................................5 Real Options............................................................................................................................8
REAL OPTIONS .................................................................................................. 5
INDUSTRY OVERVIEW ............................................................................. 10

2.1 THE PHARMACEUTICAL SECTOR .....................................................................10
2.1.1 2.1.2 2.1.3 2.2.1 2.2.2 2.2.3 2.2.4 The State of the Market.........................................................................................................11 Competitive Drivers in the Pharmaceutical Industry.................................................................13 Porters Five-Forces Analysis .................................................................................................23 Market Characteristics...........................................................................................................25 Market Sectors ......................................................................................................................26 Major Competitors .................................................................................................................27 Future Market Developments: Diabetes Care Pipeline ............................................................28
2.2
THE DIABETES MANAGEMENT INDUSTRY..................................................... 24
THE LATIN AMERICA OVERVIEW.........................................................30

3.1 3.2 3.3 3.4 THE LATIN AMERICAN AREA ......................................................................... 30
3.1.1 3.1.2 3.2.1 3.2.2 3.3.1 3.3.2 3.4.1 3.4.2 Current Economic Situation ...................................................................................................30 The Latin American Pharmaceutical Market .........................................................................31 The Brazilian Pharmaceutical Market ...................................................................................34 Regulatory Framework, Price Setting and Patent Protection.....................................................40 The Mexican Pharmaceutical Market.....................................................................................42 Regulatory Framework, Price Setting and Patent Protection.....................................................45 The Argentinian Pharmaceutical market ................................................................................46 Regulatory Framework, Price Setting and Patent Protection.....................................................49
BRAZIL ............................................................................................................ 34 MEXICO ........................................................................................................... 42
ARGENTINA ..................................................................................................... 45
NOVO NORDISK GROUP .......................................................................... 51

4.1 4.2 4.3 HISTORICAL PERFORMANCE ...........................................................................51 THE ESTIMATION OF THE WEIGHTED AVERAGE COST OF CAPITAL ............. 56 NOVOS SWOT ANALYSIS ............................................................................... 60 A TWO-STEP EXPANSION PLAN ...................................................................... 62
5.1.1 5.2.1
THE EXPANSION IN LATIN AMERICA .................................................62

5.1 5.2
The Rationale Behind the Investment ......................................................................................62 Main Transactions of the Acquisition.....................................................................................69
BIOBRS S.A. ................................................................................................... 65
THE INVESTMENTS OPERATIVE BUDGET .......................................70

6.1 THE PRODUCTION PLANT AS A STAND-ALONE INVESTMENT ....................... 70
6.2 6.3
THE PROJECTS OPERATIVE BUDGETING OPERATIVE ASSUMPTIONS............71 KEY VARIABLES ESTIMATION ......................................................................... 72
6.3.1 6.3.2 6.3.3 6.4.1
Sales Estimation....................................................................................................................73 External Variables ...............................................................................................................77 Internal Factors: The Cost Structure of the Project...................................................................80 Sensitivity Analysis................................................................................................................92
6.4
THE BASE OPERATIVE BUDGET ..................................................................... 90
THE DISCOUNTED CASH FLOW EVALUATION.................................94

7.1 THE BASE CASE: NET PRESENT VALUE ......................................................... 94
7.1.1 7.1.2 7.1.3 7.2.1 7.2.2 Other Factors: Final Growth and Discount Rate ....................................................................94 The Base Case: NPV Calculation .........................................................................................97 Sensitivity Analysis..............................................................................................................100 Probability Distribution Functions for Uncertainty Modelling................................................102 The Monte Carlo Simulation Framework.............................................................................103 The Net Present Value of the Investment..............................................................................111 Competitors Response: The Threat of New Drugs ................................................................112 The Net Present Value of the Investment..............................................................................115
7.2 7.3 7.4 7.5
INTRODUCING UNCERTAINTY: MONTE CARLO SIMULATION ......................102 THE STATIC MONTE CARLO SIMULATION ................................................ 111
7.3.1 7.4.1 7.4.2
THE AUGMENTED MONTE CARLO SIMULATION ...................................... 112 IS THE PROJECT WORTH UNDERTAKEN?...................................................... 116 THE REAL OPTIONS EMBEDDED IN THE INVESTMENT ............................... 118 THE VALUE OF THE ABANDONMENT OPTION (PROTECTIVE PUT) ............. 119
8.2.1 8.2.2 8.2.3 8.2.4 8.2.5 8.3.1
THE VALUE OF THE REAL OPTIONS ..................................................118

8.1 8.2
Applying Black-Scholes to Valuate the Abandonment Option ..............................................120 Problems with the Black-Scholes Framework ........................................................................122 Applying Real Decision Trees to Valuate the Abandonment Option .....................................123 Simulated Value of the Abandonment Option (European Put Option) .................................124 Simulated Value of the Abandonment Option (American Put Option) .................................125 The Value of the Expansion Option (American Call Option) ..............................................127
8.3 8.4 8.5
THE VALUE OF THE EXPANSION OPTION (CALL OPTION) ..........................126
THE VALUE OF THE SWITCH OPTION ........................................................... 131 ADDITIONAL REAL OPTIONS EMBEDDED IN THE PROJECT .........................132
CONCLUSIONS ......................................................................................... 139
BIBLIOGRAPHY................................................................................................. 202
APPENDIX
Sources of Uncertainty and Projects Risk Exposures ....................................................................... 142 The Pharmaceutical Industry: Porters Five-Forces Analysis............................................................ 144 Diabetes-Care Related Products ............................................................................................................ 149 Brazil - Current Situation ........................................................................................................................ 154 Mexico - Current Situation...................................................................................................................... 157 Argentina - Current Situation ................................................................................................................. 160 Novo Nordisk: SWOT Analysis ............................................................................................................ 163 Sensitivity Analysis on 2010 Cash Flow in DKK................................................................................ 169 Sensitivity Analysis on Net Present Value............................................................................................ 172 Distributions Implemented in the Monte Carlo Simulation.............................................................. 176
EXHIBITS
Exhibit 1.1. Exhibit 2.1. Exhibit 2.2. Exhibit 3.1: Exhibit 3.2: Exhibit 3.3: Exhibit 4.1. Exhibit 4.2. Exhibit 4.3. Exhibit 4.4. Exhibit 4.5. Exhibit 4.6. Exhibit 4.7. Exhibit 4.8. Exhibit 4.9. Exhibit 4.10. Exhibit 4.11. Exhibit 5.1. Exhibit 5.2. Exhibit 5.3. Exhibit 5.4. Exhibit 5.5. Exhibit 5.6. Exhibit 5.7. Exhibit 5.8. Exhibit 5.9. Exhibit 5.10. Exhibit 5.11. Exhibit 5.12. Exhibit 6.1: Exhibit 6.2: Exhibit 6.3: Exhibit 7.1: Exhibit 7.2: Exhibit 7.3: Survey evidence on Capital Budgeting methodologies......................................... 179 World Market: Global Share and Growth Sales, 1999 - 2003............................. 179 Major Mergers and Acquisitions, 2001 - 2003 ....................................................... 180 Brazil Pharmaceutical Industry: Selected Figures.................................................. 181 Brazil: Corporate Rankings, 2003 ............................................................................ 181 Generic Drug Manufacturers in Brazil.................................................................... 182 Novo Nordisk: Major Competitors Revenues Growth ...................................... 182 Novo Nordisk: ROIC Tree, 2000 - 2003................................................................ 183 Novo Nordisk: Major Competitors ROIC............................................................. 183 Novo Nordisk: Major Competitors P/E Ratios.................................................... 184 Novo Nordisk: Major Competitors ROE. ............................................................. 184 Novo Nordisk: Major Competitors ROA. ............................................................. 185 Novo Nordisk: Competitors Net Income/Growth. ............................................ 185 Novo Nordisk: Competitors Cash Flow/Growth. ............................................... 186 Novo Nordisk: Competitors P/Sales Ratio. .......................................................... 186 Novo Nordisk: WACC Sensitivity to Debt Rating ............................................... 187 Novo Nordisk: WACC Sensitivity to short-term Premium ................................ 187 Biobrs: Break-down of Sales, 2001 ........................................................................ 188 Biobrs: Exports, 1998 to 2001................................................................................ 188 Biobrs Clients 2001............................................................................................... 188 Biobrs: Balance Sheets, 1999 2002 (BRL thousands)...................................... 189 Biobrs: Balance Sheets, 1999 2002 (US$ thousands)....................................... 190 Biobrs: Income Statements, 1999 2002 (BRL thousands).............................. 191 Biobrs: Income Statements, 1999 2002 (US$ thousands) ............................. 191 Biobrs: Free Cash Flows, 1999 - 2001 (BRL thousands) ................................... 192 Biobrs: Free Cash Flows, 1999 - 2001 (US$ thousands) .................................... 192 Biobrs: Main Financial Ratios, 1999 2002 .......................................................... 192 Biobrs: Net Earnings, 1995 2002 (BRL) ........................................................... 193 Biobrs: Yearly Net Earnings, 1998 2001 (BRL thousands)............................ 193 Latin America and Caribbean: Demographic Growth ......................................... 193 Novo Nordisk & Biobrs: Income Statements Comparison .............................. 194 Production Costs Estimation - Example................................................................ 195 Selected Countries: Hist. and Forec. Inflation Rates Growth, 1998 2015..... 196 Selected Currencies: Hist. and Forec. Exchange Rates Change, 1998 2015.. 196 Selected Currencies: Standard Dev. of Exchange Rates Growth, 1999 - 2004 196
Exhibit 7.4: Exhibit 7.5: Exhibit 7.6: Exhibit 7.7: Exhibit 8.1. Exhibit 8.2.
Static M. C. Simulation Results: IRR....................................................................... 197 Static M. C. Simulation Results: PV of Terminal Value of Investment............. 197 Aug. M. C. Simulation Results: IRR ........................................................................ 198 Aug. M. C. Simulation Results: PV of Terminal Value of Investment .............. 198 Abandonment Option Based on Sim. Savage and Terminal Values Prob........ 199 American Call Option Decision Tree ..................................................................... 201
TABLE OF FIGURES
Figure 1. Figure 2. Figure 3. Figure 4. Figure 5. Figure 6. Figure 7. Figure 8. Figure 9. Figure 10. Figure 11. Figure 12. Figure 13. Figure 14. Figure 15. Figure 16. Figure 17. Figure 18. Figure 19. Figure 20. Figure 21. Figure 22. Figure 23. Figure 24. Figure 25. Figure 26. Figure 27. Figure 28. Figure 29. Figure 30. Figure 31. Figure 32. Figure 33. Figure 34. Payoffs From Positions in European Options-----------------------------------------------5 Option Replication -------------------------------------------------------------------------------5 Value of a Call Option ---------------------------------------------------------------------------6 Pharmaceutical Sales by Geographic Region, 1999 2003 (US$ billion) ------------- 11 Global Pharmaceutical and Biotech Alliances by Party, 1990 - 2002 ------------------ 17 R&D Spending: EU - US Pharmaceutical Companies, 1990-2000 (US$ billions) --- 19 R&D Spending as Percentage of Sales, 2000 (US$ million) ----------------------------- 20 Pharmaceutical Industry: Five-Forces Analysis -------------------------------------------- 24 Selected Countries: Projection of Population with Diabetes , 2000 2030 --------- 24 Therapeutic Areas in the Global Pharmaceutical Market -------------------------------- 25 Sales Forecast for the Global Diabetes Market, 1992 2010 (US$ Million) --------- 26 Diabetes Management Industry Segmentation, 2002 ------------------------------------- 27 Diabetes Care Industry, 2002 ----------------------------------------------------------------- 27 Latin America Main Indicators Growth, 1995 - 2003------------------------------------ 31 Latin America Health Care Sales and Growth, 2000 2002 (US$ Million)----------- 31 World Drug Price Index Real GDP Per Capita, 2002---------------------------------- 33 Brazil: Therapeutic Areas, 2002 -------------------------------------------------------------- 35 Brazil: Medicines Import Export, 1990 2000 (US$ million) ------------------------ 36 Brazil: R&D Investment, 1995 2000 (BRL thousands) -------------------------------- 37 Brazil: Generics Sales And Market Share, 2000 2003 (US$ thousands) ------------- 37 Mexico: Medicines Import Export 1990 2000 (US$ million)----------------------- 43 Mexico: R&D Investment 1990-1995 (US$ Million)------------------------------------- 43 Mexico: Market Concentration, 1974 - 1998 ----------------------------------------------- 44 Argentina: Pharmaceutical Sales, 1998 2002 (US$ million)--------------------------- 46 Argentina: Sales By Companys Nationality, 2002----------------------------------------- 48 Argentina: Generics Sales And Price Index Movement 2002 (ARS)------------------- 48 Argentina: Pharma Demand Segmentation 1995 - 2001 --------------------------------- 49 Novo Nordisk: Sales by Geographic Region, 1999 2003 (DKK million) ---------- 51 Novo Nordisk: Sales by Therapeutic Area, 1999 2003 (DKK million) ------------- 51 Main Competitors: Growth on Revenues, 2000 - 2003 --------------------------------- 52 Novo Nordisk: EBITA as Percentage of Revenues, 1999 2003 (DKK Million) -- 53 Novo Nordisk: Cost Composition As % Of Turnover, 1999 2003 ----------------- 53 Novo Nordisk: Free Cash Flow, 1999 2003 (DKK Million)-------------------------- 54 Novo Nordisk: After-Tax ROIC and WACC, 2000 - 2003 ----------------------------- 54
Figure 35. Figure 36. Figure 37. Figure 38. Figure 39. Figure 40. Figure 41. Figure 42. Figure 43. Figure 44. Figure 45. Figure 46. Figure 47. Figure 48. Figure 49. Figure 50. Figure 51. Figure 52. Figure 53. Figure 54. Figure 55. Figure 56. Figure 57. Figure 58. Figure 59. Figure 60. Figure 61. Figure 62. Figure 63. Figure 64. Figure 65. Figure 66.
Novo Nordisk: Sources Of Finance, 1999 2003 (DKK Million)--------------------- 55 Novo Nordisk: Exchange Rate Variation and Impact on EBIT, 2003 ---------------- 55 Novo Nordisk - KFX Index: Daily Returns, 1998 - 2004 ------------------------------- 57 Novo Nordisk Adjusted KFX Index: Daily Prices, 1998 - 2004 --------------------- 57 Biobrs: Break-down of sales 2001 ---------------------------------------------------------- 66 Biobrs: Revenues Evolution, 1988 2001 (US$ million) ------------------------------- 67 Biobrs: Free Cash Flows Evolution, 1989 2001 (US$ Million) --------------------- 67 Biobrs: Cost Structure, 1999 - 2002 -------------------------------------------------------- 68 Projects Timeline ------------------------------------------------------------------------------- 71 Investments Operations----------------------------------------------------------------------- 72 Direct Diabetes Costs, 2000 ------------------------------------------------------------------ 74 Biobrs and Novo Nordisk: Ratios as % of Revenues, 2001 and 2003 --------------- 81 Novo Nordisk: Incidence on Production Costs, 1999 - 2003--------------------------- 82 Wages Comparison: Brazil Denmark, 2000 ---------------------------------------------- 83 Novo Nordisk: Net Turnover and Fixed Costs Growth, 2000 - 2003 ---------------- 85 Novo Nordisk: Change in NWC Composition, 1999 2003 (DKK million)-------- 87 Novo Nordisk: Change in NWC, 1999 2003 (DKK million)------------------------- 87 Novo Nordisk: Assets Composition, 1999 - 2003 ---------------------------------------- 88 Free Cash Flow Sensitivity, 2010 (DKK millions) ---------------------------------------- 92 Free Cash Flow Sensitivity, 2010 (DKK million) ----------------------------------------100 NPV Sensitivity: Final Growth Rate (DKK million) -----------------------------------101 NPV Sensitivity: WACC (DKK million) --------------------------------------------------102 Selected Countries: Hist. and Forec. Inflation Rates Changes, 1998 - 2015 ---------104 Selected Countries: Forecasted Exchange Rates Changes, 2005 - 2017 -------------105 Selected Countries: Historical Exchange Rates Changes, 1998 - 2004 ---------------105 Sales Growth: Neg. Effect Of New Drugs Entering The Market---------------------113 Projects NPV: New Drug Impact - Year of Market Entry, 2007 2010------------114 Simulations NPV Comparison --------------------------------------------------------------116 Protective Put Payoff Diagram --------------------------------------------------------------119 Cash Flows With and Without Exercising the Abandonment Option, 2017--------123 Expansion Call Payoff Diagram ------------------------------------------------------------127 Switching Option Payoff Diagram (Same Exercise Price) ------------------------------131
LIST OF TABLES
Table 1. Table 2. Table 3. Table 4. Table 5. Table 6. Table 7. Table 8. Table 9. Table 10. Table 11. Table 12. Table 13. Table 14. Table 15. Table 16. Table 17. Table 18. Table 19. Table 20. Table 21. Table 22. Table 23. Table 24. Table 25. Table 26. Table 27. Table 28. Table 29. Table 30. Table 31. Table 32. Table 33. Table 34. Table 35. Analogy Between Financial Options and Real Options ...................................................8 Top Pharmaceutical: Sales and Market Share, 2003 (US$ billion) ................................12 Healthcare Spending as % of Gross Domestic Product, 1998......................................14 Parallel Imports Within Europe, 1997...............................................................................16 Pipeline: Insulins ...................................................................................................................28 Pipeline: Oral Antidiabetics.................................................................................................29 Pipeline: Late-stage Development of Insulin Using new Delivery Systems................29 Latin America: Healthcare Data, 2003...............................................................................32 Brazil: Facts............................................................................................................................34 Brazil: Pharmaceuticals Consumers Segmentation, 2001............................................39 Mexico: Facts ......................................................................................................................42 Argentina: Facts ..................................................................................................................46 Novo Nordisk - KFX Index Beta Estimation..............................................................58 Novo Nordisk: SWOT Analysis ......................................................................................60 Biobrs: Cost Structure, 1999 2002*............................................................................68 Biobrs: Main Financial Ratios 1999 2001*................................................................68 Variables Clusters ..............................................................................................................73 Insulin Share of Pharmaceutical Sales, 2000 (US$ million) .........................................74 Estimation of Novo Nordisk Sales in Latin America, 2007 (US$ million) ...............75 Selected Countries: Estimated Sales Growth, 2008 2016 (Percentage)..................76 Selected Countries: Historical and Forecasted Inflation Rates, 2003 2016 ...........77 Brazil: Inflation Differentials and Expected Exchange Rates, 2004 2016............78 Selected Countries: Insulin Price Estimation in Local Currencies, 1999 ..................79 Selected Countries: Estimated Insulin Prices, 2007 2016 (Local Currencies) .......80 Cost of Sales and Distribution Growth ..........................................................................85 Montes Claros Investment Budget: Income Statements, 2004 2016 (BRL).........91 Montes Claros Investment Budget: Income Statements, 2004 2016 (BRL).........91 Free Cash Flow Sensitivity, 2010 (DKK)......................................................................92 Base Case: NPV Calculation.............................................................................................98 Free Cash Flow Sensitivity, 2010 (DKK) .................................................................... 100 NPV sensitivity: Final Growth Rate (DKK million) ................................................ 101 NPV sensitivity: WACC (DKK million) .................................................................... 102 Monte Carlo Simulation: Variables, Distributions, and Variances .......................... 103 Simulation results Net Present Value of the Project (DKK million) .................. 111 Impact of New Drugs on the Projects NVP: Year of Market Entry..................... 114
Table 36. Table 37. Table 38. Table 39. Table 40. Table 41. Table 42. Table 43. Table 44. Table 45. Table 46. Table 47. Table 48. Table 49. Table 50. Table 51. Table 52.
Probabilities of FDA Approval and Year of Market Entry...................................... 115 Sales Growth: Negative Effect of New Drugs Entering the Market...................... 115 Augmented Simulation results Net Present Value of the Project ........................ 116 Simulation Results Terminal Value of the Investment, 2017 ............................... 120 Abandonment Option Based on Sim. Savage and Terminal Values Prob............. 123 Simulation Results NPV with EU Abandonment Option (DKK million) ........ 124 Simulation Results NPV with EU Abandonment Option Detail..................... 124 NPV with American Put Option .................................................................................. 126 Simulated Project NPV by Year of Expansion and Effect of New Drugs............ 128 Year of Information Availability for Competitive Products .................................... 129 Weighted Probabilities of New Drugs Rejection ...................................................... 129 Probability of New Drugs Rejection by Year ............................................................ 129 NPV of the Scaled-Up Project ...................................................................................... 130 Production Shift: Status Quo......................................................................................... 134 Production Shift: Possible Outcomes .......................................................................... 135 Location Shifting Opportunities ................................................................................... 135 Tax Shopping Opportunity............................................................................................ 137
Foreword
As most students might have experienced during their academic career, the choice of a topic for a Thesis is not an easy task to perform. Often it is necessary to decide among many charming alternatives, which often are mutually exclusive. Theoretical researches might have indeed a more prestigious academic value, while practical applications of economic and financial theories have the clear advantage to make the authors face real problems and deal with the limitations and necessary adaptation of theory to real life complexity. The second alternative appeared indeed more appealing to the authors, considering the dissertation as the final trait dunion between the theory learnt during the last two years and its application and implementation in the real world, challenge that the authors will (hopefully) face with success for many years to come. And real problems are what it had been faced indeed. The almost complete lack of information about whatsoever related to the project, and the Novos unwillingness to share its knowledge regarding any aspect of the investment, forced the authors to change, adapt and build the whole framework, which differed in the end quite much from the original plan. To quote Lillian Hellman, the famous play writer, nothing you write, if you hope to be good, will ever come out as you first hoped. What started as an insider analysis of the investment (therefore from Novos point of view) abruptly turned to become then an external inspection on the project. Somehow, the paper is an example of fundamental analysis over the recent implementation of Novos strategy in Latin America, performed by a two-people team whose aim is to decide whether this strategy is a profitable one, or simply a bad one. Is Novos investment in Brazil able to add value to the groups shares? Or will it be detrimental? How is it possible to fill the blank spaces in the investments framework, when information is not available? What kind of analyses is necessary for being able to take educated guesses regarding the investments cost structure, inflation rates in Argentina, the price response of insulin to inflation in Mexico, or Novos WACC variance during the years? Where the value for Novo comes from? From the investment itself, or from the possible options that this investment gives? This case study might be considered as a rough, back-of-the-envelope evaluation, based on no insider information. But it is an evaluation based on the authors assumptions and brain-storming teamwork, where nobody elses estimations or forecasts have been taken for granted. To conclude, as Uncle Scrooge replied to his employees complaining about the crappy oldfashioned goldmine in Klondike, this is the best, most modern mine in the Worldthat we could afford.
Alfredo & Carsten
The Value of Managerial Flexibility in Project Appraisal A Case Study About the Expansion of Novo Nordisk in Latin America
I - Introduction
I.
INTRODUCTION
For most companies, capital budgeting decisions are still based on the implementation of basic discounted cash flow methodologies. Often though, these traditional approaches may not be enough to properly evaluate investment possibilities and to illustrate, to those individuals deputed to the final decisions, the real value of a project for the company. The Discounted Cash Flow (DCF) methodology is, of course, an extremely useful tool for achieving a basic understanding of investments fundamental dynamics and outcomes. Nowadays, sophisticated scenario analysis and simulation techniques allow firms management to clearly recognize and forecast possible factors and variables and their impact on their projects cash flows, providing a fair landscape of what can go wrong (or fine), and a reasonably precise quantification of an investments upsides and downsides. Often though, many factors are not under managements direct control as competitive dynamics and macroeconomic variables cant be decided or influenced most of the times. Companies headquarters, then, have no choice, from a DCF point of view, but passively witness the development of their projects affected by unpredictable situations that cant be changed. However, executives have the possibility to influence additional factors related to their projects. An extremely positive project can be scaled up. On the other hand, a disastrous one can be abandoned. What traditional DCF approaches fail to recognize, is the extra value added by the managements ability to react to situations during the projects life. Those in charge; have the opportunity to plan, follow and adjust their strategies according to each state that may occur. Several times, investments are justified by strategic or tactical reasons and they are not limited to their intrinsic Net Present Value (NPV). But what is this strategic extra value? And most important, is the magnitude of such extra value big enough to compensate for possible negative outcomes? This case study will try to analyze; from both a qualitative and a quantitative point of view; the added value provided by opportunities that companys management may encounter and use to adjust its strategy during the life cycle of a project. In other words, these study intents to quantify and qualify the value given by the strategic flexibility.
Alfredo Galletti Carsten Wong Iversen
II - Objective
II.
OBJECTIVE
The objective of the paper is to set up a framework for the evaluation of a project, both in its intrinsic net present value (through a Discounted Cash Flow methodology) and in the extra value added by a particular form of managerial flexibility embedded in the investment. The framework will be put in practice through its application to a real case: the analysis of the planned expansion of Novo Nordisk in Latin America, implemented through the acquisition of one of its biggest competitors in Brazil (Biobrs S.A.) and the enhancement of its production facilities through an investment of US$ 200 million.
II
III Scope and Limitations
III.
SCOPE AND LIMITATIONS
The scope of the paper is to evaluate a real project, and quantify the value added by a particular switch real option (abandonment and scale up options) embedded in the investment under analysis. The valuation has been performed on the prospected US$ 200 million investment in Montes Claros (Brazil) by Novo Nordisk for the production and commercialization of human DNA recombinant insulin in Latin America. Nevertheless, the prospected case study had to face two sources of limitations. The first one refers to the authors choice to focus on the project only as a stand alone one for the quantitative analysis. Therefore the possible extra value added to the project for being a tile of a broader group strategy wont be investigated, at least from a quantitative point of view. Moreover, among the possible real options embedded in the stand alone investment, it has been decided to focus only on the explicit evaluation of a particular case of real switch option, composed by a protective put option to abandon, and a scale up call option. The second set of limitations is represented by the information unavailability. Due to companys information disclosure limitations, Novo Nordisk wasnt allowed to share any detail information regarding the investment with the authors, apart from the ones published in the publicly available documentation (such as annual reports, investors presentations and SEC filings). Moreover, giving the peculiarity of the Companys business and of the geographical area involved, freely available information is scarce and fragmented. Most of the case study has then being based on a wide range of hypothesis set up by the authors (detail description will be presented in each chapter). Even though these limitations have the power to influence the results quite consistently, with the possibility to undermine the precision of the quantitative results and making them diverge from Novos evaluations; the study reflects the possible external agents point of view on the matter. In addition, what has been considered a more important issue; is the methodology applied to the case study, not its precision. The core point of the paper is to demonstrate and apply an evaluation framework to a real case, and try to explicitly quantify the value added by a particular case of managerial flexibility given by the switch option embedded in the investment.
III
IV - Methodology
IV.
METHODOLOGY
In order to achieve the purpose of the case study, the methodology that has been followed is resumed in the below figure:
The paper will begin providing a brief presentation of the theoretical background that lies at the base of the evaluation methodologies implemented throughout the case study. In detail, discounted cash flow and option evaluation techniques will be presented in their fundamental features. After the brief theoretical overview, the paper will start proceeding through the projects evaluation basic steps. In order to perform an investments examination, in fact, a number of basic analyses are required to be performed. First a comprehensive industry breakdown will be presented, performed through the exploration of its peculiar characteristics and dynamics, and its most important value drivers and possible developments. To complete the industrial landscape, a quick general review regarding political, economical, sociological, technological, environmental and legal factors will be performed. An examination of the countries which the project will relate to is essential. After the general industry analysis then the paper will proceed to the second step of the framework, represented by a more detail investigation of the Latin America landscape, both from a general and a pharmaceutical market focused point of view, underling its main characteristics and peculiarities. After completing the operative business and geographic landscape, the paper will focus on the projects implementation. Thus the main actor, Novo Nordisk, will be briefly analyzed through an historical performance analysis, the calculation of its Cost of Capital (that will used later during the projects evaluation), and through an in-deep analysis of the companys strengths and weaknesses, and the available opportunities and threats that it may face in the future. Once this initial and necessary overview is completed, the paper will finally get deeper into the prospected investment. First; a quick outline of the strategic reasons behind
IV
IV - Methodology
Novos choice will be shown, analyzing motivations and factors that influenced the companys decision and studying the major steps of the planned strategy of implementation. In addition, a brief presentation of the acquired company, Biobrs S.A., will be introduced. Once the fundamental tiles of the framework will be posed, the paper will finally focus of the evaluation of the investment through the implementation of a Discounted Cash Flow methodology. Based on the previous analyses; the cost structure of the project, budget plan, scenarios when needed, and the key external/internal variables with their possible fluctuations will be assessed; followed by the estimation of the potential outcomes. Obtained an estimation of the projects net present value, it will be finally the time to define and quantify the extra value added by the managerial flexibility, represented by the switch real option embedded in the investment. Finally, a brief qualitative discussion of other possible real options, both from a stand alone and a group strategy point of view will be presented.
1 Theoretical Background
THEORETICAL BACKGROUND
One of the cornerstones of the modern finance theory states that the value of an asset equals the discounted present value of its expected future cash flows. Accordingly, firms considering capital investments, and whose objective is represented by the maximization of their value, should use the Net Present Value (NPV) as decision rule: reject the project if the NPV is negative. Several methods, other than the NPV rule, can be indeed used in the process of deciding whether or not those investments are worth to be undertaken. These techniques are: the extended NPV, Payback Period (PBP), Discounted Payback Period (DPBP), Internal Rate of Return (IRR), Average Rate of Return (ARR), Economic Value Added (EVA) and Real Option Valuation (ROV) methods amongst others1. Even though more than one technique can then be implemented to estimate the value of an investment, and companies indeed usually apply a combination of two, three and even four methodologies on their project appraisal processes, the two most used methods are the Net Present Value and the Internal Rate of Return2.
According to a survey performed by Mekonnen and Akalu (2002), around two thirds of the surveyed companies uses more than one valuation method. The most used popular single method was the NPV with almost 14%, followed by the IRR with around 11%. Furthermore, their evidence reveals that companies tend to use more than one technique at the same time. The author suggests that, of those surveyed companies that used combined methods, 35% of them employed four valuation methods. The percentage of companies that used two models at the same time was 30% and those that used the mixture of three techniques arose 27%.
1
Appraisal Methods Used NPV IRR PBP ARR Combined methods
% 13.7 10.3 6.8 3.4 65.8
Amount of Methods Used Two models There models Four models Others
% 30 27 35 8
2 Regarding capital budgeting and according to Graham and Harvey (2002), most companies follow the academic theory and use the discounted cash flow and the net present value techniques to evaluate new investment projects. Most surveyed companies mentioned net present value and internal rate of return as their most common capital budgeting techniques; 74.9% of CFOs always or almost always used NPV and 75.7% always or almost always used IRR (see Exhibit 1.1). The authors note, however, that firm size significantly affects the practice: large companies are more likely to use NPV and small ones tend to rely on the payback technique. Other than NPV, IRR and the hurdle rate, the payback period was the most frequently used capital budgeting technique (56.7% always or almost always used it), even though it ignores the time value of money and the value of cash flows beyond the, usually arbitrary, cut-off date. The results suggested that small firms used the payback period almost as frequently as they used NPV or IRR. The attractiveness of the technique may respond to its simplicity added, in some cases, to the managements lack of expertise with the more complicated techniques. Although Real Option Valuation techniques are fairly new and complex due to its quantitative applications, more than one-fourth of the companies affirmed to utilize them.
1.1
The Net Present Value and DCF Methodology
The use of the DCF method for capital budgeting and valuation is well-established in finance theory and practice.3. While originally conceived primarily in response to compound interest problems; modern literature has broadened the application of the DCF techniques, particularly in relation to capital budgeting and security valuation. Relative newcomers with deep conceptual thoughts such as Irving Fisher provided careful theoretic foundations. In 1930, Fisher showed that any asset or liability can be valued by discounting its generated expected cash flows at a rate that reflects the risk carried by the asset or liability4. The simplicity beneath this methodology made its implementation widespread, not only as a project appraisal technique, but also in the valuation of financial investments such as stocks and bonds. As previously underlined, the fairly simple decision criterion in a DCF approach is one of the reasons for its extensive use in the financial World. Project appraisal techniques, basing on the use of the cost of capital in the discounting of future cash flows, use the net present value as reference criterion in investment decisions: a project is accepted if its NPV is positive, otherwise is rejected. The standard technique for calculating the NPV based on the expected cash flows discount at an appropriate rate has not changed much since Fisher. 1.1.1 The Basic Methodology
The Discounted Cash Flow (DCF) method discounts the expected future cash flows to calculate the Net Present Value (NPV) of an investment. The NPV can be calculated as follows5:
NPV =
t =0
FCFt (1 r ) t
(1.1)
Where FCFt is the expected free cash flow for period t, and r is the appropriate riskadjusted discount rate (the opportunity cost of capital) and n the total periods of the
3 This meticulous treatment dates back at least to the Old Babylonian period of 1800-1600 B.C. See Shrieves and Wachowicz (2000). 4 See Dullaway (2001). 5 See Butler (2000).
projects life. For projects investment valuation, the Weighted Average Cost of Capital (WACC) is often used6. Some companies use arbitrary inflated discount rates (burden rates) based on rules of thumb and are often 3-4 times the companys WACC7. When projects are expected to have very long existence, this technique is applied by valuating a detailed-forecast period and the terminal value (also known as continuing value) of the project. The terminal value can be calculated with the following formula8: ContinuingValue = FCFt +1 /( r g ) (1.2)
Where FCFt+1 is the free cash flow of the subsequent period to the last detailed forecast period, r is the opportunity cost of capital and g is the final growth of the free cash flows. The DCF methodology, with its fairly simple decision rule (positive NPV implies the enterprise of the investment; a negative one means its abandonment) is straightforward to use and it works fine in stable environments since the basic assumption of this technique is that market uncertainty is low. Hence, all opportunities are estimated on current information and there will be no possibility to make decisions in the future9. In the absence of managerial flexibility, the NPV of both, certain and risky cash flow streams, is a sound project valuation method which is consistent the firm's objective of maximizing shareholders' wealth. DCF then is a valid approach under low uncertainty. Thus, when uncertainly is high and flexibility is important, the DCF should not be used alone as the main valuation method10. Most business environments are exposed to a variety of risks and uncertainty that my affect the results of the related projects, deviating their cash flows from initial estimations. Firms, during their activities, are exposed to different types of risks11, such as operational risks, interest rate and exchange rate risks, competition risk and market-demand risks, technology risks and country risks (for a detailed analysis of uncertainty and projects risk exposures refer to Appendix A). Hence, evaluations without considering uncertainties that projects may face, can turn highly inaccurate and with serious consequences.
See Copeland and Keenan (1998). See Dixit and Pindyck (1995). 8 For the derivation of the formula and alternative formulas refer to Copeland et al. (2000). 9 See DSouza (2002). 10 See Copeland and Keenan (1998). 11 See Trigeorgis (1999).
6 7
1.1.2
Including Uncertainty in Projects Valuation
A common method to include uncertainly is performing a simulation with the purpose of reproduce the outcomes of a project involving one or more random variables. In order to complete the analysis, assumptions of the variables distributions then must be specified, and the higher the number of simulation iterations performed, the more precise the results. A widespread example of a simulation technique is the Monte Carlo simulation12. Other frequently-used technique to include uncertainty is the performance of scenario analysis, in order to valuate each of them and their respective outcomes. Each scenario is assigned a weight or probability to occur, and the overall result of the evaluation is the average of all the scenarios outcomes weighted by their probability to happen. These methodologies, as most of valuation techniques, require the evaluation team to perform a number of basic analyses. First, an in-deep analysis of the companys strengths and weaknesses, the available opportunities and threats that it may face (also know as SWOT analysis). In addition; in most situations, an examination of the countries in which the project will interrelate is essential. Therefore and when necessary, a review regarding political, economical, sociological, technological, environmental and legal factors of the related countries has to be performed as well (know as PESTEL analysis). Moreover, the team has to carry out an assessment of companys past performances, cost structures and all relevant financial ratios. Based on these analyses, the team should be able to build up the cost structure of the project, budget plan, scenarios when needed, and the key external/internal variables with their possible fluctuations, estimate the probable project outcomes and finally assess its the viability and, when present, the real options embedded in the investment.
12
See Schmidt (2003). Alfredo Galletti Carsten Wong Iversen
1.2
1.2.1
Real Options
The Basic Financial Option Theory
A call option gives the owner the right to buy, a put option the right to sell, an underlying asset at a fixed date (European option) or at any time up to a fixed date (American option) at a specified price (exercise price, EX). The payoff of the respective option depends on the price of the underlying asset (Pt) at the exercise date. If the price of the underlying asset is higher than the strike price (call option) or lower (put option), the option is exercised. Otherwise, it will not be exercised, because the holder would incur a loss. In every option contract there are two sides: The one who holds the option (long position) and the one who sells (writes) the option contract (short position). Thus, there are four possible positions: A long position in a call option, a long position in a put option, a short position in a call option, and a short position in a put option. These four cases are illustrated in Figure 1 for European options with their respective payoffs.
Figure 1. Payoffs From Positions in European Options
Source Schmidt (2003), authors elaboration.
Financial Option Valuation The basic assumption of option theory is that securities which have the same riskreturn profile require an equivalent price and no profit can be made without risk (arbitrage theory). An option valuation is based on a replication portfolio that has
Source Schmidt (2003), authors elaboration.
Figure 2. Option Replication
the same payoffs as the option itself. The option and the replicated portfolio produce a hedge position. Therefore, the owner of the option and the replicated portfolio will earn the risk-free interest rate. The replication principle is depicted in Figure 2.
The higher the uncertainty of the underlying assets value (volatility measured as the standard deviation of the value of the underlying asset), the higher the current value of the option. This is noticeable when examining a call option,
Figure 3. Value of a Call Option
Source: Brealey, Myers (2003), authors elaboration.
the higher the volatility of the underlying asset, the higher the probability for a high price and thus for a high payoff13. In contrast, a low price of the underlying asset does not decrease the payoff, as the lowest payoff is 0. This means that an option gives the owner the chance to earn money while securing him against losing money. Therefore, as shown in Figure 3, the value of a call option is always above or equal to its payoff. There are a few techniques to valuate options, binomial trees, simulation and the Black and Scholes formula. Following, a brief description of each of these methods is presented. Binomial Trees The binomial methodology was originally developed by Cox, Ross and Rubinstein14. The fundamental assumption of the method is that in each period t, the value of underlying asset V either moves up to uV with a probability of p or down to dV with a probability 1-p (where u>1, v<1 and 0p1). The value of a call after period t is either Cu=max(0,uV-V) or Cd=max(0, dV-V) with probabilities q and 1-q respectively. With a risk-neutral probability of p=(r-d)/(u-d), the expected return of the underlying asset is a risk-free rate investment. Hence, its future cash flows have to be discounted back with the risk-free rate in order to calculate its present value15. The value of the call is then: C=[Cu+(1-p)*Cd]*e-rt. Refer to Hull (1997) for a detailed derivation of the formula. (1.3)
See Schmidt (2003). See Schmidt (2003). 15 See Brealey and Myers (2003).
13 14
Simulation Methods Simulation techniques simulate the outcome of a situation that involves one or more random variables. As stated before, the higher the number of trials used in the simulation, the valuation will be closer to the real outcome. In order to perform the simulation, assumptions regarding the distributions of the random variables must be set. This method is useful for options which payoffs are dependent on past values of particular variables or where there is more than one underlying variable16. The Black-Scholes Formula Developed in 1973 by Fisher Black and Myron Scholes, the model can be used to valuate different types of options, depending on the conditions chosen. The simplest form of the model is used to calculate the value of a European call option on a non-dividend paying stock. A riskless portfolio consisting of an amount of options and an amount of the underlying asset is set up. Assuming no arbitrage and risk neutral preferences of the investor, this portfolio earns the risk-free interest rate r that is observable in the market, since both the option and the underlying asset are affected by changes in the price of the underlying asset. The value of a European call option is obtained applying the following formulas:
Call = [N (d1 ) * P ] [N (d 2 ) * PV ( EX )] P ln PV ( EX ) t + d1 = 2 t
(1.4)
and
d 2 = d1 t
while the value of a European put option is calculated through the put-call parity:
Put = Call + PV ( EX ) P
(1.5)
where Put is the value of the European put option, Call is the value of the call option, EX is the exercise price, PV(EX) is the present value of the exercise price discounted by the risk-free rate r, P is the price of the stock, is the volatility per period of the return on the stock, t is the number of periods to the exercise date, N(d) denotes is the cumulative normal probability of d.
16
Assumptions of the Black and Scholes Model: The stock pays no dividends during the option's life, European exercise terms are used, markets are efficient, no transaction costs are charged, interest rates remain constant and known, and returns are lognormally distributed. 1.2.2 Real Options
The real options theory is the application of the options concept to real assets. The concept is to evaluate options that are related to real assets or option that are embedded in investments projects. Examples of real option can be a delay or waiting to invest option (immediate and later expansion), growth options (choice to enter a new market), flexibility option (one central plat or two plants in different locations), exit options (closing and/or selling a plant), temporary suspension and switching production options amongst many others. Assuming that real options can be evaluated as financial options (as suggested by the equivalences shown in Table 1), it is feasible to estimate the value to a particular real option. The extra value of the real option can then be used to calculate the total value of a project and then make the investment decision.
Table 1. Variable P EX t r Analogy Between Financial Options and Real Options Financial Option Stock Price Exercise Price Uncertainty Time to expiration Risk-free interest rate Real Option Expected value of the investment project Present value of all fixed costs of the investment Volatility of the project value Time to expiration of the investment opportunity Risk-free interest rate
Source: Schmidt (2003).
However, an investment decision is never based on real options alone. Real options are only giving additional value to a project. They are used together with the DCF models. The real options approach accounts for total risk that the real assets face and total risk can be divided into market risk and private risk. Market risk is measured by the volatility of the underlying asset and the private risk can be calculated by comparing market premiums to market volatilities and comparing the result to the volatility of the underlying asset17. For real options, the concept of option replication also applies. This means that in order to be able to evaluate a real option, it is necessary to find a
17
replicating portfolio that is perfectly correlated to the real option. This is the significant issue about real options, since the replicating portfolio is difficult to construct and real assets are not as liquid and have higher transaction costs
2 Industry Overview
INDUSTRY OVERVIEW
This chapter will present a brief description of the pharmaceutical industry, main characteristics and peculiarities that differentiate it from other more traditional sectors, the forces that govern it and its main competitive and operating drivers. After a general introduction to the pharmaceutical marketplace, the diabetes management industry will be analyzed; first through a brief overview of the disease and its management possibilities, and then focussing on the current state of the industry and the factors that distinguish it from the general healthcare business.
2.1
The Pharmaceutical Sector
The market for pharmaceutical drugs, due to the combined action of an increase rate of life style related pathologies (as diabetes) and a wider awareness and access to proper medication by the largest part of the worlds population, has grown at an exceptional rate in recent years. For more than a half century the pharmaceutical industry has played a major role in the health care sector and the global economy. What started as the commercialization of a few active molecules with disease-fighting properties has become a massive and profitable industry, with a scope that recognizes no borders. Nevertheless, issues surrounding the production of generic drugs, health care reforms, and worldwide competition have led stakeholders in the pharmaceutical market to employ new strategies to maintain a competitive edge. The most evident feature of the pharmaceutical industry is the consistent level of investment in research and development (R&D) activities, whose profitability depends on the level of protection granted to the companys intellectual properties. This characteristic is quite common for all the knowledge-intensive industries. What makes the pharmaceutical industry peculiar is the social and economical environment it operates in. Health is a major issue for every country in the world, so the amount of external or public control the industry is subjected to is exceptional, both towards its products characteristics (formulation, testing, side-effects) and towards their commercialization (price, availability). Demand and offer dynamics within the industry are not, apart from few exceptions, market driven. In addition, pharmaceutical producers around the world have to continuously adjust their tactics (horizontal and vertical consolidation through
10
2 Industry Overview
mergers and acquisitions, legal protection, patent enforcements), and often tune their strategies in order to consider pricing issues, impact of health care policies, demand in relation to third-party payers, systems of health care compensation, and characteristics of the population. 2.1.1 The State of the Market
Market Volumes and Fragmentation According IMS Heath and as shown in Figure 4, global drug sales in 2003 amounted US$ 466 billion, led by North America (Canada and the USA), with 49%, followed by Europe (28%), Japan (11%), Africa/Asia (8%) and Latin America (4%) . There are more than 10.000 manufacturers, but a small group of 100 controls around 90% of the products. The 50 biggest, which jointly account for 65% of total revenues, are all
18
Figure 4. Pharmaceutical Sales by Geographic Region, 1999 2003 (US$ billion)

500 400 300 200 100 0 1999 2000 2001 2002 2003 North A merica Rest of Europe A sia, A f rica and A ustralia European Union Japan Latin A merica
Source: IMS Health (2001), (2002a), (2003b), (2004b), authors elaboration.
multinationals19. America is the biggest producer, but is not a major exporter. Its market absorbs around a third the Organisation for Economic Co-operation and Development (OECD) members outputs and accounts for around s half of the blocs total production. It also has the highest per-capita consumption in the world, margins are higher and doctors are constantly willing to prescribe innovatory drugs, making it a highly attractive market. The biggest multinational exporters are based in Switzerland, Germany, the UK and Sweden, but Belgium, Denmark and Ireland also feature a drugs trade surplus. The Eastern European countries, South Korea, Australia, Italy, Finland and Norway are net importers, as is Japan (the biggest importer in the OECD). At the end of 2003, sales of the pharmaceutical industry in the global market totalled around US$ 466 billion (after adjusting for inflation, the total volume back in 1982 was just under US$ 30 billion). The biggest part of this, at close to US$ 230 billion, was generated in North America (refer to Exhibit 2.1). This situation explains the strategic importance of acquiring and maintaining
18 19
See IMS Health (2004b). See IMS Health (2004b). Alfredo Galletti Carsten Wong Iversen
11
2 Industry Overview
a significant market share in North America for European pharmaceutical companies. The USA is by far the largest and fastest growing market for pharmaceutical products (around 11% ahead of Europe between 1990 and 2000)20, and it also offers the highest margins. The current trend toward globalization leads to pharmaceutical markets without borders and emphasizes the need for companies to gather comprehensive information and to make informed investment decisions. Major Players Even though the 1990s and the first four years of 2000 witnessed a consolidation process of considerable magnitude, the pharmaceutical competitive. industry The top remains quite drug-producers
Table 2. Top Pharmaceutical: Sales and Market Share, 2003 (US$ billion)
Company Merk & CO Johnson & Johnson Glaxo Smith Klein Pfizer Inc Bayer AG Novartis AG Aventis Bristol Myers Squibb Astrazeneca PLC Abbott Laboratories Akzoy Nobel NV Wyeth Eli Lilly & CO Novo Nordisk Others Total Sales 51,8 36,3 34,2 32,4 30,4 23,2 21,7 18,1 17,8 17,7 14,7 14,6 11,1 4,01 138,1 466,0 Share 11,1% 7,8% 7,3% 6,9% 6,5% 5,0% 4,6% 3,9% 3,8% 3,8% 3,2% 3,1% 2,4% 0,9% 29,6% 100%
control more than half of the world market, but only the first one seems to control more than a 10% share21 (see Table 2). The high degree of rivalry among the firms operating in the industry is characterized by consistent R&D and marketing investments22.
Source: www.Quicken.com, authors elaboration.
The two main drivers that ensure a strong and lasting competitive advantage, in fact, are the discovery and production of new and revolutionary products (the so called blockbusters), and the achievement of the widest degree of awareness and commercialization possible. The pharmaceutical industry has many examples of extremely successful and profitable drugs, whose undisputable dominance is the result of a state-of-the-art R&D activities and widespread marketing and commercialization. The first mover advantage is therefore frequently rewarded by elevated margins (generic or bioequivalent drugs tend, in fact, to be less profitable than the original ones). This is sometimes the only possible way to recover the massive financial commitment required by the development and commercialization of the drug. Failing to achieve the creation of
See EFPIA (2002). See Hasenclever (2002, pg. 12). 22 For example, US pharmaceutical R&D expenditures grew from $19 billion in 1997 to over $30,3 billion in 2001, while marketing expenses rose from $11 billion to nearly $16 billion. See Bowonder and Yadav (2002, pg. 7).
20 21
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2 Industry Overview
a blockbuster (situation whose likelihood is considerably high) may in fact mean losses that can reach several million dollars. Nevertheless, nowadays for the major pharmaceutical companies it is not enough to create just few innovative medicines to achieve and maintain their status and their profitability. The increasing pressure by generic drugs (generics in US accounted for 47% of unit volume in 2000 compared with 33% in 1990) that conquer consistent market shares as drug patents expire23 and force significant price reductions (generic competition can make the price of a drug fall up to 80%24), drive the major companies to constantly seek for new frontiers and discoveries in the field in order to maintain their expensive commitments in research and development. 2.1.2 Competitive Drivers in the Pharmaceutical Industry
The pharmaceutical industry is characterized by peculiar features that differentiate it, and its fundamental drivers, from the markets for more common products and services. The analysis of the political, economical, socio-cultural, technological, environmental and legal frameworks (also known as PESTEL analysis) in which the pharmaceutical companies operate in, play therefore a major role within the strategy setting of the companies. Next, a brief PESTEL analysis of the pharmaceutical industry is exposed. Political Environment Besides more common sources of political risk (for example, some developing countries instability may jeopardize investments, for example production facilities), the different political environments in which companies operate may have a strong influence on its activities and operations. Of course, competitors may also be affected in the same way. Political drivers reflect governmental influences on the business environment and how these are likely to affect individual organizations. Worldwide, the governmental organizations present an increased attention towards health care issues, and consequently their expenditure and support towards research and towards drug consumption through
23 24
See PhRMA (2001a). See Fragkakis et al. (2002, pg. 7). Alfredo Galletti Carsten Wong Iversen
13
2 Industry Overview
increasing
welfare
commitment25.
In
addition, healthcare represents a large fraction of the population expenditure (see Table 3), and therefore an important public concern and a major political campaign platform. As a result, governments have progressively tightened their control on the pharmaceutical industry through industrial policies. This policies fall in three distinct lines of intervention: price setting policies, drug approval regulations and commercialization regulations.
Table 3. Healthcare Spending as % of Gross Domestic Product, 1998

Country USA Switzerland Germany France Canada Netherlands Australia Denmark New Zealand Sweden Italy Japan Spain Finland UK Luxembourg Mexico
Source: LEU Investment Research (2001).
% 12,9% 10,4% 10,3% 9,3% 9,3% 8,7% 8,6% 8,3% 8,1% 7,9% 7,7% 7,5% 7,0% 6,9% 6,8% 6,0% 5,3%
Regarding Price Setting Policies, they are dictated by the fact that Governmental institutions worldwide have to continuously face numerous factors in the health sector. Reducing out-of-pocket expenses for prescription drugs has become a priority, while the aging population will drive up the demand for cost-effective healthcare and pressure lawmakers to define a solution for prescription drug pricing. Parallel trading to import cheaper foreign drugs and wider generic drugs availability (through changes in the patent laws), are issues that concern many governments26. Additionally, health crises in emerging economies are creating a demand for cheaper pharmaceuticals, implying a possible general price drop in the markets. Then, as it has been previously mentioned, these factors drive one fundamental characteristic of the pharmaceutical industry: its almost complete absence of an independent market-driven price policy. In most countries, in fact, the pharmaceutical sector is target of government controls regarding price, sale and advertisement regulation. The US is the only developed nation where prices are almost entirely market-driven. The European countries have the longest tradition of regulation due to their public health services and some nations have imposed limits and even compulsory reductions regarding prices. Therefore, it is possible to witness huge price differentials for wholesale drugs; which, in certain, cases can promote parallel import of
A clear example of this commitment is the involvement of the Danish Government into promotion and support of the research, favoring international exchange and cooperation (as in the so-called Medicon Valley between Denmark and South Sweden), and developing biotechnology and ethics in the European Union through the BioTIK plan in 2000. 26 See LEU Investment Research (2001).
25
14
2 Industry Overview
the most expensive products, whose effects might have a considerable impact on the strategy and the overall profitability of pharmaceutical companies27. Moreover; cost control measures imply that, for numerous new products, development costs cant even be covered prior to the patent expiration, meaning high research and development costs to be very difficult to finance. Drug Approval Regulations are inspired by the fact that Governments require severe and detailed research and experimentation in order to avoid unknown and dangerous counter effects. As a result, the development process from the new molecular entity stage to the consumer market may take, in some cases, more than a decade and imply a considerable level of financial commitment (even though international cooperation and mutual recognition agreements are considerably shortening the whole process28). Consequently, bringing innovative products to the market might represent a burdensome process and can consume large amount of resources. Nevertheless, many products approved in clinical trials end up provoking serious problems due to their application under conditions which have not been adequately tested, the atypical reactions of a significant minority of patients or simply overprolonged use29. The situation in developing nations is aggravated by a legislation that
Regarding the possible effects of non-market impositions on prices and dynamics of the market on indicators at the national level have shown statistically significant relationships with market size and R&D expenditure, influencing them on a negative way (the higher the factor, the smaller the related variable). See Agrawal (1999).
27
Factor Price Regulation Price Regulation Approval Time Approval Time

28
Type of influence Negative Negative Negative Negative
On Market Size R&D Expenditures Market Size R&D Expenditures
Now the standard process required to bring a drug to market is established at the International Conference on Harmonization of Technical Requirements for Registration of Pharmaceuticals for Human Use (ICH). The United States, Europe, and Japan have participated for nine years in the IHC in an effort to facilitate reciprocal approvals and shorten the time lapse between development and entrance in the consumer market. The creation of the European Medicines Evaluation Agency (EMEA), which is expected both to shorten total review times and to provide mechanisms for marketing and selling authorizations throughout the whole European Community, reduced considerably the bureaucratic process of mutual recognition, through the Pharmaceutical Evaluation Report plan, among the United Kingdom, Canada, Australia, Italy, Germany, and other countries. The United States and the European Union negotiated a Mutual Recognition Agreement in 1997. For further information, see EMEA (2003). 29 One recent (and notorious) example was Bayers cholesterol-lowering compound, Baycol/Lipobay, withdrawn from the market in August 2001 after having caused the death of 53 people, not to mention more than a thousand cases of muscular atrophy. Alfredo Galletti Carsten Wong Iversen
15
2 Industry Overview
may be less strict and less detailed inspection procedures which are unable to prevent pharmacies from selling potentially dangerous drugs without a doctors prescription30. Commercialization Regulations about the marketing and commercialization of pharmaceutical products can vary from country to country, involving labelling, advertisements, promotional claims, and comparisons. A particularly sensitive area for the pharmaceutical industry is product liability. For example, the pharmaceutical industry in Europe is straitjacketed by a series of rules and market controls. Thus a price war is practically impossible and consumers freedom of choice is sharply limited. Fragmentation of the EU pharmaceutical market individual markets with, in some cases, major price differences is also leading to the creation of a disparity between citizens of different countries. In certain circumstances, drugs availability in particular markets may require a delay of several years. Moreover, the price disparity
Table 4. Parallel Imports Within Europe, 1997
Country Netherlands Denmark UK Germany Austria Finland Belgium; France; Greece; Ireland; Italy; Luxembourg; Portugal; Spain EU Total
Source: EurActiv.com (2003).
Parallel Imports 14% 11% 7% 2% <1% <1% No parallel imports 1.4 %
among countries is also leading to a situation in which the parallel trade phenomenon is growing. In countries like the UK, Netherlands and Denmark, parallel imports already account for a considerable part of the pharmaceutical markets31 (Table 4 shows the figures for 1997). If this factor creates a more favourable situation for the health financial expenditure of both end-users and national institutions, it will negatively affect companies operational margins and market potentialities. Economic Factor The growing aging and incidence of diseases in most industrialised countries and the contemporary opening of developing markets towards import are spreading the potential
However, even if they were to demand a prescription, this would not necessarily resolve the problem: in the US, most doctors prescribe what the patient asks for, even when the medication in question may not be indicated. An estimated 20% of antibiotics in America are prescribed for common colds, which is not only utterly ineffectual (antibiotics have no effect whatsoever on viral infections), but also helps to select new strains of resistant bacteria, creating a health danger which is substantially more serious. As if this were not enough, doctors also accept 90% of requests by patients, who frequently have nothing wrong with them, for anti-depressants such as Prozac. 31 See West and Mahon (2003).
30
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2 Industry Overview
range for an overall growth in the demand for health related products. The recent expansion represents companies Moreover, towards new the involved China in the or for India the sector possibilities pharmaceutical
Figure 5. Global Pharmaceutical and Biotech Alliances by Party, 1990 - 2002

1.800 1.500 1.200 900 600 300 0 1990 1992 1994 1996 1998 2000 2002 Drug/Drug Uni/Biotech Drug/Biotech Uni/Drugs Bio/Biotech
business.
established itself as a defensive growth sector in the 1980s and 1990s, as the economic cycle have virtually no influence
Source: Rasmussen (2003), authors' elaboration.
on demand for healthcare products32. Nevertheless, the industry as a whole is experiencing a merging wave since the last decade (see Figure 5), and it is becoming one of the most important phenomena in the area. The reasons for this consolidation stream are multiple. Anyway, two might be considered the prime ones. First of all, the increasing expenditure level in research required by the sector, forces companies to expand their critical mass to achieve the necessary economies of scale. Secondly, the risk embedded within the expansion towards less developed countries oblige pharmaceutical companies to build structures that can stand and suffer two types of negative impacts: strong appreciations towards local currencies might turn positive growth into an overall decrease in profitability; and lower purchasing power for developing countries may drive western products out of the market through their substitution with considerably less expensive generic drugs manufactured in cheaper markets. The global economys downturn and the rapid opening up of many East European and Southeast Asian markets, together with the ongoing technological progress in information technology and telecommunications; is providing new opportunities and enhancing competition at the same time. New corporate focuses and realignments are inevitable, if firms are to successfully avoid harsher international competition in the long run, through the implementation of merging and acquisition dynamics, and through the formation of strategic alliances. As a result, the pharmaceutical industry is in the midst of
32 In times of crisis, prices of pharmaceutical shares have significantly outperformed the total market owing to their defensive characteristics. Therefore, the pharmaceutical industry has being substantially less affected from downturns in the World economy that influence heavily other branches. For further information, refer to Mehrotra (2002)
17
2 Industry Overview
a consolidation process. Virtually no other sector has experienced such a welter of corporate mergers as pharmaceuticals have over the past few years, even though nowadays this phenomenon keeps on at a considerably slower pace than the past33 (refer to Exhibit 2.2). Socio-Cultural Factors Socio-cultural factors have a large impact on the demand side of pharmaceutical goods. The prices of pharmaceutical products vary widely from one country to another for many reasons (living standards, income levels, consumer preferences, disease patterns, drug consumption patterns, product volume, exchange rates, product liability, regulatory requirements, degree of competition), and prices exercise a strong influence on medicines consumption patterns. Even though the demand for life-sustaining medications is quite inelastic (that is, a significant increase or decrease in prices does not substantially affect the quantity demanded34), is anyhow influenced by the level of income and increases/decreases of patients wealth. High-income patients are not as price sensitive and are able to pay more out-of-pocket for pharmaceuticals than are low-income patients. Therefore, pharmaceutical markets are strongly influenced by the size of the country and the economic segmentation of the population. Thus, the main determinant of pharmaceutical price in a specific country is its per capita income level35. The total population and the percentage of those able to afford drugs are often good indicators of how much drugs will be consumed and how much they are able to spend. It is often influenced by the purchasing power of each segment of the population, as well as by how affordable the out-of-pocket cost is to the consumer.
33 In 2001, for example, there were only 25 deals versus 32 in 2000, and their combined value was only US$ 34 billion, as against the US$ 239 billion recorded the year before. However, this should not be interpreted as a sign that the movement is coming to an end. Even during 2002 and 2003 mergers and acquisitions continued apace. The biggest operation during 2002 was Pharmacias US$ 60 billion purchase by Pfizer, consolidating the latters global sales lead, which was approved by the US antitrust body in December. As a result, Pfizer also gained the outright lead in Brazil, with annual sales of around US$ 300 million. In February 2003 even the European Commission approved Pfizers US$ 56 billion acquisition of Pharmacia, although Pfizer had to shed 5 compounds in order to avoid excessive market concentration Darifenacin (incontinence), Parkemoxin (a veterinary product), Ketensin (arterial pressure) and two experimental erectiledysfunction drugs. The deal was approved by the US in April, with similar impositions. In October, DSM concluded its purchase of Roches vitamin and fine-chemical division after more than a year of negotiations. The division was renamed DSM Nutritional Products. Information and details are extracted from the related companies reports and Marketletter Publication Ltd (2004). 34 See Greczyn (2003, pg. 285). 35 See Schweitzer (1997).
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2 Industry Overview
Age is also a determinant factor in the overall size of a market. Elder population, for obvious reasons, has statistically a higher per-capita consumption of medications. Individuals over 65 years of age consume three times more drugs and hospital services than those under 65, and tend to take several drugs on a daily basis36. Demand is also influenced by cultural beliefs and national idiosyncrasies. For instance, in Japan, doctors receive a margin for each medicine they prescribe and deliver to their patients37. In addition, pharmaceutical costs are 30% of the healthcare budget versus 10% of the US budget. In U.S., the tendency to follow patients requests of unnecessary or no longer necessary drug prescription is somehow quite widespread38. Ethnic origin also appears to be a significant factor in consumer demand for drug prescriptions. For example, the total expense in developing markets averages, as percentage of GDP, vary quite consistently even among comparable countries from the same geographical zone, as for example for the case of Latin America (Argentina 8.0%, Brazil 5.2%, Chile 6.0%, Colombia 8-9%, Mexico 5.5%, Peru 4.4%, Venezuela 1.8%)39. Technology Analysis Technology for pharmaceutical companies is mainly represented by their research and development activities and facilities for one main reason: the companies ability to produce high profits is linked to their capacity to introduce new drug to the market; new products will take a long time to be replicated by competitors, and the
Figure 6. R&D Pharmaceutical (US$ billions)
30 25 20 15 10 5 0 1990 1990 - 1995 EU Pharmaceutical Industry US Pharmaceutical Industry 1995 - 2000
Spending: EU - US Companies, 1990-2000
Source: LEU Investment (2001), authors' elaboration.
marginal production and selling costs of the approved drug is considerably modest. Figure 6 shows the research and development spending in the US and in Europe for the period
See Schweitzer (1997). Till recently, in fact, in Japan there was no distinction between the prescriptive and distributive channel of medicines. Doctors can prescribe and purchase drugs for their patients, and then charge them for the actual cost plus a markup, or in case of refundable medicines, they would apply their markup to their patients reimbursement. For more details, see Watanabe et al. (1999). 38 See Lazarou and Pomeranz (1998). 39 See Sandullo (2003).
36 37
19
2 Industry Overview
New-drug research and development is highly complex and time-consuming, requires massive investments equivalent to around 18.5% of the firms revenues.(see Figure 7). According to the Pharmaceutical Researchers and Manufacturers of America (PhRMA), global R&D expenditure in 2002 totalled US$ 60 billion (US$ 32 billion in America alone). Before a new drug reaches
Figure 7. R&D Spending as Percentage of Sales, 2000 (US$ million)

5.000 4.000 3.000 2.000 1.000 Novo Nordisk GlaxoSmithKline Roche Schering AstraZeneca Novartis 0 Serono Aventis Sanofi 25% 20% 15% 10% 5% 0%
R&D Spending
R&D/Sales
Source: LEU Investment (2001), authors elaboration.
the market it is subjected to a series of procedures, including molecular synthesis/extraction, bio screening, pharmacological, toxicological and safety tests, dosage calculations, stability and bioavailability studies, clinical trials, development of industrial processes, and quality controls. One out of 5.000 to 10.000 compounds under study is authorized for sale. The entire process can last 12 to 15 years, absorbing average investments of several hundred million of dollars40. On the other hand, due to a quite rapid formula replication by competitors and consequent substitution, revenues possibilities might be quickly jeopardized. Since costs and economies of scale are largely irrelevant when it comes down to production, the temptation for small firms to copy existing products is enormous; such outfits can normally offer prices as much as 80% lower than the patent-holder and still turn profit41. In recent years, many countries have previously allowed their industry to legally ignore foreign drug patents (including Brazil); have finally banned the practice following intense diplomatic and economic pressure from the US. India, China, Russia42 and Argentina (the latter until the end of 2003); are also trying to slowly introduce patent protection laws43. Yet others recognize patents but not foreign marketing approval procedures44.
See Findlay (1999, pg. 228). Dimasi (2000). 42 See The Hindu (2004). 43 See Bale (1996). 44 Japan, for example, refuses to consider clinical trials with non-Japanese, alleging physiological racial differences a scientifically dubious argument, to say the least, but providing a handy means of protecting the national drug industry, since most overseas firms are unwilling to bank the additional costs of extensive clinical trials on the Japanese population.
40 41 See
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2 Industry Overview
Nevertheless, patent protection will assure commercial exclusivity for a limited amount of time. After this period, the substance can be freely copied, even in those countries which recognize the validity of the patents, triggering a scramble to produce low-cost generic items. Thus, big firms are under intense pressure to come up with more effective drugs or with ones that can take care of previously untreatable conditions. As a result, big drug firms shares then invariably suffer when patents lapse and they face increasing competition from generics. Finally, another source of risk for R&D activities is represented by the fact that some products on which the manufacturers pin their hopes, are simply rejected by the authorities or are subsequently found to have dangerous side effects and are withdrawn from the market45. However, despite the intrinsic risk, R&D investments are growing exponentially46. Recent advances in genetics, coped with technology and information availability development in the latest years, may result in a spectacular boost in the number of discoveries and increase the possibility of new break-through in the pharmacology field47. Environmental Analysis As populations become more environmentally aware and conscious of their responsibility to preserve the world environment, companies are increasingly forced to take this factor into account in their strategies. The increasing sensitivity towards environment-friendly politics are setting new standards in animal testing procedures and pollution prevention, implying an overall increase companies costs. The recently bioethical controversies might also have an impact on the companies operations.
45 The launch of a new drug represents a very real risk even with increasingly rigorous legislation and clinical trials, the use of medically-prescribed drugs still causes around 100,000 deaths every year in America. Liability lawsuits, either for punitive damages or joint and several liabilities, are likely to increase the cost of research and development owing to the additional costs of ensuring drug safety and of avoiding certain areas of research associated with a high risk of liability costs. 46 An example of strong and increasing commitment to R&D investments is given by the giant multinational Bristol-Myers, for example, that has spent US$ 16.5 billion since 1990 without producing a single sales-leader. See Gardiner (2002). 47 The creation of international research centers (as in Boston or Medicon Valley in the resund region) in cooperation between companies and public structures (as universities labs and hospitals) easies the burden of the overall research and development expenses for companies. The application of new technologies (as HTS) in the field should contribute to the general decrease in the amounts of capital required for an effective research and development activity. See Oxford Research (2002, pg. 91) and Matthews et al. (1999, pg. 604-605).
21
2 Industry Overview
Legal System Apart from the imposed regulatory state shackles over the market dynamics that, apart from some notable exceptions (as US), dont allow market driven price setting, and substantially limit consumers freedom, a primary importance over pharmaceutical companies operations is played by the legal frameworks that operate in each country, and that may differ quite consistently. The most important topic on the subject under discussion is represented, as briefly introduced before, by patent protection and expiration issues, which in the recent years have placed new pressures on the pharmaceutical industry. Today the economic value of an innovation is directly correlated with the length of its legal protection. Managing the legal framework to extend the exclusivity rights on a product has thus become an increasing priority for pharmaceutical companies. The World Trade Organization (WTO) Trade-Related Intellectual Property Rights (TRIPS) agreement requires WTO member countries to make patents available for any inventionswhether products or processesin all fields of technology without discrimination. These patents are of course subject to the normal tests of novelty, inventiveness, and industrial applicability. Patents must be available and patent rights enjoyable without discrimination as to the place of invention or whether products are imported or locally produced48, and during the term of protection availability, a patented molecule is protected from the introduction of generics. Even though competitors can introduce modified molecules designated me-too drugs49, there is evidence that the drug introduced earliest keeps the first mover advantage in terms of market share.
WTO Agreement on Trade-Related Aspects of Intellectual Property Rights, Art. 27, 1: Subject to the provisions of paragraphs 2 and 3, patents shall be available for any inventions, whether products or processes, in all fields of technology, provided that they are new, involve an inventive step and are capable of industrial application. Subject to paragraph 4 of Article 65, paragraph 8 of Article 70 and paragraph 3 of this Article, patents shall be available and patent rights enjoyable without discrimination as to the place of invention, the field of technology and whether products are imported or locally produced. 49 Although patents prevent other companies from producing exactly the same drug claimed in the patent, they usually do not prevent the introduction of similar but slightly differentiated drugs. In many cases, several different chemical entities can be found that use the same basic mechanism to treat an illness. Since patents are frequently obtained on a specific chemical formulation, not on a therapeutic mechanism, many patented products are "functionally similar." Thus, a breakthrough drug--the first innovator drug to use a particular therapeutic mechanism--may have only one to six years, at most, of pure market exclusivity before a similar patented drug (sometimes called a "me-too" drug) is approved by the FDA. See Spoor et al. (1998).
48
22
2 Industry Overview
The impact of patent protection over prices of medicines, and its detrimental effects on the overall expenses and welfare of (especially developing) economies, even though quite consistent, wont be dealt with in the paper50. More relevant for the scope of the dissertation, instead, is the relationship between patent protection and profitability and R&D efforts of pharmaceutical companies51. Inadequate patent protection in foreign countries costs the US pharmaceutical industry several billions of dollars per year
52
and
discourages the diffusion of innovative drugs in developing markets. The countries identified by PhRMA as infringing on international treaties include Argentina, India, Egypt, South Africa, Andean Community, China, Israel, and Turkey53; although, the TRIPS rule breaking behaviour is somehow allowed for particular emergency situations by the WTO itself54. There are several types of patent protection failures, such as: Lack of pipeline protection (an issue not considered by TRIPS) A term of protection shorter than that established by TRIPS A lack of clinical data protection The exclusion of pharmaceutical compounds from patenting Compulsory licensing and mandated local manufacturing. Several confrontations have occurred between producer nations and countries accused of patent infringement regarding the TRIPS agreement and its implementation, especially concerning the transition periods granted55. 2.1.3 Porters Five-Forces Analysis
This model helps to identify the five competitive or driving forces that shape the industry and market. These forces determine the attractiveness of the overall industry. The fiveforce analysis of the pharmaceutical industry and their interactions are summarised in Figure 8 (refer to Appendix B for a more detailed analysis).
As stated above, the issue has not a particular key relevance for the scope of the paper. Nevertheless, for more exhaustive information and empirical evidences related to the topic, the authors suggest the following empirical research: Chaudhuri et al. (2003). 51 For the positive relationship between patent protection and R&D investment and companies profitability, see Petr Hanel and St-Pierre (2002, pg. 305-322). 52 See Frank and Salkever (1997, pg. 75-90). 53 See Holmer (2002). 54 In fact, the Doha round of negotiations exempted the least developed nations from TRIPS requirements and allowed compulsory licensing of pharmaceutical rights, when justified by public health emergencies, until 2016. See WTO (2001). 55 See Correa (1997).
50
23
2 Industry Overview
Figure 8. Pharmaceutical Industry: Five-Forces Analysis
Accordingly, the pharmaceutical industry faces relative low threats from new entrants due to the high entry barriers (high R&D costs and patents protection). In addition, the bargaining power of suppliers is fairly low since they are comparatively small and fragmented businesses. Moreover and in general terms, end-customers have low bargaining power as most drugs are prescribed by general practitioners (GP) and patients are relatively loyal to their brands. On the other hand; the tendency of the industry to reach even higher levels of concentrations and the recurrent cooperation between firms suggest that competition intensity is rather moderate. Additionally, generics and over the counter (OTC) drugs represent a moderate threat in the industry.
2.2
The Diabetes Management Industry

Figure 9. Selected Countries: Projection of Population with Diabetes , 2000 2030 (Million)
France UK Canada Germany Italy Mexico Japan Brazil Pakistan US China India 0 2000 15 30 2030 45 60 75 90
Diabetes is a metabolic pathology in which the body does not produce or properly use insulin. Insulin is a hormone that is needed to convert substances (typically sugar, starches and other food) into the energy that the body itself requires for operating properly. The causes of diabetes are currently unknown, even though both genetics and environmental factors (life
Source: Poinasamy (2004), authors elaboration.
style, nutritional disorders) appear to play a fundamental role in the developing of the disease. The number of people with diabetes is expected to increase alarmingly in the coming decades. In 1985 an estimated 30 million people worldwide had diabetes, in 2000,
24
2 Industry Overview
little over a decade later, the figure had risen to over 150 million. This figure is expected to rise to almost 300 million by the year 2025. There are three major types of diabetes: Type 1 is a disease in which the body does not produce any insulin, most often occurring in children and young adults. People with Type 1 diabetes must take daily insulin injections to survive. Type 1 diabetes accounts for 5 to 10 percent of diabetes. Type 2 is a metabolic disorder resulting from the body's inability to make enough or properly use insulin. It is the most common form of the disease. Type 2 diabetes accounts for 90 to 95 percent of diabetes. Diabetes Type 2 is assuming an epidemic proportion, due to a steady increasing number of people affected. Gestational Diabetes is a disease that affects women in the later stages of pregnancy. It is a disease in which insulin resistance makes it difficult for the mothers body to use insulin. Around 135.000 American women are diagnosed with gestational diabetes each year. The type of diabetes and the severity of the condition dictate the proper treatment procedures. Type 2 diabetes patients require either oral antidiabetic drugs (OAD) or insulin doses (or actually neither of them, whenever the severity of the condition allows it), while type 1 diabetics are forced to consume insulin on a daily basis, otherwise the patient might not survive. 2.2.1 Market Characteristics
Figure 10. Therapeutic Areas in the Global Pharmaceutical Market
Others Onco lo gy Central N ervo us System Gastro intestinal
The diabetes management products market, as a branch of the pharmaceutical industry, shares many common features with it, as the primary role played by the research & development expenses and the marketing and production promotion activities. While health care professionals are highly
P ulm o nary
A rthritis D ia be t e s Infectio ns C ardio vascular Osteo po ro sis
influential in the initial purchase decision,
Source: LEU Investment (2001).
subsequent upgrades or purchases are often based on multiple influences that include
25
2 Industry Overview
patients desires or the media. Companies such as TheraSense, LifeScan and Roche spend large amounts in direct-to-consumer advertising to generate recall and recognition for their brands. It allows them to communicate their differentiation to a high percentage of consumers that self select products such as glucose self-monitoring kits. Therefore an effective marketing effort combined to a state-of-the-art R&D capability are crucial to success in a highly concentrated market (in the insulin branch, four key participants hold almost 90 percent of the share). Smaller companies, finding it difficult to allocate limited funds between R&D and marketing, are looking for opportunities to establish partnerships or mergers with larger companies in order to take advantage of their distribution channels, marketing muscle, and R&D resources. Therefore, the consolidation wave influenced considerably even the diabetes management industry through some notable acquisitions, as for example the Amira Medical one by Roche and Inverness by LifeScan (J&J) in 2001. 2.2.2 Market Sectors
Figure 11. Sales Forecast for the Global Diabetes Market, 1992 2010 (US$ Million)
25.000 22.500 20.000 17.500 15.000 12.500 10.000 7.500 5.000 2.500 0 1992
The diabetes management market counts approximately for the 4% of the overall pharmaceutical industry56. The market for the management of the disease is expanding quite fast, and has rosy potentialities. The diabetes management market in United States, for example, totalized $7,8 billion (including OAD drugs) dollars between August 2002 and August 2003, for an
1995 1998 2001 2004 Oral antidiabetics Human Insulin and A nalogues
2007
2010
Source: IMS Health (2002b).
overall growth of approximately 7%57. The most optimistic forecasts, based on the higher incidence of the disease on the world population, prospect a double-digit growth rate for the next years, when the worldwide diabetes related drug industry will pass from the current US$10 billion to US$ 30 billions by the end of the decade58 (see Figure 11), thank to the exponential growth rate prospected for the oral antidiabetic drug sales.
See LEU Investment Research (2001, pg. 28) See IMS Health (2003, a). 58 See IMS Health (2002, b).
56 57
26
2 Industry Overview
Including also the diagnostic and device compartment, from the current $ 13 billions will grow to $31.7 billion by 2007, with a compounded annual growth rate (CAGR) of 13.9%59, being the self monitoring blood glucose market the largest self-test market for medical diagnostic products in the worldwide60.
Figure 12. Diabetes Management Industry Segmentation, 2002

Oral Diabetes )45%(
Others )5%(
Self Monitoring )27%(
Ins ulin )23%(
Source: Hasenclever (2002), authors elaboration.
world, and it is estimated to be worth around $2 billion in the US and $3.5 billion
The diabetes medication branch is formed by mainly three sub-sectors: Insulin and insulin administration devices, glucose monitoring devices, oral OADs. Figure 12 exposes the segmentation of the diabetes care industry for 2002, where OADs and insulins accounted for 45% and 23% of the total diabetes care sales; whereas, self monitoring devises represented 27%. For a concise description of the main diabetes-care related products refer to Appendix C. 2.2.3 Insulin Major Competitors and the general diabetes
Figure 13. Diabetes Care Industry, 2002
Eli Lilly
management branch is an important part of the product portfolio for its established manufacturers. During the last fiscal year, insulin and other diabetes-related products represented the second-largest product line for Lilly and the largest product group for
Novartis A ventis
Others
Novo Nordis k
Source: LEU Investment (2001), authors elaboration.
Novo Nordisk. In 2002, the overall diabetes-care market leaders where Eli Lilly, Novo Nordisk, Aventis and Novartis (see Figure 13). Four major players control more than half of the diabetes management market. In the insulin niche, two companies, Novo Nordisk and Ely Lilly, jointly control the 80% of the World market. Even though in the last years, due to the increasing percentage of diabetes patients all over the World, these companies have witnessed an increase in the competitive pressure by other pharmaceutical
See Ellis (2001). See Diabeticinvestor.com (http://www.diabeticinvestor.com/mission.php) Alfredo Galletti Carsten Wong Iversen
59 60
27
2 Industry Overview
companies trying to access this market through an intensive capital expenditure and research activities. The increased competitive pressure arose also from the wider diffusion of insulin analogues that, through their non-invasive posology, tend to attract more and more costumers, whenever the severity of their condition allows it. Even though the diabetes management market has been historically concentrated on insulin products, nowadays the future growth of the global diabetes management market is primarily driven by the introduction of an increasing number of insulin analogs. At the same time, the new forms of diabetes treatments and drugs introduced in the market have somehow slowed down the insulin niches growth. 2.2.4 Future Market Developments: Diabetes Care Pipeline
The current state of the diabetes care branch has its major value driver into the ability of the competitors to beat competition in the race towards new revolutionary products that could guarantee a long-lasting market leadership in the sector. The major players, therefore, spend a considerable amount of financial resources in research and development activities to augment their pipeline, and increase their chances to reach the goal before the competitors. As a result, several drugs are currently under development, which reached different stages in the Diabetes Care Pipeline. There also exist additional laboratories with several drugs under development with different proposed use and estimated year of availability. Tables 5 and 6 present the most important components of the Insulin and Oral Antidiabetic Pipelines, including the estimated year of availability of each drug, their proposed use, the companies developing them and the generic names. In addition, when available, the brand is also presented.
Table 5.
Brand Symilin Basulin
Pipeline: Insulins
Generic Insulin Detemir Exenatide Pramlintide Basal Insulin Company Novo Nordisk Amylin/Lilly Amylin Bristol-Myers Squibb/Flamel Proposed Use Long-acting Insulin Diabetes (Type 2) Diabetes (Type 1 and 2) Long-acting Insulin Availability 2004 2005 2005 2007+
Source: Express Scripts (2004).
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2 Industry Overview
Table 6. Pipeline: Oral Antidiabetics

Brand Avandaryl Galida Generic Rosiglitazone/Glimepiride Belaglitazone Muraglitazar Tesaglitazar MK-0431 Liriglutide LAF-237 Pioglitazone/Metformin Company GlaxoSmithKline Novo Nordisk Bristol-Myers Squibb AstraZeneca Novo Nordisk Novartis Takeda Proposed Use Oral Antidiabetic Oral Antidiabetic Oral Antidiabetic Oral Antidiabetic Oral Antidiabetic Diabetes (Type 2) Oral Antidiabetic Oral Antidiabetic Availability 2004 2006 2006 2007 2007 2007 2007 Unknown
Source: Express Scripts (2004).
Special attention has to be paid to the next major development in the treatment of insulin-dependent diabetics, the launch of new insulin products with revolutionary delivery systems, such as inhaled (pulmonary) and oral posology. These products will offer alternatives to injections, which are expected to significantly improve patient treatment. Table 7 shows those insulin products with new delivery systems under development and their correspondent phase.
Table 7. Pipeline: Late-stage Development of Insulin Using new Delivery Systems
Name Exhubera AERx iDMS Transfersulin Nobexinsulin Oralin Macrulin
Source: IMS Health (2004a).
Phase III III II II II II
Delivery Inhaled Inhaled Transdermal Oral Oral Oral
Licensor Pfiezer, Nektar Aradigm IDEA Nobex Generex Provalis
Licensee Aventis Novo Nordisk n/a n/a Lilly n/a
29
3 The Latin America Overview
THE LATIN AMERICA OVERVIEW
The chapter will present a brief analysis of the Latin American pharmaceutical market. First a short evaluation of the current macroeconomic landscape of the area will be performed, and then a fast overview of its healthcare market will be presented, evidencing peculiarities and factors that differentiate it from the markets of other areas in the World. The chapter then will dedicate more attention to the three biggest markets in the area (Brazil, Mexico and Argentina), that together account in value for more than 70% of the total Latin pharmaceutical market. The analysis for the mentioned countries will focus on the evolution and the characteristics of their pharmaceutical markets, evidencing atypical characteristics both in their and in their regulatory and legal framework.
3.1
The Latin American Area
After being passed through a six-year recession, culminated with the crisis of Argentina in 2002, the Latin American area seems finally ready to come out from the economic depression and experience a long-lasting growth, characterized by countries with more solid basis and healthier fundamentals than in the past. 3.1.1 Current Economic Situation
The economy of the Latin American area has grown by 1.5% in 2003, finally reverting the cyclical downturn trend that reached the bottom level in 2002, after the crisis that affected some of its countries, primarily Argentina. The regional economy is expected to grow by 3.5% in 200461, entering into a gradual expansion phase after a recession that lasted for the last six years. The more positive economic international environment, the reduction of the areas overall risk and the increase of exports not linked to natural energy resources (as oil or natural gas) are the main factors of the recovery. Also many countries in the area are implementing more conservative monetary policies in order to stabilize and improve their fiscal debt, inflation and employment rates, and ensure a certain degree of stability on interest and exchange rates (through a substantial decrease in its volatility), while at the same time opening to higher degrees of trade liberalization
61
See ECLAC (2003). Alfredo Galletti Carsten Wong Iversen
30
and integration with neighbour countries through the strengthening and

62
the
Figure 14. Latin America Main Indicators Growth, 1995 - 2003

30% 25% 20% 15% 10% 5% 0% -5% 1996 1997 1998 1999 2000 2001 2002 2003 GDP External debt Per capita GDP Consumer price index
enlargement of the Common Market of the South Cone (MERCOSUR) . The increase in export prices (15.9%) and volumes represented the most dynamic factor of demand, highlighted by a record trade surplus (US$ 41 billion) during 2003.
Source: Authors elaboration form ECLAC (2003)
Capital inflows seem to have reverted to a positive trend, passing from the negative US$ 14 billion outflow recorded in 2002 to a US$ 3.5 billion inflow (see figure 14). The positive impact of the start of a recovery allowed then most of the countries to implement inflation controlling and stability ensuring policies, achieving a reduction in the general price index growth equal to a 4% in 2003. 3.1.2 The Latin American Pharmaceutical Market
The General Landscape Latin American pharmaceutical industry experienced a severe downturn during the last years (compound growth rate from 2000 to 2002 equal to -6,5%, compared to the 1993 1998 period, in which a 9,4% was recorded), reflecting the result of economic austerity and crisis wave that affected the biggest markets (nominally Mexico, Argentina, and Brazil that together
Figure 15. Latin America Health Care Sales and Growth, 2000 2002 (US$ Million)
20.000 16.000 12.000 8.000 4.000 0 2001 Argentina Brazil 2002 Mexico 2003 Others
Source: Chawla et al.(2003) and IMS (2004)
account for more than 70% of total pharmaceutical sales in the area). The total Latin America pharmaceutical industry, turning over US$ 17,4 billion in 2003; represents approximately 4% of the total World market63 (see figure 15). After a difficult few years, Latin American healthcare industry should strengthen its growth for the next years to come. The increase in the consumers purchasing power and expenditure possibilities,
62 The Common Market of the South Cone is a trade agreement that calls for common external tariffs and coordination of macroeconomic policy among Argentina, Brazil, Paraguay, and Uruguay. The four member countries cover an area of 12,000,000 square kilometers, with a population of 220 million. 63 See IMS HEALTH (2004b)
31
along with the renewed public institutions intentions to increase healthcare spending, should boost expenditure and market growth. Latin Americas governments are in fact targeting healthcare as a fundamental sector to address their expenditure, area that historically has being lagging behind if
Table 8. Latin America: Healthcare Data, 2003

Consumer expenditure: Health (US$ Bn) Life expectancy, total (yrs) Life expectancy, male (yrs) Life expectancy, female (yrs) Infant mortality rate (per 1,000 live births) Doctors (per 1,000 pop) Healthcare spending (US$ per head) Healthcare spending (% of GDP) Pharmaceuticals sales (US$ Bn) 54,7 72,2 68,6 76 25,9 1,6 230,3 6,29 13,8
Aggregate of Argentina, Brazil, Chile, Colombia, Mexico, Venezuela Source: Economist Intelligence Unit
compared to the industrialized countries ones64. An increase in future growth expectations, is given by the raising harmonization and strengthening of the South Cone Common Market (Mercosur)65, that should be able to stimulate trade activities among Latin countries. Harmonized standards and requirements could be especially important for multinational companies that aim to concentrate production in a few localities within the region in order to gain efficiency and economies of scale, and then enterprise export activities towards the other member countries. Lack of Intellectual Property Protection One of the most peculiar characteristics of the Latin American pharmaceutical market is the general and widespread lack of an effective intellectual property and patent protection system. Even though often enforced and prescribed by laws ad hoc in each single country, in most cases intellectual property theft is a pretty common practice. This mainly depends form two factors: firstly, even if governmental and public institutions are willing to operate surveillance on the matter and try to implement instruments for this purpose, the efficiency of these tools is quite deficient, due both to a more or less widespread clandestine counterfactual production industry66 and to a lax intellectual property rights enforcement by authorities; secondly, governments may give their explicit
64 Public spending for this sector as a proportion of GDP varies from a low of 1.8% in Venezuela to as much as 9% in Colombia. In Brazil, per capita health spending is about US$50 a year. Chile spends the most per capita, at US$200 per year, well below the minimum recommended by the World Health Organization (quantified as a US$500-a-year per capita). See Sandullo (2003). 65 The Mercosur market is achieving a larger action range (acquiring new members, as for example Mexico, and joining other trade agreements, as NAFTA) and is converging toward harmonization in different areas, as for example, the adoption of common good manufacturing practices (GMP) in production of biological and pharmaceutical goods, and the aim is to reach a common requirements standard code similar to the ICH one. 66 US law-enforcement officials believe that up to 25% of the pharmaceuticals sold in Mexico may be counterfeit or substandard, according to the International Chamber of Commerce (ICC), which last year established a Counterfeit Pharmaceuticals Initiative within its Counterfeit Intelligence Bureau. Many of the drugs are purchased by US consumers crossing the border in search of lower-cost products. See AIG Online (2004).
32
authorization, granted by the countries laws, to license production of patented drugs generic versions in case of public utility or national health emergencies (as for example the Brazilian HIV program)67. Increasing Importance of Generics The strong presence of generics is another peculiar characteristic of the Latin American market. Due to the general extremely unequal distribution of income among the population, markets in general are mostly price, rather than brand, driven. Average prices for pharmaceuticals in Latin America have historically been quite high compared to other developing and developed
0 0 0,2 0,4 0,6 0,8 1 30.000
C anada UK Italy Japan Sweden
Figure 16. World Drug Price Index Real GDP Per Capita, 2002
40.000
US
20.000
S. Ko rea S. A frica Thailand India M exico A rgentina
10.000
B razil
Source: Maskus (2003)
countries, also considering the average low income of a big share of the population (see figure 16). Lower-cost generic drugs are then sometimes the only affordable option for many consumers, and brand loyalty, which plays an important role in purchases within developed countries population, seems not to have a prime part in Latin American ones. Governments, moreover, encourage their prescription and purchase, as is the case of Brazil or Argentina, These factors turn into a strong impulse for sales of generic drugs that are increasing their market share exponentially (in Brazil, for example, after their introduction in 1999, yearly sales grew by 47% between June 2002 and June 2003), at the expense of brand drugs producers, that witness a strong shift from their products to the generics ones. The Effect on the Human Insulin Branch Competitive pressure from generics, anyway, strongly depends from which niche of the pharmaceutical industry is involved. Regarding the diabetes management industry, for example, generics menace is quite intense regarding Oral Antidiabetic Drugs68, or insulin
67 Nevertheless, as it will analyzed in more detail after, multinational pharmaceutical companies still invest in local production, aiming to expand towards the domestic and export markets both with brand products and with generics. 68 The Brazilian Health department in fact lately allowed the approval for the production of the first OAD generics to the Brazilian companies Biosintetica and Merck. See Ciencia Farmaceutica (2004).
33
synthesisers, while it is virtually absent in the insulin branch due to the consistent entry barriers in the niche. The progressive and now almost complete discard of animal derivates insulin, relatively easier to produce than the synthetic human one, but with many more counter effects for patients, changed the overall landscape of the industrys competitive puzzle. The highly technical and technological skills for manufacturing such products and the considerable level of investment required69 is a consistent deterrent for keeping generic manufacturers out of the arena, that are likely to focuse on relatively cheaper and more profitable sectors. Therefore the duopoly of the major players, Novo Nordisk and Eli Lilly, is unlikely to decrease for the time being.
3.2
Brazil
Table 9. Brazil: Facts
Population Nominal GDP GDP per head Average wage Corporate tax Risk Assessment Currency 176 million (2002) US$ 453bn US$ 2.570 US$ 176/month 34% Moderate (C) Brazilian Real (BRL)
Brazil is the largest and most populous country in Latin America, with a nominal GDP of $450 billion, the ninth largest in the world, representing approximately US$ 2.500 per capita. Brazil was the ninth largest
Source: Economist Intelligence Unit
market for pharmaceutical products worldwide70. Although the Brazilian market has suffered a decline because of its currency devaluation, it still represents approximately 34% of the Latin American market and 60% of Mercosur. For a detailed discussion of Brazil current situation and its risk assessment, please refer to Appendix D. 3.2.1 The Brazilian Pharmaceutical Market
The General Landscape Brazil is the 5th biggest producer behind the United States, Japan, Germany and France. In 2002, the industry turned over US$ 3,87 billion71. Due to the strong depreciation of the Real Brazil, and the consequent drop in sales denominated in US dollars, the country witnessed a significant fall of its share in aggregate sales, passing to 27% in 2001 (from
69 Novo estimates the cost of building a large-scale human insulin analogue plant at around $120 million and the latest Aventis Lantus production facility resulted in a 160 million Euros investment See Datamonitor (2003, pg. 21) and Bartec (2003). 70 See Hasenclever (2002, pg. 12). 71 See Chawla et al. (2004, pg. 4).
34
34% in 2000). Brazils share is expected to drop further to below 24% by 200672, for an overall market value of US$ 4,7 billion. According with the Agncia Nacional de Vigilncia Sanitria (ANVISA) and as shown in Figure 17, the most important therapeutic areas are represented by antibiotics (17% of sales), analgesics (5%), vitamins (4%), cold
Figure 17. Brazil: Therapeutic Areas, 2002

A ntibiotics 17% Hypertension 13% A nalgesics 5% V itamins 4% Cold Med. 4% Diabetes 4%
Others 53%
Source: ANVISA
and cough medicines (4%), anti-inflammatory and rheumatism drugs (4%), gastrointestinal remedies (3%), cardiovascular drugs (2%), cerebrovascular remedies (2%), sexual hormones (2%), hypertension (12,5%), diabetes (3,8%), antidepressives (3,4%). The Brazilian pharmaceutical sector comprises about 1000 companies, 400 of which are manufacturers. According to ALANAC (the manufacturers association) these firms account for 32% of total sector sales73 (see Exhibit 3.1 for Brazil pharmaceutical Industry figures). Most production is centred in So Paulo, Rio de Janeiro and Gois. The 2002 sales leaders were Roche and Novartis, Swiss-owned, the French Aventis and the American Pfizer (refer to Exhibit 3.2 for Brazil corporate rankings). There are few Brazilian-owned firms of any significant size and almost all concentrate on related and generic drugs. Between 1996 and 2000, around 40 such companies were taken over by the multinationals. The Competitive Puzzle Private manufacturers have to face a quite high level of competition. Even though Brazil is one of the biggest pharmaceutical products producers, still relies heavily on imports that implied an idle production equal to approximately 40% of potential output due to increased imports (mainly form United States). Overall drug imports rose to US$1,64billion last year, from US$1,53billion in 200274, while local producers have to face price fixing policies operated by the Brazilian health ministry. Moreover, the 30%, taxes on medicines applied by the Brazilian Government are among the worlds highest, producing an estimated US$1billion in government revenues each year, but reducing considerably potential demand. In addition, manufacturers face competition from stateSee Chawla et al. (2004, pg. 2). See De Magalhes et al. (2003). 74 See www.abifarma.org.br
72 73
35
owned producers as well75. To offset these domestic front weaknesses, companies have to rely on export activities (mainly flowing to Brazils Mercosur partners, Argentina, Paraguay and Uruguay, that during 2003 rose to US$ 261million from US$ 253 million in 2002 and US$ 220 million in 2001) (see figure 18), currently supported by
Figure 18. Brazil: Medicines Import Export, 1990 2000 (US$ million)
1.500 1.200 900 600 300 0 1992 Import 1994 Export 1996 1998
2000
Source: De Magalhaes et al. (2003)
official Government policies aimed towards sustaining exports and reduce bureaucracy76. Around 86% of sales are handled by distributors and retailers and the remainder is made directly, divided more or less equally among private and public hospitals. For economic reasons, usually public institutions accord their preference to generics mostly supplied by small-scale national companies and to the firms affiliated to ALFOB (Brazilian Official Laboratory Association)77. Despite the relatively large number of manufacturers, supply is highly concentrated, especially in the case of active ingredients, whose biggest share is imported. It is not that a single group controls a huge overall market share, but rather that one or a few firms dominate determined niches. In addition, technological, scale and market barriers make it difficult for new players to enter the arena. The big outfits therefore have enormous price-fixing power due to the difficulties in providing adequate substitutes for their products. Lack of Active Ingredient Industry As previously mentioned, another source of danger for Brazilian based companies profitability is represented by the absence of a domestic, competitive market for active ingredients, necessary to produce the final products78. In recent years, however,
In February the government of So Paulo state, for example, unveiled plans to invest US$77.5m to build three new drug-manufacturing plants by 2006. The federal government also plans to expand its own 17 laboratories, to reduce imports and produce raw materials for sale to private-sector producers. The government reportedly buys about 10% of the total domestic output. 76 In March, Braslia eliminated export licences on some 638 products, mainly pharmaceuticals. These goods will no longer require preshipment inspection from federal police and sanitation authorities. Moreover, the Government is planning to reduce the Industrialised Products Tax (IPI) on capital goods, to 3.5% from 5%. The IPI is scheduled to drop to zero by 2006. 77 See Hasenclever (2002, pg. 61). 78 According to ABIQUIF (the fine chemicals association), the Brazilian active-ingredient market turned over US$ 1,248.4 million in 2001, 68.6% of which imported (mainly vitamins and antibiotics). This huge
75
36
investments in clinical research into newdrug studies and development have moved up, especially after 1997, when the Patent Law was passed previously, the lack of an effective intellectual-rights protection mechanism proved a strong deterrent (see figure 19). According to INTERFARMA, the industrys annual R&D expenditure
Figure 19. Brazil: R&D Investment, 1995 2000 (BRL thousands)

120.000 100.000 80.000 60.000 40.000 20.000 0 1995 1996 1997 1998 1999 2000 2001
Source: De Magalhaes et al. (2003).
grew from BRL 20 million in 1995 to BRL 115 million in 200179. The role of Generics and Naturopathy Another possible factor that may undermine companies margins is given by the growing strong presence of generic drugs. Their manufacturing in Brazil has been permitted since 1999, although production per se only began in the following year. They are substantially cheaper than their brand-name counterparts because R&D investments and marketing expenditure are unnecessary. In million, 7% of overall value80 (see figure 20). According to Pr Genricos (the segment association), the market leader is Medley, with a 26,9% share, followed by EMS (19,8%), Biosinttica (14,5%) and Eurofarma (10,8%), all of whom are 100% nationally owned. In fact, Brazilian firms are responsible for 85% of the local generic market (refer to Exhibit 3.3). Even though their introduction was expected to result into an across-the-board reduction in prices, attracting consumers until now
ratio depends on the fact that, unlike in India for example, the local industry has never received adequate incentives and protection in this area and therefore lacking the necessary know-how, capital and scale to meet demand. Apart from notable exemptions (paracetamol, AAS, cyclamates and vitamin C), national synthetic output is based on imported intermediates. Production is more vertically integrated in the case of fermented substances (antibiotics, enzymes, etc.) and those obtained from natural raw materials (hormones, stimulants, enzymes, therapeutic chemicals, pectin, etc.). 79 www.interfarma.com.br 80 www.progenericos.org.br Alfredo Galletti Carsten Wong Iversen
Figure 20. Brazil: Generics Sales And Market Share, 2000 2003 (US$ thousands)
20000 16000 12000 8000 4000 0 m-00 s-00 m-01 s-01 m-02 s-02 m-03 Sales (US$ '000) % Total market Share 60% 50% 40% 30% 20% 10% 0%
Source: Pro Genericos
the end of 2003, Brazilian generic sales totalled 75 million units, turning over US$ 200
37
stopped due to their limited purchasing power, the only notable effect has been a consumption shift from their brand-name rivals81. Generic prices are 40 percent below branded products prices, with significant impact on prices for products addressed to blood pressure (up to 53% less); benign prostatic hyperplasia (-43%); gout (-40%); glaucoma (40%) and diabetes (-37%),82 implying a further erosion of the international brand product manufacturers sales and profits. Lately, major international companies are entering as well into the market so far dominated by local firms (notably from Germany, Canada and Switzerland), doubtless attracted by the healthy growth potential83. Naturopathic remedies contribute to a further enhancement of the competitive pressure. These products, mostly based on substances extracted from plants, turn over around US$ 22 billion per year worldwide and are growing at around 12%. In Brazil, they account for 7% of the pharmaceutical market (US$ 400 million per year)84. The Demand Structure Demand, basically comprising the different types of illness afflicting the population, is generally income-inelastic, although this fact depends heavily on the buyer85. In Brazil, medications purchased anywhere other than hospitals are not reimbursed, so individuals
81 Due to the extremely uneven distribution of wealth and therefore the inaccessibility to the drug markets by a quite big share of the population, generics increased sales volume and greater share of the market had little to do with new consumers, situation proved by the overall decline in sales. Competition from copy products and generics has contributed to price erosion of original brands, with average prices in US dollar terms declining since 1999, when devaluation of the real had a significant impact on prices. With price being the sole competitive advantage for generics, manufacturers are exploring ways to secure market share. Over the past two years, some R$700 million was invested in increasing generics production. See Hasenclever (2002, pg. 53). 82 See Pro Genericos (2004). 83 Actually even international generic drug producers are entering the Brazilian and the Latin American generic market. Major international generics companies, attracted by financial incentives, also are setting up local production facilities in Brazil to reduce dependence on imports. Canadas Apotex has invested in a new production plant, and other companies, such as Indias Cadila Healthcare and Germanys Stada, also are investing in Brazil. Local production facilities could be used by these foreign concerns for future exports to Mercosur countries. Multinational brand manufacturers are seeking to gain a share of the expanding market, with companies such as Novartis and Abbot already present. This trend is expected to continue as demand for generics increases, through the massive Brazilian governments public education campaign, heightening consumer awareness of generics. 84 Certain traditional or alternative forms of medicine, marginalized or virtually prohibited in the United States and many European nations, continue to receive official and academic recognition in other countries, including Brazil where some of the most respected medical schools maintain courses in naturopathy and homeopathy, both of which are recognized here by the Federal Medical Council and the substances are relatively cheap and are freely available after the Health Ministry Edict 6 of 31/Jan/95 that permitted the unrestricted sale of certain herbal remedies 85 For example, price is not an issue for prescription drugs acquired by high earners, but there is some sensitivity among over-the-counter drugs, where substitution is possible.
38
pay
about
80%
of costs.
the a
nations to large
pharmaceutical socioeconomic
Due
Table 10. Brazil: Pharmaceuticals Segmentation, 2001

Group A B C Income index >10 4 - 10 <4 % Total Pharma 48% 36% 16% Av. Health Expenditure US$ 193,40 US$ 64,15 US$ 18,95
Consumers
% of Population 15% 34% 51%
problems,
percentage of the population has little
Source: Hasenclever (2002, pg. 37)
or no access to medications. There are also notable differences in the geographic distribution of pharmaceutical demand, which is concentrated in the richest and most populous states. As a result, the majority of the population represents only 16% of the pharmaceutical sales (see table 10). In the lower income groups demand is much more dependent on earnings than price per se86. Therefore prices do not obey the law of supply and demand the former is uncompetitive and the latter inelastic. Even the sectors marketing strategy is somewhat different from that of other consumer industries, because most advertising is not geared towards final consumers, but to doctors, whose prescriptions result in purchases and pharmacies (people only acquire medicines when they need them).87. The Diabetes Management Industry Brazil is potentially the largest market (in number of people affected by the disease) for diabetes care products in Latin America, and diabetes is a growing problem within the Country, with more than five million Brazilians affected by the pathology. In 2000, sales of diabetes care products in the Brazilian market were estimated at US$ 133 million. Sales of insulin products accounted for an estimated US$ 42 million (32%), and oral antidiabetic drugs accounted for an estimated US$ 91 millions (68%). In 2003 the market segmentation changed to approximately 80% for oral anti-diabetic drugs and 20% for the insulin market88. The insulin market is expected to grow by 6.4% per year, and the market for Oral anti-diabetic drugs is expected to grow by 6%89. The demand is driven mainly by the public sector, that represents approximately the 80% of the total sales in units, and the biggest share of the demand is concentrated in the south east area of the country.
86 Around 49% of people taking some kind of medication belong to high-income groups and together account for 84% of total consumption, while the other 51% account for just 16%. Fifty million Brazilians or around 30% of the population has no access to medical drugs whatsoever. See Hasenclever (2002, pg. 37). 87 There are several firms who specialize in this, whose representatives meet regularly with physicians and retail outlets, not only to see, but also to gather information. This is particularly true in the case of the pharmacies, since Brazils huge ratio of self-medication gives them enormous purchasing influence. See Arrais et al.,(1997, pg. 71 77). 88 See Novo Nordisk Do Brasil (2003a). 89 See Hasenclever (2002, Annex II Table 34).
39
Regarding the insulin niche, before the Novos acquisition of Biobrs, only 4 companies shared the monopoly of the market90: Biobrs, Eli Lilly, Aventis and Novo Nordisk. After the acquisition of Biobrs, one of the largest insulin manufacturers in the World91, Novo Nordisk conquered the absolute leadership in the market, reaching the 56% of the Brazilian market of insulin and the 47% of the biphasic insulin analogues market mainly through the commercialization of its NovoMix 30, and the Danish company is expected, due to the acquisition of its main competitor, the enhancement of its production facilities and the lack of generics in the market, to reach the 80% of the insulin market92. 3.2.2 Regulatory Framework, Price Setting and Patent Protection
The National Agency for Sanitary Health93, an agency of the Brazilian Ministry of Health that is the counterpart of the U.S. Food and Drug Administration, issues authorizations to market pharmaceutical products94. After liberalizing the price of medicines in 1994, the Brazilian Government re-imposed a strict policy of price controls for prescription drugs in 2001, mainly as a result of disagreements between the Government and the industry in relation to the regulation of the generic drugs market and patent issues. However, nowadays precise price control policies are not in force within the country95. Nevertheless, Brazilian authorities have the power to influence the price of medicines and therefore avoid excessive prices and the exploitation of dominant positions through the enhancement of the competition among companies obtained using three main
De Magalhes, (2002, Nota Tcnica). Biobrs accounted for more than half of the Brazilian market, thanks to a wide array of products that include animal and human insulin as well as the OAD Glucoformin (metformin). In 2000, Biobrs had a turnover of BRL 58 million (USD 24 million/DKK 202 million) and an operating profit of approximately BRL 3.1 million (USD 1.3 million/DKK 10.8 million). See Novo Nordisk Do Brasil (2003b). 92 See Magalhes et al., (2003). 93 Created by Presidential Decree nr. 3029 of April 16, 1999. 94 According to Brazilian law, the production, manufacturing imports, exports, and sales of medical products, pharmaceuticals, and cosmetics can be handled only by companies that are registered with ANVS, which is responsible for authorizing products to be sold on the Brazilian market and for licensing manufacturers operating in Brazil. The agency oversees an estimated $120 billion worth of products and services, representing about 15% of the GDP. ANVS can give special registration for a period of one year to all registered imported generic drugs as products for public consumption. (Directive 3675, November 28, 2000). 95 Negotiations between the pharmaceutical industry and the Government have resulted in a greater flexibility regarding price controls , implying that Brazilian drug sale price index versus the Gross Domestic Product per capita is considerably high, if compared to other developing (and some developed) countries . See Bermudez et al., (2002) and Maskus (2003).
90 91
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channels96. Firstly, through the accordance of special fiscal exemptions and tax reductions for particular companies97 (typical small and medium companies, or national companies). Second, through the implementation of the antitrust law98, that can oblige companies to reduce the prices of their products, or can influence companies operations and activities99. Last, through the implementation of the compulsory licensing granted by the TRIPS agreement100, that permits the exploitation of a patent without the owner's consent, provided that such action is justified by the general public interest (as national health emergencies or excessive prices restraining) that results into the accordance of generics production. Especially the patent protection issue has considerable importance for foreign companies that operate in Brazil. According to Brazilian medical patent law, passed in accordance with the World Trade Organizations (WTO) agreement on trade-related aspects of intellectual property rights (TRIPS), any drug commercialized anywhere in the world before May 14, 1997, will always be unpatented in Brazil101. Even though the new patent law, enacted in 1996, includes, among other features, a 20-year patent protection term, pipeline protection for products applying for approval, patentability for genetically modified organisms, a ban on parallel imports, and a one-year implementation period. An unfavourable aspect of this law is a requirement to manufacture locally when technically possible (known as local working). Failure to comply with this mandate after three years may result in the license for production being granted to another company102.
See Naretto (2002). See Ferreira (2004, pg. 21-22). 98 Lei Antitruste, Lei 8884/94. 99 For example, the acquisition of Biobrs by Novo Nordisk has been perceived as creating a potential monopoly in the insulin market. Novo Nordisk had to negotiate with CADE an agreement whereby it undertook not to adopt certain practices seeking the merging of Biobrs into its insulin business until CADE granted a final decision on the case. It was the first time a company and the Brazilian Antitrust Authorities negotiated an agreement that made it possible to CADE to revert the transaction in case the authority decided not to approve it. 100 Trips Agreement, Article 31, comma b): Where the law of a Member allows for other use of the subject matter of a patent without the authorization of the right holder [] the following provisions shall be respected: (b) This requirement may be waived by a Member in the case of a national emergency or other circumstances of extreme urgency or in cases of public noncommercial use [..]. 101 See Cannabrava (2002). 102 Brazil Industrial Property Law (Law 9.279/96) Art. 68: The patent owner shall be subject to compulsory licensing of his patent if he exercises his rights therein in an abusive manner of if he uses it to abuse economic power according to the law in force, under the terms of an administrative or judicial decision. The following may also be grounds for a compulsory licensing: I - failure to exploit the object of the patent within the Brazilian territory for failure to manufacture the product or failure to fully use a patented process, except in case of economic unfeasibility, in which case importing shall be admitted; or II - marketing that does not satisfy the needs of the market.
96 97
41
Another concern among stakeholders in the pharmaceutical industry is, as introduced in the previous paragraph, the capacity of the Brazilian government to grant compulsory licenses in any situation defined as a national emergency. Recently the government has attempted to authorize the commercialization of cheaper, generic AIDS drugs and to exclude the original drugs from patentability by claiming a national emergency. The intention of the government to coerce pharmaceutical companies into freezing their prices also has raised objections.
3.3
Mexico
Table 11. Mexico: Facts
Population Nominal GDP GDP per head Average wage Corporate tax Risk Assessment Currency 102 million (2002) US$ 637 billion US$ 6.260 US$ 296/month 34% Moderate (C) Mexican Peso (MXP)
Mexico is expected to have the highest growth rates in Latin America by 2003, given its growing economy and population, which should turn into an increment of population able to afford pharmaceuticals.
In 2003, health care products in Mexico amounted to US$6,3 Billion; with an annual growth rate equal to 6.8% from 2000. In 1998, private sector prescription drug purchases accounted for approximately 25% of Mexicos total pharmaceutical sales, over-thecounter sales for 10%, and the public sector accounted for the remaining 65%. It is important to note that the pharmaceutical industry is one of the few remaining industries that are subject to price controls in Mexico. For a detailed discussion of Brazil current situation and its risk assessment, please refer to Appendix E. 3.3.1 The Mexican Pharmaceutical Market
The General Landscape Mexican pharmaceutical industry is divided into two main sectors: manufacturers of active ingredients and materials and the manufacturers of drugs. The first group exports mainly to Europe and the United States, while the second one focuses mainly on local markets.
This condition stands in opposition to the article 27 of TRIPS. This resulted in to a formal proceeding by the U.S. government at the WTO, proceeding that has been retired by the U.S. Government after the negative opinion expressed by the public. Alfredo Galletti Carsten Wong Iversen
42
In 2001, exports of medications totalled approximately US$ 850 million (mainly other Latin American countries, as Panama, Colombia, Venezuela, and Brazil) and imports US$1.060 million
103
Figure 21. Mexico: Medicines Import Export 1990 2000 (US$ million)
2.000 1.600 1.200 800 400 0 1998 Import 1999 Export 2000 2001
(see Figure 21),
mostly from the United States (28%). The share of import is likely to increase considerably in the next years due to the elimination of import duties, according to the implementation of NAFTA agreements, and the consequent possible price dumping strategies pursued by Canadian and US companies to achieve the majority of the market.
Source: KPMG Mexico (2004, pg.37 38)
Figure 22. Mexico: R&D Investment 19901995 (US$ Million)

140 120 100 80 60 40 20 0 1990 1992 1994 1996
Source: Bale (1996)
International drug manufacturers are then increasing their commitment to
Mexico and augmenting their R&D activities (especially after the introduction of intellectual property protection in 1991104, see figure 22), pushed by an increase in health coverage and the relative economic stability105, and reaching the predominant position in the market Market Characteristics The Mexican market is still quite concentrated. The first 10 players controlled, at the end of the 90s, more than one third of the total market, and the biggest 30 firms accounted for almost 80% (see Figure 23), even though, due to the increasing presence of generics during last years, these values are possible to be subjected to radical changes. Among the biggest players, Pfizer is the largest drug producer, with more than US$ 500 million in sales and a 10% market share in 2003. Regarding distribution, similarly to what has been
See KPMG Mexico, (2004). See Mansfield (1994). 105 On this matter, Pfizer is currently investing US$72m to upgrade two of its three local plants and expects the new outlays to boost capacity and better capitalise on its 2003 acquisition of US-based Pharmacia, which further diversified its product portfolio. Pfizers expansion plan also calls for increased marketing expenditures in Mexico this year to promote its top-selling products. The companys local growth has been supported by healthy sales of Lipitor, an anticholesterol medication, and an erectile-dysfunction drug, Viagra. Some 35% of production from the two expanded plants will be exported to Latin America and Switzerland. Source: Companys pressroom.
103 104
43
highlighted for Brazil, in Mexico usually companies prefer to rely on independent large distributors (for example Nacional de Drogas, Casa Saba, Casa Marzam, Frmacos Especializados, Farmacias Nacionales), that then place the products to pharmacies or drug stores linked to large retail malls
Figure 23. Mexico: Market Concentration, 1974 - 1998

80% 70% 60% 50% 40% 30% 20% 10% 0% 1974 Top 10 f irms 1988 1997 Top 30 f irms 1998
Source: Combe and Zuniga (2002)
The Role of Generic, Me-Too and Counterfeit Drugs Different from the Brazilian situation is instead the generics incidence over the market. In Mexico generics have so far not gained a large market share, even though the trend is expected to change drastically in the next future due to price reasons (up to 30% less than the patent protected medicines). Through extensive marketing efforts directly on patients and on the responsible for drugs and medicines prescriptions, and due to the absence of a strong support of generics by government entities in the past, generics havent historically been an important factor. Still, as it has been witnessed in other countries, generics are likely to improve their market share, also thank to an amplified attention to healthcare expenditure control by public institutions106. A higher incidence on the overall competitive framework, instead, is given by counterfeit drugs (produced clandestinely, not respecting patents and offering a much lower price than the official brand name medicines)107 and by copy-cat (or me-too drugs) known as Farmacias de Similares, that do not contain the same amount or dose of active ingredients branded products, and so dont need the expiration of the relative patent before being produced. The demand side of the market presents similarities with the other Latin American countries, characterized by an access and expenditure for medication that is heavily dependent on personal and household income.
In September 2003 through reforms to the Health Supplies Regulation and the Industrial Property Law Regulations, published in the Official Gazette the Mexican government intends regulating companies that are interested in developing generic drugs. In this way, these companies may apply for registering a drug for experimental purposes three years before a patent expires so that when this happens they will be ready for producing an already proven drug, which they will sell at a much lower price. See KPMG Mexico (2004, pg. 6-7). 107 On this regard, CANIFARMA estimates that each year goods imported illegally through the Tijuana border reach US$100 million. See KPMG Mexico (2004, pg. 27) and Anisfeld (2002).
106
44
3.3.2
Regulatory Framework, Price Setting and Patent Protection
The registration to the National List of the Chemical Pharmaceutical Industry is a necessary requirement to proceed with the marketing and commercialization authorization in Mexico. An interesting peculiarity of the Mexican pharmaceutical marketplace is represented by the requirement of a minimum of a 50% local manufacturing for any product that competes in a public tender (as, for example, government sponsored or funded drug purchases). This requirement might produce relevant effects in the competitive landscape, imposing a sort of discrimination between companies with manufacturing facilities within the country and the ones whose production lies abroad. Intellectual property protection for pharmaceuticals has been re-introduced in 1991108 after its formal abrogation occurred 1976109, and eliminating the authorization that permitted copying pharmaceutical compounds when using a different manufacturing process. Anyway, serious deficiencies can be detected in the Mexican institutions voted to the patent protection. Unauthorized disclosure of clinical trials and research activities are problems that arose often. Moreover, several generics obtain the authorization to the commercialization without any crossed control with the Mexican Institute of Industrial Property for possible patent violations. Other implementation flaws may lead to for example administrative errors that can provoke the revocation of a previously accorded patent, or insufficient market screening and consequent counterfeit products introduction110. Mexico still subjects pharmaceutical products to price controls, fact that raised several complains by NAFTA members111.
3.4
Argentina
Once the wealthiest Latin American country, with a GDP per capita of US$ 7.700 in 2000, Argentina had to face in January 2002 a major devaluation of the Peso (around 42%)
Law for the Development and Protection of Industrial Property, June 25th 1991 (emended by Presidential Decree in December 26th 1997). 109 1943 Industrial Property Law and the 1976 Law on patents and Trademarks excluded patent protection for pharmaceuticals 110 See Combe and Zuniga (2002). 111 For further informations regarding intellectual properties and Price control issues between Mexico and NAFTA members regarding pharmaceuticals, please refer to www.phrma.org/issues/nte/mexico.html
108
45
after the abandonment of the fixed peg to the US dollar. Hyperinflation and economic uncertainty made poverty and unemployment rates sky-rocketing (reaching respectively 40 and 20 percent). The
Table 12. Argentina: Facts

Population Nominal GDP GDP per head Average wage Corporate tax Risk Assessment Currency 37,8 million (2002) US$ 102 billion US$ 2.700 US$ 249/month 35% Moderate (C) Argentinean Peso (ARS)
Argentinian health sector, therefore, couldnt avoid the effects of the exceptional turmoil and the dramatic crisis that followed. Global companies have to face the scarcity of US dollars for trade purposes, the unwillingness of the Government to sustain health expenditure and in some cases the exceptionally high prices of imported goods and medicines. For a detailed discussion of Brazil current situation and its risk assessment, please refer to Appendix F. 3.4.1 The Argentinian Pharmaceutical market
The Pharmaceutical Industry In 2002, the industry turned over US$ 1.1 billion112. Due to the strong depreciation of the peso, and the consequent drop in sales denominated in US dollars, the country witnessed a spectacular fall form the past levels both in revenues and in products sold (from 412 million in 1999 to 260 million in 2002, see figure 24)
113
Figure 24. Argentina: Pharmaceutical Sales, 1998 2002 (US$ million)

5,0 4,0 3,0 2,0 1,0 0,0 1998 1999 2000 2001 2002
levels that are unlikely
Source: Tarragona and De la Puente (2004)
to be achieved for the years to come. The main reason for this extraordinary reduction in the value of the market has many motivations. The 2001 crisis of course implied an overall reduction in demand that affected all the sectors (including therefore also pharmaceuticals), but it is not the only one. The deregulating policies of the liberist wave, allowing free imports and no price restrictions, in fact, contributed to inflate prices above sustainable levels (during the period 1986 2000 sales in units fell approximately 15%, while revenues grew of 250%)114.
See Tarragona and De la Puente (2004, pg. 6). See Tobar (2004 pg. 12). 114 See Tobar (2004 pg. 9).
112 113
46
The de-regulative liberal market policy also affected the pharmaceutical market in the active product side. Before the crisis, Argentinean manufacturers preferred to rely on international active product manufacturers for their needs, because due to the easier access to the market they could exploit their size efficiency and economies of scales, and therefore offer lower prices compared to the local manufacturers115. Nowadays, with a reduced possible access to international markets, and with the contemporary investment and research expenditure crunch that reduced the already scarce active ingredient local industry, local drug manufacturers are forced to find new strategies in order to survive, and a cannibalization of the small and medium companies by the biggest ones seems likely to happen116. The insulin Market The Argentinean insulin market is worth approximately US$ 78 million in 2003, and it is shared among four players: Novo Nordisk (44%), the Argentinian Beta (28,7%), Eli Lilly (16,3%), Aventis (11%)117. As previously seen in Brazil, also the Argentinean insulin market is characterized by the absence of generics. The amount of investment required to establish new production facilities makes the entrance of new competitors quite unlikely at the moment, especially if, from one side the capital inaccessibility for local firms, and from the other the unwillingness to invest while the situation is still uncertain for foreign companies, are considered. Therefore the dominant position of the four players is unlikely to decrease in the next future. The Role of local Industry Contrarily to what can be witnessed in Brazil and in Mexico (and, more in general, for most of the Latin American countries), Argentinian manufacturers in the past played a much more significant role in the market, with a share that in 2002 was estimated to be around 52%118 (see figure 25), resulting therefore in a highly fragmented market with more than 220 laboratories, among which the primary competitors were the local firms Roemmers and Bago and the European companies Roche, Novartis, and Aventis. The relatively high income and average age of the population, the availability of skilled labour and the
See Panadeiros (2002 pg. 16). See Tarragona and De la Puente (2004, pg. 4). 117 See Nutrar (2003). 118 See Tarragona and De la Puente (2004, pg. 5).
115 116
47
support of local interest groups as the Centro Industrial de Laboratorios Farmacuticos Argentinos (CILFA) created a fertile ground for the establishment of the most flourishing pharmaceutical industry in Latin America. This difference from the usual Latin America landscape is mainly given by the historical lack of patent protection in Argentina, introduced only in middle 90s,
Figure 25. Argentina: Sales By Companys Nationality, 2002

US 21% Germany 11%
Sw itzerland 9%
Others 7% Argentina 52%
Source: Tarragona and De la Puente (2004, pg. 6)
that forced international companies to enter the markets through partnership instead of implementing acquisition strategies (even though many examples of mergers can be found for the same period119), and so strengthening the local industry, instead of absorbing it. The recent crisis is likely to change the landscape quite deeply. International players may be willing to have a more consistent foothold in the country, when the situation will stabilize. The Generics Influence on Prices Lately generic drugs, before virtually a niche within a market characterized by brand drugs, are increasing their role in the competitive puzzle due to the government interventions for allowing a wider access to medicines to the population and thus reducing prices. The new health policy of the government, that imposes the prescription of generics as mandatory to
Figure 26. Argentina: Generics Sales And Price Index Movement 2002 (ARS)
27.000 26.000 25.000 24.000 23.000 22.000 21.000 20.000 19.000 Dec 2001 Unit sold May 2002 Dec 2002 15 10 5 0 35 30 25 20
Average Price Index
Source: Tarragona and de la Puente (2004).
indigent people for public institutions and doctors, has boosted the sales and the growth of generics, decreasing dramatically prices at the same time (see figure 26). The inaccessibility to the drug markets by a quite big share of the population, and the incapacity of the government to afford a minimum health standard to the population, implied the introduction of generics, that had significant impacts on prices for products addressed to for example blood pressure (up to 58% less) and flu (60% less).
119
See Panadeiros (2002, pg. 16). Alfredo Galletti Carsten Wong Iversen
48
The Demand Segmentation Historically, demand has been quite

Figure 27. Argentina: Pharma Segmentation 1995 - 2001
2001
Demand
widespread among the social classes, even though the incidence of healthcare products on the overall household expenditure had a different impact for each different social class (for the richest 20% heath related expenditure represented the 41% of their
1995
0%
20% Households
40% 60% Social system
80% 100% Public institutions
Source: Tobar, (2004 pg. 9)
overall expenses, while for the poorest 20% of the population it represented the 78%120, see figure 27). Households represented almost 50% of the overall market of medicines in the country, that then was mostly composed by private demand and insurance companies (the domestic budget expenditure was in average only 2% of the total GDP). Health expenditures were estimated to be on average US$ 675 per-capita, and the social policies of the Argentinian Government implied a reimbursement of health related expenses only for lower social classes. With the constant growth in prices the situation couldnt be sustained anymore. After the initial dramatic moments, in which the government wasnt literally able to pay for stocking life sustaining medicines and the population couldnt afford a proper access to medications, implying a dramatic fall in the demand, now the implementation of the Programa Remediar and the consequent transfer on generics (and their more widespread availability) is rebuilding a more consistent demand. 3.4.2 Regulatory Framework, Price Setting and Patent Protection
After the crisis, the newly established Argentinean Government implemented the Health National Policy (the Politica Nacional de Medicamento121), that is articulated in three points: the generic prescription (Promocion del Nombre Generico122) policy, that mandates to doctors and the prescription of the cheapest available medicine among the possible alternatives; the selective financing (Financiacion Selectiva123) policy, that indicates and enumerates the one and only life-sustaining medicines and remedies that can be reimbursed by public
See Tobar (2004, pg. 11). Decree 486/02. 122 National Law 25.649/02. 123 Resolution 201/02.
120 121
49
finance; the Public sustain (Provision Publica124) policy, that indicates which social classes have the right to obtain free access to free life sustaining pharmaceutics. This general policy has the aim to rationalize the public health expenditure and to grant to the highest share possible of the population the access to medicines, at the lower possible price. Regarding property rights, the National Institute of Industrial Property introduced for the first time in 1995 the new patent law to extend protection to innovative medicines125. Many small local pharmaceutical companies had to face serious budgeting constraints due to the obligation of royalty payments to the patenting firms, while the biggest producers had to enterprise alliances and joint ventures. Nevertheless, even though patent protection has been introduced, still patent protection is lacking. Argentina is still considered one of the worst implementers of intellectual property law126. No protection for genetically modified organisms and discretional compulsory licensing make the overall assessment of legal protection quite lacking on many fronts. Regarding price setting policies, historically Argentina never implemented any artificial intervention on price dynamics, and in fact Argentinean medicine prices where among the highest in the World. Even after the crisis, there is no policy that artificially regulates the prices. Nevertheless, the new generic drugs policy is pushing prices down, and the favour accorded to these medicinals by the public institutions forces companies to struggle on price reduction to gain market share.
Decree 808/02. Decree n. 260/96. 126 For example, the Law 24.766/997 grants confidentiality for the trial tests submitted to health institutions for approval, without specifying the time extension of the protection.
124 125
50
4 Novo Nordisk Group
NOVO NORDISK GROUP
This chapter will present a brief introduction and analysis of the historical performance of Novo Nordisk basing on the published companys annual financial reports. After the performance analysis, the chapter will focus on the estimation of Novos weighted average cost of capital, which will be used in the following chapters as discount rate for the discounted cash flow analysis. At last, a summary of Novos SWOT analysis will be presented, attempting to recognize current and future developments for the company.
4.1
Historical Performance
Figure 28. Novo Nordisk: Sales by Geographic Region, 1999 2003 (DKK million)
30.000 25.000 20.000 15.000 10.000 5.000 0 1999 2000 Europe Japan & Oceania 2001 2002 2003 North A merica International operations
Novo Nordisk is a Danish-based company that operates in the Health Care Business. The company develops, manufactures and markets products for the treatment of diabetes and coagulation disorders. Since its foundation Novo Nordisks main focus has been on diabetes and insulin therapy. Over the years, this commitment has resulted in some of the most important advances in
Source: Novo Nordisk, authors elaboration.
diabetes therapy, through the development of a wide range of diabetes products, insulin, insulin analogues, and diabetes management devices. Europe and the US represent its biggest markets, followed by Japan and Oceania (see Figure 28). As shown in Figure 29, the companys second largest operational area, behind diabetes management, is the Haemostasis Management (HM) branch, which develops and markets products to treat haemophilia. Other segments include Human Growth Hormone Therapy (GHT) and Hormone Replacement Therapy (HRT). Over a fifth of the companys employees are employed
Figure 29. Novo Nordisk: Sales by Therapeutic Area, 1999 2003 (DKK million)
30.000 25.000 20.000 15.000 10.000 5.000 0 1999 2000 HM 2001 GHT 2002 HRT 2003 Other Diabetes Care
within research and development, fact that underlines the companys emphasis and
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commitment on these activities. Of the 16.000 people employed, 85% work within the diabetes division. In 2002, Novo Nordisk invested DKK 4,1 billion in research and development of new drugs and their delivery, over 16% of total turnover. Revenues During the period 19992003 revenues have shown an average annual growth of 15% (excluding the effect of currency) and an average annual growth of only 5% (including the effect of currency). Diabetes care and haemostasis management divisions have mainly driven this growth. In 2003, diabetes care roughly accounted for 70%,
Figure 30. Main Competitors: Growth on Revenues, 2000 - 2003
60% 40% 20% 0% 2000 -20% Novo Nordisk A ventis A verage Novartis Eli Lilly
2001
2002
2003
Source: Companies information, authors elaboration.
whereas haemostasis management stands for the 15% of the total revenues127 (see Figure 29). The relatively high growth in diabetes care sales, even with significant changes within quarters and years, has been enabled by the underlying growth in diabetes prevalence, increasing diagnosis rates, a trend towards more intensified therapy and the conversion from animal to DNA recombinant human insulin and insulin analogues, and from insulin sold in vials to premium-priced insulin sold for use in injection devices. Overall, Novos growth on revenues have been declining since 2000, whereas the main competitors average has been increasing (key competitors have been experiencing positive growths with the only exception of Eli Lilly). Anyhow, the growth figure for 2002 is comparable to the same years average of the main competitors (see Figure 30, refer to Exhibit 4.1 for more details). The slowdown in turnover growth can be explained through an increase pressure from direct competitors directed towards alternative diabetes treatments which contributed to erode the overall growth margins. Major companies, as Pfizer, Bayer AG and Johnson & Johnson, invested heavily in order to exploit new opportunities in the
127
The therapy areas of growth hormone therapy and hormone replacement therapy have experienced modest growth rates. Growth hormone therapy accounted for 8% of net turnover, and the hormone replacement therapy accounted just for 5%. A trend towards an increasing share of the Companys sales in North America has been observed. In 1998 12% of net turnover originated from North America. By 2003 this share had increased to 24%, primarily driven by increased market shares and the introduction of NovoSeven in the market in 1999. The growth in North America and modest growth in Europe and Japan & Oceania in 2002 has reduced the relative share of turnover stemming from Europe and Japan & Oceania. In 1998 53% of net turnover originated from Europe and 21% from Japan & Oceania. By 2002 the share of net turnover from Europe had decreased to 43%, whereas the share from Japan was 17%. Alfredo Galletti Carsten Wong Iversen
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market, jeopardizing growth opportunities for the companies that already are operating in the business. EBIT and Cost Structure Even facing an Novo increased Nordisk level scored of a
Figure 31. Novo Nordisk: EBITA as Percentage of Revenues, 1999 2003 (DKK Million)
8.000 6.000 4.000 25% 24% 23% 22% 2.000 0 1999 2000 2001 2002 2003 Reported EBITA 21% 20% EBITA /REV ENUES
competition,
constant level of around 23% of EBIT margin during the last 3 years in line with the characteristics of the industry. The company expects to follow that trend the following periods. The positive growth in the EBITA/Revenues ratio is granted by a from 2000 to 2003. During 19982003 non-production costs as a percentage of revenues decreased from 62% in 1998 to 54% in 2003. The development in sales & distribution and research & development costs is almost steady with 2931% and 1617% of net turnover, respectively (see Figure 32). This positive production cost development (23% competitors average of 23,5%128. Free Cash Flow and ROIC
Source: Novo Nordisk reports, authors elaboration.
good overall cost control, which increased the absolute level of the EBITA recorded
Figure 32. Novo Nordisk: Cost Composition As % Of Turnover, 1999 2003

100% 80% 60% 40% 20% 0% 1999 2000 COGS Depriciation 2001 2002 2003 SGA Other Op. Expenses
cost incidence over turnover in 2003) keeps on being substantially in line with the
A higher incidence of capital expenditure due to investment in production facilities and the acquisition of Biobrs has deteriorated, throughout the years 2001 and 2002, the cash flows generated by the company. The heavier capital expenditure for investments in new production facilities during the years 2001 2002 can be seen even through the
In 2002; Novartis had 23%, Aventis had 26%, Astrazeneca had 25%, and Eli Lilly 19% of turnover as cost incidence. The main competitors average was 23,5%. Source: Companies reports. Alfredo Galletti Carsten Wong Iversen
128
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cash/revenues ratio, defined as percentage of free cash flow on the operating turnover, which has decreased from about 10% in 1999 to around 1% in 2002 (see Figure 33). The effect of a higher incidence on capital expenditure can be witnessed also on the development of the pre-tax Return On
Figure 33. Novo Nordisk: Free Cash Flow, 1999 2003 (DKK Million)
5.000 4.000 3.000 2.000 1.000 0 1999 2000 2001 2002 2003 Free Cash Flow FCF Grow th 750% 600% 450% 300% 150% 0% -150%
Invested Capital that showed an overall decrease due to: as previously stated, an increase in the capital expenditure for the enhancement of production capacity; a slight increase in the incidence of the cost of good sold, partly counterbalanced by an improvement in the general and selling costs; an increase in the operating working capital needs, due to an overall increase in the stocks of the Group caused by a slight decrease in the orders from costumers during the beginning of 2002 (refer to Exhibit 4.2 for the ROIC tree analysis). Although this reduction, the after-tax ROIC had been always positive during the analyzed years, and always in line with the results recorded by the major competitors (see Exhibit 4.3). This fact justifies the positive market expectations created by the capacity of Novo Nordisk to ensure value creation (estimated through the Economic
Figure 34. Novo Nordisk: After-Tax ROIC and WACC, 2000 - 2003
30% 25% 20% 15% 10% 5% 0% 2000 2001 2002 W ACC 2003 After Tax ROIC
Profit metric) throughout the last years due to a ROIC value constantly higher than the Companys Cost of Capital (estimated as equal to 7,85% in the following part of the chapter). For a more comprehensive analysis of Novos and competitors most important financial ratio comparisons, refer to exhibits 4.4 4.9. Financial Structure The solidness of the company is also given by its sound financial structure. It is part of Novo Nordisks Treasury Policy to maintain sufficient financial resources, and to rely
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mainly
on
equitybased
sources
of
finance129. The groups long-term debt is in fact of modest entity if compared to the overall financial structure (DKK 753 million at 31 December 2003). Given the significant and positive cash flow from operating activities added to the net cash position of the Group, the credit risk that the firm faces
Figure 35. Novo Nordisk: Sources Finance, 1999 2003 (DKK Million)
60.000 50.000 40.000 30.000 20.000 10.000 0 1999 2000 Equity f inancing Long term financing
Of
2001 2002 2003 Short term f inancing Other long term financing
is therefore very low. Figure 35 shows the proportion of Novo Nordisks sources of finance for the period 1999 2003. As it can bee observed in the figure, long-term financing sources are rather moderate. Currency Risk Management Even regarding eventual currency risks, Novos condition seems quite conservative and prudent. In fact, the company hedges commercial exposure and consequently does not enter into speculative positions130. Nevertheless, currency movements might have significant effects (positive or negative) on the firms overall profits. Since Novo
Figure 36. Novo Nordisk: Exchange Rate Variation and Impact on EBIT, 2003
250 150 50 -50 -150 -250 U SD JPY GBP 4% 2% 0% -2% -4%
Nordisk revenues are in numerous currencies, while main production costs are in few currencies131, it can be estimated that an effect on sales will translate in an almost similar effect on EBIT. Movements in USD are most likely to affect positively (or negatively) the results. A change of 5% in the exchange rates has an estimated impact of approximately DKK 210 million on EBIT, while changes in Yen and British pounds will
129 Financial resources amounted to DKK 11.400 million at 31 December 2003 and consist of the Groups cash and cash equivalents of DKK 2.699 million together with undrawn committed credit facilities of DKK 8.701 million. The undrawn committed credit facilities consist of a USD 500 million, a EUR 500 million and a DKK 2.000 million facilities committed by a number of Danish and international banks. The facilities mature in 2004, 2006 and 2007, respectively. Cash and cash equivalents consist primarily of bank deposits and short-term government bonds. 130 The financial instruments used in conjunction with the Groups financial risk management include currency forwards, currency options and cross-currency swaps. In addition short- and long-term debts as well as money market deposits are used in the financial risk management. 131 Novo Nordisk has production facilities in Denmark, US, France, China, Japan and Brazil.
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affect EBIT by 130 and DKK 75 million respectively 132 (see Figure 36). As a result, any mayor changes in US dollars will affect heavily Novos results, which may raise suspicion if the recent development in exchange rates are considered. Consequently, future appreciations of the Euro against the USD the might substantially erode Novos financial results.
4.2
The Estimation of the Weighted Average Cost of Capital
The Weighted Average Cost of Capital (WACC) will be used to translate expected future free cash flows into present values133. The general formula for estimating the after-tax WACC is simply the weighted average of the marginal after-tax cost of each source of capital. This formulation can be expressed as follows:
WACC = rSD * (1 T ) * DS r * (1 T ) * DL rE * E + + LD D N + DS + D L + E D N + DS + D L + E D N + DS + D L + E
(4.1)
where rSD is the interest rate on short term debt, rLD is the interest rate on long-term debt, T is the tax rate (30 % in Denmark), rE is the cost of equity capital, E is the market value of the equity, DS is the market value of short-term debt, DL is the market value of the long-term debt, and DN is the value of the non-interest bearing debt. Thus, in order to calculate the WACC, partial estimations regarding variables such as cost of equity capital and cost of debt financing have to be performed. Likewise, it is necessary to compute Novo Nordisks beta () to estimate the cost of equity capital as proposed by the Capital Asset Pricing Model (CAPM). Following, the estimation of Novos beta will be performed, followed by the firms cost of equity financing, cost of debt financing and finally by the WACC it self. The Beta Estimation To find the correlation coefficient between the returns on Novo Nordisk B stocks and the returns of the KFX index, the ordinary least square estimation procedure had been applied considering different time series and different periods of time. In detail, the time
Novo Nordisk (2003). As will be more profoundly explained in chapter 7, the WACC will be implemented throughout the DCF calculation of the project as discount rate.
132 133
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series in analysis for the KFX Index and for the Novo Nordisk B shares, quoted at the Copenhagen Stock Exchange, cover different time spreads (from one up to five years from now) and different quotations (in detail: opening quotation, highest quotation of the day, lowest quotation and closing quotation). For each analyzed time series, a data filtering approach has been applied. First it has been chosen to analyze the data set after a data standardization procedure, obtained considering one fifth of the Novos quotation values prior the 4th of April 2001, data in which a stock split (5:1) occurred.
Figure 37. Novo Nordisk - KFX Index: Daily Returns, 1998 - 2004
25% 20% 15% 10% 5% 0% -5% -10% -15% -20% Novo Nordisk KFX Index
Source: www.yahoo.dk, authors elaboration.
Since returns are used to estimate companies beta and not the absolute value of quotation (see Figure 37), this procedure shouldnt affect the results obtained. Subsequently, it has been chosen to apply a data filtering approach (see Figure 38), consisting into an arbitrary exclusion from the regression of the periods of time corresponding to each distribution of dividends (in this case, the three days before and after the distribution had been
Figure 38. Novo Nordisk Adjusted KFX Index: Daily Prices, 1998 - 2004
450 400 350 300 250 200 150 100 50 0 Novo Nordisk A djusted KFX Index
Source: www.yahoo.dk, authors elaboration.
eliminated), to the 5:1 stock split (again three days prior and after have been eliminated) and to the exceptional market turmoil after the September 2001 (in this case the whole period till the 1st of November has been excluded). The reason for this choice can be explained considering that particular moments during the time period from 2001 to 2003, then, is likely to negatively affect the recognition of the long-period correlation between Novo shares and the KFX, and therefore shouldnt be taken into the regression. The beta values obtained for each category and period of time, as shown in table 13, vary in a range that goes from 0,35 and 1,05. Excluding the inference results from the lowest daily quotation data set, it is possible to reduce this array to a range equal to 0,69 and 0,89; that is consistent to other empirical valuations regarding the pharmaceutical industry beta average. Other Novos beta estimations assign a value to this variable equal
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to 0,8134; which then will be the assigned value to Novos beta and will be applied throughout the calculations.
Table 13. Novo Nordisk - KFX Index Beta Estimation
Time period Jan 1998 - May 2004 Jan 1999 - May 2004 Jan 2000 - May 2004 Jan 2001 - May 2004 Jan 2002 - May 2004 Jan 2003 - May 2004 Average Data set Filtered Not Filtered Filtered Not Filtered Filtered Not Filtered Filtered Not Filtered Filtered Not Filtered Filtered Not Filtered Filtered Not Filtered Opening 0.768 0.716 0.795 0.733 0.774 0.739 0.776 0.742 0.728 0.725 0.656 0.656 0.750 0.719 High 0.879 0.811 0.872 0.790 0.864 0.813 0.853 0.782 0.881 0.878 0.678 0.673 0.838 0.791 Low 0.397 0.373 0.357 0.334 0.392 0.382 0.372 0.363 0.340 0.341 0.103 0.105 0.327 0.316 Closing 0.997 0.940 1.006 0.936 1.005 0.960 1.036 0.964 1.016 1.008 0.731 0.721 0.965 0.922 Average 0.760 0.710 0.758 0.698 0.759 0.723 0.759 0.713 0.741 0.738 0.542 0.539 0.720 0.687 Average excluding low 0.881 0.822 0.891 0.820 0.881 0.837 0.888 0.829 0.875 0.870 0.688 0.683 0.851 0.810
The Opportunity Cost of Equity Financing The opportunity cost of equity financing can be estimated using the capital asset pricing model (CAPM), and can be calculated by using the following formula:
rE = r f + E (rm ) r f *
(4.2)
Where rE is the cost of equity capital, rf is the risk-free rate of return, E(rm) is the expected rate of return on overall market portfolio, E(rm) rf is the market risk premium and is the systematic risk of the equity. The risk free rate of return has been estimated as the rate of a 10-year Danish Treasury bond, equal to 4.5%. The market risk premium135 is assumed to be (E(rm) rf ) = 5 %. The systematic risk is calculated to be 0,8. After computing the above-mentioned values we obtain a cost of equity rE = 8,5 %. According to Novo Nordisks annual report, the company had at the end of 2003, share capital that amounted to DKK 107.487.200 in A shares capital (equal to 53.743.600 shares, book value DKK 2,00) and DKK 601.901.120 in B share capital (equal to 300.950.560 shares, book value DKK 2,00). At the moment, Novo Nordisk B-shares are traded at the Copenhagen stock market and the market price on the 14th of May, 2004
134 D. Carnegie A.B. estimation in the Novo Nordisk A/S report claim a beta value equal 0,8 (report date 10 Feb. 2003) 135 Source: www.nationalbanken.dk
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was 280 DKK/share. By multiplying the market price of a share with the number of shares, the value of the B-shares has been estimated to be DKK 84, 266.billion. The Ashares are not publicly traded therefore we assume that their value has increased with an equal percentage compared with B-shares. The assumption was made considering the objective function of the corporation, which is to maximize the shareholder value. The estimated total market value of A shares is DKK 15, 048 billion. According to the assumptions made, the total market value of equity is equal to DKK 99, 314 billion. The Cost of Debt Financing The companys long term debt is not publicly traded; the company financial report for year 2003 estimates the market value of long term debt as equal to a book value of DKK 753 million and a market premium equal to DKK 1 million. The market value of debt will then be DKK 754 million. In addiction to the long term debt, the short term interest bearing debt amounts to DKK 975 million. By the end of 2003 the total interest bearing liabilities was DKK 1729 million. A precise estimation of the cost of debt of Novo Nordisk is not a simple task to perform due to lack of information available in the annual reports. The company has debt in different currencies and with diverse terms to maturity136. The reports lack of detail regarding those terms and amounts and an estimation using durations of debts is not possible. But given the capital structure of the company, the exact quantification of the interest rate may have little or no influence on the overall WACC estimation. Therefore it had been assumed that the cost of debt financing is equal to the 10-year Danish Treasury bond (4,5 %) plus the risk premium paid by Novo Nordisk. Even regarding the precise quantification of the risk premium, theres a substantial immateriality. Given the extremely low value of the debt financing in Novos WACC, the financial distress can be considered as irrelevant. The rating for the debt can be therefore considered extremely positive, reducing the value of the risk premium. The value used for the computation of the WACC had been set as equal to 0,5%, corresponding to an AAA rating. However, increases in the risk premium up to 2% have an almost inexistent impact on the final WACC value (see Exhibit 4.10).
136
See Novo Nordisk (2003, pg. 32). Alfredo Galletti Carsten Wong Iversen
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The short-term cost of debt had been estimated to 2,4%, equal to the 12 month Danish Government bond interest rate. It has been chosen not to add any market premium to this interest rate, hypothesis that is not likely to influence the overall WACC (refer to Exhibit 4.11) of Novo, given the quite limited extent of the short-term loans in the overall capital structure of the company137. The Estimation of Novo Nordisks Weighted Average Cost of Capital The market weights used in the WACC calculation are 91,5% % (equity), 0,7 % (long term debt), 0,9% (short term debt) and 6,9% (no interest bearing debt). Novo Nordisks WACC results therefore equal to 7,85%; calculated with the (4.1) and using the numbers estimated above, result consistent with the one from BNP/Paribas in July 2003.
4.3
Novos SWOT Analysis
Table 14 summarizes Novos SWOT analysis (refer to Appendix G for a more detailed examination).
Table 14. Novo Nordisk: SWOT Analysis
STRENGTHS
Highly specialized research activity Access to international financial markets Active and profitable synergies Sound environmental policies Array of analogue products and devices of known reliability
WEAKNESSES
Difficult to conquer market shares European research centre relatively modest Seasonality of sales
OPPORTUNITIES
Diabetes is growing at epidemical proportions Possible expansion towards emerging markets Use of haemostatic drugs in new treatments Several new products under development
THREATS
Strong incentive for big companies to enter New types of diabetes cure are under development by competitors (oral, inhaled) Loss of competitiveness of the Danish Krone Strict controls and to drug counter-effects
Relatively few international pharmaceutical Companies characterize the insulin market. In practice Eli Lilly, Aventis, Novartis and Novo Nordisk are the only competitors the market, even though in the last years, due to the increasing percentage of diabetes patients all over the World, these companies have witnessed an increase in the competitive pressure by other pharmaceutical Companies that are trying to access this market through an.
137
The amount of financial leasing is not specified in the annual report so it had been considered immaterial for the WACC calculation. In the annual report stock options are valued for DKK 177 million and therefore had been considered immaterial. Alfredo Galletti Carsten Wong Iversen
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intensive capital expenditure and research activity, especially in the Oral Antidiabetic Drugs industry. At the same time, the increasing research into new forms of diabetes cure and drugs has somehow slowed down the growth in the market.
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5 The Expansion in Latin America
THE EXPANSION IN LATIN AMERICA
This chapter describes the fundamental characteristics and the motivations behind the strategy pursued by Novo Nordisk for strengthening its position in the Brazilian and, on a wider perspective, the whole Latin insulin market. The expansion plan is essentially composed by two consequent phases: first, the acquisition of Biobrs S.A., and then a US$ 200 million investment for a new human insulin production facility in Montes Claros. The chapter will focus on the first step of this plan, describing the motivations that lay at the base of Novos choice, and presenting the acquired company and the merging process in their main characteristics.
5.1
A Two-step Expansion Plan
As previously introduced, Novo Nordisk implemented its expansion in Latin America in through a two-step action plan: the acquisition of Biobrs S.A., and a consequent US$ 200 million (approximately BRL 550 million) investment starting in 2003 to enhance its production capacity of human insulin in Brazil through an enlargement and re-adaptation of Biobrs current animal insulin production facility and the construction of a new stateof-the-art plant located in Montes Claros in the State of Minas Gerais. The new facilities will be dedicated to the formulation, filling and packaging of human insulin products for the treatment of diabetes. The new plant is forecasted to employ about 500 workers, and to generate approximately 160 millions doses of DNA recombinant human insulin per year, for turnover estimated to reach US$ 220 millions138. 5.1.1 The Rationale Behind the Investment
"The investment in Biobrs marks a major expansion of Novo Nordisks activities in the large and growing market for diabetes care products in Brazil and Latin America, and reflects our vision of being there for people with diabetes around the world. []. Reflects Novo Nordisk's commitment to the Latin American market and our goal of being the Latin American leader in diabetes care.'' - Lars Rebien Srensen, CEO of Novo Nordisk.
138
Associasao Commercial, Industrial o de Servicos de Montes Claros (2003). Alfredo Galletti Carsten Wong Iversen
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There are several reasons behind the choice of Brazil as location of the new production facility. From a strategic point of view, as it can be detected within the words of the companys top management, Novo Nordisk aims to increment its position into Latin America (which is already considerable) due to the increasing importance and the massive potential growth of these countries for the commercialization of diabetes management products. It is in fact believed that the combined interaction of Biobrs expertise and knowledge of the Brazilian insulin market and of Novos research and development activities and technical capabilities will ensure a large, long lasting predominance in Brazil and a potentially large influence and control in Latin America139. According to Novo Nordisk140, in 2000, total sales of diabetes care products in the Brazilian market were estimated at US$ 133 million. Sales of insulin products accounted for an estimated US$ 42 million, and oral anti-diabetic drugs (OADs) accounted for an estimated US$ 91 million. As mentioned in chapter 3, the insulin market is expected to grow by 6,4% from 2000 to 2001, and the market for OADs is expected to grow by 6% in the same period. Biobrs was a well-established player in the Brazilian diabetes care market. In 2000, Biobrs had a turnover of BRL 58 million (US$ 24 million) and an operating profit of approximately BRL 3.1 million (US$ 1.3 million). In 2000, Novo Nordisk's turnover in Brazil was DKK 208 million (US$ 25 million), 82% of which came from diabetes care products. By acquiring Biobrs, Novo Nordisk would enjoy a local production base, combined experienced sales force, highly competitive portfolio of diabetes care products, larger market shares, and broader portfolio of clients. In addition, the transaction would offer Novo a solid base and networks for future launches of diabetes care products in order to supply the diabetes markets in Brazil and Latin America, and eventually other continents. Furthermore, the new plant will be the only insulin production facility in the whole Latin America to manufacture the drug not from animal insulin (which is almost expelled from the diabetes care market, as previously mentioned in chapter 2), but on the human DNA
139 As it has been pointed out by Guilherme Emrich, chairman of Biobrs: We believe that by combining Biobrs' knowledge of the Brazilian market and our excellent relations to the Brazilian diabetes community with Novo Nordisk's expertise in the research and development of new diabetes care products, the two companies will be better positioned to improve the lives of people with diabetes in Brazil and other countries in Latin America.'' See Biospace (2004). 140 See Novo Nordisk (2001).
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recombinant one141. The superiority of the human insulin compared to the animal one for patients metabolic system, and the lack of production facilities in loco of any of the major international players, should grant a substantial competitive advantage for Novo Nordisk. Another important reason for the creation of a production platform in Brazil (instead of other possible destinations that had been considered, as China142), arose from the substantial savings granted to the company by the State of Minas Gerais and by the Brazilian federal government, that agreed on a considerable reduction on import taxes regarding the necessary assets and equipment for the plant establishment. The above mentioned cost cutting opportunities have also been linked to the possibility to create and exploit a form of natural hedge towards some risks that Novo Nordisk has historically run with its Latin Americas operations. First of all, a local manufacturing plant should shield Novo by at least one of the country risks that characterize its operations in Brazil, given by the possible application of the article 68 of the Brazilian Industrial Law (Lei 9.279/96); and the consequent removal of patent protection from non Brazilian companies in favour of local ones. If this specific risk is quite irrelevant for the human insulin industry (due to the considerable entry barriers formed by the huge capital expenditure needed to start up a production facility), it may become an important factor (and a protection from it an extremely important resource) whenever Novo Nordisk would re-address its production towards other products, such as OADs or drugs from its pipeline, when possible competition (for example by generics) may assume a much bigger magnitude. Another risk that can be hedged through the establishment of the Montes Claros plant is represented by the fact that production facilities outside Denmark should create a form of natural hedge against possible further appreciations of the Danish Krone against weaker ones143.
See Isto Dinheiro (2003). Associasao Commercial, Industrial o de Servicos de Montes Claros (2003). 143 As mentioned in chapter 4, Latin American currencies historically represented a source of considerable currency risk for Novo. Lehman Brothers analyst Jo Walton considers the choice of Brazil, and in general of Novo Nordisk's capacity [] being built outside of Denmark to provide some form of natural hedge []. See Krause (2003).
141 142
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Finally, the commitment towards the American continent investment represents a source of tactical flexibility for Novo Nordisk. The production capacity of the new plant is at the moment way in excess than the current market potentialities. Excess capacity can be anyway either employed for cover potential increases in the demand; or diverted towards the production of other products, as OADs; or some pipeline products currently under development (as the phase II NN2211 testing)144. Moreover, Novo Nordisk has the chance to ensure itself a large amount of flexibility in the production locations. The average lower cost of labour in Brazil may grant costsaving policies of significant magnitude, that may involve not only the products sold in Brazil itself and, more in general, the Mercosur area (in which transportation costs are likely to be reduced due to the lower geographical distance between production and sale locations), but also towards other countries (as, for example, U.S. or Europe) whenever the prospected production savings would be able to offset the higher transportation costs145. Thus, the transaction would offer Novo a solid base and networks for future launches of diabetes care products in order to supply the diabetes markets in Brazil and Latin America, and eventually other continents.
5.2
Biobrs S.A.
Biobrs was founded in Montes Claros in 1971 by university researcher Marcos Mares Guia and started its industrial operations in 1976. At first, Biobrs faced difficulties to enter into a market controlled by some of large multinationals enterprises. However, soon it had the opportunity to enter into a joint-venture with Eli Lilly - one of the most important producers of insulin at the time and nowadays. This association lasted for about six years when Eli Lilly left the project. The main heritage of the venture was the
Analysts believe that an extra manufacturing capacity is necessary, in part, based on positive results from recently completed Phase II trials of NN2211 (liraglutide), a GLP-l (glucagon-like peptide- 1) insulin analogue, that is expected to initiate Phase III trials of NN2211 by mid-2004. Fortis Bank analyst Geraldine O'Keefe believes, in fact, that [...] higher amounts of the drug are required than initially expected. See Krause (2003). 145 On this regard, Biobrs general manager Marcelo do O, pointed out that, apart from being able to [] find opportunity to export to South American countries", Novo Nordisk is also moving some of its packaging operation for oral antidiabetic NovoNorm (Repaglinide) from Europe to Brazil. "We are trying to use the extra capacity present at Biobrs to help reduce production costs for such a tablet product," says Mr. do O. "Production lines may potentially be added in order to export NovoNorm. See Krause (2003). Moreover, some estimation predicts that a considerable part of the Monte Claros turnover will be generated by exports towards other countries. Around US$ 165 millions are in fact forecasted to be granted by abroad sales activities. See Associasao Commercial, Industrial o de Servicos de Montes Claros (2003).
144
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high-tech Crystal Insulin146 Manufacturing Unit at Montes Claros and the retention of the technology and know-how by Biobrs147. Biobrs -headquartered in Montes Claros, 300 kilometres north of Belo Horizonte in the Brazilian state Minas Gerais-, started as an enzymes manufacturer for the
Pharmaceutical Products 82,9% Industrial Products 7,7%
Figure 39. Biobrs: Break-down of sales 2001

Diagnostic Products 9,5%
pharmaceutical industry and; later on, it progressively switched to the production of insulin, diagnosis related devices and other industrial products. The company's principal
Source: LAFIS (2003a)
activities were, by 2001, the production, marketing, and distribution in domestic and international markets of medical and pharmaceutical products for human and veterinary use. By 2001, Biobrs had specialized in health biotech with around of 82,9% its total turnover from pharmaceutical products; 9,5% from products related to diagnostics and approximately 7,7% from industrial products148(see Figure 39 and Exhibit 5.1). By 2001, Biobrs was one of the four largest international companies that kept technology of and produced human recombinant insulin. In addition; the firm was in 1999, the only Brazilian producer of drugs used in the treatment of diabetes with 75% of the insulin market share in the home market.149 Additionally, research and development activities were a very important driver of their strategy, as Biobrs set up a large Research and Development laboratory intended to support technological activities of the smaller biotechnology firms of its region. Revenues Regarding sales and revenues, Biobrs experienced an astonishing growth in 2001, around 75% after a year nearly without any growth, whereas sales growth in 1999 amounted 49% approximately (see Figure 40). Until 2001, Biobrs primarily sold its production internally, exploiting in this way the Brazilian market and only marginally the
Insulin Crystals are the raw material necessary for the production of animal insulin. See Alcorta et al. (1997). 148 See LAFIS (2003, a). 149 See Biotech Holdings LTD (1999).
146 147
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foreign one (mainly Argentina and the rest of South America). From 1998 to 2001, the average value of the companys exports represented 8% of the total value of its sales (see Exhibit 5.2). According to the Institute of Industry Development of Minas Gerais, the firm was, in 2000, capable of producing double of the estimated consumption of insulin of Brazil150. Hence, it can be
Figure 40. Biobrs: Revenues Evolution, 1988 2001 (US$ million)

40 100%
30
80%
60% 20 40% 10
20%
0 1998 Sales 1999 % Grow th 2001 2000
0%
perceived that the firm had vast unused production capacity. Additionally, as shown in Exhibit 5.3, more than 50% of the companys revenues relied on two main clients. Moreover, only the Public Health Sector represented 46% of the total sales of Biobrs. Free Cash Flows Regarding the evolution of Free Cash Flows (FCF), the company had a negative result in year 2000, dropping from a positive US$ 0,9 million of FCF to a negative US$ 3,2 million in 2000; but in 2002, and the situation was reverted and the firm achieved a positive recovery to US$ 3,7 million (see Figure 41). Cost Structure Based on the Income Statements presented on Exhibits 5.4 - 5.9, the estimation of cost structure of Biobrs operations had been performed. The figures are shown in Table 15 and in Figure 42. Biobrs had in 2001 an operating profit of 27% of its revenues, dramatically higher than the 9% of 2000 and 5% higher than 1999. This can be explained by the significant decrease on the operating costs: On the whole, BioBrs had decreased its administrative and general expenses from 18% in 1999 and 2000, to levels of 14% in 2001. In 2000, the companys production costs increased from 42% to 47%. In addition; sales expenses amounted 27%, suffering a major increase compared to the 18% of the
See Instituto de Desenvolvimento Industrial de Minas Gerais: http://www.indi.mg.gov.br/ingles/profile/sectors/bio.html
150
Figure 41. Biobrs: Free Cash Flows Evolution, 1989 2001 (US$ Million)
12.000 8.000 4.000 0 1999 -4.000 -8.000
10.777
1.629
2000 -5.790
2001
67
previous year. The partial results for 2002 (first three quarters), show that the firms cost of goods sold had increase considerably to a level of more than 50%; having, in this way, a negative impact on the operating profit, if compared to those of 2001. Anyhow, those results are partial and the need of additional information regarding the results of the last quarter of 2002 may
Figure 42. Biobrs: Cost Structure, 1999 2002

100% 80% 60% 40% 20% 0% 1999 2000 Operating Prof it Cost of Sales 2001 2002 Gen. & A dm. Costs Costs of Goods Sold
suggest drawing no conclusion based on those figures. Any conclusion made founded on them, have the possibility to be incomplete or biased.
Table 15. Biobrs: Cost Structure, 1999 2002*
Percentage of Revenues Costs of Goods Sold Sales, General & Administrative Costs Cost of Sales Administrative & General costs Operating Profit Note: *Three Quarters 2002
Source: LAFIS (2003a).
1999 42% 36% 18% 18% 22%
2000 47% 45% 27% 18% 9%
2001 41% 32% 18% 14% 27%
2002* 52% 28% 18% 10% 21%
Main Operating and Financial Ratios In order to give a better overview of the company, the main financial and operational ratios are presented hereafter in Table 16. For a more in deep analysis of the companys ratios refer to Exhibit 5.10.
Table 16. Biobrs: Main Financial Ratios 1999 2001*
Ratio Net working Capital General Liquidity Total Debt (%) Interest bearing debt (%) Gross margin (%) EBIT (%) Operational Margin (%) Net Margin (%) Net Income Growth (%) Net Profit Growth (%) FCF / Net Profit Return on Assets (%)
Source: Bradespo ShopInvest
1999 26 615 0,097 52 19 2,42 0,84 0,88 0,42 2,01 5,28 0,022 0,79
2000 27 493 0,070 78 40 2,21 0,29 0,21 0,01 0,01 -92.84 -17,20 0,17
2001 18 616 0,053 85 41 2,46 1,26 1,17 0,75 3,21 170,82 0,042 1,58
Sept 2001 32 349 0,071 78 32 2,63 1,34 1,38 0,71 1,42 168,78 -
Sept 2002 16 640 0,063 357 170 1,92 0,92 0,17 0,17 3,84 -155,74 -
The case of Biobrs has been consider as an example of business success since the original technique utilized in its products consumed 10 years of research and around US$ 5 million. During that period, Biobrs kept growing from its start-up and become the world's fourth largest insulin producer and the worlds largest supplier of insulin
68
crystals.151 This also was reflected on its share prices. According to FIR Capital, between 1995 and 2000, the firms shares appreciated 1.512%; the third highest price appreciation on the Sao Paulo Stock Exchange's (BOVESPA) during that period. In addition; until 2001 was a top performing stock, returning a total of 4.444% to its shareholders.152 Biobrs was also the best investment ever made by BNDESPAR, the investment arm of Brazil's National Economic Development Bank153 (see Exhibits 5.11 5.12). 5.2.1 Main Transactions of the Acquisition
In January 2002, Novo Nordisk acquired the shares held by Biopart Ltda., a Brazilian limited liability company owned by the founders of Biobrs, for BRL 53 million (US$ 22 million). In total, the acquired shares represent 76% of the voting shares of Biobrs and 39% of the total capital of Biobrs. In October 2002, Novo Nordisk acquired an additional 55,4 % of the total share capital in Biobrs of Brazil in the delisting tender offer submitted to the companys minority shareholders. The purchase price of the shares was BRL 55,7 million equal to US$ 15,3 million. This purchase of shares allowed Novo Nordisks holding with a total of 99.3% of the voting shares and 97.5% of the total capital of Biobrs. As a result, Biobrs became a wholly-owned subsidiary of Novo Nordisk A/S and the total purchase price of Novo Nordisk's shareholding was BRL 133,5 million (US$ 47,4 million/DKK 380 million). Finally, in November 2002, Biobrs shares stopped being negotiated at the Bovespa. In august 2003, the acquisition of Biobrs S.A. by Novo Nordisk A/S was approved by the Brazilian anti-trust authorities. The decision by the Administrative Council of Economic Defence (CADE) was made approximately 18 months after Novo Nordisk acquired the majority of the shares in the Brazilian pharmaceutical company. Accordingly, Biobrs' former owners, who hold the patent to produce recombinant insulin, were not allowed to make use of the patent and to remain on the market any longer.
See Insulin Dependent Diabetes Trust Internationals Website. See Regueira (2003). 153 See www.firpartners.com
151 152
69
6 The Investments Operative Budget
THE INVESTMENTS OPERATIVE BUDGET
Due to information availability constraints, it has been necessary to estimate a considerable amount of items and attributes of the project in order to formulate the operative budget; in the following chapters, with the evaluation of the investment. The chapter will then present an exhaustive examination of the whole set of operative assumptions, necessary to perform this task. First, the reason for choosing an evaluation limited to a fictitious stand-alone project will be introduced. Once explained the motivations that lay at the bottom of the followed methodology, the chapter will proceed towards on the analytic presentation of the elements that compose the structure and the operations of the production facility, and their quantification. At the end, the chapter will present the operative budget of the project, the formulation of each years cash flow up to year 2017, and then an analysis of the impact of relevant variables that might affect the development of the cash flows originated by the investment throughout its useful life through a sensitivity analysis.
6.1
The Production Plant as a Stand-Alone Investment
The main base hypothesis that has been set is that the evaluation of the project performed in the chapter has, as a target, the evaluation of a stand-alone investment, and not as a component of a broader group strategy. The Costs Linked to the Assumptions Many elements may be opposed to this choice. As it has been previously pointed out, the investment in Brazil for Novo is not just an investment per se, but it is of course only a tile of a wider strategic puzzle, whose advantages may go beyond simple economic DCF valuations. Flexibility or cost-saving opportunities are potential sources of advantage for Novo Nordisk that cant be neglected. And Their Inevitability Unfortunately, the difficulty of estimating these advantages and the lack of available information in order to perform any sort of analysis of these elements would, given their complexity, firstly exile from the scope of the paper, and secondly imply results that,
70
being based on such an elevate number of assumptions and personal evaluations and estimations, present an almost complete lack of significance, at least for the purpose of the dissertation. Therefore the restraint of a fictitious stand alone investment, even though neglects an important part of the intrinsic value of the Brazilian investment, is seemed as a necessary constraint, in order to avoid the sacrifice of unnecessary effort for the production of unreliable results or evaluations.
6.2
The Projects Operative Budgeting Operative Assumptions
To evaluate the project, it is necessary to estimate an operative budget for a certain period of time in order to forecast with reasonable accuracy the possible originated cash flows. From the collected available information, the investment has a time development represented in Figure 43.
Figure 43. Projects Timeline
Since the project is assumed to have indefinite duration, it has been necessary to set two different discretionary timeframes: one relative to an explicit budget forecasting, and another one for the continuing value of the project. Since a detailed forecast of future yearly cash flows that would occur in many years from now seemed quite hazardous, and would be undermined by intrinsic imprecision, it has been preferred to limit the explicit yearly cash flow formulation to ten years after the operations start (fact that will occur, according to the available information, in 2007 then the explicit budgeting formulation will reach year 2016 included). From year 2017 to ever after, the continuing value of the investment has been calculated. Once the operative time framework for the budget construction has been set, in order to proceed towards the evaluation of the project based on the Discounted Cash Flow approach is indeed the forecast and calculation of the aforementioned cash flows. In order to estimate the cash flows, the first step is to set assumptions regarding the geographical location of operations. Since not all the production is destined to local
71
markets, it is necessary to recognize which countries the companys export activities will be addressed to. Therefore, in addition to Brazil, the primary targets for export activities are Argentina and Mexico, due to the fact that these are the largest and most relevant markets in the Latin American region. Secondary markets are Chile, Colombia, Peru and Venezuela. The first targets will be treated as single, independent variables, while the secondary ones will be grouped into a common macro variable
Figure 44. Investments Operations
under the label other countries. Being small and not easily accessible, the remaining Latin American countries will not be considered as possible operation field for Novo Nordisk, and will be excluded by the analysis. Revenues originated by the prime target locations will be denominated in local currencies, while for simplicity reasons; revenues from secondary ones will be denominated in a common currency, chosen to be US dollars. The production side of the operations of the facility is supposed to occur in the home location only, and then will be denominated in Brazilian Real. Therefore all the costs linked to production and commercialization of the production, including the ones originating from export activities, will be denominated in home currency. Figure 44 graphically exemplifies the followed approach and the discussed operative assumptions.
6.3
Key Variables Estimation
As previously underlined, due to the fact that the plant will start its production during the year 2007, no information is available about the consistency and level of either external (exchange rates, inflation rates) or internal variables (market share, level of revenues or cost structure). It has been necessary to formulate a range of hypothesis regarding the aforementioned key variables of the investment in order to proceed with the NPV calculation of the project. Three distinct clusters of variables have then to be hypnotised and analyzed: sales estimation, external variables and internal variables. The clusters are shown in Table 17. Not all the necessary variables to evaluate the projects NPV (such as for example the discount rate) will be introduced in the chapter. Here only the strictly
72
necessary ones for constructing the companys base budget will be presented, deferring the others formulation for the next chapter, more specifically dedicated to the Discounted Cash Flow approach evaluation of the investment..
Table 17. Variables Clusters
Clusters Sales estimation External Variables Variables Initial Market Share, units sold Sales Growth, unit terms Inflation Exchange Rates Local Prices, prices response to inflation rates Cost of Good Sold (Direct and Labour Costs) Sales and Distribution Costs General & Administrative Costs Net Working Capital Tangible Assets Estimation and Depreciation Capital expenditure Tax rate Royalties
Internal Factors
Other Factors
6.3.1
Sales Estimation
Estimation of Initial Market Share and Sales Due to the lack of data regarding specific sales of Diabetes Care products and insulin market consistencies and values154 in Latin America, in order to estimate market shares and future revenues arising from the operations of the new plant, a set of assumptions have been made by the authors. As introduced before, revenues will be generated by sales activities in the home country (Brazil) and in other countries in Latin America, divided among two clusters: primary targets and secondary targets. The first cluster is composed by Argentina and Mexico, due to their size and relative importance in the region. The second cluster, commonly referred as other countries, is formed by Chile, Colombia, Peru and Venezuela. Due to their negligible size, no sales activities will be addressed to the remaining Latin American markets. The first problem to be addressed is the estimation of Novos insulin market share in each market in the year 2007. To complete this task, it is necessary to first estimate the absolute size of each relevant insulin market. Since this information is not completely available, to overrun this limitation it has been decided to artificially infer the data from
Detailed information and reports are unfortunately not freely available. They can nevertheless be purchased from several market analysis and consultant companies.
154
73
the total size of each pharmaceutical market. Therefore, an estimation of the proportion of diabetes care products and insulin on the total pharmaceutical sales
Table 18. Insulin Share of Pharmaceutical Sales, 2000 (US$ million)

Total Pharmaceutical 3 422 5 153 Insulin Sales % n/a 42 0,82%
Argentina Brazil
has been performed. Based on total pharmaceutical sales and total diabetes care sales in Brazil and in Argentina, information mentioned in Chapter 3, the share of insulin sales has been calculated as shown in table 18. In 2000, Latin American sales reached approximately US$ 19 billions (see Chapter 2), in which Argentina, Brazil and Mexico accounted for around 70 percent of the market. The proportion of other countries and the rest of Latin American countries have been based on the available data on direct costs of diabetes (insulin, oral ant
Mexico 21%
Figure 45. Direct Diabetes Costs, 2000

Other Countries; 16% Rest of Latin A merica 14% Argentina 8%
Brazil 42%
Source: Barcel et al. (2003), authors elaboration.
diabetics, etc) in Latin America155. As shown in Figure 45, the result is that Chile, Colombia, Peru and Venezuela altogether are assumed to have around half of the remaining share (therefore 15%), just as the rest of the Latin American countries. Diabetes Care sales in Argentina and in Brazil arrange between 2,6% and 2,3% of their total pharmaceutical sales. An average value of 2,5% will be assumed for the rest of Latin American countries. On the other hand, insulin sales represent 0,82% of total pharmaceutical sales in Brazil, value that seems to comply with the global insulin sales proportion156. Accordingly, this value will be assumed and will be applied to estimate total sales in the rest of the abovementioned countries. Estimated pharmaceutical sales for 2006 in the key Latin American markets are US$ 1,96 billion for Argentina; US$ 4,7 billion for Brazil and US$ 8,6 billion for Mexico. Mexico is expected to displace Brazil and become the largest pharmaceutical market in the region, with an estimated share, in US dollar terms, of over 44%. Brazil is expected to drop to
See Barcel et al. (2003).. In 2002, global pharmaceutical sales amounted US$ 400,6 billion, and insulin sales were US$ 3,2 billion; corresponding to 0,8% of the global pharmaceutical sales. See IMS Health (2004b).
155 156
74
below 24% by 2006 and Argentinas share is expected to fall from around 18% in 2001 to 10% in 2006157. Once each markets size has been estimated, assumptions on Novos market shares of the insulin market in each region have to be made. Unfortunately, detailed information regarding the firms actual and estimated market shares is not available. Nevertheless, as seen in chapter 4, Novo Nordisk had increased its insulin market share to 49% in 2003158. Supposing that a similar figure can be applied to each country of operations, a value of 50% will be assumed as starting share of the insulin market in 2003 in the countries in mention. Finally, in order to estimate the figures for 2007- year in which the new plant in Montes Claros will start its operations - a suggested growth rate is applied to the 2006 values. In 2001, the world insulin market experienced a growth of 6,1%. Accordingly, it is assumed that the growth of the insulin market in Latin America for 2006 will be 6%. As a result, based on the above-mentioned estimations and applying the set of assumptions on percentages to other countries and rest of the Latin America Countries, Diabetes Care & Insulin sales proportions of total pharmaceutical shares, and Novo Nordisks market shares; the projected sales in 2007 are shown in Table 19. In order to perform the valuation, the future sales in Argentina, Brazil and Mexico are assumed to be in local currencies; while sales in other countries will be assumed to be in US$. This assumption has been made in order to avoid adding extra complexity to the study, and since sales in other countries have relative low contribution to and less effect on the companys total sales in Latin America.
Table 19. Estimation of Novo Nordisk Sales in Latin America, 2007 (US$ million)
Total Pharma 4,700 8,600 1,960 2,140 2,200 19,600 2006 Share % 24% 44% 10% 11% 11% 100% Insulin (0,8%) 38 69 16 17 18 157 Insulin Growth 6% 6% 6% 6% 6% Total Insulin 39,9 72,9 16,6 18,4 18,4 166,2 2007 NN Share 50% 50% 50% 50% -
NN Sales 18,8 34,4 7,8 8,6 69,6
Brazil Mexico Argentina Other Countries Rest LA Latin America
As a result and based on this figures, it will be employed as initial sales for 2007 the following figures: US$ 19 million for Brazil, US$ 35 million for Mexico, US$ 8 million for Argentina, and US$ 8,5 million for other countries.
157 158
See Chawla et al. (2004). See Novo Nordisk (2004). Alfredo Galletti Carsten Wong Iversen
75
Sales Development and Growth Estimation The initial sales, in unit terms and for each country, had been estimated as the total sales in local currencies for 2007 divided by local insulin prices for the same year. The basic assumption is that Novo Nordisks sales will, in units and at the beginning of the projects life, grow at similar rates as the insulin markets will, and eventually will converge to lower values. As mentioned in Chapter 2, the pharmaceutical and insulin market have been estimated to grow at rates of 6%. Therefore, it will be assumed that the growth of in 2007 will be 6% for Argentina and other countries. For the case of Mexico, it will be assumed that sales will growth at 7,5%, a percentage and a half point will be added since the growth of the pharmaceutical industry in Mexico is estimated to be substantially higher that the rest of the Latin American countries, see Chapter 3. Regarding Brazil, the sales growth for 2007 will be assumed to be 6,5% because of, as discussed in Chapter 5, the firm will benefit from enhanced networks and further advantages derived from the acquisition of Biobrs. Finally, assuming that new drugs major breakthroughs will not occur and that competitors will also react during the period, limiting the firms market share to similar level as the present ones, sales growth will tend to converge during the 10-year period of the analysis to the actual markets potential growth rates (6-7%), giving that no firms sales can be expected to grow forever at a rate higher than the markets one. rates. As a result, sales growth for 2016, in unit terms, is assumed to decline to 3% in Argentina and in other countries and to 3,5% in Brazil and Mexico. These assumptions are based on average demographic growth between 1-2%, and improved diagnoses coverage around (Exhibit 6.1 shows population growth rates in Latin America and the Caribbean).
Table 20. Selected Countries: Estimated Sales Growth, 2008 2016 (Percentage)
Argentina Brazil Mexico Other Countries 2008 6,0% 6,5% 7,5% 6,0% 2009 6,0% 6,0% 7,5% 6,0% 2010 5,0% 6,0% 7,0% 5,5% 2011 5,0% 5,5% 7,0% 5,5% 2012 4,5% 4,5% 6,5% 5,0% 2013 4,0% 4,5% 5,5% 4,5% 2014 4,0% 4,5% 5,0% 4,5% 2015 3,5% 4,0% 4,0% 4,0% 2016 3,0% 3,5% 3,5% 3,0%
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6.3.2
External Variables
Inflation Inflation rates may influence many factors on a budgets projections. Inflation rates affect the evolution of prices of units sold in each country over the years. In addition, inflation has effects on the costs of the projects operations (such as production, administrative and general costs, etc.) as it will be mentioned in the following sections. Following; historical, estimated and forecasted inflation rates of Argentina, Brazil, Denmark, Mexico and US are shown in Table 21 for the period 2003 - 2016.
Table 21. Selected Countries: Historical and Forecasted Inflation Rates, 2003 2016 (%)
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 13,4 6,7 9,5 4,8 2,5 4,2 4,3 6,3 6,5 7,0 6,7 6,1 6,0 6,0 14,7 5,9 4,7 4,4 4,4 3,5 3,1 2,8 3,0 3,3 3,3 3,5 3,8 3,8 2,1 1,7 1,8 1,6 1,4 1,2 1,0 1,1 1,2 1,3 1,3 1,3 1,4 1,4 4,6 4,3 3,2 2,5 3,1 3,4 3,2 3,6 3,3 3,3 2,9 2,8 2,6 2,6 2,3 2,3 2,2 2,5 2,9 2,5 2,2 2,1 2,4 2,7 2,9 3,1 3,5 3,5 Source: Euromonitor, authors estimation. Historic (2003), estimated (2004) and forecasted inflation rates (2005 2015) for all the Argentina Brazil Denmark Mexico US
selected countries have been obtained from Euromonitors database. Inflation rates for 2016 have been assumed equal to those of 2015.
According to Euromonitor and as exposed in Table 21, inflation in Argentina is estimated to be higher than the other selected countries throughout the whole period, with higher values between 6% and 7% from 2010 and over; whereas in Denmark, inflation rates are estimated to be lower for the same time period, with values around 1,31,4%. Inflation in Brazil is estimated to gradually fall to 2,8% in 2010 and then experience slightly increases reaching levels of 3,8% in 2016. Inflation rates in Mexico are estimated to rise to 3,6% in 2010 and then experience small reductions reaching levels of 2,6% in 2016. Finally, for the US, inflation is estimated to be to some extend lower than Brazil and higher than in Denmark during the evaluation period. Exchange Rates Being a large part of the projects operations addressed towards foreign markets, exchange rates are a fundamental variable to keep into account. As aforementioned, sales in Argentina and Mexico will be nominated in local currencies, whereas sales in other countries in US dollars. In order to translate those revenues into BRL and subsequent into DKK - to transfer them to the parent company- nominal exchange rates of BRL against the relevant currencies will be used.
77
Estimation of future spot rates has to be performed since forecasted rates for the whole period under analysis are not available. Amongst the major market-based exchange rate forecast theories, it has been selected the purchasing power parity (PPP) to estimate the future spot rates. Even though the theories hold on the long run, they are reasonable predictors, and in this specific case, the PPP is the best proxy due to the availability of data on expected inflation rates. The basic formulation is as follows:
E (St
BRA / C
) = S t 1
BRA / C
* 1 + inf t 1
[(
BRA n
) / (1 + inf ) ]
C n t 1
(6.1)
where E(StBRA/C) is the expected average exchange rate of BRL against currency in country C for year t, St-1BRA/C is the average exchange rate of BRL against currency in country C for the previous year (t-1), inft-1BRA and inft-1C are the forecasted inflation rates in Brazil and country C for previous year (t-1) respectively, n is the number of periods, and [(1+ inft-1BRA )/(1+ inft-1C )] is the inflation differential between Brazil and country C for year t-1 (the estimation will be done on a yearly basis, therefore n=1). As a result and based on Euromonitors inflation rates forecast and applying formula (6.1), yearly average exchange rates have been estimated and shown in Table 22.
Table 22. Brazil Against Selected Countries, Inflation Differentials and Expected Exchange Rates, 2004 2016
BRA/ARG 99,25% 95,62% 99,62% 101,85% 99,33% 98,85% 96,71% 96,71% 96,54% 96,81% 97,55% 97,92% Inflation Differentials BRA/DK BRA/MX 104,13% 101,53% 102,85% 101,45% 102,76% 101,85% 102,96% 101,26% 102,27% 100,10% 102,08% 99,90% 101,68% 99,23% 101,78% 99,71% 101,97% 100,00% 101,97% 100,39% 102,17% 100,68% 102,37% 101,17% 102,37% BRA/US 103,52% 102,45% 101,85% 101,46% 100,98% 100,88% 100,69% 100,59% 100,58% 100,39% 100,39% 100,29% BRL/ARS 0,9493 0,9420 0,9380 0,9290 0,9231 0,9169 0,9063 0,8765 0,8477 0,8184 0,7923 0,7729 0,7568 Expected Exchange Rates BRL/DKK BRL/MXP 0,5305 0,2972 0,5620 0,2963 0,5859 0,2963 0,6051 0,2951 0,6231 0,2947 0,6372 0,2950 0,6505 0,2947 0,6614 0,2924 0,6732 0,2915 0,6865 0,2915 0,7000 0,2927 0,7152 0,2947 0,7322 0,2981 0,7495 BRL/USD 3,1800 3,2500 3,3300 3,4000 3,4800 3,5140 3,5449 3,5692 3,5901 3,6111 3,6251 3,6392 3,6497
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Source: Euromonitor, authors estimation.
According to the expected rates, the Brazilian Real will appreciate against the Argentinean Peso during the whole period; whereas against the Danish Krone, the BRL will have a considerable depreciation during the same time period. Regarding the Mexican currency, BRL will not have any significant appreciation or depreciation against MXP. Finally, the BRL will have a considerable depreciation against the USD during the same period of time, but not as high as against the DKK.
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Price The procedure to estimate of insulin prices for the selected countries and for the period under analysis had been based on the latest price information in US dollars, applying the relevant exchange rates in order to translated them into local currencies for Argentina, Brazil and Mexico (the values for other countries will be assumed constant and in USD). The prices for the following years of the evaluation period had been estimated by adjusting previous-years prices by the assumed response to inflation in each country. Hereafter, a detailed description of the method used to estimate the insulin price for the evaluation period is presented. The prices for the same, or at least for comparable items for each country, have been based on the markets selling price of human insulin products. During 1999; the average sale price of a human insulin
Table 23. Selected Countries: Insulin Price Estimation in Local Currencies, 1999
Price (USD) 20,00 15,00 19,00 12,00 Exchange Rate 1,00 1,81 9,56 Price
159
Argentina Brazil Mexico Other Countries
20,00 27,15 181,64 12,00
Source: International Diabetes Federation, Euromonitor, authors estimation.
package in Brazil was around US$ 15, in Mexico was around US$19, in Argentina the market price was around US$ 45-48, while for the other countries category (Chile, Colombia, Peru and Venezuela ), an average price of US$ 12 has been estimated160. For Argentina, the 1999 price level has been considered especially high, taking into account the recent happenings in the country. Therefore, as a starting point, a price of US$ 20 per doses has been considered for Argentina. As a result, the estimated prices for 1999 in local currencies are shown in Table 23. Due to inflation effects, local prices of most products will tend to adjust following those inflation rates. For the case of pharmaceuticals and especially for insulin related products, this may not be the case in countries where specific regulations against drugs prices exist (for example, as seen in chapter 3, pharmaceutical prices in Mexico are regulated by the local governments), and due to many socioeconomic factors, the will to guarantee affordable life-sustaining medications is particularly important. Therefore, increases in insulin prices may not respond 100% to inflation rates. Hence, the estimation of the
159 Prices in Argentina, Brazil, and Mexico expressed in local currencies. Price in other countries expressed in US Dollars. 160 See International Diabetes Federation, Andalo (1998), Bibliomed Holdings Llc. (2003), Los Andes online (2001).
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insulin price over the evaluated period will depend upon the respond to inflation rates and prices regulations in each country. Based on the country overview presented in Chapter 3, the following assumptions will be made in order to represent the adjustment of prices in response to inflation rates for each country. In Brazil, prices will respond to 95% of the yearly inflation rate (e. g. a yearly inflation rate of 5% will represent an increase of or 4,75% - 0,95 times 5% - of the previous year price); in Mexico, prices will be increased by 85% the inflation rate; and in Argentina, the increase in price of insulin will follow 100% inflation rates. Based on the inflation rates presented in Table 21 and on the response to inflation assumptions abovementioned, insulin prices for the period 2007 2016 had been estimated and shown in Table 24.
Table 24. Selected Countries: Estimated Insulin Prices, 2007 2016 (Local Currencies)
Argentina (ARS) Brazil (BRL) Mexico (MXP) Other Countries(US$) Adjustment 100% 95% 85% 2007 2008 35,1 36,6 45,4 46,9 254,7 262,4 12,0 12,0 2009 2010 2011 38,2 40,6 43,2 48,3 49,6 51,0 270,0 278,8 287,0 12,0 12,0 12,0 2012 2013 46,2 49,3 52,6 54,3 295,6 303,3 12,0 12,0 2014 2015 2016 52,3 55,5 58,8 56,1 58,1 60,0 310,9 318,2 325,4 12,0 12,0 12,0
Source: IDF (1999), Euromonitor, authors estimation. Prices in Argentina, Brazil, and Mexico are expressed in local currencies. Prices in other countries are expressed in US Dollars
6.3.3
Internal Factors: The Cost Structure of the Project
Biobrs or Novo Nordisk? Due to the fact that the plant will start its production during the year 2007, no information is available regarding its cost structure yet. Therefore, it has been necessary to formulate a range of hypothesis regarding the key variables of the investment in order to proceed with the evaluations performed in the next chapters. The first choice that had to be made is whether Novo Nordisks or Biobrs cost structure is the most likely to occur, i.e. which one of these two sets of information is the best approximation for describing Montes Claros plant operations. It has been preferred to rely on Novos available data to base the authors assumptions regarding these matters for two reasons. The first, because it is believed that, even though Biobrs is a company that actually worked and produced in the Brazilian insulin market, Novo will try to implement its own operative and productive procedures and processes to its new plant (so for example incidence of fixed costs or of labour on the production). The latter,
80
because having Biobrs been de-stock listed during 2002, no more recent financial reports are available, and the ones that are actually publicly available present a level of detail which is unsatisfactory for the scope. Nevertheless, a comparison between Novo and Biobrs, for the last available year, has been made, reported in Exhibit 6.2. Even though, between the two companies, exists a substantial difference in the cost allocation; still operating profit against revenues, EBT/Revenues and Income Before Taxes/Revenues are more or less of the same magnitude. The explanation for the differences that occur on the incidence of each item that composes the cost structure of the two companies is a thorny problem indeed. It may depend in fact on different factors, such as differences in accountancy procedures and rules in force in Brazil and in Denmark, which allow companies to registry some costs as a part of sales, instead of as a part of production; on the different technology available; on the different marketing expenses operated by the two companies. Unfortunately, the lack of detail available for Biobrs doesnt allow a more detailed investigation of the matter. Nevertheless, it seems quite reassuring to witness that the margins from the core operations of the two companies dont differ much (Figure 46). Therefore, choosing Novo cost structure as the probable one for the investment, even though might change the relative weights of the components that actually contribute to determine the final profit (and that probably will be closer to the probable
20% 0%
Figure 46. Biobrs and Novo Nordisk: Ratios as % of Revenues, 2001 and 2003
80%
60%
40%
Gross Proft
Adm.& Gnrl. Costs
Production Costs
B io brs 2001
No vo N o rdisk 2001
N o vo N o rdisk 2003
Source: Novo Nordisk and Biobrs, authors elaboration.
ones, since it seems reasonable that the technology applied by Novo to its current production activities will be implemented also to its new facility); will likely not imply differences of significant amount in the final results. Moreover, the substantial lack of distance between Biobrs and Novos core ratios, allows to overrun another source of uncertainty; the income statements which the previously calculated ratios had been inferred from are based on the overall Novo groups cost structure, i.e. not only on the human insulin branch (and the companies
Operative EBT
Operating Profit
Sales Costs
81
related to it), but also on its other divisions. Not being a detail of each divisions cost structure publicly available, this factor might represent a probable source of bias for the hypnotised production dynamics. However, being the two companies final ratios quite close, it seems that the hypothesis of Novos general cost structure as the Montes Claros facilitys one, with some adjustments where needed, as not excessively binding The Cost Structure of the Project As previously stated, Novos cost structure will be taken as a starting point for formulating an hypothetical one related to the new facility in Montes Claros. Hereafter, the most important elements will be analyzed, pointing out where adjustments have been made or new elements have been added, and stating their growth patterns development, if required. The approach followed for the quantification of the starting level in 2007 of all of the elements has been the computation of each of them as its percentage ratio in comparison with revenues. Cost of Goods Sold Costs of good sold for Novo are essentially of two kinds: direct productive costs and labour employed, whose historical contribution to the overall variable costs is about 60% and 40% respectively (see Figure 47). If regarding the direct production costs it can be assumed that their incidence would remain constant (even though some of the costs i.e. energy
Figure 47. Novo Nordisk: Incidence Production Costs, 1999 - 2003
70% 60% 50% 40% 30% 20% 10% 0% 1999 2000 2001 Labour 2002 2003 Prod. Factors
on
or packaging material - might result cheaper in Brazil compared to other countries, the basic highly sophisticated and specialized chemical components are believed not to be cheaper, being imported from abroad), labour is expected to be relatively cheaper in the chosen location. Even though detailed information concerning average wages on specific economic activities in Brazil is not available - such as drug industry, pharmaceutical or biotech manufacturing a comparison between Brazil and Denmarks general manufacturing wage level seems to confirm this expectation. The historical data on
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average monthly wages are presented in figure 48161. This value (percentage of revenues) has been used to estimate a first quantification of the overall variable costs. Taking into consideration all manufacturing labour wages, the monthly averages in dollar terms, have been several times higher in Denmark than in Brazil
162
Figure 48. Wages Comparison: Brazil Denmark, 2000

5.000 4.000 3.000 3,00 2.000 2,00 1.000 0 1996 1997 1998 1999 2000 2001 2002 Brazil Denmark DK/BRA 1,00 0,00 6,00 5,00 4,00
(see Figure 48).
Source: U.S. Department of Labour, authors elaboration.
After the required adjustments, the general manufacturing employee for 2001 in Denmark received a monthly average wage of around 5,4 times as much as the one in Brazil. Considering the high skills required from the employees in Montes Claros, and the fact that a certain number of employees may actually come from abroad for example from other Novos production locations it had seemed reasonable to reduce this ratio163. The final impact of production factors and labour on variable costs therefore has been estimated as equal to 73% and 27% respectively, for an overall incidence on turnover equal to 17% and 6%. The combined impact of these types of costs over revenues has been historically equal to 27%. Applying the proportion and the figures previously calculated, the ratio for the new plant has been estimated to be approximately around 23%. This value (percentage of revenues) has been used to estimate a first quantification of the overall variable costs. Nevertheless, as previously discussed, using the same approach for all the projected budget cash flow years would be incorrect. In fact, for example an increase in revenues due only to positive exchange rate development (or price dynamics) wouldnt imply an increase in
The calculations of monthly wages are based on twenty-two working days per month and, in the case of Brazil, on eight hours a day. In the Danish case, the calculation for is based also on twenty-two working days per month, but on only 7,5 hours per day. Therefore the overall impact of labour in the production cost has been reduced, applying a simple proportion. 162 In 2001, a general manufacturing employee in Denmark received a monthly average base wage of around nine times as much as his counterpart in Brazil. Additionally, labour costs have to be adjusted due to compulsory benefits imposed by the Brazilian government. Wages may be inflated by 50-80% to base wages of full-time permanent employees. The adjustment due to compulsory benefits will be set to levels of 65% of the base monthly wages. See American International Group, Inc. 163 It is important to mention that recently, real average wages have suffered significant decreases. In March 2004, average wages fell 6.2% in real terms, condition that may have impacts on wages policies, such as minimum wages and so forth. See The Economist (2004).
161
83
production costs. These types of factors, and their influence, wont then be captured using the simple cost-as-percentage-of revenues approach164. For that reason, it has been preferred to try to estimate a possible level of sold production in 2007 applying the following equation:
Sold production =
j =1
revenues j price j
(6.2)
in which Revenuesj are the authors initial estimated revenues for country j in 2007 in foreign currency, and Pricej is the selling price per unit for country j. Once obtained the estimated sold production in units, the base variable cost estimation (23% of revenues) has been used to calculate an estimated unit production cost in BRL. Exhibit 6.3 exemplifies the discussed approach. Applying this framework, the estimation for the variable production costs gave a production factors cost per item equal to BLR 9,13 and a labour cost per item equal to BLR 3,22. Sales and Distribution Costs The estimation of the costs of sales over revenues related to the new investment is a quite complex task, because there are many factors and estimations that rely on the imputation policies of the parent company. The main component (but not the only one, of course) is represented by marketing and sale force expenditure related to the commercialization of the products manufactured by the facility. It is a quite cumbersome task to correctly impute each sale cost to the products, because many factors play an important role. For example, for goods that are exported towards other regions and
The correct operative framework would in fact require the expression of each cost charge per item. The logical event sequence, of course, requires that first comes production, then sales, and not the other way around. The expression of costs as percentage of sales would then create two distinctive sets of problems: first, it implies that all the production would actually turn into sales (basing costs on revenues would mean that the producer should know in advance the amount of sales before they actually occur, situation that is quite unlikely); second, it would loose possible market dynamics. For example, in condition of strong market uncertainties, an increase in sales growth may not turn into an equivalent revenue growth. Just to mention a simple example, in case of sell activities into countries whose currency experiences a strong devaluation, sale revenues denominated in that currency may be offset by the negative development of the exchange rates. Would then a decrease in revenues due to negative exchange rate development imply a decrease in variable costs? Of course it is not. Therefore it has been necessary to apply a different approach, whose exemplification is presented on Exhibit 6.3 together with its comparison with different approaches and their effect over the operative result of companies activities.
164
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commercialized there, it is difficult to compute which part of marketing expenses in those regions should be addressed to the new investment, and which shouldnt. To override these problems, it has been decided to apply Novos general sales costs expenses as percentage of revenues to the new investment, at least as a starting point. Novos historical ratio moved approximately between 27% and 30% (Figure 49). Considering the economic characteristics of the location, it has been preferred to apply a value equal to 28% to the hypothized cash budget. For the following periods, being these costs fixed for their nature, they are then supposed to develop over time according to their own dynamics, unlinked from revenues. Novos sales and distribution costs grew during the last years at a rate equal to approximately 5% (see Figure 49), growth which is due to two main components: a real growth in the absolute level of spending, and a nominal growth, caused by inflationary dynamics. Due to the difficulty to estimate the effective inflation rate, and so separate the two effects in the consolidated income
Figure 49. Novo Nordisk: Net Turnover and Fixed Costs Growth, 2000 - 2003
40% 30% 20% 10% 0% 2001 -10% Net Turnover Grow th Sales & Distribution Costs grow th A dministrative Expenses Grow th 2002 2003
statements of the group, it has been decided to take the average inflation rate in Denmark (around 2% during the period 2000 2004) as deflator for the growth. Following the same approach discussed above, the estimated level of each year for the category under analysis has been calculated as follows:
Cost of Salest = Cost of Salest 1 * (1 + growtht ) * (1 + Inflt )
(6.3)
in which Inflt is the rate of inflation in year t in Brazil, and growtht is the growth rate, estimated as expressed in Table 25:
Table 25. Cost of Sales and Distribution Growth
Year Growth Year Growth 2007(starting point) 28% of revenues 2012 3,5% 2008 3% 2013 4% 2009 3% 2014 5% 2010 3% 2015 5% 2011 3,5% 2016 6%
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General & Administrative costs For Novos, General & Administrative costs account for a considerable portion of its overall cost structure. During the 1999-2003 period, they accounted in average for an amount equal to approximately 25% of revenues. While administrative costs were responsible for an expenditure level equal to roughly 8% of overall revenues, the big bulk of the general expenses were represented by Research and Development costs (17% of revenues). The administrative cost level can be applied also to the new Brazilian plant, therefore a starting point equal to approximately 8% of revenues. As it has been pointed out for the costs of sales, even for G&A costs the inflation impact is considered separately, and the absolute level at year t is calculated as follows:
G & At = G & At 1 * (1 + growtht ) * (1 + Inflt )
(6.4)
in which Inflt is the rate of inflation in year t in Brazil, and growtht the yearly growth equal to 2% for each year. Royalties A different approach must be taken in consideration of R&D expenditure instead. In theory, it could be possible to apply the same method applied previously for other items (therefore simply state that R&D expenses are 17% of Montes Claros plant revenues), but it is believed that this particular category is way more complex than the others examined so far, for many reasons. First of all, the Brazilian plant is not supposed to perform any R&D activity; secondly, general R&D expenses may involve products that are not related at all with any of the product pipeline of the location. Consequently, a theoretically more correct approach is to consider a royalty expense surcharge over the Brazilian investment, quantified as equal to 5% of gross yearly revenues in Brazilian Real165.
165
A royalty is a payment for the use of, or the right to use, something that does not belong to the payer. This may well concern the right to use intangible property. The Royalties Article, Article 12 of the January 2003 edition of the OECD Model Convention on Income and on Capital, defines the term at 12(2): The term 'royalties' as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience. In Brazil, royalties may vary from 1% to 5%, depending on type of service or good involved. For further information, please refer to Deloitte Development LCC (2004). Alfredo Galletti Carsten Wong Iversen
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Net Working Capital Requirements and Growth The net working capital (NWC) has been defined as expenses on stocks increase plus operative accounts receivable diminished by operative accounts payable, instead the more common concept of current activities minus current liabilities, in order to obtain a more specific focus on the typical operative side of the company. For the last two years, Novo Group required a Net Working
Figure 50. Novo Nordisk: Change in NWC Composition, 1999 2003 (DKK million)
2.000 1.500 1.000 500 0 -500 -1.000 -1.500 -2.000 -2.500 Trade and other Creditors Stocks Trade and other Debtors 1999 2000 2001 2002 2003
Source: Novo Nordisk, authors calculation.
Capital equal to approximately 30% of revenues (respectively 30,1% and 29% for 2003 and 2002) to generate the achieved levels of turnover. Hence, as a starting point for the Montes Claros NWC, it has been assumed to be slightly lower than Novos one, set as equal to 25% of the first turnover level (then approximately BRL 42,5 millions), divided into two distinct components: stocks (equal to 10% of the amount of products sold), and accounts payable and receivable, equal to 15% of revenues. Since not all the production turns into sales, and it being extremely unlikely that Montes Claros production stockpiles will constantly be equal to zero, it has been preferred to separate and explicitly state the stock component of the Net Working Capital from the rest, because while stocks value depends on the number of items produced (and therefore on their actual cost of production), the rest depends on the consistency of credits and debts. Regarding instead the incremental
Figure 51. Novo Nordisk: Change in NWC, 1999 2003 (DKK million)
1.500 1.000 500 y = -378,4x + 591,2
requirement of the residual working capital per year, Novos average should be used as a benchmark for estimating the Montes Claros one. On the contrary to what it has been witnessed so far, it is difficult to recognize a constant yearly growth pattern for the last five years (see Figure 51). Therefore, in order to avoid any arbitrary
0 -500 -1.000 -1.500 -2.000 Change in w orking capital Linear (Change in w orking capital)
87
fixed quantification of the growth regardless sales level, it has been preferred to keep the NWC level requirements as equal to 15% of sales, and estimate the NWC variation as the residual between the differences on levels. Tangible Assets Estimation and Depreciation The total sum of the investment (US$ 200 millions) is composed by different typologies of assets, whose repartition is not available. Even though the allocation among the types of assets is not likely to affect the free cash flow estimation by a considerable amount, still it is important to recognize each type, and the proper depreciation procedure, since each amortization quota represents a tax saving related to the investment itself. For simplicity reasons, it has been set that each item belonging to a particular category follows the proper depreciation regime for the group. The plant, land and buildings are assumed to be depreciated, for tax purposes; according to a 5% yearly straight line procedure; while operating assets a 10% one. Current assets and other type of assets are supposed not to be depreciated during time, but expensed Again, in the year of occurrence. Novos Asset
Figure 52. Novo Nordisk: Composition, 1999 - 2003
100% 80% 60% 40% 20% 0% 1999 2000 2001 2002 2003 Current assets Operating assets Plant & Equipment Others
Assets
composition (Figure 52) has been taken has
Source: Novo Nordisk, authors elaboration .
benchmark for the Montes Claros production facility, according the following repartition: Lands, buildings and equipment: 37% (for a total of US$ 73 million); current assets: 47% (US$ 94 millions); operating assets: 3% (US$ 6 million); others 13% (US$ 26 million.). Taxes For the tax rate, the Brazilian tax code applies a tax rate to corporate earnings equal to 34%, the same amount applied by the Danish one166. For simplicitys sake, it has been
166
Corporate Income Tax (IRPJ) and Social Contribution on Net Income (CSLL) IRPJ is a federal tax and CSLL is a social contribution, both charged on taxable income. IRPJ is charged at the rate of 15% plus a surcharge of 10% on annual taxable income in excess of R$240,000.00 (approximately US$120,000). CSLL is charged at the rate of 9% for the period of February 1, 2000 through December 31, 2002. Taxpayers may Alfredo Galletti Carsten Wong Iversen
88
excluded any other taxation apart from the federal taxes over companies activities. It has been kept into account possible positive effects of tax shield that might originate in case of negative income, that according to the Brazilian tax code are not subjected to expiration, but can reduce corporate positive taxable income up to 30% of its amount as maximum. Regarding eventual taxation charge on dividends or cash pooling activities, it has been chosen to set them as equal to zero, being recognized a tax credit to Danish based entities for withholding taxes imposed by the Brazilian government based on the mutual agreement between the countries signed in August 1974. Net Financial Income Using Novos weighted average of its cost of capital for the evaluation of the Montes Claros investment, the hypothesis of the same financial structure for both the entities is implicitly introduced. Therefore being the project almost completely equity financed, it is likely to forecast that firstly no net financial expense will occur (as happened in Novo during the last years), and secondly that the net financial income, quite modest in its dimensions for Novo, is likely not to affect considerably the cash flows from the project. Moreover, excluding any financial impact on the computation of the forecasted cash flows, the evaluation will result more focused on the operative side of the new investment. Therefore, even though the hypothesis is quite restrictive and might present questionable foundations, it has been preferred to consider this category on the free cash flow projections of the project as equal to zero.
choose to pay corporate income tax and social contributions on net income on a calendar year or quarterly basis. Tax is calculated upon the total taxable income which corresponds to book profit before taxes adjusted by certain additions (e.g. bonus paid to directors, losses on investments accounted for in the equity method) and deductions (e.g. gains on investments accounted for in the equity method). Companies that opt to pay on an annual basis must make monthly advance payments. These are calculated on an amount equal to a percentage of monthly gross revenue, adjusted as determined by the prevailing legislation, and will be considered as prepayments of the total corporate income tax and social contribution due at the end of the calendar year. The percentage aforementioned, as determined in the legislation, is: Social contribution: 12%; Corporate income tax: variable, according to the companys activity (from 8% to 32%). Alfredo Galletti Carsten Wong Iversen
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The Initial and Continuing Capital Expenditure To set the budget, it is necessary to estimate a pattern for the beginning level of investment, equal to US$ 200 million. There is no information either regarding the division of the amount of investment per year, or about its nature (as said before, what is the tangible asset component or its proper accountancy classification). It has been therefore preferred to assume an arbitrary division of the starting capital expenditure equal to US$ 25 millions for the first two years (2004 and 2005), and postpone the biggest share of the investment (US$ 150 millions) to the last inoperative year (2006). Even though this hypothesis might seem quite restrictive (possible further payment delays seem not such a remote possibility indeed), lack of information on the topic suggested a more prudent approach. In order to proceed with a valuation focused only on the project, capital expenditure is set to be zero from 2007 up to 2016. The investment shouldnt in fact require any additional capital expenditure or disinvestment following its normal forecasted development over time. Nevertheless, a necessary amount of capital expenditure is required, for the estimation of the terminal value, since the investment cant be supposed to operate ever after 2016 without any additional investment. The expenditure required to allow the cash flow estimation, which the terminal value is based on, has been calculated as equal to the depreciation quota for the two asset categories and an additional BLR 20 millions per year (equal to 5% of the residual amount of the initial investment), yearly actualized by the forecasted inflation rate.
6.4
The Base Operative Budget
Applying all the assumptions and hypothesis formulated so far, the operative budget of the investment (income statements and expected cash flows for years 2004 2016) has been estimated, whose calculation is reported in Tables 26 and 27.
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Table 26. Montes Claros Investment Budget: Income Statements, 2004 2016 (BRL)
2004 Revenues in BRL - Brazil - estimated amount of sales - Average price in real - Argentina (in BRL) - estimated amount of sales - Average price in pesos - Argentina (in ARP) - Mexico (in BRL) - estimated amount of sales - Average price in pesos - Mexico (in MXP) - Other countries (in BRL) - estimated amount of sales - Average price in US$ - Other countries (in USD) Costs of Good Sold - Production costs - Labour - Items sold Costs of Sales Adm.& Gen costs Royalties Depreciation Lands and Buildings (res.) Operative Assets (Res.) Total Costs in BLR Taxes NET INCOME 2005 2006 2007 245.797.157 64.600.000 1.422.252 45,42 26.275.846 833.621 35,12 29.280.000 125.724.274 1.612.603 250,03 403.200.000 29.197.038 708.333 12,00 8.500.000 56.533.346 9,13 3,22 4.576.810 68.823.204 19.663.773 12.289.858 14.332.837 233.878.176 18.211.134 171.643.018 25.212.407 48.941.732 2008 272.859.697 71.086.567 1.514.698 46,93 29.560.170 883.638 36,60 32.340.346 140.812.951 1.733.549 257,26 445.966.416 31.400.010 750.833 12,00 9.010.000 62.422.891 9,45 3,34 4.882.719 73.368.977 20.759.045 13.642.985 14.332.837 221.568.798 16.187.675 184.526.735 30.033.207 58.299.755 2009 299.282.859 77.570.870 1.605.580 48,31 32.461.585 936.657 38,17 35.754.839 155.641.671 1.863.565 264,25 492.453.955 33.608.732 795.883 12,00 9.550.600 68.562.224 9,74 3,44 5.201.685 77.912.717 21.830.627 14.964.143 14.332.837 209.259.420 14.164.215 197.602.548 34.571.306 67.109.006 2010 327.463.205 84.412.311 1.701.915 49,60 35.815.139 983.489 40,58 39.907.764 171.466.297 1.994.014 272,34 543.049.659 35.769.458 839.657 12,00 10.075.883 74.782.558 10,02 3,53 5.519.076 82.497.102 22.890.722 16.373.160 14.332.837 196.950.043 12.140.756 210.876.379 39.639.521 76.947.306 2011 355.478.908 91.593.055 1.795.520 51,01 38.731.597 1.032.664 43,22 44.626.857 187.158.754 2.133.595 279,98 597.361.957 37.995.502 885.838 12,00 10.630.057 81.611.274 10,32 3,64 5.847.618 87.946.035 24.048.992 17.773.945 14.332.837 184.640.665 10.117.297 225.713.084 44.120.380 85.645.444 2012 385.048.921 98.715.399 1.876.319 52,61 41.884.476 1.079.134 46,24 49.899.520 204.320.006 2.272.279 287,83 654.035.627 40.129.039 930.130 12,00 11.161.559 88.777.197 10,66 3,76 6.157.862 94.027.943 25.339.461 19.252.446 14.332.837 172.331.287 8.093.837 241.729.885 48.728.472 94.590.563 2013 414.313.694 106.391.583 1.960.753 54,26 44.871.170 1.122.299 49,34 55.372.499 220.871.101 2.397.254 294,93 707.016.273 42.179.840 971.986 12,00 11.663.830 96.091.700 11,01 3,89 6.452.292 101.016.100 26.699.177 20.715.685 14.332.837 160.021.910 6.070.378 258.855.498 52.855.787 102.602.409 2014 445.417.305 114.875.913 2.048.987 56,06 47.934.921 1.167.191 52,35 61.100.231 238.357.196 2.517.117 301,95 760.035.424 44.249.275 1.015.725 12,00 12.188.702 104.028.640 11,39 4,02 6.749.020 109.779.247 28.186.321 22.270.865 14.332.837 147.712.532 4.046.919 278.597.910 56.718.594 110.100.801 2015 476.377.495 123.783.850 2.130.947 58,09 51.300.689 1.208.043 55,49 67.033.063 255.095.167 2.617.802 308,62 807.905.495 46.197.789 1.056.354 12,00 12.676.250 112.207.624 11,83 4,17 7.013.145 119.648.401 29.842.549 23.818.875 14.332.837 135.403.154 2.023.459 299.850.286 60.019.251 116.507.958 2016 508.325.204 132.741.283 2.205.530 60,19 54.847.619 1.244.284 58,82 73.186.698 273.014.656 2.709.425 315,44 854.661.813 47.721.646 1.088.045 12,00 13.056.537 120.359.986 12,28 4,33 7.247.283 131.646.743 31.596.097 25.416.260 14.332.837 123.093.777 0 323.351.923 62.890.915 122.082.365
Table 27. Montes Claros Investment Budget: Income Statements, 2004 2016 (BRL)
NET INCOME Depreciation Changes in NWC - Stocks - Stock year start (in items) - Stock year start (in BLR) - Stock year end (in items) - Stock year end (in BLR) - Other components - Year start - Year end Capital Expenditure Free Cash Flow in BRL Free Cash Flow in DKK 2007 48.941.732 14.152.500 42.522.908 2008 58.299.755 14.152.501 4.648.335 2009 67.109.006 14.152.502 4.577.408 2010 76.947.306 14.152.503 4.849.085 2011 85.645.444 14.152.504 4.885.227 2012 94.590.563 14.152.505 5.152.094 2013 102.602.409 14.152.506 5.121.166 2014 110.100.801 14.152.507 5.459.236 2015 116.507.958 14.152.508 5.461.927 2016 122.082.365 14.152.509 5.607.392
0 457680,9711 488271,8604 520168,495 551907,5712 584761,7644 615786,1534 645229,2424 674902,0359 701314,5219 0 5653334,614 6242289,143 6856222,377 7478255,808 8161127,402 8877719,734 9609169,953 10402864 11220762,44 457.681 488.272 520.168 551.908 584.762 615.786 645.229 674.902 701.315 724.728 5.653.335 6.242.289 6.856.222 7.478.256 8.161.127 8.877.720 9.609.170 10.402.864 11.220.762 12.035.999 0 36.869.574 0 20.751.661 35.547.864 36.869.574 40.928.955 0 67.984.257 113.111.420 40.928.955 44.892.429 0 76.864.435 125.044.244 44.892.429 49.119.481 0 86.431.057 137.743.400 49.119.481 53.321.836 0 95.093.054 149.041.705 53.321.836 57.757.338 0 103.771.306 159.801.035 57.757.338 62.147.054 0 111.814.080 168.852.666 62.147.054 66.812.596 0 118.974.402 176.187.090 66.812.596 71.456.624 0 125.378.868 181.724.712 71.456.624 76.248.781 0 130.807.810 185.209.782
-79.500.000 -79.500.000 -149.867.850
-82.297.654 -82.297.654 -148.988.860
-505.864.836 -505.864.836 -890.434.398
6.4.1
Sensitivity Analysis
The sensitivity analysis has been performed for each variable considering its effect on the cash flows. Since the results obtained for each year are quite similar, it has been decided to present the results relative only for one year (2010), and to omit the ones relative to the other years. The most important variables as effect on the cash flow by a 1% variation change from the base value are presented in Figure 53 and Table 28 (refer to Appendix H for a complete sensitivity analysis for each categorys variable).
Figure 53. Free Cash Flow Sensitivity, 2010 (DKK millions)
120 BLR DKK 2010 BLR MXP 2010 Net w orking capital 2010 Labour as % revenues Production Factors as % revenues Royalties 2010 Cost of Sales as % revenues Adm & Gen as % revenues BLR USD 2010 BLR ARS 2010 Tax rate 2010 BRA Inflation rate 2010 0,689 0,285 16% 7,0% 18,0% 6% 29,0% 9,0% 3,202 0,810 35% 3,80% 14% 5,0% 16,0% 4% 27,0% 7,0% 3,898 0,985 33% 1,80% 130 140 150 0,566 0,346
Table 28. Free Cash Flow Sensitivity, 2010 (DKK)

Variables BLR DKK 2010 BLR MXP 2010 Net working capital 2010 Labour as % revenues Direct Costs as % revenues Royalties 2010 Cost of Sales as % revenues Adm. & Gen as % revenues BLR USD 2010 BLR ARS 2010 Tax rate 2010 BRA Inflation rate 2010 Base value 0,63 0,32 15% 6% 17% 5% 28% 8% 3,55 0,90 34% 3% DKK change Downside Upside 14.894.228 -12.253.662 -12.845.663 12.845.663 5.114.340 -5.114.340 3.393.772 -3.393.772 3.393.772 -3.393.772 3.375.464 -3.375.464 3.037.048 -3.037.048 2.949.446 -2.949.446 -2.664.808 2.664.697 -2.659.303 2.662.464 1.820.860 -1.820.860 1.365.043 -1.365.043 % change Downside Upside 10,81% -8,90% -9,33% 9,33% 3,71% -3,71% 2,46% -2,46% 2,46% -2,46% 2,45% -2,45% 2,20% -2,20% 2,14% -2,14% -1,93% 1,93% -1,93% 1,93% 1,32% -1,32% 0,99% -0,99%
As predictable, the exchange rates are among the variables that have the highest impact on each years cash flow, since revenues in local currency (BRL) depend from their impact over the translation from foreign currencies.. The BLR/DKK exchange rate, as expected, is the variable that has the highest impact, due to its translation effect of the cash flows from local to home currency for the group. It is interesting to notice that this
92
variable is the only one that doesnt present a linear relationship with the cash flow (i.e. positive and negative variations of the same magnitude dont have the same effect over the cash flows). The BLR/MXP exchange rate importance can be explained by the importance that revenues generated in Mexico have for the prospected budget. Among the other variables, it is important to underline the importance of the inflation rate in Brazil due to its influence over all the operative costs of the investment..
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7 The Discounted Cash Flow Evaluation
THE DISCOUNTED CASH FLOW EVALUATION
In the last chapter, the projects budget for the period 2007 2016 has been estimated. The formulated budget will then become the starting point for the DCF evaluation of the project. Nevertheless, to proceed with the calculation of the NPV of the investment, a last group of variables has to be estimated: the discount rate and the final growth rate. Once this task will be completed, the chapter will proceed presenting the base case cash flow projections and its Net Present Value, and then analyzing the impact of any relevant variable that might affect the development of the cash flows originated by the investment throughout its useful life through a sensitivity analysis. Once formulated the base case, characterized by the absence of uncertainty and variability within its components, these elements will be introduced in the DCF approach through the application of MonteCarlo simulation framework. Since uncertainty does not depend only on the operations made by the company and on the different market dynamics that it has to face, but also from possible actions made by competitors, the simulation will take into account both the aspects, comparing then the different results that the two approaches generate, and drawing conclusions based on the aforementioned results.
7.1
The Base Case: Net Present Value
The last chapter presented the forecasted budget, summarized in Table 26 and 27. The aforementioned budget will be used as cornerstone for the formulation of the base case of the investment, and its NPV calculation. But, in order to be able to proceed to the application of the Discounted Cash Flow methodology, a last set of variables (other factors) still has to be estimated. 7.1.1 Other Factors: Final Growth and Discount Rate
Final Growth Rate Estimation In an investment whose useful life cant be determined or estimated basing on objective facts, the estimation and then the quantification of its terminal value often assumes a prime role into its net present value. Small changes in the final growth rate can affect heavily the terminal value, and hence the NPV. To perform the estimation of this key variable, a common method used is based of the expected long-term rate of consumption
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growth, plus the inflation rate167. Being Novo Nordisk an established international player in the insulin market, it would be shortcoming to consider possible markets only limited in the Latin America area. Given a demographic and disease incidence growth rate for the potential markets (then Latin America and the developed countries, as North America and Europe) equal to 1-2% (as seen in chapters 2 and 3), and a possible long run estimated yearly inflation rate equal to 1,5%, the final growth results equal to 2,5% 3,5%. In order to choose then a precise value, another consideration has been made. It seems quite unlikely that the future final growth rate, being basically a growth rate applied to the last explicitly forecasted free cash flow, would assume an absolute value different from the last free cash flow growth rate. For example, if the last three FCF growth rates have been equal to 1%, a final growth rate equal to 4% wouldnt make much sense. Using this average approach to benchmark the final growth rate, an estimation of 3% seemed the proper choice (the last three FCF growth rates average is in fact approximately 3,13%). Discount Rate The choice of the proper rate to discount the projected cash flows nominated in Danish Krone depends form many factors. The natural and most practical decision would be assuming Novos WACC as discount rate (as previously calculated in chapter 4), approach that will be adopted for the following evaluation. Nevertheless, some arguments may be raised against this choice. The first doubt is represented by questioning whether the systematic (or undiversifiable) risk of the prospected investment, reassumed by its beta, is the same as Novos. Choosing Novos WACC as discount rate for the investment implies in fact the assumption of equal systematic risks. This hypothesis may be justified analyzing the core activities of the company and of the project. As expressed in chapter 4, Novos main activity (more than 80% of its revenues) is the production and commercialization of diabetes management related products, nominally insulin. The prospected investment is also directed towards the production and commercialization of insulin. Assuming then that the company and the new project, being both of them focused on the same market, share the same level of unsystematic risk seems not an excessively binding hypothesis. Also regarding the financial structure of
167
Copeland et al. (2000, pg. 279). Alfredo Galletti Carsten Wong Iversen
95
the project, Novos policy to rely mainly on equity finance should remain constant also in relation to the new investments capital funding. A more thorny issue is represented instead by the necessity to include in the WACC a country risk component. The country risk factor can be included in a DCF framework either adjusting the numerator (so including risk factors under the form of a higher variance on the elements of the cash flows), or adjusting the denominator, for example through the implementation of techniques such as Harveys Country spread approach168 (even though this kind of approach has no universal consensus among authors about its theoretical validity169). Country Risk adjustment in the WACC are mostly used for particular types of risk whose impact over the FCFs, are difficult to estimate, such as civil wars or expropriation. The choice not to include such an adjustment has been inspired by three considerations: first of all, these particular kinds of risk seem quite remote for a country like Brazil (that, even though its economy has been in its past characterized by a certain level of instability, doesnt present many cases of such extreme private property exploitation phenomena); second of all, the cash flows that are discounted (and evaluated) are denominated in home currency (therefore Danish Krone) by the relevant exchange rates year by year. A worsening in the Brazilian economy should then be reflected by the exchange rate development, absorbing then the possible risks linked to these factors (for example, a dramatic increase in inflation in Brazil would be counterbalanced by the depreciation of its currency against the Danish one; the result
"When regressing the company returns (measured in US dollars) on the benchmark return (either US portfolio of the world portfolio), the Beta is either indistinguishable from zero or negative. Given the correlation between many of the emerging markets and the developed markets are low and given the evidence in Harvey (1995), it is no surprise that the regression coefficients (Betas) are small. The implication is that the cost of capital is the US risk free rate or lower. The following is a popular modification used by a number of prominent investment banks and consulting firms. A regression is run of the individual stock return on the S&P 500 stock price index return. The Beta is multiplied by the expected premium on the S&P 500. Finally, an additional factor is added which is sometimes called the "Country Spread". The spread between the country's government bond yield for bonds denominated in US dollars and the US Treasury bond yield is added in. The bond spread serves to increase an unreasonably low cost of capital into a number more palpable to investment managers. There are many problems with this type of model. First, the additional factor is the same for every security. Second, this factor is only available for countries whose governments issue bonds in US dollars. Finally, there is no economic interpretation to this additional factor. In some way, the bond yield spread represents an ex ante assessment of the country risk premium, which reflects the credit worthiness of the government. However, beyond this, it is difficult to know how to fit this factor into a cost of capital equation" See Harvey (1995). 169 Quite explicit on the matter seem the considerations by Mimi and Koller: (2000) Investors can diversify most of the risks peculiar to emerging markets, such as expropriation, devaluation and war [...]. The discount rate should reflect only nondiversifiable risks [and] diversifiable risks is better handled in the cash flows []. Many risks are idiosyncratic: they dont apply equally to all industries or even to all companies within an industry. The common approach to build additional risk into the discount rate involves adding to it a country risk premium equal to the difference between the interest rate on a local bond and [home] bonds of equal maturity [] doesnt take into account the different risks that different industries face [].. On the topic, please refer also to Brealey and Myers (2002, pg. 236-237), regarding the critics to such an approach.
168
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would then that nominal growths in cash flows nominated in Real would be counterbalanced by exchange rates adjustments); at last, Brazil is the production centre and the base of operations, but the possible areas of commercialization are not limited to Brazil (or Latin America only). Given the international nature of Novos operations, it is difficult to assign a proper country risk factor for increasing the discount rate. Most of sales are forecasted for example to happen in Mexico. Should then the Mexican one the most proper country risk to be used? Also, Novo might decide to redirect its US based production activities to Brazil for a successive commercialization in United States. Then the most proper country risk should be the US one. The discount rate choice then has been chosen as equal to Novos WACC (7,85%), as previously calculated. 7.1.2 The Base Case: NPV Calculation
Applying all the assumptions and hypothesis formulated so far, a base case cash flow projection has been estimated, whose detailed calculation has been reported in table 29., and the Net Present Value of the investment, based on this base case, is equal to DKK 610 millions, and an internal rate of return equal to approximately 14%. This result has anyway to be taken with a certain degree of carefulness. The base case incorporates all the main assumptions and dynamics of the projected investment. Nevertheless, it represents a static view of the investment, i.e. it doesnt incorporate any source of risk or uncertainty in itself, therefore any decision about whether enterprising the prospected investment or not based only on the above value would be incorrect. Anyway, the base case represents a useful starting point first for analyzing the influence and the impact that each component on the final net present value and on each cash flow, and then for simulate the possible scenarios that may influence the NPV of the project.
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Table 29. Base Case: NPV Calculation

2004 Revenues in BRL - Brazil - estimated amount of sales - Average price in real - Brazil - Argentina (in BRL) - estimated amount of sales - Average price in pesos - Argentina (in ARP) - Argentina in BRL - Mexico (in BRL) - estimated amount of sales - Average price in pesos - Mexico (in MXP) - Mexico in BRL - Other countries (in BRL) - estimated amount of sales - Average price in US$ - Other countries (in US$) - Other countries in BRL Total Revenues in BRL Costs of Good Sold - Production costs (per unit) - Labour (per unit) - Items sold - Total production costs - Total labour costs Costs of Sales Adm. & Gen costs Royalties Depreciation - Lands & buildings (residual) - Operating assets (Residual) Total Costs in BLR Operative income Taxes NET INCOME 2005 2006 2007 245.797.157 64.600.000 1.422.252 45,42092446 64.600.000 26.275.846 833.621 35,1238742 29.280.000 26.275.846 125.724.274 1.612.603 250,0304837 403.200.000 125.724.274 29.197.038 708.333 12 8.500.000 29.197.038 245.797.157 56.533.346 9,13 3,22 4.576.810 41.785.517 14.747.829 68.823.204 19.663.773 12.289.858 14.332.837 12.309.378 233.878.176 2.023.459 18.211.134 171.643.018 74.154.140 25.212.407 48.941.732 2008 272.859.697 2009 299.282.859 2010 327.463.205 2011 355.478.908 2012 385.048.921 2013 414.313.694 2014 445.417.305 2015 476.377.495 2016 508.325.204 132.741.283 2.205.530 60,18567065 132.741.283 54.847.619 1.244.284 58,81832115 73.186.698 54.847.619 273.014.656 2.709.425 315,4403152 854.661.813 273.014.656 47.721.646 1.088.045 12 13.056.537 47.721.646 508.325.204 120.359.986 12,28 4,33 7.247.283 88.961.729 31.398.257 131.646.743 31.596.097 25.416.260 14.332.837 12.309.378 123.093.777 2.023.459 0 323.351.923 184.973.280 62.890.915 122.082.365
71.086.567 77.570.870 84.412.311 91.593.055 98.715.399 106.391.583 114.875.913 123.783.850 1.514.698 1.605.580 1.701.915 1.795.520 1.876.319 1.960.753 2.048.987 2.130.947 46,93117019 48,31329316 49,59842675 51,01198192 52,61120755 54,26056891 56,06473282 58,08866968 71.086.567 77.570.870 84.412.311 91.593.055 98.715.399 106.391.583 114.875.913 123.783.850 29.560.170 32.461.585 35.815.139 38.731.597 41.884.476 44.871.170 47.934.921 51.300.689 883.638 936.657 983.489 1.032.664 1.079.134 1.122.299 1.167.191 1.208.043 36,59907692 38,17283723 40,57772597 43,21527816 46,24034763 49,33845092 52,34809643 55,48898222 32.340.346 35.754.839 39.907.764 44.626.857 49.899.520 55.372.499 61.100.231 67.033.063 29.560.170 32.461.585 35.815.139 38.731.597 41.884.476 44.871.170 47.934.921 51.300.689 140.812.951 155.641.671 171.466.297 187.158.754 204.320.006 220.871.101 238.357.196 255.095.167 1.733.549 1.863.565 1.994.014 2.133.595 2.272.279 2.397.254 2.517.117 2.617.802 257,2563646 264,2537378 272,3399021 279,9790364 287,8324484 294,9275182 301,9467932 308,6198173 445.966.416 492.453.955 543.049.659 597.361.957 654.035.627 707.016.273 760.035.424 807.905.495 140.812.951 155.641.671 171.466.297 187.158.754 204.320.006 220.871.101 238.357.196 255.095.167 31.400.010 750.833 12 9.010.000 31.400.010 272.859.697 62.422.891 9,45 3,34 4.882.719 46.138.659 16.284.233 73.368.977 20.759.045 13.642.985 14.332.837 12.309.378 221.568.798 2.023.459 16.187.675 184.526.735 88.332.962 30.033.207 58.299.755 33.608.732 795.883 12 9.550.600 33.608.732 299.282.859 68.562.224 9,74 3,44 5.201.685 50.676.426 17.885.798 77.912.717 21.830.627 14.964.143 14.332.837 12.309.378 209.259.420 2.023.459 14.164.215 197.602.548 101.680.311 34.571.306 67.109.006 35.769.458 839.657 12 10.075.883 35.769.458 327.463.205 74.782.558 10,02 3,53 5.519.076 55.274.065 19.508.493 82.497.102 22.890.722 16.373.160 14.332.837 12.309.378 196.950.043 2.023.459 12.140.756 210.876.379 116.586.827 39.639.521 76.947.306 37.995.502 885.838 12 10.630.057 37.995.502 355.478.908 81.611.274 10,32 3,64 5.847.618 60.321.376 21.289.898 87.946.035 24.048.992 17.773.945 14.332.837 12.309.378 184.640.665 2.023.459 10.117.297 225.713.084 129.765.824 44.120.380 85.645.444 40.129.039 930.130 12 11.161.559 40.129.039 385.048.921 88.777.197 10,66 3,76 6.157.862 65.617.928 23.159.269 94.027.943 25.339.461 19.252.446 14.332.837 12.309.378 172.331.287 2.023.459 8.093.837 241.729.885 143.319.036 48.728.472 94.590.563 42.179.840 971.986 12 11.663.830 42.179.840 414.313.694 96.091.700 11,01 3,89 6.452.292 71.024.300 25.067.400 101.016.100 26.699.177 20.715.685 14.332.837 12.309.378 160.021.910 2.023.459 6.070.378 258.855.498 155.458.196 52.855.787 102.602.409 44.249.275 1.015.725 12 12.188.702 44.249.275 445.417.305 104.028.640 11,39 4,02 6.749.020 76.890.734 27.137.906 109.779.247 28.186.321 22.270.865 14.332.837 12.309.378 147.712.532 2.023.459 4.046.919 278.597.910 166.819.395 56.718.594 110.100.801 46.197.789 1.056.354 12 12.676.250 46.197.789 476.377.495 112.207.624 11,83 4,17 7.013.145 82.936.070 29.271.554 119.648.401 29.842.549 23.818.875 14.332.837 12.309.378 135.403.154 2.023.459 2.023.459 299.850.286 176.527.209 60.019.251 116.507.958
2004 Depreciation Changes in NWC - Stocks - Stock year start (in items) - Stock year start (in BLR) - Stock year end (in items) - Stock year end (in BLR) - Difference - Other components - Year start - Year end - Difference Capital expenditure in BLR - Lands & Buildings - Operative assets - Other items Free Cash Flow in BR$ Free Cash Flow in DKK PV in BLR PV in DKK 79.500.000
2005
2006
2007 14.152.500 42.522.908 0 0 457.681 5.653.335 5.653.335 0 36.869.574 36.869.574
2008 14.152.501 4.648.335
2009 14.152.502 4.577.408
2010 14.152.503 4.849.085
2011 14.152.504 4.885.227
2012 14.152.505 5.152.094
2013 14.152.506 5.121.166
2014 14.152.507 5.459.236
2015 14.152.508 5.461.927
2016 14.152.509 5.607.392 701314,5219 11220762,44 724.728 12.035.999 815.236 71.456.624 76.248.781 4.792.156 0
457680,9711 488271,8604 520168,495 551907,5712 584761,7644 615786,1534 645229,2424 674902,0359 5653334,614 6242289,143 6856222,377 7478255,808 8161127,402 8877719,734 9609169,953 10402864 488.272 520.168 551.908 584.762 615.786 645.229 674.902 701.315 6.242.289 6.856.222 7.478.256 8.161.127 8.877.720 9.609.170 10.402.864 11.220.762 588.955 613.933 622.033 682.872 716.592 731.450 793.694 817.898 36.869.574 40.928.955 4.059.381 0 40.928.955 44.892.429 3.963.474 0 44.892.429 49.119.481 4.227.052 0 49.119.481 53.321.836 4.202.355 0 53.321.836 57.757.338 4.435.502 0 57.757.338 62.147.054 4.389.716 0 62.147.054 66.812.596 4.665.542 0 66.812.596 71.456.624 4.644.028 0
79.500.000 -79.500.000
82.297.654 505.864.836 246.187.553 20.234.593 82.297.654 239.442.689 -82.297.654 -505.864.836
20.751.661 35.547.864 16.542.168 28.336.947
67.984.257 113.111.420 50.249.038 83.603.769
76.864.435 125.044.244 52.677.444 85.696.475
86.431.057 137.743.400 54.922.327 87.528.584
95.093.054 149.041.705 56.028.339 87.814.607
103.771.306 159.801.035 56.691.257 87.300.834
111.814.080 168.852.666 56.638.944 85.531.596
118.974.402 176.187.090 55.879.439 82.750.874
125.378.868 181.724.712 54.601.264 79.139.326
130.807.810 185.209.782 52.819.207 74.786.314
-149.867.850 -148.988.860 -890.434.398 -79.500.000 -76.307.514 -434.904.791
-149.867.850 -138.144.515 -765.528.969
NPV in BLR NPV in DKK
553.389.181 610.089.728
TERMINAL VALUE LAST FCF BLR 134.908.413 CAP EXP 54.678.901 Growth 3,13% TV in BRL 1.701.519.247 TV in DKK 2.353.464.844 PV in DKK 881.141.736
7.1.3
Sensitivity Analysis
The sensitivity analysis has been performed for each variable considering its effect on the NPV of the investment. The influence of each variable on the overall net present value has been calculated as a percentage change that involves all the values in the estimated category (e.g. a 1% change in general costs would imply a 1% variation in the category for each year). Refer to Appendix I for a complete sensitivity analysis for each categorys variable.
Figure 54. Free Cash Flow Sensitivity, 2010 (DKK million)
300 MEX sales grow th var Cost of sales grow th var Production Factors grow th var BRA sales grow th var Labour as % revenues Production Factors as % revenues Royalties as % revenues Cost of Sales as % revenues Adm & Gen as % revenues Tax rate Labour grow th var 400 -1,0% 1,0% 1% -1,0% 7,0% 18,0% 6,0% 29,0% 9,0% 35,0% 1% -1,0% -1% 1,0% 5,0% 16,0% 4,0% 27,0% 7,0% 33,0% -1% 500 600 700 800 1,0% 900
Table 30. Free Cash Flow Sensitivity, 2010 (DKK)

Variable MEX sales growth variance Cost of sales growth variance Direct cost growth variance BRA sales growth variance Labour as % revenues Direct cost as % revenues Royalties as % revenues Cost of Sales as % revenues Adm & Gen as % revenues Tax rate Labour growth variance Base value 0% 0% 0% 0% 6% 17% 5% 28% 8% 34% 0% DKK change Downside Upside -154.324.802 163.313.816 101.334.282 -110.274.852 73.082.963 -80.276.552 -65.055.145 67.923.550 59.537.132 -61.076.032 59.537.132 -61.076.032 57.368.500 -58.907.401 52.747.715 -54.286.616 46.108.018 -47.646.918 30.967.579 -32.506.479 25.296.107 -28.830.780 % change Downside Upside -25,03% 26,48% 16,43% -17,88% 11,85% -13,02% -10,55% 11,02% 9,66% -9,90% 9,66% -9,90% 9,30% -9,55% 8,55% -8,80% 7,48% -7,73% 5,02% -5,27% 4,10% -4,68%
Among operative variables, sales growth in Mexico and Brazil seem to have crucial importance for the value of the investment. This can be easily explained considering the
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importance of these two markets for the projects revenue generation. Great importance, also, is given by the incidence of variations in variable costs (direct costs and labour), both in their initial incidence as percentage of revenues and in their growth during the years. On this matter, the sensitivity analysis seems to point out the importance of a correct estimation of the initial costs. As it can be seen in Figure 54 and Table 30; 1% variation on the estimation of initial costs has a huge impact on the final NPV of the investment. Due to the importance and magnitude of the discount rate and final growth to the project NPV, the two variables have been analyzed separately. The final growth rate used for estimating the terminal value of the investment assumes a crucial importance for the assessment and the quantification of the net present value of the project. A decrease up to -4% from the base value estimated for the final growth (4%) is able to reduce the NPV of the investment up to the 93% of its original value (from DKK 610 million down to 42 DKK million), as shown hereafter in figure 55.
Figure 55. NPV Sensitivity: Final Growth Rate (DKK million)
1.000 800 600 400 200 0 -4,0% -2,8% -1,6% -0,4% 0,8%
-4,00% 4,00% -500 0 500 1.000 1.500
2,0%
3,2%
Table 31. NPV sensitivity: Final Growth Rate (DKK million)

Variable Final growth Base value 0% DKK change Downside Upside -574.453.364 212.880.150 % change Downside Upside -93,16% 34,52%
WACC Even though dramatic changes in the companys WACC are unlikely to happen, given the financial policy adopted by Novo, a sensitivity analysis has been performed in order to investigate possible effects of sudden changes in the hurdle rate of the investments cash flows. Changes in the magnitude of 1% from the existing WACC (7,85%) have a considerable effect on the NPV of the project, that in percentage values varies from 44% in case of an increase of the WACC to a +69% in case of its reduction.
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Figure 56. NPV Sensitivity: WACC (DKK million)

1.200 1.000 800 600 400 200 6,85%
500
1.000
1.500
8,85%
6,85%
7,15%
7,45%
7,75%
8,05%
8,35%
8,65%
Table 32. NPV sensitivity: WACC (DKK million)

Variable WACC Base value 8% DKK change Downside Upside 424.986.205 -276.627.815 % change Downside Upside 68,92% -44,86%
7.2
Introducing Uncertainty: Monte Carlo Simulation
As previously stated, the base case NPV cant be used either to infer the effective value of the project, because no uncertainty or risk has been involved in its calculation, or to opt for the strategic choice of getting involved in the project itself. In order to achieve then an average value for the NPV of the project, and therefore reaching a more suitable decision criterion for deciding whether the investment is worth to be undertaken or not, a Monte Carlo simulation has been performed. The development of the project has been simulated 500.000 times according to random fluctuations based on the variance assigned to the projects key variables. Hereafter a description of the methodology used is presented. 7.2.1 Probability Distribution Functions for Uncertainty Modelling
In the simulation framework, three types of distribution have been implemented in order to replicate the possible fluctuations on the values of the key variables. Those are: the triangular, uniform and normal distributions. The triangular distribution had been used to assign unpredictability to variables which the mean is given by the forecasted value, and the minimum and maximum values are given by the estimated variation range for each variable. The option of using a triangular instead of other types of distribution is given by the higher uncertainty assigned to the extreme value, without excessively decreasing the chance that the forecasted mean value will occur. In detail, two distinct triangular distributions have been implemented: symmetric
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and skewed triangular distributions. The uniform distribution represents the situation where a random number can take values within a finite range [, ] with equal probability. Hence, the distribution has been implemented to include uncertainties of variables whose likelihood to vary within the assigned boundaries are considered equal. Finally, the normal distribution has been used to assign variability to the discount rate, in which the mean is equal to Novos cost of capital (refer to Appendix J for more details regarding these distributions and their probability density functions). 7.2.2 The Monte Carlo Simulation Framework
Table 33 presents a summary of the key variables in the simulation, their distributions, their assumed variances and their reference to the formula used. After the table, a description of each variable formulation will be presented.
Table 33. Monte Carlo Simulation: Variables, Distributions, and Variances
Inflation Changes Argentina Brazil Denmark Mexico US Exchange Rates Changes BRL/ARS BRL/DKK BRL/MXP BRL/USD Prices Adjustment to Inflation Argentina Brazil Mexico Sales Growth Argentina Brazil Mexico Other Countries Internal Variables Costs of Gods Sold Costs of Sales Changes in Stocks Changes in NWC Other Variables Taxes Royalties WACC Distribution Triangular Symmetric Triangular Symmetric Triangular Symmetric Triangular Symmetric Triangular Symmetric Distribution Triangular Symmetric Triangular Symmetric Triangular Symmetric Triangular Symmetric Distribution Triangular Skewed Triangular Skewed Triangular Skewed Distribution Triangular Symmetric Triangular Symmetric Triangular Symmetric Triangular Symmetric Distribution Triangular Symmetric Triangular Symmetric Triangular Symmetric Triangular Symmetric Distribution Uniform Uniform Normal Variance 35% 10% 1% 10% 1% Variance 33% 27% 17% 20% Variance 15% 10% 15% Variance 12% 8% 6% 6% Variance 5% 5% 10% 5% Variance 5%=+1,5%= -1 5%=+1,5%= -1 0,25 Formula (7.1) (7.1) (7.1) (7.1) (7.1) Formula (7.2) (7.2) (7.2) (7.2) Formula (7.3) (7.3) (7.3) Formula (7.4)) (7.4) (7.4) (7.4) Formula (7.5) (7.6) (7.8) (7.9) Formula (7.7) (7.7) (7.11)
Inflation Rates Forecasted inflation rates are not always precise and may considerably differ from real future ones. Therefore, a first source of uncertainty appears in the evaluation. Figure 57 shows historical and forecasted change on inflation rates (for detailed values refer to
103
Exhibit 7.1). It can be observed in the figure that the forecasted changes on inflation rates for Mexico and Brazil are less volatile than Argentina. As a result, based on the economic variance overview on the presented in Chapter 3 and on the abovementioned, assumed. forecasted inflation rates changes has been
Figure 57. Selected Countries: Historical and Forecasted Inflation Rates Changes, 1998 - 2015
100% 80% 60% 40% 20% 0% -20% -40% -60% -80% A rgentina Mexico Brazil USA Denmark 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Euromonitor, authors calculations.170
Since Brazil and Mexico have been and may remain economically and politically more stable than Argentina, a variance of 10% over the forecasted inflation changes have been assumed (e. g. if the inflation change has been forecasted to be 5% for year t and country B, the simulated rate will fall between 4,5% and 5,5%). Whereas, for Argentina, a variance of 35% had been assumed since the country remains economically unstable. Finally, due to higher economic stability, it has been assumed a variance of 1% for Denmark and the US. As a result, the uncertainty due to fluctuations on forecasted inflation rates has been calculated according to the following equation:
Inft _ A = Inft 1 _ A * (1 + Gt _ inf_ forecasted _ A (1 + x * (Varinf_ A ) ))
(7.1)
in which Inft_A is the inflation in country A for year t, Inft-1_A is the previous-year inflation rate for the same country, Gt_inf_forecasted_A is the forecasted inflation change for country A and period t, Varinf_A is the possible variation assumed (10% for Brazil and Mexico; 35% for Argentina, and 1% for Denmark and the US) and x is a random value included in the range [-1, 1] by a symmetrical triangular distribution (-1,0,1), and it will be simulated for every country and year under analysis. The uncertainty effect is, therefore, included in the simulation by incorporating the random value of change between Gt_A_inf_forecasted*(1-Varin_Af) and Gt_A_inf_forecasted*(1+Varinf_A), with mean value equal to Gt_A_inf_forecasted (inflation rate change is equal to the forecasted one).
170
Values are expressed as percentage change against previous year rates. Argentinean inflation growth for 1998 to 2001 had deliberately excluded from the graph due to abnormal values derived from hyperinflation and other issues discussed in Chapter 3. Alfredo Galletti Carsten Wong Iversen
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Exchange Rates Exchange rates of BRL against USD, ARS and MXP may also differ from spot values in the future. Consequently, a second source of uncertainty is added to the evaluation. Figure 58 shows the estimated changes of the BRL against selected currencies171 (for detailed values refer to Exhibit 7.2). It can be observed in the figure that forecasted changes of all
Figure 58. Selected Countries: Forecasted Exchange Rates Changes, 2005 - 2017
4% 3% 2% 1% 0% -1% -2% -3% -4% -5% BRL/ARS BRL/MXP BRL/DKK BRL/USD 2005 2007 2009 2011 2013 2015 2017
Source: Euromonitor, authors elaboration.
currencies tend to constant values. Nonetheless, economic and political instabilities as mentioned in Chapter 3 may lead to dramatic and unexpected fluctuations on exchange rates. This supposition is supported by the variance on historical changes. Figure 59 shows the exchange rates changes for the period 1988 2004. As suggested by the figure, the values have a significant variance, especially for Argentina. These volatilities can be expressed by their variances. Hence, variances for the mentioned period reached values of 33%
Figure 59. Selected Countries: Historical Exchange Rates Changes, 1998 - 2004
80% 60% 40% 20% 0% -20% -40% -60% -80% BRL/A RS BRL/MXP BRL/DKK BRL/USD 1999 2000 2001 2002 2003 2004
Source: Euromonitor, authors elaboration.
for BRL/ARS; 27% for BRL/DKK, 17% BRL/MXP and 20% for BRL/USD (see Exhibit 7.3). Thus, these values will be considered in the evaluation of the project. Accordingly, uncertainty derived by fluctuations on estimated exchange rates has been taken into consideration in the simulation as follows:
Fxt _ B = Fxt 1 _ B * (1 + Gt _ Fx _ forecasted (1 + x * (VarFx _ B ) ))
(7.2)
in which Fxt_B is the exchange rate of BRL against currency B for the year t (yearly average and in nominal terms), Fxt-1_B is the previous years exchange rate against the
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Values as percentage change against previous years. Argentinean inflation change for 1998 to 2001 had been deliberately excluded from the graph due to hyperinflation issues as mentioned in Chapter 3. Alfredo Galletti Carsten Wong Iversen
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same currency, Gt_Fx_B_estimated is the estimated exchange-rate change of BRL against currency B for the year t (see Exhibit 7.2), VarFx_A is the possible deviation assumed (33% for BRL/ARS; 27% for BRL/DKK, 17% BRL/MXP and 20% for BRL/USD) and x is a random value in range [-1,1] by a symmetrical triangular distribution (-1,0,1); simulated for every country and year under analysis. Thus, the uncertainty effect have been incorporated by simulating a random value on exchanges change between Gt_B_Fx_forecasted*(1-VarFx_B) and Gt_B_Fx_forecasted *(1+VarFx_B), with mean value equal to Gt_A_inf_forecasted (exchange rate change will have the same value as estimated one). Prices The uncertainty on local insulin prices has been taken into consideration by simulating the adjustment of those prices to local inflation rates. As mentioned on Chapter 3, it has been assumed that, as a starting point, prices in Brazil and in Mexico will respond (Adjinf) 95% and 85% respectively and 100% in Argentina. Moreover, prices in other countries will be assumed to remain constant over the evaluation period and will be expressed in US dollars. Since is not certain that the adjustment will occur at those levels, it has been assumed the following formula in order to simulate local prices of insulin:
pricet _ A = pricet 1 _ A * (1 + Inf t _ A * Adjinf_ A * (1 + Varadj _ inf_ A * y ))
(7.3)
in which Pricet_A is the price in country A for the year t, Pricet-1_A is the price for the past year in the same country, Inft_A is the inflation rate for country A in year t (value simulted and calculated through the formula 7.3), Adjinf_A is the base adjustment to inflation for country A, Varadj_inf_A possible variance of the adjustment in country A (assumed to be 15% in Argentina and Mexico, and 10% in Brazil), y is a random value included in the range (-1,1/10) by a asymmetrical triangular distribution (-1,0,1/10); meaning that its assumed that it will be less likely to rise the prices over the adjustment levels and that there will more chances that prices will adjust with lower rates than inflation ones (e. g. in Argentina the adjustment to inflation is set to be 100% and the variance 15%, therefore the simulated adjustment will fall in the range [100%-15%,100%+15%/10] of the yearly inflation value, namely 85% and 101,5%). This random variable will be simulated for every country and every year under analysis, being independent form previous years and from country to country. Accordingly, uncertainty effects related to prices have been implemented by simulating a random value
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on price adjustment due to inflation between Inft_A* Adjinf_A *(1-Varadj_inf_A) and Inft_A*(1+ Varadj_inf_A /10), with base value equal to Inft_A* Adjinf_A. Sales Growth The uncertainty derived from fluctuations on sales growth estimation has been incorporated in accordance to the following equation:
Gt _ sales _ A = Gt _ sales _ estimated _ A * (1 + x(VarG _ sales _ A ) )
(7.4)
In which Gt_sales_A is the simulated sales growth in country A for year t, Gt_sales_estimated_A is the estimated sales growth in country A for year t (shown in Table 20 in Chapter 6), VarG_sales_A is the assumed variance on sales growth for country A (12% for Argentina, 8% for Brazil; and 6% for Mexico and other countries; being lower in Mexico due to its economic as discussed in Chapter 3); and, once more, x is a random value included in the range [-1,1] by a symmetrical triangular distribution (-1,0,1) which will be simulated for every country and year individually. The uncertainty effect is, with this procedure, taken into consideration in the evaluation by incorporating the random value of sales growth between Gt_sales_estimated_A*(1-VarG_sales_A) and Gt_sales_estimated_A*(1+VarG_sales_A), with mean value equal to Gt_sales_estimated_A (Sales growth is equal to the base estimated value). Cost of Goods Sold The uncertainty in the productive factors and labour has been calculated according to the following equation:
Pf t = Pf t 1 * (1 + Inflt ) * 1 + x(VarPf )
(7.5)
In which Pft is the productive factor cost per item at time t, Inflt is the inflation rate in Brazil at time t, VarPf is the possible variation estimated as equal to 5% of the base value and x is a random value included in the range [-1,1] by a symmetrical triangular distribution (-1,0,1). In qualitative terms, the productive factors are estimated to grow each period by the rate of inflation (then the base case value). The uncertainty is introduced then by a supplementary factor which is equal to a random value between 5% and 5%, with modal value equal to zero (then no supplementary effect). The same approach has been used for the introduction of uncertainty on labour cost per item, whose growth variance has also be set equal to an arbitrary value of 5%.
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Sales & Distribution and Administrative & General Costs The uncertainty in sales and distribution costs has been implemented in the simulation on the prospected real growth rates development (so unlinked from the nominal growth in expenditure created by inflation) previously introduced. The formulation is the following:
Cost of salest = Cost of Salest 1 * (1 + Inflt ) * { 1 + [growtht * (1 + x(varcs ))]
(7.6)
In which Cost of Salest is the cost of sales and distribution in absolute terms at time t, Inflt is the Brazilian rate of inflation at time t, growtht is the estimated real growth rate in expenditure, varcs is the possible variation (estimated to be equal to 5%) and x is a random value included in the range [-1,1] by a symmetrical triangular distribution (-1,0,1). In qualitative terms, the absolute level of sales and distribution expenditure is equal to the value from the previous year, indexed by the inflation occurred in the year, and increased by a growth whose base value is the estimated one (for example, 3% for 2008), with a variance equal to 5% (so in 2008, the growth can randomly vary between 2,85% and 3,15%, with mode value equal to 3%). The same approach has been implemented for Administrative and General costs, whose real growth rate variance has also been estimated as equal to 5%. Royalties and Tax Rate The uncertainty on royalties has been implemented through the use of a uniform distribution [0,1]. The possible values of royalties (expressed as percentage of gross revenues) at time t has been set as follows:
Royaltiest = Royaltiest-1 + if x < 0,05 -1% = +1% if x > 0,95 0 otherwise
(7.7)
In which Royaltiest is the percent royalty charge at time t, and x is a random generated number from a uniform [0,1] distribution. The low likelihood assigned to increases or decreases from the estimated base value (5%) is due to the fact that royalties are set by the parent company, but at the same time have to complain to anti transfer pricing indications from the OECD (and then cant be set to a level that contrasts the suggested
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ones for respecting the arms length principle), and moreover, being the tax rates in home and foreign country considered equal (34%) in the base case, changes in royaltys surcharges would have no effect at an aggregated level. The same approach has been used for estimating uncertainty in the tax rate. The base tax rate (34%) can be increased or decreased year by year by 1% with a probability of 5%. Once again, the low probability associated to positive or negative variations depends from the consideration that such changes are not in the immediate agenda of the Brazilian Government. Nevertheless, sudden changes in all the elements that compose the applied corporate tax rate (such as indirect taxes, social contributions and so on) shouldnt be underestimated. Changes in Stocks and Net Working Capital Requirements The introduction of uncertainty in the elements composing the change in Net Working Capital requirements (stocks, accounts payable and accounts receivable) is based on the following equation:
Stockst = { [Items sold t * ( Stock % + x *Varstock )]*VarCosts t
} Stockst 1
(7.8)
In which Stockst is the increase in stocks (expressed in BLR) at time t, Items Soldt is the amount of items sold in year t, Stock% is the amount of items kept as stock expressed as percentage of items sold (hypnotized in the base case as equal to 10%), Varstocks is the possible variation in Stock% (equal to 10%), x is a random value generated by a symmetric triangular distribution (-1,0,1), VarCostst is the production cost per item at time t and Stockst-1 is the value in BLR of last years stock level. The same approach has been followed for the other working capital elements, expressed by the following equation:
OWCt = [revenuest * (OWC % + x *VarOWC )] OWCt 1
(7.9)
In which OWCt is the increase in other working capital elements (expressed in BLR) at time t, revenuest is the revenues in year t, OWC% is the other working capital elements requirement expressed as percentage of revenues (hypnotized in the base case as equal to 10%), VarOWC is the possible variation in OWC% (equal to 5%), x is a random value generated by a symmetric triangular distribution (-1,0,1) and OWCt-1 is the value in BLR of previous years working capital requirement.
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Final Growth As previously expressed, changes in the final growth rate have a substantial influence over the terminal value quantification, and then over the NPV of the project. Therefore simply assuming that the final growth rate will always be equal to the insulin World market growth (estimated to be approximately 4%) seems a too simple approach. It has been chosen then to estimate the final growth rate as a function of x: x x (4%,4%) 4% x 4% final growth ratet (x) = 4% x 4% n ( FCF growth ratet i ) x = i =1 n
(7.10)
In which FCF growth ratet-I is the growth rate of free cash flows in Danish Krone from time t-i-1 and time t-i. So the final growth rate is defined as the average growth rate of the last n cash flows if the average itself falls within the range of -4% and +4%, while for values exceeding the forecasted boundaries, the extremes themselves will be chosen. The reason behind this methodology is based on the consideration that assuming a pathindependent final growth rate may imply a lost in significance and correlation with the previous years within the NPV. At the same time, it seems unrealistic to believe that the investment will grow forever at a rate higher than the market itself. For symmetrys sake, it has been necessary to limit the possible downside. The value assigned to n is equal to 3 (so the last four cash flows have been considered), in order to neither include obsolete values in the final growth rate estimation, nor limit too much the explanatory power of the average. WACC Even though sudden changes in the weighted cost of capital of Novo, chosen as hurdle rate, can be considered quite unlikely given the companys stability on financial policies, the high magnitude in the impact of variations over this variable suggest its simulation, even though in a quite reduced range of variability. The simulation for changes in the hurdle rate has been implemented through the following equation:
WACC = 7,85% + x
(7.11)
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In which WACC represents the hurdle rate which all the cash flows have been discounted with 7,85% is the base value of Novos WACC and x is a random variable, included between 7,35% and 8,35%; generated by a (0, ) normal distribution.
7.3
The Static Monte Carlo Simulation
The Monte Carlo framework is based on the application of the possible variations previously presented, simulating for 500.000 the Net Present Value of the investment. The base framework presented hereafter takes into account only market and macroeconomic dynamics, regardless of possible developments in the competitive landscape. The simulation then can be seen as a static one from the competition point of view, meaning that possible breakthroughs or new revolutionary products that may be launched by other players in the market are not considered. A more detailed explanation regarding this topic will be presented in the next section, where an augmented version of the simulation will be formulated and performed. 7.3.1 The Net Present Value of the Investment
Under all the assumptions discussed in this chapter, the simulations results suggest a mean net present value of the investment equal to DKK 546,5 million (see Table 34). Moreover, the mean value of the internal rate of return (IRR) as a result of the simulation is 13,03% (see Exhibit 7.4). Thus, under these assumptions and circumstances and based on the fundamental idea of the DCF approach, the investment should be undertaken (NPV>0). The IRR method supports this decision, since IRR>WACC.
Table 34. Simulation results Net Present Value of the Project (DKK million)
3,5% 3,0% 2,5% 2,0% 1,5% 1,0% 0,5% 0,0% -60 100 260 420 580 740 900 1.060 1.220
Statistics Mean 546,5 Median 527,6 St. Deviation 250,3 Skewness 0,21 Kurtosis 2,32 Variability 0,46 Range Min. -146,5 Range Max. 1.496,4 Range Width 1.642,9
Percentiles 0% -146,5 10% 228,8 20% 313,6 30% 384,6 40% 454,2 50% 527,6 60% 608,1 70% 693,6 80% 782,9 90% 889,3 100% 1.496,5
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The NPV distribution approximately resembles a normal distribution. The left skewness is due to the particular formulation of the price response to inflation, which for Brazil and Mexico is supposed to be less than the inflation. Because the terminal value (continuing value) have such a large impact on the projects NPV it has also been forecasted. According to the simulation outcomes, the mean PV of the terminal Value is DKK 826,7 million (see Exhibit 7.5). This suggests that the terminal value has enormous impact and importance for the overall value of the project.
7.4
The Augmented Monte Carlo Simulation
As briefly introduced in the last section, considering only normal macro and microeconomic variables to evaluate the possible outcomes of the investment, neglecting at the same time other possible factors, might not only be a myopic procedure, but also could be a seriously misleading mistake. The market potentiality for a product like human insulin, due to its uncomfortable invasive posology, can be seriously jeopardized by the introduction of other substitute medications, such as for example oral insulin, which could reduce or eliminate such unpleasant features. Competitors then have some real options, whose exploitation may influence considerably the investments profitability. Therefore it is necessary to introduce, or better to extend, the simulation framework, in order to include these subtle but potentially powerful factors. An augmented Monte Carlo simulation (again 500.000 tries) will then be presented, with the inclusion of possible substitute products discovery and commercialization, and the results obtained will be compared to the static base simulations ones. 7.4.1 Competitors Response: The Threat of New Drugs
As remarked on Chapter 2, there are several drugs under development that may enter the market in the mid-term future and that could negatively affect the projects operations, namely insulin products that will use new delivery systems (inhaled and oral). Hence, it will be assumed that these events will have significant effect on the projects results through the decrease on sales in the countries under analysis. Other drugs possible effects have been excluded from the analysis. As discussed in Chapter 3, insulin generics
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will be assumed to have no effect on the projects results. Additionally, any other drugs are assumed to have no substantial effects and therefore will not be included in the analysis. Accordingly, the effect of the introduction to the market of inhaled and/or oral insulin to the projects results will be incorporated as a decrease on unit sold in each country. It is not clear that patients will pay a higher price for the new insulin products, such as inhaled and oral presentations. With several products in development, their commercial success depends on insulin-dependants willing to accept the higher treatment costs that these new delivery systems will certainly carry. According to IMS (2004b), not all analysts are convinced that they will, especially in price-driven markets such as the ones in emerging economies. Therefore, it will be assumed that the effect will slowly increase form 0% for the first year (year in which the drugs may have the FDA approval and denominated Year 0) to 3,5% for pulmonary insulin and 5% for the case of oral insulins. Inhaled insulins are assumed to have less impact than oral ones due to the higher costs and
Y ear 0 Y ear 2 Pulmonary Insulin Oral Insulin Y ear 4 Y ear 6 Y ear 8 Y ear 10
Figure 60. Sales Growth: Negative Effect Of New Drugs Entering The Market, First 10 Years
6% 5% 4% 3% 2% 1% 0%
complexity in its use. Figure 60 shows the assumed negative impact as a decrease in unit sales. For a detailed year by year effect of the new drugs refer to Table 37. As a result, the overall yearly growth or reduction of units sold will be calculated as the difference of the estimated sales growth presented in Chapter 6 and shown in Table 20, less the impact of new drugs (e. g. if the estimated growth is 5% for a certain year and the impact of the new drugs is 3,5%, the overall sales would be 1,5%). Estimation of the Impact of New Drugs Development on the Projects NPV In order to evaluate the impact of inhaled and oral insulins on the NPV value of the project is essential to estimate the arrival year of the drugs to the market. As the impact on sales is assumed to gradually grow over the years, the earlier the new drug will enter the market the higher the impact will have on the projects NPV. According to IMS
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(2004b); analysts believe that, if approved by the FDA, inhaled and oral insulins will not enter the market earlier than 2007 and 2008 respectively. Therefore, it has been assumed that the FDA approval may occur within a 3-year range beginning with the earliest year aforementioned (20072009 for inhaled insulin and 2008-2010 for the projects NPV
Figure 61. Projects NPV: New Drug Impact According to Year of Market Entry, 2007 2010 (DKK million)
-300 -250 -200
-150 -100
-50 2007 0 Oral Insulin Pulmonary Insulin 2008 2009 2010
oral insulins). Figure 61 and Table 35, present the effect of each drug independently on
Table 35. Impact of New Drugs on the Projects NVP: Year of Market Entry, 2007 - 2010 (DKK million)
NPV Pulmonary Insulin Oral Insulin Both Change on NVP Pulmonary Insulin Oral Insulin Change on NPV (%) Pulmonary Insulin Oral Insulin Base Case 610 610 610 Base Case 610 610 Base Case 610 610 2007 -291 2008 -208 -250 -480 2008 -611 -702 2008 -100% -115% 2009 -128 -188 -369 2009 -562 -628 2009 -92% -103% 2010 -126 2010 -563 2010 -92%
2007 -665 2007 -109%
Under the discussed assumptions, it can be observed the huge impact of the arrival of any of these drugs to the market, especially oral insulins. It is also evident that the effect is greater the earlier the drugs enter the market. Simulating the Arrival of New Drugs to the Market As mentioned in Chapter 2, at the present there are two inhaled insulins under development in phase III, AERx iDMS by Aradigm/Novo Nordisk and Exhubera by Pfiezer, Nektar/Aventis. Accordingly, three oral insulin products are currently in phase II; those are Nobexinsulin by Nobex, Oralin by Generex/Lilly, and Macrulin by Provalis. According to McGraw-Hill Healthcare (2004)172; from 5.000 compounds that enter preclinical tests, only five of them pass to phase I in the pipeline, and only one of them will have the FDA approval for a successful launch to the market. Based on the aforementioned statements, the probabilities that the FDA will approve oral and pulmonary insulin compounds will be assumed to be 40% and 60% respectively.
172
See McGraw-Hill (2004). Alfredo Galletti Carsten Wong Iversen
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Meaning that there is only 40% of probability that Aventis will enter the market with Exhubera, and that this event is assumed to impact the projects operations whether Novo Nordisk obtains the FDA approval to launch AERx iDMS or not. Regarding oral insulin products, and since they are in early stage of clinical tests (phase II), the probability of each compound to achieve the FDA approval has been set to 20%, adding all three together a 60% of chances to enter the market. It will be assumed that the effect of one will be similar to the impact of two or all three entering the market. In addition, McGraw-Hill Healthcare points out that the average time spent by the compounds in phase II and III are two and three years respectively. Hence, it has been assigned probabilities to the year that oral and pulmonary insulins will be launched, if approved by the FDA. Table 36 and 37 summarize the abovementioned assumptions that will be used in the simulation in order to estimate the new drugs impact on the projects NPV.
Table 36. Probabilities of FDA Approval and Year of Market Entry
FDA approval 40% 60% 2007 10% 2008 20% 15% 2009 70% 15% 2010 70%
Inhaled Insulin Oral Insulin
Table 37. Sales Growth: Negative Effect of New Drugs Entering the Market, First 10 years
Year Pulmonary Insulin Oral Insulin 0 0,00% 0,00% 1 0,0% 0,5% 2 0,5% 1,0% 3 0,5% 1,0% 4 1,0% 1,5% 5 2,0% 2,0% 6 2,5% 3,5% 7 3,5% 4,5% 8 3,5% 5,0% 9 3,5% 5,0% 10 3,5% 5,0%
7.4.2
The Net Present Value of the Investment
Under these new assumptions, the results obtained by the simulation are significantly different than the static case. The results show a mean net present value of the investment equal to DKK -45,3 million (see Table 38). Likewise, the mean value of the internal rate of return (IRR) as a result of the simulation is 5,91% (see Exhibit 7.6). Thus, under these new assumptions and considering the options that direct competitors have, the investment should not be undertaken (NPV<0). The IRR rule supports this proposition, since IRR<WACC. The distribution of the NPV is characterized by three peaks. These peaks are due to the effect of the introduction of substitute products in the market, influencing considerably the frequency of the simulations outcomes.
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Table 38. Augmented Simulation results Net Present Value of the Project (DKK million)
7,0% 6,0% 5,0% 4,0% 3,0% 2,0% 1,0% 0,0% -740
Statistics Mean -45,3 Median -169,6 St. Deviation 369,8 Skewness 1,30 Kurtosis 3,69 Variability -8,16 Range Min. -657,0 Range Max. 1.416,5 Range Width 2.073,5
-540 -340 -140 60 260 460 660 860 1.060
Percentiles 0% -657,1 10% -377,6 20% -320,0 30% -254,9 40% -203,8 50% -169,7 60% -133,9 70% -77,7 80% 289,0 90% 593,6 100% 1.416,5
Again, the terminal value outcomes have been also simulated. According to the simulation results, the mean PV of the terminal Value is DKK 296,8 million (see Exhibit 7.7). Under these conditions, not high enough to, jointly with the cash flows, cover the initial investment.
7.5
Is the Project Worth Undertaken?

Figure 62. Simulations NPV Comparison
8,0% 7,0% 6,0% 5,0% 4,0% 3,0% 2,0% 1,0% 0,0% -490 -190 110 410 710 1.010 1.310
Depending on which landscape the valuation team is examining, the final decision whether to undertake the prospected investment or not seems very different. From the base point of view, the forecasted mean Net Present Value of the project seems surely positive,
Base Case
Augmented Case
therefore the natural choice would then be to go for the investment. Nevertheless, considering other factors, such as considering competitors option to launch new drugs, the final decision seems quite the opposite (see Figure 62). A quick glance at the comparison of the two results marks quite explicitly the radical change in the forecasted values. If the evaluation of the project is based only on a discounted cash flow approach, the project does not seem worthy to be undertaken. A cautionary note about the results must be raised anyway. First of all, the investment evaluation is based on an elevated number of assumptions and hypothesis. Not having information regarding the operative structure of the plant, sales, potential market share, markets peculiarities and dynamics, results
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obtained reflect the authors point of view, subjective as all the opinions, and for this reason biased. Secondly, the investment has been evaluated as a stand alone investment, as clearly stated in the beginning of the chapter. Other possible spillover effects of the investment at a group level, surely positive and able to revert the conclusions drawn so far, have not been taken into account. The last, the DCF approach for its formulation is not able to consider other elements, which will be object of analysis and discussion in the next Chapter.
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8 The Value of Real Options
THE VALUE OF THE REAL OPTIONS
The chapter will first introduce the concept of real options, why and how their analysis is relevant for a more precise assessment of the investments evaluation. Two options embedded in the project will be analyzed and calculated in detail: the protective put option and the scale up call option. To calculate their value, several approaches have been implemented. First a more theoretically correct one (Black & Scholes approach), and afterwards several simulation-based ones. The differences between the approaches (and the results obtained) will then be discussed. At the end of the chapter, a qualitative discussion of other real options will be introduced, both from the project as a stand-alone entity, and from the project as a tile of a broader groups strategy point of view.
8.1
The Real Options Embedded in the Investment
In the last chapter, the implementation of the discounted cash flow approach to evaluate Novos prospected investment has been reviewed. While the first estimation of the possible net present value of the investment (the static simulation framework) appeared to be quite positive, the augmented one, taking into account possible actions by the other players in the market, suggested that the projects estimated average net present value is actually negative, advising then that the project shouldnt have been undertaken. In other words, the competitors option to launch new products in the market is potentially valuable enough to turn a project characterized by a rosy expected net present value into a lousy one. If the competitors have then some options, it is quite obvious to ask whether Novo might have as well some linked to the project, to investigate their magnitude, and to question if their value might be so relevant to be able to actually reverse the opinion about the investments value. The evaluation of such options, unfortunately, cant be performed basing only on a DCF approach, no matter how sophisticated it can be. The DCF, for its characteristics, implicitly assumes that the firm will hold the project passively, while instead a proactive management of the project can lead to decisions to capitalize on good fortune, or to mitigate losses. The real value of the project then is composed by the value of the project itself (value that can be inferred from the DCF approach), plus the value of the real options embedded in it.
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8.2
The Value of the Abandonment Option (Protective Put)
In finance, a combination of a stock and a put option is known as protective put. A protective put is a financial instrument aimed to create a downside protection against possible negative developments in the share price.
Figure 63. Protective Put Payoff Diagram
120 Buy Share 100 80 60 40 20 0
120 100 80 60 40 20 0
120
Buy Put
100 80 60 40 20 0
Dow nside protection
At the expiration time, whenever the value of the share is above the exercise price, the put option would be out of the money, and therefore will not be exercised, while the gains from the share will be enjoyed. If the value is instead lower than the exercise price, the put will be in the money, and then compensate the loss from the share. For Novo, starting up the investment is exactly like buying the 100% of the fictitious shares that form the investment. But starting the investment also means the purchase of the correlated protective put over the investment. Lets suppose that, right before year 2017 (where the terminal value starts from), Novo can reasonably estimate the projects remaining value that is equal to the forecasted possible continuing terminal values. If the terminal values projections seem too low or even negative (as in case of new substitute products launched on the market by competitors), the company is not enforced to continue with the project. It can decide in fact either to mothball its investment, to continue it or to bail out and recover the value of the remaining assets (through their sale or utilization in some other project). The company then purchases, together with the investment, a protective put, whose exercise value varies according to the strategy that the company is willing to implement (the choice to freeze the investment, in fact, implies an exercise price equal to zero, while the option to sell or reuse the remaining assets has an exercise price equal to their market value at the time of expiration). The option to abandon and sell the assets is, in principle, comparable to the freeze option, except for its higher value due to its intrinsic higher exercise price. The option
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that will be analyzed then will be the European put option to bail out, and recover the value of the remaining assets, from the terminal value. 8.2.1 Applying Black-Scholes to Valuate the Abandonment Option
To calculate the value of the European protective put, the put-call parity relation has been implemented (as presented in Chapter 1):
Put = Call + PV ( EX ) P
In which:
(8.1)
Call = [N (d1 ) * P ] [N (d 2 ) * PV ( EX )] P ln PV ( EX ) + t d1 = 2 t
The Basic Assumptions The Strike Price The terminal value at time 14 (year 2017) can be seen as a particular cash flow that the company can obtain by continuing the investment, a cash flow whose average value is equal to DKK 791 million and that can vary from DKK -333 million to DKK 4.130 million. At time zero (year 2004) the terminal present value, discounted by the WACC, is therefore equal to DKK 296, 4 million.
Table 39. Simulation Results Terminal Value of the Investment, 2017 (DKK million)
10,0% 9,0% 8,0% 7,0% 6,0% 5,0% 4,0% 3,0% 2,0% 1,0% 0,0% -275 225 725 1225 1725 2225 2725 3225 3725
(8.2)
and
d 2 = d1 t
Percentiles 0% -333,4 10% 71,6 20% 167,5 30% 309,3 40% 391,6 50% 448,4 60% 519,9 70% 649,7 80% 1.549,6 90% 2.329,7 100% 4.130,1
The Exercise Price The exercise price of the option is equal to the market value of the remaining assets at the time of the expiration of the option (2017). It is hypnotised that the remaining assets
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that the company can sell are equal to the book value of the assets indexed by the inflation rate (to reflect their real intrinsic value), plus the net working capital accumulated until the exercise date (therefore stocks plus the difference between accounts payable and receivable)173. Depending on the simulation, the exercise price can assume different values that vary within DKK 282 million and DKK 310 million. Even though in literature some models have been formulated to evaluate options whose exercise price is comparable to risky assets174, it has been preferred to avoid the introduction of unneeded complexity in the option evaluation. The exercise price has then been considered equal to the average of the possible outcomes (then DKK 295 million), whose present value is the mean discounted by the risk free rate. Years to Maturity The time to maturity of the option is equal to 13 years. Risk Free Rate The free risk rate implemented in the calculation of the value of the option has been chosen equal to the 10 years Danish Government bond, whose yearly interest rate is equal to 4,5%. Standard Deviation The standard deviation of the terminal values calculated during the simulation gave a value equal to 110,4%, that corresponds to a yearly standard deviation of approximately 31% (/ t ), figure that will be implemented in the calculation of the option value. Applying (8.1) and (8.2), the value of the protective put is equal to DKK 44, 3 million.
173 Of course this hypothesis is based on the assumption that the market value reflects the value that these items have for Novo, situation that may not occur in reality. For example, if the buildings are highly customized for the investments performed activities, and cant be re-utilized by third parties without structural changes, their market value might be considerably lower than the value that represent for Novo Nordisk. Also, bad credit towards customers might have a much lower market value than the book one in case of their sale. To avoid unnecessary complications, it has been preferred to simplify the problem assuming that the value that such items have for Novo reflect the real market value of the items themselves. 174 See Margrabe (1978, pg. 177-186).
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8.2.2
Problems with the Black-Scholes Framework
The Black-Scholes formula is theoretically correct to evaluate European call options. Unfortunately, the formula expressed above requires the range of possible present values of the terminal values to be lognormally distributed. If this phenomenon can be easily assumed while dealing with stock prices (which the Black-Scholes formula applies to in its original formulation), in a real option framework application this hypothesis represents a stronger conjecture175. The terminal values fluctuate between a range of DKK -129 million and DKK 1.628 million. Since the lower boundary is below zero, the stochastic variable cant be lognormally distributed. Moreover, as it can be seen from the actual frequency distribution graph (Table 39), supposing lognormality on the distribution of the stochastic variable under discussion goes clearly against the empirical evidence. Even if the problem given by the actual possibilities to construct a replicating portfolio that could mimic the payoffs of the option due to the absence in real assets world of costless arbitrage (no transaction costs), and the unobservability of real infrequently traded commodities prices that make this approach non feasible could be overrun, the implemented option pricing model might be not accurate in its results due to the restrictions discussed so far. A possible solution is to apply more practical methodologies that though less correct from a theoretical point of view; are more realistic and better reflect the actual value of the option. A technique that can be used is to estimate the possible outcomes and their relevant probabilities such as building up scenarios and including the flexibility to decide whether to abandon and take the savage value or not, through the implementation of decision trees based on real probabilities instead of risk-neutral ones. This technique can be enhanced by applying a Monte Carlo simulation and obtaining the possible outcomes and their probabilities. Following, the value of the put option under analysis is estimated by means of those more practical approaches.
175 If stock prices cant be negative (it is unrealistic to hypothize a stock price less than zero for obvious reasons), for real options this limit can often be trespassed. A project can in fact have a negative net present value, and a lognormal distribution cant assume negative values, since the logarithm of a negative quantity is not defined.
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8.2.3
Applying Real Decision Trees to Valuate the Abandonment Option

Figure 64. Cash Flows With and Without Exercising the Abandonment Option, 2017
5.000 4.000 3.000 2.000 1.000 0 1 -1.000 -2.000 With Option Without Option
With this technique, the value of the option will be estimated based on a range of the possible terminal values and the likelihood of them to occur. Therefore, the values and probabilities of the terminal value have been extracted from the simulation of the augmented case discussed in Chapter 7. The mean of
terminal value is calculated with those figures. Subsequently, each continuing value lower than the savage value (possible inflow originated by selling the remaining assets or the value of them if used in other projects), is replaced by the savage value. The savage value used is the mean value of the simulation abovementioned. Accordingly, the new mean value with the option is calculated and the difference with the original mean is evaluated. There may be different ways to calculate the present value of the option under this method, such as simulation the savage and terminal values for time t (year 2017), and discounting them back with the cost of capital and calculating the difference of the means of the final values with and without exercising the option. An additional way is, if the cost of capital has been also assumed to have variance in the simulation, to forecast the present values in time 0 (year 2004) of the savage and terminal values and calculating the same difference. More accurate results correspond to higher simulation trials and the lower value ranges.
Table 40. Abandonment Option Calculation Based on Simulated Savage and Terminal Values Probabilities (DKK million)
Terminal Value (t=13, year 2017) Savage Value (Exercise Price) 295,00 Probability Base Value Value w/Option 0,0000 -750,00 295,00 0,0527 -250,00 295,00 0,5240 250,00 295,00 0,1824 750,00 750,00 0,0349 1.250,00 1.250,00 0,0665 1.750,00 1.750,00 0,0561 2.250,00 2.250,00 0,0536 2.750,00 2.750,00 0,0278 3.250,00 3.250,00 0,0020 3.750,00 3.750,00 Mean Value 786,04 838,35 Option Value 52,31 PV of the Option (t=0) 19,59 Terminal Value (t=0, year 2004) Savage Value (Exercise Price) 111,00 Probability Base Value Value w/Option 0,0000 -750,00 111,00 0,0527 -250,00 111,00 0,7255 250,00 250,00 0,1572 750,00 750,00 0,0645 1.250,00 1.250,00 0,0001 1.750,00 1.750,00 0,0000 2 250,00 2 250,00 0,0000 2 750,00 2 750,00 0,0000 3 250,00 3 250,00 0,0000 3 750,00 3 750,00 Mean Value 366,89 385,92 PV of the Option (t=0) 19,03
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As seen on Table 40, using fewer than 10 values and their related probabilities give similar results. As a result, the value of the abandonment option estimated using this methodology is around DKK 19,5 million. In order to get more accurate results, a lower value ranges have to be used (e. g. every DKK 50 million instead of every DKK 500 million). Applying the same methodology with value ranges of every DKK 50 million, the value of the abandonment option is estimated to be DKK 20,77 and DKK 20,93 million accordingly (see Exhibit 8.1). 8.2.4 Simulated Value of the Abandonment Option (European Put Option)
The European protective put option has been evaluated through the implementation of an algorithm on the results of the simulation that applies the rule of choosing in year 2017 between the salvage and the terminal values.
Table 41.
8% 7% 6% 5% 4% 3% 2% 1% 0% -584
Simulation Results NPV with EU Abandonment Option (DKK million)

Statistics Mean Median St. Deviation Skewness Kurtosis Variability Range Min. Range Max. Range Width Aug. Case -45,3 -169,7 369,9 1,3 3,69 -8,16 -657,1 1.416,5 2.073,6 Abandon Opt. -24,8 -169,7 351,9 1,47 3,97 -14,18 -436,3 1.416,5 1.852,8
-321 A ugmented Case
-59
204 466 EU A bandonment Option
729
991
Table 42.
8% 7% 6% 5% 4% 3% 2% 1% 0%
Simulation Results NPV with EU Abandonment Option Detail (DKK million)

Statistics Mean Median St. Deviation Skewness Kurtosis Variability Range Min. Range Max. Range Width Aug. Case -45,3 -169,7 369,9 1,3 3,69 -8,16 -657,1 1.416,5 2.073,6 Abandon Opt. -24,8 -169,7 351,9 1,47 3,97 -14,18 -436,3 1.416,5 1.852,8
-584 A ugmented Case
-321 EU A bandonment Option
-59
As predictable, the put option doesnt increase of course the value of the upside (as it can be seen in the graph reported in Tables 41 and 42), but cuts the downside outcomes of the investment project, increasing then the mean value of the investment. The value of the put option is equal to the difference between the of the net present means of the investment with and without exercising the option, and the result is the difference
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between DKK -24,81 and -45,34 million. As a result, the value of the European protective put is equal to DKK 20, 5 million. Of course, an American Option fits better than the European one since the company can exercise the option at any time, the company can abandon the project at any moment not only in year 2017. Thus, the American option value is estimated in the next section. 8.2.5 Simulated Value of the Abandonment Option (American Put Option)
The last simulation-based approach implemented to evaluate the option is represented by the introduction, within the simulation, of a simple mathematical algorithm, that works comparing the present simulated salvage value occurred at time t with the present value of all the expected future cash flows from time t to ever after. This system turns quite useful for two reasons: firstly because since in the simulation changes of the companys hurdle rate have been introduced, not every time the present value of the possible salvage values, for example, correspond to their value at time t discounted by a WACC equal to 7,85%176; secondly and more important, because the methodologies exposed so far can be used for evaluating European options. European options are exercisable only at the maturity date, while Novo has the opportunity to abandon the project even before that moment. Whenever the net present value of the salvage value is higher than the expected present value of all the future cash flows, Novo would be better off to bail off and enjoy the salvage value. The common approach used to evaluate an American option is to build a risk neutral binomial tree. Unfortunately, this approach is difficult to implement in the current situation for two reasons. First of all, the cash flows variations depend on a wide array of variables that would multiply the branches to an indefinite number which cant be managed in an explicit way177. The second problem is given by the fact that it is impossible to express the cash flows future outcomes as products of constant up or down factors.
Indeed small changes within the WACC have been simulated, therefore the actual value of the excerpted from the simulation shouldnt differ much from the discounted one. Nevertheless, some differences occur, and in situations where more important variations in the hurdle rate may occur, the exposed approaches may differ considerably. 177 Just to make a small example, a non-recombinant binomial tree at time 0 has 20 = 1 branch, at time 1 has 21 = 2 branches, at time 14 has 214 = 16384 branches. A multinomial tree with 10 possible outcomes would have at time 14 a number of branches equal to 1014, impossible to manage in an explicit form.
176
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The American protective put has been evaluated through the implementation of an algorithm on the results of the simulation that applies the rule of choosing at time t between the salvage value at time t and the present value at time t of all the possible future cash flows. As foreseeable, the put option doesnt increase of course the value of the upside (as it can be seen in the graph reported in table 43), but slashes the downside range of the investment, increasing then the value of the project. Since the value of the American protective put option is equal to the difference between the mean values of the net present value of the investment
Table 43.
8% 7% 6% 5% 4% 3% 2% 1% 0% -584
NPV with American Put Option
-321 Augmented Case
-59
204 466 EU Abandonment Option
729
991
Statistics Mean Median Standard Deviation Range Minimum Range Maximum Range Width
NPV of Investment -45.341.186 -169.679.998 369.863.551 -657.051.743 1.416.502.296 2.073.554.039
NPV with abandonment option -24.813.977 -169.679.998 351.898.843 -436.314.323 1.416.502.296 1.852.816.619
without the chance to exercise the protective put and the net present value of the investment with the exercise of the option, it is then equal to DKK 20,5 millions. Surprisingly, the value of the American and the European put options are the same. After an investigation of the reasons of such result, the answer appeared to rely on the fact that the cash flows up to tear 2016 are positive, and also the downside values are still positive enough to discourage the exercise of the option. As it can easily understandable from the results of the simulation reported in chapter 7, the discriminator between a positive and a negative NPV is the terminal value, due to its elevated weight on the determination of the NPV of the project. Therefore, basing on the results it seems that an early exercise of the put option would be detrimental.
8.3
The Value of the Expansion Option (Call Option)
Strong bullish expectations in finance can be exploited through the contemporary purchase of a share and a call option. If this strategy doesnt provide any downside protection against possible negative developments, it doubles the positive effects of increases in the share price.
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Figure 65. Expansion Call Payoff Diagram

120 Buy Share 100 80 60 40 20 0
100 80 60 40 20 0 120 Buy Call
120 100 80 60 40 20 0
Upside increase
At the expiration time, whenever the value of the share is above the exercise price, the call option would be in the money, and therefore will be exercised, increasing the gains from the share. If the value is instead lower than the exercise price, the call will not be exercised, and only losses from the fall in the share value will be suffered (see Figure 65). For Novo, the prospected investment also includes the purchase of an expansion option over the investment itself. If in 2017 (where the terminal value starts from) Novo estimates positive developments in the terminal value of the project (for example due to the lack of new products launch in the insulin markets by competitors), it has the chance to expand its investment. This chance, anyway, is not an obligation. If negative developments of the market discourage the company to invest into an enhancement of the structure, Novo doesnt have to double up its losses. The second option that will then be analyzed is the call option to scale up the investment in 2017. 8.3.1 The Value of the Expansion Option (American Call Option)
The simulation of the American expansion option will follow a relatively different approach from the one used for the evaluation of the abandonment ones. As known, an American option is exercisable in any time before the expiration date. Anyway, for practical purposes, it has been assumed that the decision of expanding the project will occur at the beginning of each year. As stated in chapter 5, the new production facility has bulk production capacity. Therefore, an increase in items produced wont require any additional capital expenditure (which will then set to zero). The hypnotised expansion will be subsequently achieved through a 50% increase of the current sales, and this extra production will be addressed
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to other regions (for example to the US, Canada, Europe and other industrialized countries; and, in a smaller extent, to those countries in Latin America that have been neglected so far). Variable costs will depend on the amount of units produced and on the production costs per unit as seen so far. However; in order to achieve the mentioned boost on sales, marketing & sales efforts are expected to increase. Likewise, administrative & general expenses are presumed to raise as organizational activities will increase. As a result; these fixed costs are assumed to grow also by 50% (e. g. marketing & sales and general & administrative costs will also increase 50% when the decision to scale up is taken). Additionally, the negative effect of new drugs on sales growth has been assumed to be twice as high, since most part of the new production is assumed to reach markets which arent as price-driven as the Latin America ones. Consequently, a sensitivity analysis through a simulation framework has been performed involving the possible effects of the entrance of substitute products on the profitability of the expanded project (see Table 44). Whenever any of the competitive products will gain access to the markets, the exercise of the scale-up option will actually give a lower NPV than the normal case, i.e. the exercise of the option in case of competitors entrance is detrimental, and shouldnt be then implemented (also refer to Table 35). The only situation in which the project will be better off after a scaling-up decision is when none of the two hypnotised substitute products will enter. If at least one of the new drugs is accepted by the FDA, the expected NPV of the expanded project will be lower than the augmented case (DKK -45 million as seen in Chapter 7).
Table 44. Simulated Project NPV by Year of Expansion and Effect of New Drugs (DKK million)
2007 2008 2009 772,2 763,5 746,2 -390,7 -377,8 -364,9 -404,8 -388,6 -372,4 -743,6 -732,1 -720,6 -45 -45 -45 2010 730,3 -352,0 -356,2 -709,1 -45 2011 712,0 -339,0 -340,0 -697,6 -45 2012 692,7 -326,1 -323,8 -686,1 -45 2013 675,4 -307,7 -304,2 -667,3 -45 2014 658,4 -303,4 -294,2 -666,6 -45 2015 643,1 -293,4 -282,7 -660,1 -45 2016 626,2 -275,1 -249,5 -642,1 -45 2017 609,3 -257,2 -245,5 -622,1 -45
Scale-up Year None Drugs Inhaled Insulin Oral Insulin Both No Scale-up
Hence, the decision to expand the project (and the way it will affect its NPV) should be strongly linked to the available information. Because of the assumed growth pattern discussed in Chapter 6; the sooner the option is exercised, the higher the future cash flows and the projects NPV will be. On the other hand; an early exercise that might increase possible revenues while uncertainty is still present, might also cause the project to incur in bigger losses than in the normal case. For example, if the scale up decision is taken in year 2008, while competitors still have a chance to introduce new products in
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the market, the project has a certain probability to become more profitable than the normal situation, but at the same time, it can face greater losses if substitute products will access the markets. Thus, the decision will be is based on the additional information available each year. As the new pharmaceutical products have to face several procedures before getting the approval by the relevant health departments; Novo Nordisk can obtain supplementary information regarding the approval/disapproval of its competitors related products. According to the framework introduced in Chapter 7, the information should be available between 2007 and 2009 for inhaled insulin and between 2008 and 2010 for oral insulin products. Table 45 shows the probabilities of information release for each product and year.
Table 45. Year of Information Availability for Competitive Products
2007 10% 2008 20% 15% 2009 70% 15% 2010 70%
Therefore, every year, competitors have a certain probability to receive the approval or disapproval for the products commercialization by the relevant health authorities. As discussed also in Chapter 7, the products approval has a probability of 40% for inhaled insulin and 60% for oral insulin. From Novos perspective, the key probability is the one linked to the knowledge of the censure of both the possible competitive products, probabilities that are exposed in Table 46.
Table 46. Weighted Probabilities of New Drugs Rejection
2007 6% 2008 12% 6% 2009 42% 6% 2010 28% 2011
Obviously; as time passes by, Novo Nordisk will acquire additional knowledge concerning the substitute products rejection by the FDA, reducing in this way its uncertainty. This added awareness is expressed by the calculation of the joint cumulative probability of both drugs rejection, shown in Table 47.
Table 47. Probability of New Drugs Rejection by Year
2007 6,0% 2008 18,0% 6,0% 1,1% 1,1% 2009 60,0% 12,0% 7,2% 6,1% 2010 60,0% 40,0% 24,0% 16,8% 2011 60,0% 40,0% 24,0% 2012 60,0% 40,0% 24,0% 2013 60,0% 40,0% 24,0% -
Inhaled Insulin Oral Insulin Oral and Inhaled (Both) Probability Increase (Both)
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As it can be seen in the table, no more uncertainty will be present in year 2010. Either the products will be accepted by FDA, or they will have no more chance to enter the markets (the cumulative probability, in fact, dont increase after 2010, but they stay equal to 24%). From the scale-up option perspective, this factor has a considerable effect. As uncertainty decreases, the higher the possibility to make a proper decision and take advantage of the added value of the expansion and to reject further losses. From a binomial tree perspective, augmented information availability increases the probability linked to the highest branch. Of course, delaying the exercise of the option reduces the number of amplified cash flows given by the increase in production, but this negative effect may be counter balanced by the actual increased probability of bigger profits. In order to evaluate the projects NPV including the option to expand whenever both new drugs are rejected by the FDA, all the possible NPVs (with and without expansion), their related exercise years and probabilities have been estimated. Accordingly, the value of the project is given by the average value of those NPVs weighted by their associated probabilities. The results are given in Table 48.
Table 48. NPV of the Scaled-Up Project
2007 772,19 2007 -45,30 100% -45,30 -45,30 -45,30 142,17 2008 763,52 1,08% 8,25 8,25 2008 -45,30 -1,08% 0,49 -44,81 -36,56 2009 746,23 6,12% 45,67 53,92 2009 -45,30 -6,12% 2,77 -42,04 11,88 2010 730,27 16,80% 122,68 176,60 2010 -45,30 -16,80% 7,61 -34,43 142,17 2011 711,99 176,60 2011 -45,30 -34,43 142,17 2012 692,67 176,60 2012 -45,30 -34,43 142,17 2013 675,36 176,60 2013 -45,30 -34,43 142,17
Scale-up NPV of the Project Certainty Increase Increase in NPV Cumulative Value Normal NPV of the Project Uncertainty decrease Increase in NPV Cumulative Value Cumulative Total Total Value Scaled up Project
As shown in the table, the estimated value of the project including the option to scale-up as soon as the Company gets the information of both drugs failing to obtain the FDAs approval is DKK 142,17 million. As a result, the value of the option itself will be the difference between this value and the one of the augmented case; 142,17 (- 45,30) or DKK 187,47 million. The procedure is comparable to the valuation of a series of options with deferent expiration dates and probabilities to occur. Also, this procedure is a shorter, implicit form of a decision tree calculation approach. Shorter, but with the same results. Anyway,
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the explicit formulation and graphical representation of the decision tree related to the American scale up option is reported in Exhibit 8.2.
8.4
The Value of the Switch Option
So far two distinct and independent possible options, exercisable by the management, have been evaluated. In reality, these two options can be seen as the two sides of the very same coin. The management can decide, whenever the time is mature, to implement either one of the prospected option (or neither of them, of course). In literature these options are known as switch option, defined as alternating call and put options in which one option is exchanged for another upon exercise178. Once again, a look at the switch option payoff diagram clearly exemplifies how the switch option modifies the possible payoff of the investment.
Figure 66. Switching Option Payoff Diagram (Same Exercise Price)
120 Buy Share 100 80 60 40 20 0
120 100 80 60 40 20 0 Buy Put
120 100 80 60 40 20 0 Buy call
120 100 80 60 40 20 0 Sw itch option Investment
The value of the switch option is then a way to actually evaluate what is the extra value added by the managerial skills to the investment. The management, in fact, doesnt have to relate passively to the investments dynamics. It has the chance to seize and exploit opportunities when they occur to limit losses or enhance incomes, adapting its strategic plans through the exploitation of the aforementioned options179. This factor that can be labelled as managerial flexibility is able to increase the expected net present value of an investment through the increase of the positive outcomes and reduction of negative ones. The final step, then, is to calculate the value of the managerial flexibility for the project under examination (provided that the possibility of a path-adjusting strategy implementation through the exploitation of the possibilities given by the options embedded in the investment itself is available to the management), and to recognize if
178 179
See Carr (1998). See Kulatilaka and Trigeorgis (1994); Chod J., et al., (2004). Alfredo Galletti Carsten Wong Iversen
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what appeared as a bad investment might turn into a more appealing one, once this embedded extra value is included. The value of the managerial flexibility is then equal to the value of the switch option, so:
PV (managerial flexibility ) = PV (abandonment option) + PV ( scale up option)

And the value of the investment with managerial flexibility is then simply equal to:
NPV (investment with man. flex) = NPV (investment ) + PV (managerial flexibility )

From the values previously computed, the net present values of the options were DKK 20, 5 million for the abandonment option, and DKK 187 million for the scale up option. The value of the managerial flexibility is then equal to approximately DKK 202,5 million. In the last chapter, the value of the investment appeared to be equal to DKK -45,3 million. The value of the project, including the value of managerial flexibility, is then equal to approximately DKK 157,2 million. Then what it appeared to be a no go investment due to its negative net present value turned to be a profitable investment for Novo.
8.5
Additional Real Options Embedded in the Project
As introduced before, the extra value added to an investment by the managerial flexibility is represented by the value of the options that are embedded into the investment itself. This approach appears particularly relevant for real investments, especially for the ones that have great source of inner uncertainty. Often exogenous sources of uncertainty play a much greater role into the final outcome of a project, as in the Montes Claros one. The difference between make it or break it lays on variables that are not under the direct control of Novo, and that then are not predictable at the time of the investments enterprise. If competitors fail to introduce new substitute products, the prospected project will turn into a profitable one. If the other players instead will succeed, the project has extremely high chances to become a failure. Evaluate a project supposing that the management will simply sit and wait passively for the natural course of the events doesnt represent its real value. People in charge have the chance to react to the situations that may occur, have the chance to decide to exercise their options, have the chance to change strategy whenever competitors exploit theirs.
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Of course, the options that the management has are not limited only to abandon or scale up the project. So far only these two simple and basilar options have been analyzed and evaluated, but many more are available, both related to the project itself (as a stand-alone) and, in a broader landscape, to the group as a whole. The more the options available, the more value the managerial flexibility has, and therefore the more value the project itself has. At a stand-alone level, the company had, before deciding to actually start with the project, the chance to wait for future events. As it has been said before, a great source of uncertainty is given by the possible actions of the other players. To wait and see whats going to happen, before actually starting the operations, has a value. Indeed, Novo killed the option after deciding to start the investment. Nevertheless, before this decision, the delay option had a precise value. Lets try to roughly calculate it in order to estimate its magnitude. Supposing that Novo had to pay, in 2004, the first instalment of the investment (DKK 150 million) in order to purchase the right to build the production plant. The following payments can be delayed until the decision of starting up the investment. Theres a 24% chance that none of the competitors will introduce a new product ((1-60%)*(1-40%)), and then start the project, and a 76% that another player (or Novo itself, for what matters) will introduce a substitute. The base simulation gave an average NPV equal to DKK 546 millions (including the first payment of DKK 150 millions), that means that the project without substitute products has an NPV equal to DKK 696 millions. If, for simplicitys sake, the hypothesis of a risk free rate equal to zero and a constant expected NPV independent from the starting point, in year 2011 all the possible sources of uncertainty (based on competitive products) will be gone. The value of the project then becomes: NPV=-150+(696*0,24)+(0*0,76)=17,2 Comparing this value with the augmented simulation, the value of the delay option is obtained. Of course, due to the rough simplifications made, this value would considerably overestimate the real value of the option. Nevertheless, this example is useful to understand the value hidden in the option to delay, and indeed the value that Novo wasted deciding to start the project right away. Another set of available options is given by the possibilities to scale down the investment. Whenever the project may turn to become unprofitable, the management
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can decide to scale down the operations or to mothball the investment without abandoning the whole project. This option might turn particularly profitable especially if evaluated at a corporate level. In fact, many reasons might justify the decision to keep a foothold in the area, reasons whose value might be able to overcome the negative returns from the investment evaluated on a stand alone basis. These considerations lead then to recognize the array of options given by the project not seen as a project in it, but as a tile of a wider group long term strategy. One of the options available, for example, is given by the opportunity to switch production from other locations to Brazil. Given the lower production costs of the new facility, at a corporate level might turn more profitable to scale down the production in more expensive location, and augment the production in the new, cheaper one. Consequently, the production from Brazil could be used to feed the markets that, for their geographical location, were previously covered by the other production facilities (as North America or Europe). Whenever the increasing accessory costs (i.e. transportation costs for example) would be counterbalanced by lower production costs, the group as a whole would witness an increase in its overall net income. An extremely simple example will help clarifying the concept. Lets suppose that a Novos generic production plant is characterized by variable costs equal to 27% of revenues, and fixed costs equal to DKK 500.000. This plant has a production capacity equal to 1.000.000 units, which is
Production Price Revenues Variable costs Fixed costs Total costs Income
Table 49.
Production Shift: Status Quo

Generic plant 1.000.000 1 1.000.000 27% 270.000 500.000 770.000 230.000 Montes Claros 100.000 1 100.000 23% 23.000 100.000 123.000 (23.000) Group level
1.100.000 293.000 600.000 893.000 207.000
destined to cover a certain geographical areas market. The Brazilian plant has variable costs equal to 23%, fixed costs equal to 100.000 and indefinite production capacity. The Latin American market is able to absorb a production equal to 100.000 units. Selling price is equal to 1 DKK per unit. At aggregated level, the net income is equal to DKK 207.000, and the Brazilian facility is generating negative returns, situation in which the exercise of an abandonment option could be optimal (see Table 49). Now lets suppose that the shipping costs to send the excessive capacity from the Brazilian plant to other locations is equal to 5% of revenues. At aggregated level, there is
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no advantage to shift production (see table 50). But what if these shipping costs are forecasted to fall (or the variable cost of production spread between locations increases), for example to 1% in one year time with 20% chance? At a corporate level, Novo would be better off shifting its production to Brazil, paying the extra shipment costs and having a negative income in its generic location. The value of the option at time 1 then would be [(207.000)*0,8+(231.000)*0,2] -(207.000), equal to 4.800 DKK. Regardless its simplicity, this trivial example is able to the possibility of shifting production. Strongly linked to the concept of flexibility is also the option to more easily scale down or reduce the investment linked with the location. For example, workers protection as a collectively is actually lower in Brazil than in Denmark (or other locations in Europe). Since scale down strategies may not be implemented with the same ease in each Country (for example, it may result quite
Table 50.
Production Shift: Possible Outcomes

Generic plant 200.000 1 200.000 Montes Claros 900.000 1 900.000 23% 5% 247.000 100.000 347.000 553.000 Montes Claros 900.000 1 900.000 23% 1% 215.000 100.000 315.000 585.000 269.000 600.000 869.000 231.000 301.000 600.000 901.000 199.000 Group level 1.100.000 1 1.100.000 Group level 1.100.000 1 1.100.000
Production Price Revenues Variable costs (% 27% revenues) Accessory costs over 100.000 items Variable costs 54.000 Fixed costs 500.000 Total costs 554.000 Net income (354.000) Generic plant 200.000 1 200.000
Production Price Revenues Variable costs (% 27% revenues) Accessory costs over 100.000 items Variable costs 54.000 Fixed costs 500.000 Total costs 554.000 Net income (354.000)
explain the value that is hidden behind the prospected investment for the group due to
Table 51.
Location Shifting Opportunities
Location A (Three years notice before firing employees) time 0 time 1 time 2 time 3 Revenues 600 400 200 100 Variable Costs 240 200 160 140 Direct costs 20% 20% 20% 20% Labour 120 120 120 120 Income 360 200 40 -40 NPV 560 Location B (No notice before firing employees) time 0 time 1 time 2 time 3 Revenues 600 400 200 100 Variable Costs 300 200 100 50 Direct costs 25% 25% 25% 25% Labour 25% 25% 25% 25% Income 300 200 100 50 NPV 650
hard - or impossible at all - to fire employees to reduce production in a short amount of time), locations that allow an easier access to these types of strategic moves might have an intrinsic value. Another simple example will help understand the value of this option (please refer to Table 51). Lets consider two production facilities in two different locations (A and B). In location A, the production requires DKK 120 in labour and DKK of direct costs (equal to 20% of revenues), while location B requires a cost of 25% of revenues in labour and direct costs to produce the same amount of revenues.
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Naturally, location A is preferable. But location A presents a hysteresis regarding the scale down possibilities, i.e. it is necessary to give a certain notice to employees if they have to be fired (estimated in three years). Location B, due to the lack of workers union agreements, requires no such notice. If it is necessary to scale down the production facility, location B is more efficient in terms of time. Another source of added value is given by the intrinsic value of the geographical location of the investment. As it has been introduced in chapter 3, Brazil presents a peculiarity in its patent law. Products sold in the Country that are not manufactured for a certain percentage (local manufacturing clause) are not protected by the intellectual property law. At the extreme, the Government itself might expropriate the production process, and assign it in concession to local manufacturers. Even though the possible detrimental effects might be hard to estimate precisely, it is certain that a legally based expropriation of copyright might imply considerable losses in market share due to the competitive menace from local generic products. This can also be relevant not only for the existing product (the human insulin), but also in the perspective of possible new products to be introduced in the future. Particularly in the hypothesis of new blockbusters launches, the threat of lack of patent protection would turn the Brazilian market as off-limits. Being able to transfer part of the production process to local-based plants (for example packaging and labelling operations) would open these markets, and make even more profitable the new products. Still linked to the location is the advantage arising from the Tax saving opportunities option. Particular fiscal regimes on corporate income (or on other components of the companys operations) might imply a source of extra value. As previously seen in chapter 5, the State of Minas Gerais accorded to Novo a favourable tax reduction on the duties for importation of the equipment for the new plant. Since Governments and the State authorities might repeat such favourable manoeuvres to attract or retain investments in their soil for macroeconomic reasons (such as decrease in unemployment rate, stimulation of capital inflows from abroad), reductions in the fiscal pressure might enhance the value of the investment, both for the investment in itself and at a corporate level. Just to mention an example, if the Brazilian authorities decide to lower the indirect taxation to increase commercial activities (as it is under discussion with a considerable
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reduction of VAT taxes on export activities from Brazil to the rest of the Mercosur countries), this would enhance, other factors being equal, the revenues and then the cash flows generated by the investment. At the same time, given the current tax agreement between Brazil and Denmark, lower export duties in Brazil compared to the Danish ones would imply a tax saving at a corporate level. Another brief example will help explain the concept. In location A, the VAT tax on exports is set to 20% of revenues, and it is not supposed to change during time. Location A is more cost efficient than location B, but the Government in location B is considering the hypothesis to lower the current VAT tax (20% of revenues) to 15% to stimulate export activities, an theres a 50% chance that this would happen. If the fiscal charge remains the same (20% of revenues), at a group level Novo would be better off closing the location B plant, transfer all its production in location A and enjoy a higher NPV. But once the location is abandoned, theres no way back.
Table 52.
Tax Shopping Opportunity

950,4 Location A time 0 time 1 time 2 time 3 1200 1200 1200 1200 600 600 600 600 240 240 240 240 360 360 360 360 122,4 122,4 122,4 122,4 238 237,6 237,6 237,6 NPV 950,4 Location B NPV 0 Corporate NPV 950,4 953,1
Group NPV abandoning location B
Revenues Variable Costs VAT charge (20%) Income Tax (34%) Free cash flow
Group NPV keeping location B 50% chance of having 20% VAT for four years Location A VAT charge 20% four years time 0 time 1 time 2 time 3 Revenues 1000 1000 1000 Variable Costs 500 500 500 VAT charge (20%) 200 200 200 Income 300 300 300 Tax (34%) 102 102 102 Free cash flow 198 198 198 NPV
1000 500 200 300 102 198 792
Location B VAT charge 20% for four years time 0 time 1 time 2 time 3 Revenues 200 200 200 200 Variable Costs 104 104 104 104 VAT charge (20%) 40 40 40 40 Income 56 56 56 56 Tax (34%) 19,04 19,04 19,04 19,04 Free cash flow 37 36,96 36,96 36,96 NPV 147,84 Corporate NPV 939,84
50% chance of having 10% VAT in years 3 and 4 Location A VAT charge 20% four years time 0 time 1 time 2 time 3 Revenues 1000 1000 1000 1000 Variable Costs 500 500 500 500 VAT charge (20%) 200 200 200 200 Income 300 300 300 300 Tax (34%) 102 102 102 102 Free cash flow 198 198 198 198 NPV 792 Location B VAT charge 20% for first 2 years; 10% ever after time 0 time 1 time 2 time 3 Revenues 200 200 200 200 Variable Costs 104 104 104 104 VAT charge) 40 40 20 20 Income 56 56 76 76 Tax (34%) 19,04 19,04 25,84 25,84 Free cash flow 37 36,96 50,16 50,16 NPV 174,24 Corporate NPV 966,24
What is the value to keep a certain level of activity in location B and wait for the decision of authorities? Lets suppose that the minimum level of activity is set as generating DKK 200 per year.
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At a group level, theres a higher NPV (supposing a risk free rate equal to zero for simplicity) to actually keep location B active and wait. Therefore the option of being able to tax shop between the two countries is valuable. It would be even more valuable if it can be supposed that it is possible to shift the production from location A to location B. This brief overview of possible hidden options has no meaning of being fully exhaustive. Other options can be considered, and options often interact within themselves, or are mutually exclusive. The purpose is instead to introduce and show the large variety of possibilities that may lay behind an investment, and that are not necessarily correlated to the investment itself. For some reasons, an unprofitable investment in place can be justified by the wide range of strategic opportunities and flexibility that grants to the group as a whole. Flexibility of course has a cost, and sometimes this cost is represented by a negative return investment, that has no justification from a DCF approach, but has a high strategic value for the group itself. It has briefly introduced, for example, the production shift before. At a corporate level, the choice to keep in place a negative NPV investment might have many more value creating opportunities than the choice to simply turn it down, because its cash flow estimation is not good enough. Does this mean that any negative project will surely become a positive one once its embedded real options are evaluated and exploited? Not at all: an investment can still go bad, and generate negative returns. Nevertheless, it has some potential within, which can be exploited to improve either its own rate of return, or the cash flows of the group as a whole, and therefore maximizing the value of its shares.
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CONCLUSIONS
The final result of the analysis performed seems to indicate that; what appeared to be a non-profitable investment for Novo Nordisk from the point of view of the Net Present Value (computed through a Discounted Cash Flow), turned to be a profitable one while the value of some of the Real Options embedded in the investment were considered. Nevertheless, it is necessary to stress that the precise quantitative valuation of Novos investment is not the scope of the paper. The result of the evaluation of the project is a fruit bloomed from the authors tree of estimations, a tree that unfortunately resembles a willow, all crooked under the burden of possibly biased hypothesis and approximate suppositions. The authors dont know the Latin American human insulin markets better than Novos headquarters, and surely the authors dont have enough elements either to criticize or to approve Novos choices, basing only on a back-of-the-envelope valuation. The scope of the paper is; instead, to build and apply to a real case an evaluation framework to investigate if, taking into account managerial flexibility in a project, it may turn profitable, and to analyze if the consideration of possible extra factors hidden in an investment could make a difference in its real value. Real Options are indeed just a way to quantify the fact that flexibility, if handled properly, can add value; and a way to explicitly model the decisions that the management of an asset may take as conditions change. Hence, the DCF approach alone is often insufficient. Traditional DCF analysis is not necessarily inappropriate in all cases. For short-term focused investments, cash flows can be predicted with a good deal of confidence. If management doesnt need to implement flexibility to adapt to new information or new market conditions and revise investment decisions to maximize value, DCF techniques then remain the simplest and most efficient approach. The problem is that an increasing number of capital investments clearly violate these conditions, when both internal and external sources of uncertainty arise. Therefore, investment projects must be evaluated with full regard for the flexibility that managers have to react to changes in the business environment. As discussed, typical projects may
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contain options to defer, abandon, expand and/or to switch funds to a more profitable investment; allowing managers to limit downside losses or capitalize on upside potential. Real Options, though, are not an automatic guarantee of profitability for an investment. Real options, by their nature, are difficult to estimate and evaluate with sufficient precision. If in case of a financial option the current value of the underlying asset upon exercise is known, for real ones this is often based on estimations of future cash flows, which might (and often are) biased by estimation errors. Often, Real Options are shared by some (or all) players in an industry, which means as soon as another player executes his real option; it loses value for all other players. Furthermore, investment decisions may be influenced by other parties, such as competitors. Real Options evaluation, then, might be flawed in its quantification. But their explicit analysis is useful; firstly to keep into account the approximate value of flexibility in an investment, and secondly helps management to explicitly think, recognize chances and opportunities embedded in investments, and to avoid possible wrong decisions. These erroneous choices may be: investing in projects in which waiting is better, or not investing in potentially beneficial research and development projects because the static NPV is negative (or with high technical uncertainty or growth options), or even choosing large projects to the detriment of small ones, due to their higher NPV. A Real Options approach for investments evaluation does not add value to a project, in the sense that it adds new elements, or new sources of profitability. Often this matter is source of confusion, and it is proper to be explicit. The options discussed during the dissertation are not something that is not available in a DCF approach. Simply, the DCF approach doesnt (because it cant) take them into consideration. Options then are important because they explicitly give a value to the ability to react to the exploitation of competitors options. As it has been witnessed in the paper, the profitability of the investment heavily relies on the ability of the other players to use their own options. But if they have some, Novo has some as well, of course, that basing on the hypothized framework depend on the competitors ones. If they exploit theirs, a scale up option would have no value (because it is not profitable), while the abandonment one will be profitable instead. On the contrary, if competitors dont (or cant) take advantage
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of their options, abandoning the project wouldnt make much sense, while scaling it up would turn extremely profitable. In the case under analysis, theres an action-reaction relationship between Novo and the other players in the market. Real options as a peculiar way to interpret game theory best strategy implementation, and the value of each possible strategy ex ante.
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Appendix A
APPENDIX A Sources of Uncertainty and Projects Risk Exposures

Uncertainty is the unpredictability of the external environment and risk is the combination of uncertainty and the companys ability to react to it. As pointed out by Trigeorgis (1999), the risks that a company and its projects could face can be related to: business operations, interest rates, exchange rates, competitors, market-demand, technology and to the country in which operates. Any firms project is exposed to several or all of these risks, which are linked to uncertainties on its operational results. Hereafter, a brief introduction to those risks is presented. Operational risk This type of risk refers to the changes on business results derived from operational structure of the firm such as the nature of its business activities. This can be better explained by breaking down the firms costs into fixed and variable costs. This mix is an important meter of operating risks. All other factors being equal, operating structures characterized by a dominance of fixed costs are rigid and difficult to modify when production levels or market conditions change. The degree of cost structures strictness significantly conditions the consequences that sales variations can have in operating results. The effect that sales changes can have on operating outcomes is a direct result of the proportion of fixed costs, a concept known as operating leverage.
4
Interest rate and exchange rate risks Business operations may also be affected by two types of financial risks: interest rate and exchange rate risk. Interest rate risk derives from the possibilities that market interest rates may fluctuate causing an unexpected opportunity costs for the firm due to a difference between active and passive rates. Furthermore, a variation on interest rates may cause a change in the prices of financial activities. This can be the case in which fixed-rate bonds price and value decreases when rates increase, and vice versa. The problem of exchange rate risk appears when there are changes in the active and passive values of the currency in question. In this case, the risk may have transactional effects if the variation of exchanges rates affects commercial operations. On the other hand, exchange rate risk may have a translation effect if currency values are transformed in the process of preparing consolidated financial statements.
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Appendix A
The interest rate and exchange rate risks may certainly be interrelated, being essential for strategic decisions, especially for firms wishing to relocate their production to emerging economies. Competitor risk and market-demand risk Competitor risk originates from the possibility that the strategic decisions by competitors will affect the industrys structure and the cost-earnings of a company. For example, aggressive strategies based on price-competition, the introduction of innovative products to the market, mergers and acquisitions that create vertical integration, cost-cutting investments that shift production efficiency curves of the industry, etc. Market-demand Risk provides another angle from which to analyze the determinants of volatility. This risk can be identified in the area of customer satisfaction, due to the volatility in customer needs and preferences that may leave the firm unprepared. Such risk crosses over into other categories abovementioned. For instance, the risk arising from a firms inability to quickly adapt to changes in customer tastes is related to competitor risk. There a re, of course, sectors in which market-demand risk is more common, such as apparel and automotive industries. Technology risk Technology risk is partially related to competitor risk, and can be resumed as the combination of factors that can cause a firm to lose its competitiveness. This applies especially to those sectors characterized by continuous technological innovation such as internet/e-commerce and biotech. Specific risk can be tied to both technological obsolescence and to the loss of competitiveness, in terms of costs as well as quality. Country risk There may be country risks flowing from the commercial and industrial relationship between firms and the countrys governmental organizations. County risk is particularly important in relation to South American and East Asian countries, the two most important commercial areas outside Western economies. An example is the risk represented by the possibility of the local authorities to revoke a firms authorization to operate inside a particular country.
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Appendix B
APPENDIX B The Pharmaceutical Industry: Porters Five-Forces Analysis

Threats from New Entrants High barriers to entry characterize pharmaceutical industry. Government regulations and controls, the high level of R&D and capital required, plus a smoothly functioning patent system in the most important markets, make it difficult for new competitors to enter the market. The first entry barrier is the large amounts of capital and intellectual base required by the research and development departments. The high capital requirements are coped with the elevate possibility of failure in product development due to scrutiny from the FDA and competition from other companies. For the European pharmaceutical groups, R&D spending generally hovers in the range of 14-18% of sales, and this figure is quite lower than the average US based companies annual expenditure. Another key entry barrier is represented by the amount of marketing and distribution expenses required. The cost of launching a new product frequently exceeds the R&D expenses. Given the growing global presence of the pharmaceutical companies, the constant reduction in product differentiation, ever shorter periods of exclusivity for drugs and new distribution methods, the marketing and distribution of newly launched products are gaining a greater degree of significance.180. At last, a consistent barrier for new entrants is represented by the high level of endemic risk that characterizes the pharmaceutical industry as a whole. As it has been already underlined in the previous sections, the traditionally high margins that distinguish the industry are in fact essential, as they help to compensate for the high hazard involved in research and development. Drugs that are subsequently proven or even just alleged to be detrimental to health can potentially result in enormous losses181. In most countries, there is also the considerable risk of harsh government intervention in the field of healthcare. In light of the high R&D spending required to develop a drug, companies are forced to launch blockbuster drugs with extremely high levels of sales.
For example, in 2000, the US pharmaceutical industry for example invested combined resources in marketing activities for 15.6 billion US dollars. See PhRMA (2001b). 181 In US, for example, it has not been unusual for class action compensation claims to stretch into billions of dollars in recent years.
180
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Appendix B
Market Strength of Suppliers Pharmaceutical companies suppliers, even though constantly play a key component to their success, have little bargaining power due to the fact that most drugs require small amounts of ingredients. With the amount of key ingredients being marginal, suppliers are usually competing for the business of major drug companies. This situation is coupled with simpler production and know-how requirements on basic chemical components, reason why many major pharmaceutical companies prefer to outsource or spin off their basic component production divisions in order to stay focused on more complex and profitable activities182. So, even though small firms (especially biotech ones) are acquiring increasing importance in new products development on their own for the biggest producers183, instead of partnering with a large manufacturer, the most powerful companies still have a large bargain power that allow them to exploit a quite considerate dominant position towards suppliers. Threats from Substitute Products The threat of substitutes in the pharmaceutical industry is divided in two main branches: Prescribed drugs, or drugs protected by patents, the threat is generally limited because there is little to no substituting while a patent is effective; Freely purchasable Over the Counter (OTC) medicines - for example aspirin and acetylsalicylic based products -, or in case of medicines whose patent has expired (or is not in force for any reason), the competition level increases drastically, and therefore the substitution menace. Market Strength of End-consumers The end-users of pharmaceutical products usually have quite a small power in price bargaining with pharmaceutical companies. The only serious form of consumers related strength derives from the end-users insurance companies and public governmental institutions which try to bargain prices and discounts with the pharmaceutical companies
As for example it happened with the decision of Novo Nordisk to separate the enzyme research and production activities into a new entity called Novozymes. 183 The success of biotech pioneer Amgen demonstrates the ability of new companies to establish an independent presence in the market. Genome sequencing concern Celera revealed its desire to enter the drug development business when it acquired Axys Pharmaceuticals last fall. See Pollack (2002).
182
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Appendix B
to bring down drug costs184, and that are increasing their relative impact on pharmaceutical companies sales185. The particular characteristics of the products, moreover, imply that at a large extent the end users of medicines are not able to choose the products themselves. They are prescribed by health care professionals who show less interest on the actual cost of the product, but that are more attracted by the peculiar characteristics of the product (for example, Novos NovoSeven is a virtually unchallenged cure for some particular haemophilia-related diseases), or of the manufacturer, showing a high level of brand loyalty, factor that is often strongly encouraged by the patients themselves186. Competition within the Industry The competition amongst players varies according to the links analyzed in the companies value chain. Regarding the research and development link, companies are racing to launch new products before other companies can release similar products; therefore, the overall intensity of the competitive pressure is high. Companies have to firstly be able to recoup their R&D expenses, through approval and patenting of their products to ensure future cash flow. Secondly, they have to be able to sustain the high level of expenses and also the losses that might generate from possible failures through the achievement of an optimal critical mass187. The absolute importance of R&D activities on the acquisition and sustain of competitive advantage towards the other players in the market, therefore, is changing the overall strategic and tactical planning of the major actors in the industry. The high risk associated with the development of new drugs implies that cooperation with external firms (as biotech or genome-specialized firms) and public research centres
See Fisher Ellison and Snyder (2001). For example, in US MCOs in 1980 enrolled in their health insurance plans only 5% of the population. These entities, therefore, influenced a small fraction of prescription choices. In 1995, 71% of the insured population was covered by MCOs, and managed care was at the time responsible for more than 50% of drug market volume. See Giorgianni (1997). 186 See Grabowski and Vernon (1992, pg. 331 350). 187 Especially for the average sized, European based, companies, whose R&D spending generally hovers in the range of 14-18% of sales, the lack of critical mass, if compared to their US based competitors, makes this figure consistently more modest than the average US companies annual expenditure (situation that is likely to worsen in the future), which therefore enjoy a consistent competitive advantage. For further details, refer to Gilbert and Rosenberg (2004).
184 185
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Appendix B
(as for example universities) is steadily growing in importance. The substantial investments in genetic engineering firms, plus the growing number of research alliances and licensing agreements provide ample evidence of this new strategic orientation for companies, that nowadays is more and more based on forging R&D alliances (cooperative ventures, minority stakes, joint ventures, consortia) achieved either through contracting out the early stages of the research chain, or through intensive cooperation on contractual basis with smaller and highly specialized (biotech) firms and university partners, and on introducing improvements in productivity of research through more systematic research procedures (for achieving a better understanding of the causes of disease) and through a higher level of industrialization of the research process (automation, application of new technologies and methods as the HTS). Big companies focus also on the law and bureaucratic link (especially their patenting related activities) of their strategy, through an extension of their influence on the standardization of requirements for clinical studies and strengthening their internal patenting activities. Regarding competition for market shares and for the sales activities, a distinction has to be made between drugs protected by patent law (of course for the countries that actually enforce this protection, as previously introduced) and drugs which are not, or whose patent protection has expired. Patent protected drugs face a quite modest degree of rivalry. Firstly because the first mover advantage grants companies the totality of the market in the specific therapeutic area, at least for some time (me-too or bioequivalent drugs require a certain amount of time to be developed, and tend to be less profitable for the producers188). Secondly, because serious price competition among big companies involved in the same therapeutic area, seems a quite remote possibility in the industry. The unprotected products scenario instead seems quite different. The strong and growing presence of generics in many branches of the industry enhances competition and increases the possibility of consistent price reductions, up to 80% from the original retail price. Some niches of the pharmaceutical industry seem anyway quite immune by this type of competition189. Therefore the pharmaceutical industry faces, from the market share point of view, a degree of competition that varies according to the niche of the
See Fragkakis et al. (2002, pg. 9). For example the insulin branch seems immune to the generic drugs menace, being the necessary startup investment for production plants of such a magnitude to discourage the introduction of generics.
188 189
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Appendix B
industry and the state of the legal protection of the product. Lack of protection, in fact, increases dramatically the level of antagonism in the market. Regarding the level of integration of the markets, it seems quite moderate. It is possible of course for companies to sell their products all over the World, but the differences in regulations about marketing, testing and approval in different countries might impose barriers in the commercialization of certain products, or considerably slow down their introduction. Even though international agreements and mutual recognition treaties are trying to ease the situation, still the fragmentation of the global market can be, in some cases, quite considerable.
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Appendix C
APPENDIX C Diabetes-Care Related Products

Insulins Insulin, as a commercial product, has faced tremendous metamorphosis both from its composition, synthesis and availability, and from its market potentialities point of view. From the clinical discovery and application of insulin in the beginning of the 1920s, insulin products did not witness major changes until 1980. Traditionally, insulin had been obtained through its extraction from pig or cow pancreases, practice that implied relatively large levels of impurities in the product whose biggest and most dangerous consequence was the develop of antibodies to the impurities in the product and to the animal insulin itself by the patients. In the 1980s, two companies were on the edge of releasing completely new products, that would have changed the market and ensure them a long-lasting dominant position. Novo Nordisk introduced an array of highly purified pork insulin products. Pork insulin was much less antigenic than beef insulin, and highly purified insulin preparations were much less antigenic than the products that had been sold to that point. In 1982, Eli Lilly marketed the first purified, genetically engineered, biosynthetic human insulin. Throughout the 1990s, the human insulin showed its market potentials, gradually driving the animal insulin out of the market, and by 2000, both major manufacturers discontinued widespread sales of animal insulin. The next breakthrough in the diabetes management industry occurred during the mid1990s, when specifically modified insulin made through biosynthetic technology, was introduced. These insulin analogs are "designer insulin," with protein structures modified to achieve specific therapeutic goals and to replicate the action of the endogenous human insulin better than the standard biosynthetic products available in the market190. Insulin based drugs are divided in six categories, based on their different action rapidity191
190 191
See Gerich (2002, pg. 308-316). www.lifeclinic.com/focus/diabetes/supply_insulin.asp) Alfredo Galletti Carsten Wong Iversen
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Appendix C
Very fast acting - The fastest acting insulins are called lispro (Humalog) and insulin aspart (Novolog). They should be injected under the skin within 15 minutes before meals. These insulins start working in five to 15 minutes and lower blood sugar most in 45 to 90 minutes and their action ends in three to four hours. Fast acting - The fast acting insulin is called regular insulin. It lowers blood sugar most in two to five hours and finishes its work in five to eight hours. Intermediate acting- NPH (N) or Lente (L) insulin starts working in one to three hours, lowers your blood sugar most in six to 12 hours and finishes working in 20 to 24 hours. Long acting- Ultralente insulin prolongs the entry of insulin into the blood for four to six hours and remains active for 28 hours. Ultra-long-acting - A new type of insulin, glargine, is injected once a day. Its activity begins in just over an hour and is sustained at a constant rate for 24 hours, without any peaks. Insulin mixtures Products formulated as combination of different types of insulin. Insulin subministration and glucose monitoring devices Another niche in the insulin and diabetes management market is represented by the injection devices sector and the glucose level monitoring kits. At the current state of the market, the only way to provide insulin to the body for people affected by diabetes is through an invasive operation, commonly self-practiced by the patients themselves with the aid of a syringe and needle. But subcutaneous injection, although is the most diffused treatment posology among diabetic patients, is not the only possible way to proceed with insulin administration. Tools and treatment aids may vary for complexity, features and physical dimensions. Diabetics need to control more or less constantly the glucose level in their blood. This task is nowadays fairly simple and it can be autonomously performed by patients themselves in a minimal invasive way (just few drops of blood are necessary to obtain the response) through a wide range of convenient, small portable tools. Syringes - Most people who use insulin inject it under the skin (subcutaneously) with a needle and syringe. A variety of syringes is available in a range of sizes of needle gauge, needle length and syringe capacity.
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Appendix C
Insulin pens they are convenient way of carrying insulin in a discreet way for patients. Some pens use replaceable cartridges of insulin; other models are disposable. The tip of the pen has a fine, short needle. Users turn a dial to select the desired dose of insulin and press a plunger on the end to deliver the insulin. Novo Nordisk was the first company to introduce pen devices for insulin injection Injection Aids - A number of devices have been developed to facilitate injections. They work with most syringes. Other aids are intended for those who are visually impaired. Insulin Jet Injectors - Insulin jet injectors send a fine spray of insulin through the skin by a high-pressure air mechanism instead of needles. These are great for those who fear needles, but they're expensive and the units have to be sterilized frequently. External Insulin Pumps - Insulin pumps are available for continuous subcutaneous delivery of insulin. Many find these to be an accurate, precise and flexible insulin delivery system that helps them maintain excellent glucose control. External insulin pumps consist of a reservoir for insulin, a small battery-operated pump and a computer chip that controls insulin delivery, all in a case about the size of a deck of cards. It is connected to narrow; flexible plastic tubing that ends with a needle inserted just under the skin near the abdomen. This infusion set is changed every few days. The insulin pump weighs about 3 ounces and can be worn on a belt or in a pocket. Pumps are either waterproof or waterresistant with a waterproof cover. Users can set the pump to give a steady trickle or 'basal' amount of insulin continuously throughout the day. Most pumps have the option for setting several rates. Pumps release bolus doses of insulin at meals and at times when blood sugar is too high, based on the user's programming. Studies have shown that pump therapy can improve glucose control, particularly for those seeking tight control. Implantable Insulin Pumps - Researchers are working hard to develop an implantable insulin pump that can measure blood glucose levels and deliver the exact amount of insulin needed. Pumps in development are disk-shaped and weigh 6-8 oz. They are surgically implanted and can be programmed to deliver a basal dose continuously and bolus doses when needed.
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Appendix C
Insulin Inhalers - As another alternative to injections, a variety of insulin inhalers are under development, and some are getting closer to becoming available on the market. Some use compressed air to convert a dose of dry or dissolved rapid-acting insulin into particles that can be inhaled (a process called aerosolization). Others are breath-activated. The doses are inhaled through the mouth directly into the lungs, where it is easily absorbed and passes quickly into the bloodstream. Because most of the models use rapid-acting insulin, they are intended for use before meals, and will not totally replace injections. However, investigation of the inhalation of fast- and slow-acting insulin is also under way. Researchers who are comparing the effectiveness of the new devices to insulin injections are reporting that they are successful in delivering insulin and in controlling blood glucose levels. Glucose monitoring devices - People with diabetes who take insulin or oral medications must monitor blood glucose levels in order to determine whether treatment goals are being met and to make sure that medication dosage is correct. A number of blood glucose meters, or monitors, have been developed to help people test their blood glucose, using a drop of blood. Wide ranges of data management and computer capability features are available in today's meters. The convenience of self-monitoring, the development of alternate site testing, Medicare reimbursement for Type 2 diabetes and promotional offers on kits are among the many factors driving the adoption of self-monitoring devices. With Type 2 Diabetes growing at an unprecedented rate, product innovations and the emergence of minimally and non-invasive technologies are making the glucose self-monitoring business a promising, high growth market. Oral diabetes products Oral antidiabetic drugs (OADs)
192
fall into three basic groups of medications, which
work in different ways to lower blood glucose levels. The first group of drugs stimulates the beta cells to release more insulin. There are two classes of compound within this group; sulfonylurea drugs which have been in use since the 1950s and a new class of drugs, the meglitinides. The second group of diabetes drugs synthesizes the body to the insulin that is already present. There are two classes of these compounds; biguanide drugs which lower blood glucose by suppressing glucose production from the liver and
192
www.Diabetesforum.net and www.Protemix.co.nz Alfredo Galletti Carsten Wong Iversen
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Appendix C
thiazolidinedione drugs which enhance insulin action in muscle and fat tissues. The third group of drugs helps the body to lower blood sugar by blocking the breakdown of starches and certain sugars in the gut. Sulphonylureas are the most widely used agents. Approximately one-third of patients with type 2 diabetes do not respond adequately to sulphonylureas, most often because of dietary non-compliance or markedly impaired betacell function. The first class of insulin sensitizers to reach the market was the thiazolidinediones. The first drug in this class, Rezulin, was launched in 1997 by Warner-Lambert, which merged with Pfizer. After post-marketing reports of liver damage and deaths, Rezulin was voluntarily withdrawn from the market in March 2000. From the time of its approval to market withdrawal, Rezulin brought in revenues of US$ 2,1 billion for Warner-Lambert. The leading oral diabetes medication is another insulin sensitizer, Glucophage, which generated worldwide sales of US $2,4 billion in 2001 and US$1,8 billion in 2002, around one-third of the type 2 diabetes market. Glucophage is owned by Bristol-Myers Squibb, which also launched Glucovance in August 2000 and Glucophage XR in November 2000.
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Appendix D
APPENDIX D Brazil - Current Situation

General Facts Brazil is the largest and most populous country in Latin America, with a nominal GDP of US$ 450 billion, the ninth largest in the world, representing approximately US$ 2.500 per capita. Brazil was the ninth largest
Brazil: Facts
Population Nominal GDP GDP per head Average wage Corporate tax Currency Risk rating 176.0m (2002) US$ 453bn US$ 2,570 US$ 176/month 34% Cruzeiro real (BRL) Medium (C)
Source: Economist Intelligence Unit.
market for pharmaceutical products worldwide193. Although the Brazilian market has suffered a decline because of its currency devaluation, it still represents approximately 34% of the Latin American market and 60% of Mercosur. For a detailed discussion of Brazil current situation and its risk assessment, please refer to Appendix B. Current situation Since his election in 2003, President Luiz da Silvas strategy has been aimed towards the double target of tight fiscal and monetary discipline (following the IMF agreed framework) combined with social programmes. 2004 is seen as a year of consolidation of the trust of his electors and the financial World. It is believed that if the current decline in interest rates, together with improved investor confidence, will be able to reinforce the upturn in the domestic economy through a recover of real incomes and therefore a more broad-based growth. Decline in interest rates and an improvement in confidence should stimulate also an expansion of credit and an upturn in investment, that should be able to fuel the labour market and then imply a rising of real earnings and eventually to a reduction in the unemployment rate (particularly important for increasing the demand for particular goods, as for example pharmaceuticals). The choice to follow fiscal discipline, a floating exchange rate and inflation-targeting policies linked to a public debt reduction (rather than trying to boost demand through more relaxed monetary strategy), ensured an improvement on the primary surplus (4.25%) that should allow less onerous adjustment manoeuvres during next years. Improvements in the inflation pressure (the
193
See Hasenclever (2002, pg. 12). Alfredo Galletti Carsten Wong Iversen
154
Appendix D
indice de precos ao consumidor amplo (IPCA), the Central Bank's target consumer price index, registered in March a rate of 6% on annual terms, well below the Central Bank's forecast of 7.8%) should also allow a reduction of the benchmark Selic rate by the Banco Central do Brasil. The unexpectedly firm commitment to orthodox macroeconomic policy, positive growth on export and trade surpluses is also contributing to stabilize the currency (also supported by the commitment to the IMF agreement) that recorded an appreciation during 2003. Risk Assessment The Brazilian government might face some problems during its restructuring plans. The economy is not recovering as strongly as hoped and the authorities have come under pressure to loosen their tight fiscal and monetary stance. Moreover, the government has also had to contend with the first scandal of its administration and the threat of strike action by public-sector workers
Brazil: Risk Rating 2004

Current Rating Overall assessment C Security C Political stability B Gov. effectiveness D Legal risk C Macroeconomic risk C Foreign trade B Tax policy C Labour market C Financial C Infrastructure C Note: E=most risky; 100=most risky.
Current Score 50 46 30 68 45 50 39 56 57 50 53
over pay, which actually may turn into a decline of the Presidents approval rating and his authority. From the economic point of view, the large public-debt burden (US$220bn stock of foreign debt, the largest in the developing world) still represents a weight that is keeping real interest rates quite above the average. Even though the 4,25% of GDP for the primary fiscal surplus target has been achieved in 2003, the net public debt/GDP ratio remains around 57%, which is uncomfortably high. The risk of debt default has been mitigated by a decline in the country risk premium since late 2002 and Brazilian borrowers have regained access to international capital markets. But high debt ratios still leave the economy vulnerable to any deterioration in external conditions or business confidence. Also, the expected economic performance and recovery might continue below potential, owing to structural rigidities and the crowding out of the private sector. The currency still remains vulnerable to shocks arising from domestic political difficulties or external factors, and its recent appreciation might imply a lost of competitiveness for exports. Exports may also be damaged by the recent arguments with US regarding
155
Appendix D
intellectual properties issues, contrasts that may turn into a reduced power for Brazil concerning agreement settlements. From the political point of view, Brazil shows a good level of stability, and dramatic changes or menaces to the current democratic form of government (as armed insurgency or dictatorships) seem unlikely. Nevertheless, the political system has proven itself ineffective several times. President da Silva has a strong personality and reputation, but expectations from the international partners and the high political and social costs of his reform may increase the pressure on his coalition until unsustainable levels. The latest inner contrasts among most of the parties in the ruling alliance implies that the government still needs to negotiate support from opposition members, with a consequent slowdown of reforms that need to be diluted, or exchanged for concessions elsewhere. Corruption in a large extent in the public sector also increases the inefficiency of the political institutions. Short-term finance for corporate operations is quite costly (around 16%) due to the economic uncertainty and the high level of inflation. The market for local currency denominated medium- and long-term financing is quite expensive and uncertain as well, and companies tend to prefer foreign-denominated (mostly USD) financing. The equity market (mainly represented by the BOVESPA, the Rio de Janeiro Stock exchange) is relatively small and illiquid. Detrimental for enterprises is also the current tax system. It is in fact considered complex, and, apart from the direct income taxes (around 34%), crowded by a multiplicity of indirect taxes. Taking the effective tax on corporate income together with indirect taxes, a 0.38% financial transactions tax and high social security contributions, the tax rate may rise above 40% of income. The legal system is considerably fair, even though it is undermined by an intrinsic and chronic slow speed. Given the will to gain the confidence of international investors by the current government, expropriation of assets seems quite unlikely and private property protection is not a relevant issue. However, as it will discussed in more detail during the chapter, a lack of a clear and firm regulatory framework in sectors such as energy, telecommunications and pharmaceuticals is present.
156
Appendix E
APPENDIX E Mexico - Current Situation

General Facts Mexico is expected to have the highest growth rates in Latin America by 2003, given its growing economy and population that should turn into an increment of population able to afford pharmaceuticals.
Mexico: Facts
Population Nominal GDP GDP per head Average wage Corporate tax Currency 102m (2002) US$ 637bn US$ 6.260 US$ 296/month 34% Mexican peso
In 2003, health care products in Mexico amounted to US$ 6,3 bn., with an annual growth rate equal to 6.8% from 2000. In 1998, private sector prescription drug purchases accounted for approximately 25% of Mexicos total pharmaceutical sales, over-thecounter sales for 10%, and the public sector accounted for the remaining 65%. It is important to note that the pharmaceutical industry is one of the few remaining industries that are subject to price controls in Mexico. Current situation President Vicente Fox Quesadas policy is focused mainly toward stability, with particular attention to low inflation and fiscal deficit containment, attitude forced by a limited access to discretionary funding that could be used to stimulate growth and job creation through an increase of public spending. Therefore the political strategy will be addressed also for the future on preserving disciplined fiscal and monetary policies, sacrificing high growth rates and employment for an improvement of the fiscal deficit, inflation control and debt management. In the last years, Mexico had benefits from US growth (that affected positively its export levels), and also from the increasing demand in other Latin Countries (as Brazil and Argentina), while the euro appreciation against the Mexican peso allowed the country to favourably exploit its free-trade agreement with the EU. The current oil price also affected positively countrys revenues (oil in fact accounts for approximately one third of Mexican exports), and contributed to support public expenditure. The inflation control policy also contributed to reduce the indicator, still on a downward trajectory (3.52% on an annual base in March compared with 3.5% in
157
Appendix E
January), that together with credit expansion and increasing financial resources availability should help boosting growth and increase the amount of fixed investment which contracted during last years. General growth in Mexico, anyway, remains closely linked to US performances. Due to the high incidence of United States on Mexican export levels, growth is expected to be quite strong in the future years as long as US demand for Mexican exports will keep constant. Hence a sharp slowdown in US growth might affect negatively growth prospects. Domestic demand growth will be reduced by the restrictive fiscal and monetary policies, and the delay of the needed structural reforms (for example the privatization process of energy industry that should help reduce the prices) will probably shift some foreign direct investment. Moreover, Pesos depreciation, both in nominal (2003 exchange rate against US dollar was Ps11,2:US$1 compared with Ps10,3:US$1 at the end of 2002) and real terms (estimated average of a depreciation equal to 12% year on year), imply lower capital inflows and export earnings, and at the same time increasing the expenditure for imports. Risk assessment Mexico is politically stable. The democracy of President Vicente Fox Quesada tried, achieving some success, to introduce reforms in order to increase transparency and reduce corruption and lobbys influence (even though they are still present). Still, its ability to effectively govern the country is somehow slowed by the fragmentation of the coalition in power and being in the
Mexico: Risk Rating 2004

Current Rating Overall assessment C Security B Political stability C Gov. effectiveness C Legal risk D Macroeconomic risk C Foreign trade D Tax policy D Labour market B Financial D Infrastructure C Note: E=most risky; 100=most risky.
Current Score 55 36 50 57 65 60 61 69 39 71 47
minority in the Congress. Nevertheless, its macroeconomic policy, favouring stability over growth, reduced deficit, inflation and managed public debt. From a financial point of view, the pesos depreciation is turning beneficial for the competitiveness of firms operating in Mexico. Private property, patent and copyright protection and commercial activities are quite well established, and they are exercised also towards foreign companies. Judicial system, when required, is instead quite slow and inefficient, and
158
Appendix E
sometimes corrupt. Corruption is then a costly problem for business, as well as the strong presence of outlaw movements. Security issues (as theft and attacks against enterprises and wealthy people) are major concerns in the business environment in Mexico.
159
Appendix F
APPENDIX F Argentina - Current Situation

General Facts Once the wealthiest Latin American country, with a GDP pro capite of US $7,700 in 2000, Argentina had to face in January 2002 a major devaluation of the Peso ( around 42%) after the abandonment of the fixed peg to the US dollar. Hyperinflation and economic uncertainty
Argentina: Facts
Population Nominal GDP GDP per head Average wage Corporate tax Currency 37.8m (2002) US$102bn US$2,700 $249/month 35% Peso
made poverty and unemployment rates sky-rocketing (reaching respectively 40 and 20 percent). The Argentinian health sector, therefore, couldnt avoid the effects of the exceptional turmoil and the dramatic crisis that followed. Global companies have to face the scarcity of US$ for trade purposes, the unwillingness of the Government to sustain health expenditure, and in some cases the exceptionally high prices of imported goods and medicines. Current situation After his election during May 2003, President Nestor Kirchner will continue his strategy of reversing from the liberist political ideas that characterized Argentinas policies during the 1990s. The state then will assume a proactive role in the economy, both through its regulation and increasing social spending to stimulate demand. The rebuilding of a sound economic environment has to be coupled then with a series of major reforms for creating the basis for long-term growth, including the re-foundation of the financial sector and the introduction of new fiscal policies in accordance with the federal and provincial governments, that in the past were unable to overtake the opposition from Congress and from private sector lobbies. The weak Argentinean exchange rate should be able to push export and then growth for the next years, while the weak growth in domestic demand should be able to keep inflation under control, after the choice to abandon the indexation of wages and prices. Argentina's silent agreement with Brazil for expanding the Mercosur, should consolidate the South American trading bloc, and achieve a greater contractual power in negotiations with the Free-Trade Area of the
160
Appendix F
Americas (FTAA), especially on issues such as the agricultural policies and decrease in import duties. Argentinas export-led growth has been made possible by the strong nominal and real depreciation that occurred after the major crisis that stroke the country. However, real exchange rates will not remain indefinitely at such a low level (50% weaker than before the crisis), even though a real appreciation will probably occur at a slow pace, and the authorities will try to prevent it through monetary intervention. More uncertain is the actual growth in exports, due to the international situation and demand dynamics. Heavily relying on US and Brazil demand, their weakening will affect heavily Argentinean exports, and therefore the growth. Also the detrimental effects of the crisis and the consequent bond default on investments and production capacity (the investment crunch is moreover likely to continue in the next future due to policy and economic uncertainties and the lack of needed reforms) could provoke serious constraints on growth possibilities, implying a possible growth rate slowdown in the next future. The weak peso contributed negatively to overall growth, as imports increased in value much faster than exports. Growth will also be undermined by the heavy repayments on non-defaulted bonds, whose maturity term will depend on the outcome of negotiations with the holders of defaulted bonds. Risk assessment President Kirchners support from the public is not coupled with the sustain of his party, which is divided between him and Mr. Duhalde, his most serious adversary. Therefore the political environment appears now more challenging, also for the need of implementation of necessary structural reforms to sustain growth and recovery, reforms that will not be easy to activate. At
Argentina: Risk Rating 2004

Current Rating Overall assessment C Security B Political stability C Gov. effectiveness C Legal risk D Macroeconomic risk C Foreign trade D Tax policy D Labour market B Financial D Infrastructure C Note: E=most risky; 100=most risky.
Current Score 55 36 50 57 65 60 61 69 39 71 47
the same time, the Government has to restore confidence in investors, crushed by the collapse of the peso in 2002, and still uncertain regarding possible new crisis or defaults, and doubtful about the current legal and regulating systems within the country.
161
Appendix F
A possible help for the restructure of the Argentinian economy might be given by the strong growth rates registered in the past year (approximately 8.7%) , which is likely to continue for some time, even though the credit and investment crunch that affected the economic environment might turn detrimental for sustaining this growth, and the overall uncertainty of the situation will not help recovering the past capital expenditure levels, at least as long as decisive reforms will not be enterprised, and the internal financial market will be restored. Especially the forbidden access to international capital markets may turn detrimental for the economy as a whole. The defaulted US$ 95bn debt in the end of 2001 represents a heavy burden that will exclude Argentina from foreign borrowing for quite some time. The economic collapse also increased the security risk in the country, making crimes against property and people more frequent, even though the current democracy is not likely to be jeopardized by military dictatorships or revolutions.
162
Appendix G
APPENDIX G Novo Nordisk: SWOT Analysis

Strengths Novo Nordisk is the dominant company in the European and Japanese insulin markets, accounting for 58% and 76% of sales respectively, and that together account for approximately the 52% of the world insulin market by value. A strong current market share is an important factor for future growth potentialities for two reasons: first,
25% 20% 15% 10% 5% 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011
Percentage Of 2001 Sales With Patent Expiring In 2003 2011 (USD Billions)
the high degree of generally observable patient and physician loyalty; secondly, a dominant position improves the chances of successfully launching products in the markets. Even though some of Novos most valuable patents (for example human recombinant insulin Novolin194) are expired, many of Novo Nordisks key products will escape generic competition due to be therapeutic proteins, whose manufacturing required
195
40%
Novo Nordisk: Accumulated % Of Sales With Patents Expiring, 2002 (USD Billions)
30%
20%
complexity cannot be
and easily
10%
investment replicated .
Takeda
Merck
GSK
BMS
Novartis
Bayer
Pfizer
Moreover, the level of
turnover generated by products whose
Source: Company information
patent will expire from now to 2006 appears lower than the direct competitors ones. The menace for increased competitive pressure by possible substitutes, then, will keep a relatively low amount in the short term. Novos insulins will face an increased level of competition when other pharmaceutical companies will introduce in the markets new insulin analogs and, most notably, new
194 195
See Hdfc Securities (2004, pg. 5) See Robinson (2003). Alfredo Galletti Carsten Wong Iversen
Aventis
Eli lilly
Novo
0%
163
Appendix G
insulin non invasive delivery methods. The strong position in key markets as Europe or Japan, anyway, should be able to temper the enhancement of competitive pressure. New products, in fact, will require a certain amount of time to reach the markets (expanding the lifecycle of currently marketed products such as Novolin and NovoLog), and Novo Nordisks pre-established position should grant a higher products penetration capacity, while competitors may face difficulties on gaining physician and patient trust. An extra strength is given by Novo Nordisks potential blockbuster products within its diabetes pipeline, which have been developed to address current needs in the market. The oral antidiabetic NN2211 and the inhaled NN1998196 are forecasted to become top sellers when they will reach the markets. Oral antidiabetics (OADs) account for a much larger portion of the diabetes market than insulins, and that represents the current revenue driver for the companies competing in the branch (Novo estimates that almost three quarters of diabetics are on OAD based therapy)197. Novos NN2211, presenting less counter effects than the older OAD products198, should have a great return potential, even though this will depend upon Novos ability to introduce and properly market the product in the US, the major market for OADs. US penetration will be vital, as the price premium of analogs over human insulins is 70-100% in the US compared with 20-30% in Europe199. Novo Nordisk can also count on a strong R&D activity. It is in fact one of the principal actors in the research and development activities on the diabetes cure within Medical Valley. Its highly specialized research activity, combined with a relatively access to international financial markets, is one of the reasons for its predominance in the insulinrelated products market worldwide. Novo Nordisk, moreover, can count on active and profitable synergies throughout the resund area, both within the academic World (for example through a partnership in the Gotebrg Universitys lab facilities) and the health-
196 The NN2211 received the Clinical Proof of Concept during May 2003 (See Novo Nordisk, (2003, c), while the Pulmonary Insulin NN1998 is currently at the Phase III development (See Biospace LTD (2002)). 197 See Novo Nordisk (2003a). 198 The NN2211 represents a new development within the OAD market. It belongs to a class of drugs based on the action of natural hormone GLP-1. These drugs regulate insulin secretion in a glucosedependent manner, reducing the incidence of hypoglycemic episodes and hence having a superior side effect profile to the older OADs. NN2211 represents a significant advance in the diabetes market and, as a type II diabetes treatment, has a large patient potential. See Chang et al., (2003). 199 See IMS Health (2003a).
164
Appendix G
related apparatus (as, among many others, active research in Copenhagens Rigshospitalet, one of the leader structure for active research and cure of diabetes-related diseases). An additional strength is represented by the rigorous implementation of sound environmental policies, factor that might imply a serious competitive advantage, given the increasing attention to these matters by the society and the public organizations. Weaknesses The main source of revenues for Novo Nordisk at the moment is represented by the human insulin market, a market whose growth had been stable but not exceptional in the latest years. Other things being equal, this market might have reached a mature stage, in which a share increment may not be easily achieved without heavy marketing and sales promotion investment. Pipeline products are then the cornerstone of future revenues. As no R&D product can be guaranteed to be brought to the market, Novos strategy might be considered highly risky. The failure of the development of NN622200, a dual action insulin sensitizer licensed from Dr Reddys, expected to have a huge patient potential within the type II diabetic market (the first generation OADs, GSKs Avandia, obtained an enormous market success, therefore its improved successor NN622 was expected to rapidly overtake the older products), was a hard stroke for Novo Nordisk. Anyway this risk offers a potentially high return and that Novo Nordisk has no option but to pursue such a strategy if it wishes to remain at the forefront of diabetes care. Another weakness is given by the heavy investments in R&D projects that Novo is forced to face in order to keep pace with the rapidly developing market, since its marketed portfolio will not continue to drive revenue growth. Nevertheless, even though the efforts put towards the creation of a modern and effective biotech research area, the European research centres appear as relatively modest if compared to the US-based ones. The relatively small size of the European research investment and efforts, which in the last couple of years experimented a reduction both in capital expenditure (for example the withdraw of Biogen research centre in Hillerd during June 2003) and in the research
200 Like the first-generation sensitizers, this product targeted high blood glucose levels, but it also had the potential to regulate diabetic dyslipidemia. The high lipid levels common to type II diabetics increase the risk of cardiovascular disorders, which is the number one cause of death in people with type II diabetes. The product anyway has been withdrawn after the insurgence of tumors on animal testing during July 2002. See Novo Nordisk (2002b).
165
Appendix G
activity201, might imply a weakening of the current position in the research and development. Another complication may arise from the historical difficulties of signing cooperation agreements among different European Companies and institutions in order to achieve synergies that may compare the resources available for US Companies to the European ones. Increasing global competition might become another source of weaknesses. Historically, Novo Nordisk has avoided a direct competition with Eli Lilly in the diabetes market due to distinct geographical areas of dominance, with both focusing on their native markets. Novos new products (especially OADs), in order to express all their sales potentialities, will however need a higher presence in the US market, that so far has been lacking. The US represents in fact the major market for OADs, as doctors are more likely to prescribe OAD therapy than insulin, and the margin of OADs are much higher in US than in Europe. Novo Nordisks choice to focus on a few growth niches, where leadership positions can be created or sustained, may turn into a further source of weakness. The company might be more affected by individual project failures. The companys second growth driver, the haematology franchise, is achieving a solid growth, with a CAGR of 7.8%, but the future revenue streams are still a niche, small volume area of business. Opportunities Diabetes is widely spreading throughout the World, especially in rich Countries, due to many social factors. People affected by the disease are forecasted to triplicate within 10 years. The expansion towards emerging Countries (as for example China and the Latin America) might open new possibilities for a market whose growth experienced low levels in the past years. But as the disease keeps on growing, several different treatments are under development, as the oral insulin assumption instead of through needle injection (despite the many novel approaches that Novo has taken in its pen delivery systems, the pen does not meet one of the major unmet needs in the insulin market - that of needlefree delivery), or cures that may completely eliminate the disease from the human body. These factors represent a huge range of opportunities for Novo Nordisk, even though
201
See Ammitzbll (2001). Alfredo Galletti Carsten Wong Iversen
166
Appendix G
they cannot be exploited without heavy capital expenditure (Novo is projecting to invest 23,5 billion DKK in Denmark and abroad to enhance its production capacity), or in alternative through partnerships with other Scandinavian and European institutions to increase the diabetes research network within Europe. Novos development of the NN2211 short term, fast-acting inhaled insulin product should overcome this deficiency, at least in the fast-acting segment. Great possibilities and opportunities lay in the long-acting segment, which would allow the company to retain its title of insulin delivery specialist. Such a product would satisfy patients needs more effectively than products already existing in the markets, and would rapidly conquer market share from all other delivery methods. As previously highlighted, the US market represents a great opportunity, which is essential for Novos further growth. Novo Nordisk is struggling to increase its market share, investing heavily in its pipeline, which contains several OADs, and on marketing and sale activities 7(having increased its US sales force to 600 and has signed agreements with several US healthcare entities). Threats Future revenues are based on the current pipeline production, which has not been launched on the markets yet. Failures in any of these products might have terrible consequences for the future profitability of the company, as the currently marketed drugs, when their respective patents will expire, are forecast to be falling by 2011. The likelihood of huge research losses on experimental drugs is of considerable proportion, as the Novos withdraws from the NN622s development during 2002 demonstrates. Losses within other pipeline drugs might imply declining revenues and market shares before new products would be experimented and launched in the market. The competition for the discovery of new types of diabetes cure is still running, and many players in the market are racing. The recent progresses recorded on biotechnologies may shorten the time required to introduce new non-invasive posologies insulin products (as for example GSKs M2) or to possibly eliminate DNA and heritage diseases (as diabetes) from patients. The winner of the race will benefit of a quasi-
167
Appendix G
absolute dominant position through patenting these new products. The production of oral insulins is a long-awaited breakthrough in the diabetes market, and it is easy to forecast that its sales are likely to cannibalize the sales of injected insulin products. Generex has an agreement with Eli Lilly for Oralin, and Nobex, lacking marketing power to make its HIM-2 product a success, had signed an agreement with GSK. Novo should also seek a partnership with a company with such a compound in development. The existence of possible new cures for diabetes also represents a strong incentive to the largest pharmaceutical companies to invest seriously in the market. Their huge capital expenditure capacity is a consistent menace for the actual market leaders, due to heavy investment possibilities, capital venturing opportunities and synergies with the most important research centres (as the one located in the Boston area). Another possible threat is given by the somehow declining performances in historically key markets, as Europe and Japan. Both regions Exhibited a disappointing performance during 2002, with revenues in Europe increased by just 3.1% to $1.38 billion, due to the effect of wholesaler stockpiling in 2001, with a subsequent de-stocking in the first quarter of 2002 combined with the increased importance of parallel trading of the companys products, a practice which is actively encouraged in some countries in order to keep healthcare costs down. This characteristic of the market is expected to continue to have a negative impact on Novo Nordisks sales. The last threat is represented by the lost of competitiveness related to possible appreciations of the Danish Krone towards other currencies. Further appreciations of Euro against US dollar, British Pound and Japanese yen might erode the achieved market shares not only in the foreign markets, but also even in Europe, in which the threat of parallel import of less expensive products might become serious with the time being. Sales in Japan and Oceania fell by 5.8% to $538 million in 2002. Although the timing of future price cuts in Japan is unknown, they represent a significant risk factor for the company.
168
Appendix H
APPENDIX H Sensitivity Analysis on 2010 Cash Flow in DKK

Exchange rates
2010 Free Cash Flow Sensitivity- Exchange Rates Variations (DKK Millions)
135 BLR DKK 2010 BLR MXP 2010 BLR ARS 2010 BLR USD 2010 136 0,634 0,313 0,888 3,515 0,906 3,586 137 138 139 0,621 0,319 140
2010 Free Cash Flow sensitivity- Exchange rates variations

Variables BLR DKK 2010 BLR MXP 2010 BLR ARS 2010 BLR USD 2010 Base value 0,63 0,32 0,90 0,355 DKK change Downside Upside 1.391.347 -1.363.796 -1.303.461 1.303.461 -272.261 272.261 -271.914 271.914 % change Downside Upside 1,01% -0,99% -0,95% 0,95% -0,20% 0,20% -0,20% 0,20%
The relationship between cash flows and net present value with the BLR/DKK exchange rate is not linear due to the formulation implemented to operate the translation of the cash flows from foreign to home currency. Given the non linearity, and the importance played by the exchange rate under analysis, a larger possible variation has been analyzed, to test the possible effects of changes of a greater magnitude (10%) both for a single cash flow and for the NPV.
2010 Free Cash Flow Sensitivity- BLR/DKK Exchange Rate (DKK Millions)
110 BLR DKK 2010 120 0,690 130 140 150 0,565 160 170
2010 Free Cash Flow sensitivity- BLR/DKK Exchange Rate

Variables BLR DKK 2010 Base value 0,63 DKK change Downside Upside 15.304.822 -12.522.127 % change Downside Upside 11,11% -9,09%
169
Appendix H
Inflation rates
2010 Free Cash Flow Sensitivity- Inflation Rates (DKK Millions)
135 BRA Inflation rate 2010 MEX Inflation rate 2010 ARG Inflation rate 2010 136 3,80% 2,60% 5,30% 7,30% 137 138 139 1,80% 4,60% 140
2010 Free Cash Flow sensitivity- Inflation rates

Variables BRA Inflation rate 2010 MEX Inflation rate 2010 ARG Inflation rate 2010 Base value 2,8% 3,6% 6,3% DKK change Downside Upside 1.365.043 -1.365.043 -1.074.616 1.074.616 -256.023 256.023 % change Downside Upside 0,99% -0,99% -0,78% 0,78% -0,19% 0,19%
Sales growth variation

2010 Free Cash Flow Sensitivity- Sales Growth Variation (DKK Millions)
136 MEX estimted items sold grow th 2010 BRA estimted items sold grow th 2010 OTH estimted items sold grow th 2010 ARG estimted items sold grow th 2010 6,00% 5,00% 4,50% 4,00% 7,00% 6,50% 6,00% 137 138 139 8,00% 140
2010 Free Cash Flow sensitivity- Sales growth variation

Variables MEX estimated items sold growth 2010 BRA estimated items sold growth 2010 OTH estimated items sold growth 2010 ARG estimated items sold growth 2010 Base value 7,0% 6,0% 5,5% 5,0% DKK change Downside Upside -911.984 911.984 -341.731 341.731 -127.071 127.071 -105.535 105.535 % change Downside Upside -0,66% 0,66% -0,25% 0,25% -0,09% 0,09% -0,08% 0,08%
Price response to inflation

2010 Free Cash Flow Sensitivity- Price Response To Inflation (DKK Millions)
137 MEX Price response to inflation BRA Price response to inflation ARG Price response to inflation 137 84% 94% 99% 96% 101% 138 138 86% 139 139
2010 Free Cash Flow sensitivity- Price response to inflation

Variables MEX Price response to inflation BRA Price response to inflation ARG Price response to inflation Base value 85,0% 95,0% 100,0% DKK change Downside Upside -502.728 505.353 -252.056 254.497 -117.736 119.667 % change Downside Upside -0,36% 0,37% -0,18% 0,18% -0,09% 0,09%
170
Appendix H
Costs
2010 Free Cash Flow Sensitivity- Cost Components Variation (DKK Millions)
130 Direct prod costs as % revenues Direct prod costs per item real grow th 2010 Labour as % revenues Labour per item real grow th 2010 Cost of Sales as % revenues Estimated Cost of sales grow th 2010 Adm & Gen as % revenues Adm & Gen costs grow th 2010 Royalties 2010 Tax rate 2010 Net w orking capital 2010 Stock as % of items sold 2010 16% 11% 9% 6% 35% 33% 14% 9% 3% 1% 4% 29% 4% 2% 7% 7% 1% -1% 27% 18% 1% -1% 5% 135 140 16% 145 150
2010 Free Cash Flow sensitivity- Cost components variation

Variables Direct prod costs as % revenues Direct prod costs per item real growth 2010 Labour as % revenues Labour per item real growth 2010 Cost of Sales as % revenues Estimated Cost of sales growth 2010 Adm & Gen as % revenues Adm & Gen costs growth 2010 Royalties 2010 Tax rate 2010 Net working capital 2010 Stock as % of items sold 2010 Base value 17,0% 0,0% 6,0% 0,0% 28,0% 3,0% 8,0% 2,0% 5,0% 34,0% 15,0% 10,0% DKK change Downside Upside 3.393.772 -3.393.772 669.210 -669.210 3.393.772 -3.393.772 231.560 -231.560 3.037.048 -3.037.048 842.117 -842.117 2.949.446 -2.949.446 238.316 -238.316 3.375.464 -3.375.464 1.820.860 -1.820.860 5.114.340 -5.114.340 1.167.958 -1.167.958 % change Downside Upside 2,46% -2,46% 0,49% -0,49% 2,46% -2,46% 0,17% -0,17% 2,20% -2,20% 0,61% -0,61% 2,14% -2,14% 0,17% -0,17% 2,45% -2,45% 1,32% -1,32% 3,71% -3,71% 0,85% -0,85%
171
Appendix I
APPENDIX I Sensitivity Analysis on Net Present Value

Exchange rates
NPV Sensitivity Exchange Rate Variations (DKK Millions)
590 BRL MXP BRL DKK BRL USD BRL ARS 600 99% 101% 101% 99% 99% 101% 99% 610 620 630 101% 640
NPV sensitivity Exchange rate variations

Variable BRL MXP BRL DKK BRL USD BRL ARS Base value 100% 100% 100% 100% DKK change Downside Upside -13.076.805 13.086.667 7.586.099 -7.438.855 4.361.565 -4.358.107 -2.291.876 2.291.834 % change Downside Upside -2,12% 2,12% 1,23% -1,21% 0,71% -0,71% -0,37% 0,37%
The relationship between cash flows and net present value with the BLR/DKK exchange rate is not linear due to the formulation implemented to operate the translation of the cash flows from foreign to home currency. Given the non linearity, and the importance played by the exchange rate under analysis, a larger possible variation has been analyzed, to test the possible effects of changes of a greater magnitude (10%) both for a single cash flow and for the NPV.
NPV Sensitivity BLR/DKK Exchange Rate Variations (DKK Millions)
500 550 600 650 700 750
BRL DKK
110%
90%
NPV sensitivity BLR/DKK Exchange rate variations

Variable BRL DKK Base value 100% DKK change Downside Upside 85.167.293 -69.682.331 % change Downside Upside 13,81% -11,30%
172
Appendix I
Inflation rates
NPV Sensitivity Inflation Rates (DKK Millions)
590 Inflation var Brazil Inflation var Mexico Inflation var Argentina 600 100,98% 99% 99,02% 100,98% 610 620 630 99,02% 101% 640
NPV sensitivity Inflation rates

Variable Inflation var Brazil Inflation var Mexico Inflation var Argentina Base value 100% 100% 100% DKK change Downside Upside 14.495.951 -14.370.904 -11.941.221 12.097.426 -5.499.270 5.560.331 % change Downside Upside 2,35% -2,33% -1,94% 1,96% -0,89% 0,90%
Sales growth variation

NPV Sensitivity Sales Growth Variation (DKK Millions)
0 MEX sales grow th var BRA sales grow th var ARG sales grow th var OTH sales grow th var -1,0% -1,0% -1,0% -1,0% 1,0% 1,0% 1,0% 500 1.000 1,0% 1.500
NPV sensitivity Sales growth variation

Variable MEX sales growth var BRA sales growth var ARG sales growth var OTH sales growth var Base value 0% 0% 0% 0% DKK change Downside Upside -313.063.753 408.153.721 -144.933.856 186.924.682 -51.203.590 59.361.984 -39.493.267 45.182.107 % change Downside Upside -50,77% 66,19% -23,50% 30,31% -8,30% 9,63% -6,40% 7,33%
Price response to inflation

NPV Sensitivity - Price Response To Inflation (DKK Millions)
590 MEX Price response to inflation BRA Price response to inflation ARG Price response to inflation 600 84% 94% 99% 96% 101% 610 620 630 86% 640
NPV sensitivity Price response to inflation

Variable MEX Price response to inflation BRA Price response to inflation ARG Price response to inflation Base value 85% 95% 100% DKK change Downside Upside -14.142.525 14.360.439 -8.223.033 8.319.661 -5.413.669 5.474.467 % change Downside Upside -2,29% 2,33% -1,33% 1,35% -0,88% 0,89%
173
Appendix I
Costs
NPV Sensitivity - Cost Components Variation (DKK Millions)
200 Production Factors as % revenues Production Factors grow th var Labour as % revenues Labour grow th var Cost of Sales as % revenues Cost of sales grow th var Adm & Gen as % revenues Adm % Gen grow th var Royalties as % revenues Tax rate Net w orking capital Stock as % of items sold 1% 9% 1% 6% 35% 16% 7% -1% 4% 33% 14% 11% 9% 1% 7% 1% 29% 5% -1% 27% -1% 400 18% 600 16% -1% 800 1.000 1.200
NPV sensitivity Cost components variation

Variable Production Factors as % revenues Production Factors growth var Labour as % revenues Labour growth var Cost of Sales as % revenues Cost of sales growth var Adm & Gen as % revenues Adm % Gen growth var Royalties as % revenues Tax rate Net working capital Stock as % of items sold Base value 17% 0% 6% 0% 28% 0% 8% 0% 5% 34% 15% 10% DKK change Downside Upside 72.442.970 -71.738.791 186.962.882 -175.629.461 72.442.970 -71.738.791 62.563.707 -65.529.510 70.576.117 -69.469.290 282.526.265 -241.724.011 48.427.816 -48.384.909 57.322.473 -60.492.422 66.465.992 -66.058.928 33.392.874 -33.358.504 7.867.022 -7.867.294 1.986.602 -1.986.657 % change Downside Upside 11,75% -11,63% 30,32% -28,48% 11,75% -11,63% 10,15% -10,63% 11,45% -11,27% 45,82% -39,20% 7,85% -7,85% 9,30% -9,81% 10,78% -10,71% 5,42% -5,41% 1,28% -1,28% 0,32% -0,32%
Final growth
NPV Sensitivity Final Growth Rate (DKK Millions)
1.000 800 600 400 200 0 -4,0% -2,8% -1,6% -0,4% 0,8%
-4,00% 4,00% -500 0 500 1.000 1.500
2,0%
3,2%
NPV sensitivity Final growth rate

Variable Final growth Base value 0% DKK change Downside Upside -574.453.364 212.880.150 % change Downside Upside -93,16% 34,52%
174
Appendix I
WACC
NPV Sensitivity WACC (DKK Millions)
1.200 1.000 800 600 400 200 6,85%
500
1.000
1.500
8,85%
6,85%
7,15%
7,45%
7,75%
8,05%
8,35%
8,65%
NPV sensitivity - WACC

Variable WACC Base value 8% DKK change Downside Upside 424.986.205 -276.627.815 % change Downside Upside 68,92% -44,86%
175
Appendix J
APPENDIX J Distributions Implemented in the Monte Carlo Simulation

The Triangular Distribution The triangular distribution has been used to assign variability to the chosen variables within the hypothized boundaries, in which the most likely value (the mean of the distribution) is given by the forecasted value, and the minimum and maximum values are given by the prospected variation range for each variable. The triangular distribution gets the mode of the distribution as parameter. Dependent on the mode m the distribution in the function takes on various triangular shapes. If the mode is equal to 0,5; the triangular distribution is symmetrical. The probability density function for a (0,1) triangular distribution is specified as follows:
P(x) =
(m/2)*x 2*(1-x)/(1-m) 0
for 0 x < m < 1 for m x 1 otherwise
The choice of using a triangular instead of other types of distribution (nominally the normal one) is given by the higher uncertainty assigned to the extreme value (that therefore have a higher likelihood to occur), without excessively decreasing the chance that the forecasted mean value will occur (situation that would take place with for example a uniform distribution). In detail, two distinct triangular distributions have been implemented.
Figure A. Triangular (-1,0,1) Distr.
0,0250
Figure B. Triangular (-1,0, 1/10) Distr.

0,0250 0,0200 0,0150 0,0100 0,0050 0,0000 -0,99
0,0200
0,0150
0,0100
0,0050
0,0000 -0,99
-0,59
-0,19
0,21
0,61
-0,77
-0,55
-0,33
-0,11
176
Appendix J
The first distribution is the symmetrical triangular, used to estimate changes in variables whose upper and lower sides have the same likelihood to occur, whose modal value is set equal to zero, and the extremes are -1 and 1 (see Figure A). The second triangular distribution used is a skewed distribution with minimum -1, mode 0 and maximum 1/10, introduced to simulate variables that might have a bigger deviation in the downside from the base value 0 than in the upside (see Figure B). The Uniform Distribution The uniform distribution represents the situation whereby a random number can take values within a finite range [, ] with equal probability. The parameters assigned for and are [0, 1]. Therefore, the distribution has been implemented to include uncertainties of variables whose likelihood to vary within the assigned boundaries are considered equal (see Figure C). The uniform distribution is characterized by the following probability density function :
P(x) =
1/( - ) 0
for 0 x < m < 1 otherwise

Figure D. Normal Distribution (0, )
0,02 0,02 0,01 0,01 0,01 0,01 0,01 0,00 0,00 0,00 -0,005
Figure C. Uniform Distribution (0,1)

0,012 0,010 0,008 0,006 0,004 0,002 0,000 0,01
0,21
0,41
0,61
0,81
-0,003
-0,001
0,001
0,003
The Normal Distribution The last distribution used has been the normal distribution. This distribution has been used to assign variability to the WACC, in which the mean is equal to Novos cost of capital, and the variance has been set as equal to (see Figure D). The probability density function for a(, ) normal distribution is specified as follows:
P ( x) =
e ( x )
/ 2 2
177
Appendix J
Contrarily to the common used normal distributions, the existence interval for x has not been set as equal to x ( - , + ) but x ( -1/2,+1/2). The choice of artificially reduce the existence interval for x is given by the impossibility of extreme WACC values (it is in fact hard to believe that the WACC could ever assume odd values). At the same time, given the financial policy pursued by Novo, the WACC is unlikely to increase or decrease from the current value. Therefore the variance has been also set to a small magnitude. Nevertheless, changes in the WACC are possible, so it has been considered important to simulate eventual changes in this variable, also given the fact that changes in the WACC have a great impact over the NPV of the project.
178
Exhibits
EXHBITS Exhibit 1.1. Survey evidence on Capital Budgeting methodologies
Source: Graham and Harvey (2002)
Exhibit 2.1. World Market: Global Share and Growth Sales, 1999 2003
Sales (US$ Billion) North America European Union Rest of Europe Japan Asia, Africa and Australia Latin America Total Share of Global Sales North America European Union Rest of Europe Japan Asia, Africa and Australia Latin America Total % Growth North America European Union Rest of Europe Japan Asia, Africa and Australia Latin America Total market
Soruce: IMS Health (2004b)
1999 135,6 79,9 10,1 53,4 35,7 22,4 337,1 1999 40% 8% 3% 16% 11% 22% 100%
2000 152,8 65,8 9,5 51,5 18,7 18,9 317,2 2000 48,2% 20,7% 3,0% 16,2% 5,9% 6,0% 100% 2000 12,7% -17,6% -5,9% -3,6% -47,6% -15,6% -5,9%
2001 181,8 77,08 10,92 47,6 27,9 18,9 364,2 2001 50,0% 21,0% 3,0% 13,0% 8,0% 5,0% 100% 2001 19,0% 17,1% 14,9% -7,6% 49,2% 0,0% 14,8%
2002 203,6 90,6 11,3 46,9 31,6 16,5 400,6 2002 51,0% 22,0% 3,0% 12,0% 8,0% 4,0% 100% 2002 12,0% 17,5% 3,5% -1,5% 13,3% -12,7% 10,0%
2003 229,5 115,4 14,3 52,4 37,3 17,4 466,3 2003 49,0% 25,0% 3,0% 11,0% 8,0% 4,0% 100% 2003 12,7% 27,4% 26,5% 11,7% 18,0% 5,5% 16,4%
179
Exhibits
Exhibit 2.2. Major Mergers and Acquisitions, 2001 - 2003

Date January/2001 January/2001 May/2001 June/2001 September/2001 Transaction Sanofi-Synthelabo acquires 50% of Astra Zeneca, forming the joint venture, Astra. Abbott acquires Kroll from Basf. Novartis acquires 20% of Roche Holdings voting capital. Bristol-Myers Squibb takes over DuPonts pharmaceutical division. GlaxoSmithKline announces a partnership with the Japanese Tanabe Seiyaku Bristol-Myers Squibb buys 20% of ImClone Systems. Millennium Pharmaceuticals acquires Cor Therapeutics. Novo Nordisk buys the Brazilian Biobrs Amgen, the worlds leading lifescience firm, buys Immunex, one of its main rivals. Ache sells its 42% stake in Schering-Plough to the American Schering Plough. Johnson & Johnson agrees to buy the Belgian Tibotec-Virco NV. The Advent International investment fund acquires control of Viatris from Degussa. Pfizer acquires Pharmacia DSM acquires division Roche's vitamin Benefits ------Possibility of a partnership. or even a merger, between the two Swiss rivals. Rights to Efavirens and Melfinavir, two AIDS-cocktail ingredients. Glaxo gains access to Tanabes experimental drugs; possibility of future expansion of joint projects. Acquires a promising biotech-based drug against IMC-C225 tumors, to be used in America, Canada and Japan. Gains rights to Intergrilin, an anticlotting agent also used to treat chest pain. --Higher sales and turnover. US$ 16 billion US$ 102 million US$ 2.8 billion US$ 7.8 billion ---Value
September/2001
US$ 1.5 billion
December/2001 December/2001 December/2001
US$ 2 billion US$ 31.4 million
January/2002 March/2002 May/2002 July/2002 September/02
US$ 32 million Acquires rights to experimental HIV and hepatitis drugs. Acquires firm with branches Europe, America and Brazil. Consolidates Pfizers global lead. The division includes Redoxon, a global best-selling vitamin brand. New drug development. US$ 88 million (e) The idea was to force a merger. Access to drugs for cardiovascular diseases and arthritis. Disetronic is the worlds second biggest producer of electronic pumps for insulin injection, a market in which Roche is interested. Increased sales in Japan. US$ 2.1 billion US$ 2.4 billion in US$ 320 million US$ 405 million US$ 60 billion US$ 2.2 billion
January/03
January/03 February/03
Johnson & Johnson buys 3DP, specializing in small therapeutic molecules (discovery and development). Novartis raises its stake in Roche Holding to 32.7%. Johnson & Johnson buys Scios, a life-science firm. Roche Holding acquires Disetronic Holding.
February/03
US$ 1.2 billion
March/03
Merck increases its controlling stake in Banyu, a Japanese pharmaceutical company. Novartis acquires control of the US-owned Idenix. The Israeli Teva Pharmaceutical Industries acquires its rival, the Italian-owned Sicor.
US$ 1.5 billion N/A Increased share of the injectedgenerics market. US$ 255 million US$ 3.4 billion
March/03 November/03
Source: Marketletter Publication Ltd (2004)
180
Exhibits
Exhibit 3.1: Brazil Pharmaceutical Industry: Selected Figures

Item Manufacturers Distributors Pharmacies / drug stores Hospitals outlets Products (brands) Product types (capsules, tablets, etc.) Active ingredients Therapeutic drug categories Prescription drug categories Over-the-counter drug categories
Source: LAFIS
Number 628 1,500 52,450 5,000 5,300 10,587 1,400 264 184 80
Exhibit 3.2: Brazil: Corporate Rankings, 2003

Sustainable Growth Change in net revenue over change in adjusted shareholders equity (points) Medley 1,0109 Cristlia 1,0174 Ach 0,909 Unio Qumica Roche Prodome Merck 1,1098 1,1462 0,833 0,7267 Net Revenue Refers to annual net sales (R$ million) Roche Novartis Biocincias Aventis Pharma Pfizer Ach GlaxoSmithKline Abbott Bristol-Myers Squibb Schering-Plough Grupo EMS Sigma Pharma Sector Average 873,6 725,8 690,9 597,6 506,7 476,8 422,1 387,8 380,9 339,8 584,2 Return on Equity Net income over shareholders equity (%) Schering-Plough Prodome Grupo EMS Sigma Pharma Medley Cristlia Unio Qumica Ach Roche Merck Biosinttica Sector Average 51,6 43,6 28,8 18,3 15,9 15,5 11,5 1,2 -3,7 -19,9 -17,7
Sector Average
1,0007
Operating Margin Operating income over net revenue (%) Prodome 28,6 Cristlia 21,2 Unio Qumica 15,3 Medley 15,3 Schering-Plough 14,7 Grupo EMS Sigma 14,6 Pharma Roche 6,8 Ach 5,6 Bristol-Myers Squibb 5,2 B. Braun 4,6 Sector Average 5,1
Source: www.especiais.valoronline.com.br
Current Ratio Current assets over current liabilities (points) Prodome 4,63 Bristol-Myers Squibb 3,06 Cristlia 2,03 GlaxoSmithKline 1,93 Novartis Biocincias 1,9 Grupo EMS Sigma 1,88 Pharma Merck 1,85 Unio Qumica 1,83 Ach 1,5 Roche 1,33 Sector Average 1,68
EBITDA Margin EBITDA over net revenue (%) Prodome Cristlia Schering-Plough Medley Unio Qumica Grupo EMS Sigma Pharma Ach B. Braun Roche Merck Sector Average 32,6 22,9 18,2 17,6 16,6 14,9 14,3 11,6 9,9 9,3 9,7
181
Exhibits
Exhibit 3.3: Generic Drug Manufacturers in Brazil

Company AB Farmo Qumica Abbott Alcon Allergan Apotex Asta Mdica Ativus Bramfarma Bristol Biobrs Biolab Sanus Biosinttica Celofarm Cinfa Cristlia Ducto EMS Enila Equiplex Eurofarma Frmaco Greenpharma Genom
Source: ANVISA (September 2003)
Registrations 8 31 9 2 39 7 10 5 1 1 2 38 1 10 33 6 126 1 1 92 46 10 1
Company Halex Istar Hexal Hipolabor Hypofarma IPCA JP Kinder Knoll Libbs Luper Medley Mepha Merck Naturess Neo qumica Novartis Prodotti Ranbaxy Sanval Teuto Theodoro F Sobral Unio Qumica Zambon Total
Registrations 4 28 3 5 1 1 2 1 1 2 91 22 18 12 23 26 8 74 4 54 3 13 1 878
Exhibit 4.1. Novo Nordisk: Major Competitors Revenues Growth

Novo Nordisk Novartis Ag Ads Astrazeneca Plc Aventis Ely Lilly & Co Direct Competitors Average Pfizer Inc GlaxoSmithKlein Johnson & Johnson Merk & Co Abbott Laboratories Wyeth Bristol Myers Squibb Co. American Pharmaceuticals Prtnr Serono Sanofi-Synthelaboratoires Bayer Ag Akzoy Nobel Nv Amylin Pharmaceuticals Inc. Baxter International Inc. Becton Dickinson And Co. Major Competitors Average 2000 23,0% 6,9% -11,2% 65,2% 8,6% 17,4% 97,1% 82,5% 6,1% 23,4% 4,3% -2,1% -9,9% 8,8% -9,5% 8,1% 5,8% 19,2% 2001 15,3% -11,4% 4,3% -2,7% 6,3% -0,9% 10,4% 9,1% 13,3% 18,2% 18,5% 6,5% -0,4% 20,0% -7,1% -4,6% 11,1% 3,8% 6,5% 2002 6,2% 19,7% 8,3% 5,9% -4,0% 7,5% 14,6% 0,4% 10,0% 8,5% 8,6% 3,2% -0,1% 44,5% 12,4% 17,9% 16,9% 5,8% 7,4% 10,3% 2003 5,7% 7,4% 5,6% 3,4% 13,6% 7,5% 32,2% 18,1% 15,3% -56,6% 11,3% 8,7% 15,3% 26,6% 20,1% 29,3% 18,1% 11,6% 539,6% 9,9% 12,2% 37,4%
182
Exhibits
Exhibit 4.2. Novo Nordisk: ROIC Tree, 2000 - 2003
Exhibit 4.3. Novo Nordisk: Major Competitors ROIC.

Novo Nordisk Novartis Ag Ads Astrazeneca Plc Aventis Ely Lilly & Co Direct Competitors Average Pfizer Inc GlaxoSmithKlein Johnson & Johnson Merk & Co Abbott Laboratories Wyeth Bristol Myers Squibb Co. American Pharmaceuticals Prtnr Serono Sanofi-Synthelaboratoires Bayer Ag Akzoy Nobel Nv Amylin Pharmaceuticals Inc. Baxter International Inc. Becton Dickinson And Co. Major Competitors Average 1999 15,30% 16,80% 26,00% -5,00% 34,80% 18,15% 33,80% 41,10% 22,30% 35,90% 27,90% -12,40% 41,70% 19,30% 15,80% -150,00% 13,90% 10,10% 10,75% 2000 22,60% 18,40% 30,70% -0,20% 35,20% 21,03% 21,70% 44,50% 23,00% 37,00% 28,90% -45,50% 44,80% 14,60% 8,80% 18,50% -52,80% 16,90% 14,40% 15,23% 2001 25,50% 15,70% 29,80% 9,80% 27,40% 20,68% 37,30% 46,00% 21,40% 34,90% 11,60% 20,00% 31,60% 8,90% 14,00% 4,80% 22,10% -133,00% 10,60% 14,10% 12,61% 2002 22,00% 16,80% 27,70% 16,60% 21,40% 20,63% 41,30% 40,70% 26,70% 31,00% 18,70% 28,30% 13,60% 25,00% 12,90% 28,80% 4,07% 19,70% -146,00% 10,60% 14,06% 13,26% 2003 21,00% 14,90% 22,50% 14,40% 17,70% 17,38% 39,40% 5,50% 24,10% 33,00% 16,70% 11,80% 17,00% 29,10% 11,40% 32,60% -6,50% 11,50% -51,10% 11,60% 13,40% 14,16%
183
Exhibits
Exhibit 4.4. Novo Nordisk: Major Competitors P/E Ratios.

Novo Nordisk Novartis Ag Ads Astrazeneca Plc Aventis Ely Lilly & Co Direct Competitors Average Pfizer Inc Glaxosmithklein Johnson & Johnson Merk & Co Abbott Laboratories Wyeth Bristol Myers Squibb Co. American Pharmaceuticals Prtnr Serono Sanofi-Synthelaboratoires Bayer Ag Akzoy Nobel Nv Amylin Pharmaceuticals Inc. Baxter International Inc. Becton Dickinson And Co. Major Competitors Average 2000 31,6 26,6 29,3 N/A 33,4 29,77 78 27,7 30,9 32,3 27,2 31,3 49,9 17,1 35,6 17,7 33,5 2001 30,2 22,3 26,3 42,3 30,4 30,33 32,7 23,7 32,1 18,7 56,3 35,7 20,7 69,4 45,3 15,5 49,2 24,8 33,9 2002 17,5 18,1 19,1 19,6 25,4 20,55 20 17,7 24,9 18 22,5 11,2 21,6 19,8 27,1 23,9 14,2 10,6 22,2 15,9 19,4 2003 17,01 22,9 27,2 21,8 29,7 25,40 65,4 17 21,5 15,2 26,6 27,6 18 33,9 28,8 20,4 14,5 20,06 17,4 24,7
Exhibit 4.5. Novo Nordisk: Major Competitors ROE.

Novo Nordisk Novartis Ag Ads Astrazeneca Plc Aventis Ely Lilly & Co Direct Competitors Average Glaxosmithklein Pfizer Inc Johnson & Johnson Merk & Co Abbott Laboratories Wyeth Bristol Myers Squibb Co. American Pharmaceuticals Prtnr Serono Sanofi-Synthelaboratoires Bayer Ag Akzoy Nobel Nv Amylin Pharmaceuticals Inc. Baxter International Inc. Becton Dickinson And Co. Major Competitors Average 1999 0,13 17,90% 27,90% 54,30% 33,37% 57,60% 35,80% 25,70% 44,50% 32,90% 48,20% 22,00% 38,60% 24,60% 16,00% 34,31% 2000 0,196 19,60% 32,80% 50,60% 34,33% 54,60% 23,20% 25,50% 46,00% 32,50% 51,30% 15,00% 10,30% 39,10% 27,80% 20,50% 32,06% 2001 0,192 16,60% 31,70% 14,00% 39,50% 25,45% 58,90% 42,60% 23,40% 45,40% 17,10% 56,10% 53,30% 9,70% 14,30% 5,70% 40,90% 17,70% 19,20% 29,77% 2002 0,179 18,40% 28,50% 19,80% 32,70% 24,85% 59,80% 47,80% 29,10% 39,90% 26,20% 54,50% 23,00% 25,00% 13,00% 29,10% 6,90% 39,00% 26,50% 19,60% 29,93% 2003 16,50% 23,00% 19,40% 26,20% 58,10% 6,00% 26,80% 43,90% 21,10% 22,10% 31,70% 29,10% 13,50% 32,80% 24,10% 27,00% 19,10%
184
Exhibits
Exhibit 4.6. Novo Nordisk: Major Competitors ROA.

Novo Nordisk Novartis Ag Ads Astrazeneca Plc Aventis Ely Lilly & Co Direct Competitors Average Pfizer Inc Glaxosmithklein Johnson & Johnson Merk & Co Abbott Laboratories Wyeth Bristol Myers Squibb Co. American Pharmaceuticals Prtnr Serono Sanofi-Synthelaboratoires Bayer Ag Akzoy Nobel Nv Amylin Pharmaceuticals Inc. Baxter International Inc. Becton Dickinson And Co. Major Competitors Average 1999 0,078 10,20% 14,50% -2,00% 21,20% 10,98% 15,50% 17,40% 14,30% 16,50% 16,90% -5,10% 24,30% 11,50% 6,00% -115,90% 8,50% 6,20% 3,75% 2000 0,126 12,40% 16,90% -0,10% 20,80% 12,50% 11,10% 19,50% 15,30% 17,10% 18,20% -11,20% 26,80% 10,80% 4,60% 7,90% -48,00% 8,50% 8,70% 8,19% 2001 0,134 10,50% 17,30% 4,20% 17,10% 12,28% 19,90% 20,20% 14,70% 16,50% 6,70% 9,90% 17,40% 5,30% 10,50% 2,60% 8,30% -113,40% 6,40% 9,10% 4,62% 2002 13,0% 11,60% 14,80% 7,00% 14,20% 11,90% 20,60% 17,60% 16,30% 15,00% 11,50% 17,10% 8,30% 20,50% 9,20% 18,60% 2,50% 6,40% -65,20% 6,20% 9,50% 8,51% 2003 14,1% 10,20% 12,90% 6,90% 11,80% 18,70% 3,40% 14,90% 16,80% 10,30% 6,60% 11,30% 23,60% 8,50% 21,30% -3,40% 5,00% -39,50% 6,50% 9,80%
Exhibit 4.7. Novo Nordisk: Competitors Net Income/Growth.

Novo Nordisk Novartis Ag Ads Astrazeneca Plc Aventis Ely Lilly & Co Direct Competitors Average Glaxosmithklein Pfizer Inc Johnson & Johnson Merk & Co Abbott Laboratories Wyeth Bristol Myers Squibb Co. American Pharmaceuticals Serono Sanofi-Synthelaboratoires Bayer Ag Akzoy Nobel Nv Amylin Pharmaceuticals Inc. Baxter International Inc. Becton Dickinson And Co. Major Competitors Average Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth Net Income growth growth 1999 326 4188 2683 -859 2547 2000 385 18,1% 4395 4,9% 2909 8,4% -27 -96,9% 3058 20,1% -15,9% 6295 115,1% 3718 16,2% 4800 15,2% 6822 15,8% 2786 13,9% -901 -26,6% 4096 -1,7% N/A 301 63,9% N/A 1564 N/A 900 24,0% -44 43,8% 738 -5,3% 393 42,5% 16,0% 2001 461 19,7% 4239 -3,5% 3105 6,7% 1455 -5488,9% 2809 -8,1% -1373,5% 6444 2,4% 7752 108,5% 5668 18,1% 7282 6,7% 1550 -44,4% 2285 -353,6% 2043 -50,1% 13 N/A 317 5,2% N/A 860 -45,0% 955 6,1% -72 63,6% 664 -10,0% 438 11,6% -319,7% 2002 578 25,4% 5224 23,2% 3186 2,6% 2285 57,0% 2708 -3,6% 19,8% 6341 -1,6% 9181 18,4% 6597 16,4% 7150 -1,8% 2794 80,2% 4447 94,6% 2034 -0,4% 45 258,7% 321 1,3% 1847 N/A 1113 29,4% 859 -10,1% -110 52,5% 1033 55,6% 480 9,5% 24,9% 2003 5016 -4,0% 3036 -4,7% 2455 7,4% 2561 -5,4% -1,7% 7997 26,1% 1639 -82,1% 7197 9,1% 6590 -7,8% 2753 -1,4% 2051 -53,9% 3106 52,7% 72 58,6% 390 21,6% 2610 41,3% -1585 -242,4% 757 -11,9% -123 11,8% 922 -10,7% 547 14,0% -13,4%
2926 3199 4167 5891 2446 -1227 4167 184 726 -31 779 276
185
Exhibits
Exhibit 4.8. Novo Nordisk: Competitors Cash Flow/Growth.

Novo Nordisk Novartis Ag Ads Astrazeneca Plc Aventis Ely Lilly & Co Direct Competitors Average Glaxosmithklein Pfizer Inc Johnson & Johnson Merk & Co Abbott Laboratories Wyeth Bristol Myers Squibb Co. American Pharmaceuticals Serono Sanofi-Synthelaboratoires Bayer Ag Akzoy Nobel Nv Amylin Pharmaceuticals Inc. Baxter International Inc. Becton Dickinson And Co. Major Competitors Average Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth Cash Flow growth growth 1999 519 5137 2510 821 2986 2000 514 -1,0% 5313 3,4% 3849 53,3% 2147 161,5% 3494 17,0% 59% 7367 109,1% 4686 25,3% 6315 12,5% 8099 10,2% 3613 10,4% -366 -32,8% 4842 -0,1% 387 49,8% 3579 1530 1,4% -41 48,7% 1143 -0,7% 678,30 27,6% 29,2% 2001 590 14,8% 4824 -9,2% 3965 3,0% 3190 48,6% 3264 -6,6% 9% 7575 2,8% 8820 88,2% 7273 15,2% 8746 8,0% 2718 -24,8% 2893 -890,4% 2771 -42,8% 21 416 7,3% 3103 -13,3% 1556 1,7% -69 69,4% 1105 -3,3% 741,40 9,3% -40,1% 2002 766 29,8% 5914 22,6% 4146 4,6% 4523 41,8% 3201 -1,9% 17% 7656 1,1% 10217 15,8% 8259 13,6% 8638 -1,2% 3971 46,1% 4932 70,5% 2769 -0,1% 55 162,9% 421 1,4% 2245 4593 48,0% 1690 8,6% -106 53,5% 1472 33,2% 782,00 5,5% 21,8% 2003 -100,0% 6402 8,3% 4326 4,3% 4418 -2,3% 3109 -2,9% 2% 9512 24,2% 5713 -44,1% 9066 9,8% 7904 -8,5% 4027 1,4% 2589 -47,5% 3895 40,7% 81 46,2% 526 24,7% 3100 38,1% 4368 -4,9% 1577 -6,7% -118 10,6% 1467 -0,3% 889,40 13,7% -2,2%
3522 3741 5611 7353 3274 -545 4845 259 1509 -28 1151 531,50
Exhibit 4.9. Novo Nordisk: Competitors P/Sales Ratio.

Novo Nordisk Novartis Ag Ads Astrazeneca Plc Aventis Ely Lilly & Co Direct Competitors Average Pfizer Inc Glaxosmithklein Johnson & Johnson Merk & Co Abbott Laboratories Wyeth Bristol Myers Squibb Co. American Pharmaceuticals Prtnr Serono Sanofi-Synthelaboratoires Bayer Ag Akzoy Nobel Nv Amylin Pharmaceuticals Inc. Baxter International Inc. Becton Dickinson And Co. Major Competitors Average 2000 4,76 5,34 5,75 3,15 9,65 5,9725 9,83 6,45 5,02 5,35 5,45 6,29 7,93 19 1,15 3,75 1,85 6,3 2001 4,92 4,81 4,94 2,76 7,64 5,0375 7,75 5,15 5,46 2,8 5,32 5,73 5,44 5,24 14,6 1,02 4,2 2,56 5,3 2002 2,88 3,93 3,38 2 6,43 3,935 0,265 3,3 4,39 2,45 3,54 3,04 2,48 3,01 7,88 5,69 0,52 0,62 100,88 2,1 1,08 8,0 2003 4,55 4,35 2,37 6,28 4,3875 5,97 3,63 3,66 4,57 3,7 3,57 2,66 6,68 8,48 5,47 0,6 0,67 24,15 2,1 2 5,0
186
Exhibits
Exhibit 4.10. Novo Nordisk: WACC Sensitivity to Debt Rating

7,860% 7,858% 7,856% 7,854% 7,852% 7,850% 7,848% 0,00% 0,25% 0,50% 0,75% 1,00% 1,25% 1,50% 1,75% 2,00%
Exhibit 4.11. Novo Nordisk: WACC Sensitivity to short-term Premium

7,862% 7,860% 7,858% 7,856% 7,854% 7,852% 7,850% 7,848% 0,00% 0,25% 0,50% 0,75% 1,00% 1,25% 1,50% 1,75% 2,00%
187
Exhibits
Exhibit 5.1. Biobrs: Break-down of Sales, 2001

Product Pharmaceutical Products Diagnostic Related Products Industrial Products
Source: LAFIS
% Sales 82,90 9,45 7,65
Exhibit 5.2. Biobrs: Exports, 1998 to 2001

Year 2001 2000 1999 1998
Source: LAFIS
% of sales 9% 9% 8% 9%
Value ( US$ million ) 3.807 2.856 2.580 3.070
Exhibit 5.3. Biobrs Clients 2001

Client Ministry of Health Bennati Distribuidora Hospitalar Ltda. Diverse clients
Source: LAFIS 2003
Product Insulin, Metformin and other pharmaceutical products Insulin, Metformin and other pharmaceutical products Insulin and other products
%Sales 45.94% 8.26% 45.80%
188
Exhibits
Exhibit 5.4. Biobrs: Balance Sheets, 1999 2002 (BRL thousands)

ATIVO CIRCULANTE Dispon. + Aplic.Fin. Clientes Estoques Outros Ativos Circs. REALIZVEL LP Crd. Control.Colig. Outros Realiz. LP ATIVO PERMANENTE Imobilizado Lquido Investimentos Diferido Lquido ATIVO TOTAL PASSIVO CIRCULANTE Fornecedores Passivo Oneroso CP Financiamentos Impostos a Recolher Salrios e Encargos Dividendos a Pagar Outros Passivos Circs. EXIGVEL LP Passivo Oneroso LP Financiamentos LP Imp. Renda Diferido Outros Exigveis LP NO EXIGVEL Patrimnio Lquido Capital Social Realizado Aes em Tesouraria Reservas de Capital Reservas de Reavaliao Res. Lucros e Lucros Acum Lucros Acumulados PASSIVO TOTAL --- Ativo Operacional ---- Inv. Opercl. em Giro ---- Dvida Onerosa Total
Source: Bradesco ShopInvest
1999 36 768 10 504 5 418 19 560 1 286 1 928 1 710 218 23 730 19 209 1 845 2 676 62 426 10 153 2 625 1 456 1 456 998 1 642 3 432 11 316 6 233 6 233 5 083 40 957 40 957 26 999 575 1 257 219 13 057 62 426 58 246 21 355 7 689
2000 41 096 6 539 9 143 23 678 1 736 3 018 2 823 195 27 180 21 924 1 770 3 486 71 294 13 603 2 389 5 058 5 058 1 891 1 884 1 642 739 17 622 10 917 10 917 6 705 40 069 40 069 26 999 575 1 615 208 11 822 71 294 65 877 26 657 15 975
2001 39 702 2 350 9 515 25 881 1 956 3 238 3 145 93 36 892 30 225 1 746 4 921 79 832 21 086 3 414 4 200 4 200 3 007 3 281 2 845 4 339 15 607 13 602 13 602 60 1 945 43 139 43 139 17 899 575 3 949 188 21 678 79 832 72 862 25 694 17 802
Sep 2001 51 688 3 668 21 955 24 401 1 664 2 992 2 992 32 965 26 867 1 927 4 171 87 645 19 339 4 547 3 783 3 783 4 953 4 637 20 1 399 19 113 12 048 12 048 7 065 49 193 49 193 26 999 575 3 500 187 11 752 7 330 87 645 78 818 32 219 15 831
Sep 2002 64 110 2 428 29 901 29 852 1 929 7 149 7 149 29 396 26 861 63 2 472 100 655 47 470 17710 21 997 21 997 2 667 3 140 547 1 409 31 137 15 396 15 396 15 741 22 048 22 048 17 899 1 370 167 21 103 -18 491 100 655 89 105 36 236 37 393
189
Exhibits
Exhibit 5.5. Biobrs: Balance Sheets, 1999 2002 (US$ thousands)

ATIVO CIRCULANTE Dispon. + Aplic.Fin. Clientes Estoques Outros Ativos Circs. REALIZVEL LP Crd. Control.Colig. Outros Realiz. LP ATIVO PERMANENTE Imobilizado Lquido Investimentos Diferido Lquido ATIVO TOTAL PASSIVO CIRCULANTE Fornecedores Passivo Oneroso CP Financiamentos Impostos a Recolher Salrios e Encargos Dividendos a Pagar Outros Passivos Circs. EXIGVEL LP Passivo Oneroso LP Financiamentos LP Imp. Renda Diferido Outros Exigveis LP NO EXIGVEL Patrimnio Lquido Capital Social Realizado Aes em Tesouraria Reservas de Capital Reservas de Reavaliao Res. Lucros e Lucros Acum Lucros Acumulados PASSIVO TOTAL --- Ativo Operacional ---- Inv. Opercl. em Giro ---- Dvida Onerosa Total
1999 20 212 5 774 2 978 10 752 707 1 060 940 120 13 045 10 559 1 014 1 471 34 316 5 581 1 443 800 800 549 0 903 1 887 6 221 3 426 3 426 0 2 794 22 515 22 515 14 842 316 691 120 7 178 0 34 316 32 019 11 739 4 227
2000 22 445 3 571 4 994 12 932 948 1 648 1 542 107 14 845 11 974 967 1 904 38 938 7 429 1 305 2 762 2 762 1 033 1 029 897 404 9 624 5 962 5 962 0 3 662 21 884 21 884 14 746 314 882 114 6 457 0 38 938 35 979 14 559 8 725
2001 16 878 999 4 045 11 002 832 1 377 1 337 40 15 683 12 849 742 2 092 33 938 8 964 1 451 1 785 1 785 1 278 1 395 1 209 1 845 6 635 5 782 5 782 26 827 18 339 18 339 7 609 244 1 679 80 9 216 0 33 938 30 974 10 923 7 568
Sep 2001 22 606 1 604 9 602 10 672 728 1 309 0 1 309 14 418 11 751 843 1 824 38 332 8 458 1 989 1 655 1 655 2 166 2 028 9 612 8 359 5 269 5 269 0 3 090 21 515 21 515 11 808 251 1 531 82 5 140 3 206 38 332 34 472 14 091 6 924
Sep 2002 23 978 908 11 183 11 165 721 2 674 0 2 674 10 995 10 046 24 925 37 647 17 755 6 624 8 227 8 227 998 1 174 205 527 11 646 5 758 5 758 0 5 887 8 246 8 246 6 695 0 512 62 7 893 -6 916 37 647 33 327 13 553 13 986
190
Exhibits
Exhibit 5.6. Biobrs: Income thousands)

Revenues Production Costs Gross profit Cost of sales Gen. Adm. Costs Net Financial Income Financial expenses Financial Income Res. Equiv. Patriml. Other operating items EBT Non-operating income Income before taxes Taxes Net income before dividends Dividends Net income
Statements,
1999
2002
(BRL
1999 48 920 -20 550 28 360 -8 580 -8 970 110 -3 050 3 160 -80 -550 10 310 -240 10 070 -3 910 6 150 -890 5 260
2000 49 330 -23 090 26 240 -13 230 -8 750 -1 070 -3 270 2 200 -110 -560 2 520 -140 2 380 -1 940 440 -60 380
2001 87 550 -35 710 51 840 -15 720 -12 350 -2 010 -6 640 4 630 -110 3 370 25 020 -430 24 580 -6 730 17 850 -2 020 15 830
Sep-01 62 700 -24 730 37 970 -11 060 -8 430 -1 260 -4 630 3 370 -80 -1 570 15 580 100 15 680 -6 060 9 620 -1 400 8 220
Sep-02 60 430 -31 360 29 070 -10 670 -5 980 -9 500 -12 400 2 910 -1 740 -11 150 -9 960 -8 560 -18 520 10 -18 510 -18 510
Exhibit 5.7. Biobrs: Income Statements, 1999 2002 (US$ thousands)

Revenues Production Costs Gross profit Cost of sales Gen. Adm. Costs Net Financial Income Financial expenses Financial Income Res. Equiv. Patriml. Other operating items EBT Non-operating income Income before taxes Taxes Net income before dividends Dividends Net income
1999 26.892 -11.297 15.590 -4.717 -4.931 60 -1.677 1.737 -44 -302 5.668 -132 5.536 -2.149 3.381 -489 2.891
2000 26.942 -12.611 14.331 -7.226 -4.779 -584 -1.786 1.202 -60 -306 1.376 -76 1.300 -1.060 240 -33 208
2001 37.219 -15.181 22.038 -6.683 -5.250 -854 -2.823 1.968 -47 1.433 10.636 -183 10.449 -2.861 7.588 -859 6.730
Sep-01 27.422 -10.816 16.607 -4.837 -3.687 -551 -2.025 1.474 -35 -687 6.814 44 6.858 -2.650 4.207 -612 3.595
Sep-02 22.602 -11.729 10.873 -3.991 -2.237 -3.553 -4.638 1.088 -651 -4.170 -3.725 -3.202 -6.927 4 -6.923 0 -6.923
191
Exhibits
Exhibit 5.8. Biobrs: Free Cash Flows, 1999 - 2001 (BRL thousands)
LUCRO ANTES PARTIC. MIN. D.Fin.Lq. x (1-ir) Depretiation. Outras Desp. No-Caixa Result. Equiv.Patrimonial Outras Rec. No-Caixa GER. OPERACL. CAIXA BRUTA Acr.Inv. Operl. Cap. Giro Acr. Invest. Capital Fixo FREE CASH FLOW (FCF)
1999 5 262 -74 1 545 79 -456 6 356 545 -5 272 1 629
2000 377 696 1 311 358 110 -487 2 365 -3 177 -4 977 -5 790
2001 15 832 1 305 1 878 656 110 19 781 3 730 -12 734 10 777
Exhibit 5.9. Biobrs: Free Cash Flows, 1999 - 2001 (US$ thousands)
LUCRO ANTES PARTIC. MIN. D.Fin.Lq. x (1-ir) Deprec.,Amortiz.,Exaust. Outras Desp. No-Caixa Result. Equiv.Patrimonial Outras Rec. No-Caixa GER. OPERACL. CAIXA BRUTA Acr.Inv. Operl. Cap. Giro Acr. Invest. Capital Fixo FREE CASH FLOW (FCF)
1999 2.893 -41 849 0 43 -251 3.494 300 -2.898 895
2000 206 380 716 196 60 -266 1.292 -1.735 -2.718 -3.162
2001 5.416 446 642 224 38 0 6.767 1.276 -4.357 3.687
Exhibit 5.10. Biobrs: Main Financial Ratios, 1999 2002

Ratio Net working Capital Instant Liquidity Current Liquidity General Liquidity Total Debt (%) Interest bearing debt (%) Account Receivables (# Days) Account Payables (# Days) Inventory (# Days) Stocks turnover / Sales (%) Gross margin (%) EBIT (%) Operational Margin % Net Margin % Net Income Growth % COGS Growth % Gross Profit Growth % Growth Operational Profit % Net Profit Growth % FCF / Net Profit FCF / Net Assets Return on Operat. Assets % Return on Total Assets % Return on Liquid Assets % Turnover % Real Pay-Out %
Source: Bradespo ShopInvest
1999 26 615 0,044 0,168 0,097 52 19 31 26 309 1,80 2,42 0,84 0,88 0,42 2,01 47.69 49.65 5,40 5,28 0,022 0,003 0,79 0,71 0,59 0,06 32,00
2000 27 493 0,033 0,126 0,070 78 40 53 33 337 2,25 2,21 0,29 0,21 0,01 0,01 0,52 -7.49 -75,57 -92.84 -17,20 -0.16 0,17 0,13 0,01 0,06 -
2001 18 616 0,008 0,103 0,053 85 41 38 28 250 1,21 2,46 1,26 1,17 0,75 3,21 54.66 4,08 37,24 170,82 0,042 0,015 1,58 1,42 1,88 0,09 30,00
Sept 2001 32 349 0,013 0,130 0,071 78 32 52 30 227 5,21 2,63 1,34 1,38 0,71 1,42 0,92 1,80 7,81 168,78 0,04 -
Sept 2002 16 640 0,003 0,066 0,063 357 170 51 58 160 4,88 1,92 0,92 0,17 0,17 3,84 3,47 4,36 -160,79 -155,74 0,07 -
192
Exhibits
Exhibit 5.11. Biobrs: Net Earnings, 1995 2002 (BRL)
Exhibit 5.12. Biobrs: Yearly Net Earnings, 1998 2001 (BRL thousands)
Year Net Income 1998 2 324 1999 5 262 2000 377 2001 15 832 2002* -18 513 Note: *Until September 2002
Exhibit 6.1: Latin America and Caribbean: Demographic Growth

1999 1,03% 1,31% 1,31% 1,75% 1,62% 1,68% 2,05% 1,52% 2000 1,04% 1,36% 1,27% 1,71% 1,58% 1,63% 2,00% 1,51% 2001 1,04% 1,25% 1,23% 1,67% 1,54% 1,58% 1,96% 1,46% 2002 1,02% 1,23% 1,20% 1,64% 1,50% 1,54% 1,92% 1,42% 2003 1,00% 1,24% 1,17% 1,60% 1,46% 1,50% 1,87% 1,41%
Argentina Brazil Chile Colombia Mexico Peru Venezuela Latin America & Caribbean
Source: Euromonitor, authors calculations
193
Exhibits
Exhibit 6.2: Novo Nordisk Comparison
&
Biobrs:
Income
Statements
Revenues Production Costs Prod costs / Revenues - Direct costs Direct costs / Production costs - Cost of labour Cost of Labour / Production costs Gross profit Gross Profit / Revenues Cost of sales Cost of sales / Revenues Administrative & General Costs Administrative & Gen costs / revenues - Administrative costs Administrative costs / Revenues - Research and development costs R & D costs / Revenues - Restructuring expenses - Licence fees and other operating income Operating profit Operating Profit / Revenues Net Financial Income - Financial expenses - Financial Income Patrimonial provision Other operating items Operative EBT Operative EBT / Revenue Non operating income Income before taxes Income before taxes / Revenues Taxes Net income Net income / Revenues
Biobrs 2001 (BRL million) 87,55 -35,71 40,79%
51,84 59,21% -15,72 17,95% -12,35 14,11%
23,77 27,15% -2,01 -6,64 4,63 -0,11 3,37 25,02 28,58% -0,43 24,58 28,08% -6,73 17,85 20,39%
Novo Nordisk 2001 2003 (DKK million) 23 776 26 541 -5979 -7439 25,15% 28,03% 3746 4496 62,65% 60,44% 2233 2943 37,35% 39,56% 17 797 19 102 74,85% 71,97% -7 215 -7 799 30,35% 29,38% -5 835 -6 040 24,54% 22,76% 1 865 1 847 7,84% 6,96% 3 970 4 193 16,70% 15,80% 0 0 867 1 121 5 614 6 384 23,61% 24,05% 367 987 -132 -227 499 1 214 5 981 25,15% 49 6 030 25,36% -2 165 3 865 16,26% 7 371 27,77% 12 7 383 27,82% -2 525 4 858 18,30%
194
Exhibits
Exhibit 6.3: Production Costs Estimation - Example

First year - Home Country Revenues Price Estimated sold prod - Foreign Country A Revenues in foreign currency Price Estimated sold prod - Exch rate Revenues in home currency - Foreign Country B Revenues in foreign currency Price Estimated sold prod - Exch rate Revenues in home currency Total Revenues Sold production Production cost for sold items (as % revenues) - Productive factors - Labour cost Nr. Items produced - Sold products Production cost per items - Productive factors - Labour cost Total Production cost - Productive factors - Labour cost Second year Production - Sold production - Year start stockpile - Year end stockpile - Stock increase Production cost per item - Productive factors - Labour cost Total Production cost - Productive factors - Labour cost
1.000 1 1.000 2.000 2 1.000 0.50 4.000 2.000 1 2.000 1 2.000 7.000 4.000
4.180 400 418 18 4.198 0,30 0,11 1.247 441 1.688
1.190 420 1.610 4.000 4.000 0,30 0,11 1.188 420 1.608
- Home Country (growth x%) Sold items Price Revenues - Foreign Country A (growth y%) Sold items Price Revenues - Exch rate For/Home Revenues in home currency - Foreign Country B (growth z%) Sold items Price Revenues - Exch rate For/Home Revenues in home currency Total Revenues
1.050 1 1.050 1.030 2 2.060 1 2.060 2.100 1 2.100 2 1.050 4.160
195
Exhibits
Exhibit 7.1: Selected Countries: Historical and Forecasted Inflation Rates Growth, 1998 2015
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Argentina -233,33% -25,00% 22,22% -2454,55% -48,26% -50,00% 41,79% -49,47% -47,92% 68,00% 2,38% 46,51% 3,17% 7,69% -4,29% -8,96% -1,64% Brazil 53,13% 42,86% -2,86% 23,53% 75,00% -59,86% -20,34% -6,38% 0,00% -20,45% -11,43% -9,68% 7,14% 10,00% 0,00% 6,06% 8,57% Denmark -41,71% -15,60% -13,04% -21,25% 12,70% -19,72% -12,28% -2,00% 16,33% 3,51% 5,08% -19,35% -8,00% -8,70% -7,14% -5,13% 0,00% Mexico 4,40% -42,77% -32,63% -21,88% -10,00% -4,44% -25,58% -21,88% 24,00% 9,68% -5,88% 12,50% -8,33% 0,00% -12,12% -3,45% -7,14% USA 41,29% 54,34% -16,27% -43,82% 42,77% 1,32% -4,35% 13,64% 16,00% -13,79% -12,00% -4,55% 14,29% 12,50% 7,41% 6,90% 12,90%
Source: Euromonitor, Authors calculation.
Exhibit 7.2: Selected Currencies: Historical and Forecasted Exchange Rates Change, 1998 2015
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 BRL/ARS 56,03% 1,10% 28,96% -59,57% 11,30% -10,62% -4,38% -0,38% 1,85% -0,67% -1,15% -3,29% -3,29% -3,46% -3,19% -2,45% -2,08% -2,08% BRL/DKK 49,78% -12,66% 25,24% 30,47% 26,29% 13,50% 2,85% 2,76% 2,96% 2,27% 2,08% 1,68% 1,78% 1,97% 1,97% 2,17% 2,37% 2,37% BRL/MXP 49,18% 2,17% 30,62% 19,63% -5,57% 4,12% 1,45% 1,85% 1,26% 0,10% -0,10% -0,77% -0,29% 0,00% 0,39% 0,68% 1,17% 1,17% BRL/USD 56,03% 1,10% 28,96% 23,73% 5,48% 3,25% 2,45% 1,85% 1,46% 0,98% 0,88% 0,69% 0,59% 0,58% 0,39% 0,39% 0,29% 0,29%
Source: Euromonitor, Authors calculation.
Exhibit 7.3: Selected Currencies: Standard Deviation of Exchange Rates Growth, 1999 - 2004
BRL/ARS BRL/DKK BRL/MXP BRL/USD 1999 56,0% 49,8% 49,2% 56,0% 2000 1,1% -12,7% 2,2% 1,1% 2001 29,0% 25,2% 30,6% 29,0% 2002 -59,6% 30,5% 19,6% 23,7% 2003 11,3% 26,3% -5,6% 5,5% 2004e -10,6% 13,5% 4,1% 3,2% St. Dv. 33,4% 27,2% 16,5% 20,2%
196
Exhibits
Exhibit 7.4: Static Monte Carlo Simulation Results: IRR

Simulation results Internal Rate of Return
6,0% 5,0% 4,0% 3,0% 2,0% 1,0% 0,0% 6% 7% 8% 10% 11% 12% 14% 15% 17% 18% 19%
Statistics Mean 13,03% Median 13,08% St. Deviation 1,85% Skewness -22,01% Kurtosis 232,29% Variability 14,18% Range Min. 5,75% Range Max. 18,08% Range Width 12,33%
Percentiles 0% 5,75% 10% 10,54% 20% 11,33% 30% 11,95% 40% 12,52% 50% 13,08% 60% 13,67% 70% 14,27% 80% 14,83% 90% 15,40% 100% 18,08%
Exhibit 7.5: Static Monte Carlo Simulation Results: PV of Terminal Value of Investment
Simulation results PV of Terminal Value (DKK million)
3,5% 3,0% 2,5% 2,0% 1,5% 1,0% 0,5% 0,0% 170 370 570 770 970 1.170 1.370
Statistics Mean 826,7 Median 806,5 St. Deviation 240,1 Skewness 0,20 Kurtosis 2,22 Variability 0,29 Range Min. 190,3 Range Max. 1.703,8 Range Width 1.513,5
Percentiles 0% 190,3 10% 521,4 20% 600,7 30% 667,9 40% 735,1 50% 806,5 60% 887,4 70% 973,5 80% 1.059,0 90% 1.156,4 100% 1.703,8
197
Exhibits
Exhibit 7.6: Augmented Monte Carlo Simulation Results: IRR

Augmented Simulation results Internal Rate of Return
6,0% 5,0% 4,0% 3,0% 2,0% 1,0% 0,0% -7% -5% -2% 1% 4% 6% 9% 12% 15% 17%
Statistics Mean 5,91% Median 5,23% St. Deviation 4,78% Skewness 32,14% Kurtosis 312,9% Variability 80,81% Range Min. -36,9% Range Max. 17,80% Range Width 54,77%
Percentiles 0% -36,9% 10% 0,44% 20% 2,01% 30% 3,62% 40% 4,63% 50% 5,23% 60% 5,83% 70% 6,72% 80% 11,14% 90% 13,57% 100% 17,80%
Exhibit 7.7: Augmented Monte Carlo Simulation Results: PV of Terminal Value of Investment
Augmented Simulation results PV of Terminal Value (DKK million)
8,0% 7,0% 6,0% 5,0% 4,0% 3,0% 2,0% 1,0% 0,0% -490
-190 110 410 710 1.010 1.310
Percentiles 0% -129,3 10% 26,7 20% 62,7 30% 115,4 40% 146,2 50% 168,0 60% 195,0 70% 244,0 80% 578,0 90% 872,3 100% 1.628,0
198
Exhibits
Exhibit 8.1. Abandonment Option Calculation Based on Simulated Savage and Terminal Values Probabilities (DKK)
Terminal Value Mean Savage Value Probability Base Value 0,000 -975.000.000 0,000 -925.000.000 0,000 -875.000.000 0,000 -825.000.000 0,000 -775.000.000 0,000 -725.000.000 0,000 -675.000.000 0,000 -625.000.000 0,000 -575.000.000 0,000 -525.000.000 0,000 -475.000.000 0,000 -425.000.000 0,000 -375.000.000 0,000 -325.000.000 0,000 -275.000.000 0,001 -225.000.000 0,004 -175.000.000 0,009 -125.000.000 0,016 -75.000.000 0,022 -25.000.000 0,030 25.000.000 0,044 75.000.000 0,055 125.000.000 0,049 175.000.000 0,033 225.000.000 0,030 275.000.000 0,046 325.000.000 0,075 375.000.000 0,088 425.000.000 0,074 475.000.000 0,054 525.000.000 0,041 575.000.000 0,029 625.000.000 0,021 675.000.000 0,014 725.000.000 0,009 775.000.000 0,006 825.000.000 0,004 875.000.000 0,003 925.000.000 0,002 975.000.000 0,002 1.025.000.000 0,002 1.075.000.000 0,002 1.125.000.000 0,003 1.175.000.000 0,003 1.225.000.000 0,004 1.275.000.000 0,004 1.325.000.000 0,004 1.375.000.000 0,005 1.425.000.000 0,006 1.475.000.000 0,006 1.525.000.000 0,006 1.575.000.000 0,006 1.625.000.000 0,007 1.675.000.000 0,007 1.725.000.000 0,007 1.775.000.000 0,007 1.825.000.000 0,007 1.875.000.000 0,007 1.925.000.000 0,007 1.975.000.000 0,006 2.025.000.000 0,006 2.075.000.000 0,006 2.125.000.000 0,006 2.175.000.000 0,006 2.225.000.000 0,005 2.275.000.000 295.422.473 Value w/Option 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 295.422.473 325.000.000 375.000.000 425.000.000 475.000.000 525.000.000 575.000.000 625.000.000 675.000.000 725.000.000 775.000.000 825.000.000 875.000.000 925.000.000 975.000.000 1.025.000.000 1.075.000.000 1.125.000.000 1.175.000.000 1.225.000.000 1.275.000.000 1.325.000.000 1.375.000.000 1.425.000.000 1.475.000.000 1.525.000.000 1.575.000.000 1.625.000.000 1.675.000.000 1.725.000.000 1.775.000.000 1.825.000.000 1.875.000.000 1.925.000.000 1.975.000.000 2.025.000.000 2.075.000.000 2.125.000.000 2.175.000.000 2.225.000.000 2.275.000.000 PV Terminal Value Mean Savage Value 110.606.739 Probability Base Value Value w/Option 0,000 -975.000.000 110.606.739 0,000 -925.000.000 110.606.739 0,000 -875.000.000 110.606.739 0,000 -825.000.000 110.606.739 0,000 -775.000.000 110.606.739 0,000 -725.000.000 110.606.739 0,000 -675.000.000 110.606.739 0,000 -625.000.000 110.606.739 0,000 -575.000.000 110.606.739 0,000 -525.000.000 110.606.739 0,000 -475.000.000 110.606.739 0,000 -425.000.000 110.606.739 0,000 -375.000.000 110.606.739 0,000 -325.000.000 110.606.739 0,000 -275.000.000 110.606.739 0,000 -225.000.000 110.606.739 0,000 -175.000.000 110.606.739 0,000 -125.000.000 110.606.739 0,008 -75.000.000 110.606.739 0,045 -25.000.000 110.606.739 0,111 25.000.000 110.606.739 0,109 75.000.000 110.606.739 0,144 125.000.000 125.000.000 0,197 175.000.000 175.000.000 0,093 225.000.000 225.000.000 0,036 275.000.000 275.000.000 0,012 325.000.000 325.000.000 0,006 375.000.000 375.000.000 0,007 425.000.000 425.000.000 0,010 475.000.000 475.000.000 0,013 525.000.000 525.000.000 0,016 575.000.000 575.000.000 0,018 625.000.000 625.000.000 0,018 675.000.000 675.000.000 0,018 725.000.000 725.000.000 0,017 775.000.000 775.000.000 0,015 825.000.000 825.000.000 0,014 875.000.000 875.000.000 0,014 925.000.000 925.000.000 0,014 975.000.000 975.000.000 0,014 1.025.000.000 1.025.000.000 0,013 1.075.000.000 1.075.000.000 0,012 1.125.000.000 1.125.000.000 0,009 1.175.000.000 1.175.000.000 0,007 1.225.000.000 1.225.000.000 0,005 1.275.000.000 1.275.000.000 0,003 1.325.000.000 1.325.000.000 0,001 1.375.000.000 1.375.000.000 0,001 1.425.000.000 1.425.000.000 0,000 1.475.000.000 1.475.000.000 0,000 1.525.000.000 1.525.000.000 0,000 1.575.000.000 1.575.000.000 0,000 1.625.000.000 1.625.000.000 0,000 1.675.000.000 1.675.000.000 0,000 1.725.000.000 1.725.000.000 0,000 1.775.000.000 1.775.000.000 0,000 1.825.000.000 1.825.000.000 0,000 1.875.000.000 1.875.000.000 0,000 1.925.000.000 1.925.000.000 0,000 1.975.000.000 1.975.000.000 0,000 2.025.000.000 2.025.000.000 0,000 2.075.000.000 2.075.000.000 0,000 2.125.000.000 2.125.000.000 0,000 2.175.000.000 2.175.000.000 0,000 2.225.000.000 2.225.000.000 0,000 2.275.000.000 2.275.000.000
199
Exhibits
Terminal Value Mean Savage Value Probability Base Value 0,005 2.325.000.000 0,005 2.375.000.000 0,005 2.425.000.000 0,005 2.475.000.000 0,005 2.525.000.000 0,005 2.575.000.000 0,005 2.625.000.000 0,005 2.675.000.000 0,005 2.725.000.000 0,006 2.775.000.000 0,006 2.825.000.000 0,006 2.875.000.000 0,006 2.925.000.000 0,005 2.975.000.000 0,005 3.025.000.000 0,004 3.075.000.000 0,004 3.125.000.000 0,004 3.175.000.000 0,003 3.225.000.000 0,002 3.275.000.000 0,002 3.325.000.000 0,002 3.375.000.000 0,001 3.425.000.000 0,001 3.475.000.000 0,001 3.525.000.000 0,000 3.575.000.000 0,000 3.625.000.000 0,000 3.675.000.000 0,000 3.725.000.000 0,000 3.775.000.000 0,000 3.825.000.000 0,000 3.875.000.000 0,000 3.925.000.000 0,000 3.975.000.000 Mean Value 791.786.044 Option Value Present Value
295.422.473 Value w/Option 2.325.000.000 2.375.000.000 2.425.000.000 2.475.000.000 2.525.000.000 2.575.000.000 2.625.000.000 2.675.000.000 2.725.000.000 2.775.000.000 2.825.000.000 2.875.000.000 2.925.000.000 2.975.000.000 3.025.000.000 3.075.000.000 3.125.000.000 3.175.000.000 3.225.000.000 3.275.000.000 3.325.000.000 3.375.000.000 3.425.000.000 3.475.000.000 3.525.000.000 3.575.000.000 3.625.000.000 3.675.000.000 3.725.000.000 3.775.000.000 3.825.000.000 3.875.000.000 3.925.000.000 3.975.000.000 847.268.187 55.482.143 20.772.620
PV Terminal Value Mean Savage Value 110.606.739 Probability Base Value Value w/Option 0,000 2.325.000.000 2.325.000.000 0,000 2.375.000.000 2.375.000.000 0,000 2.425.000.000 2.425.000.000 0,000 2.475.000.000 2.475.000.000 0,000 2.525.000.000 2.525.000.000 0,000 2.575.000.000 2.575.000.000 0,000 2.625.000.000 2.625.000.000 0,000 2.675.000.000 2.675.000.000 0,000 2.725.000.000 2.725.000.000 0,000 2.775.000.000 2.775.000.000 0,000 2.825.000.000 2.825.000.000 0,000 2.875.000.000 2.875.000.000 0,000 2.925.000.000 2.925.000.000 0,000 2.975.000.000 2.975.000.000 0,000 3.025.000.000 3.025.000.000 0,000 3.075.000.000 3.075.000.000 0,000 3.125.000.000 3.125.000.000 0,000 3.175.000.000 3.175.000.000 0,000 3.225.000.000 3.225.000.000 0,000 3.275.000.000 3.275.000.000 0,000 3.325.000.000 3.325.000.000 0,000 3.375.000.000 3.375.000.000 0,000 3.425.000.000 3.425.000.000 0,000 3.475.000.000 3.475.000.000 0,000 3.525.000.000 3.525.000.000 0,000 3.575.000.000 3.575.000.000 0,000 3.625.000.000 3.625.000.000 0,000 3.675.000.000 3.675.000.000 0,000 3.725.000.000 3.725.000.000 0,000 3.775.000.000 3.775.000.000 0,000 3.825.000.000 3.825.000.000 0,000 3.875.000.000 3.875.000.000 0,000 3.925.000.000 3.925.000.000 0,000 3.975.000.000 3.975.000.000 296.944.750 317.872.386 20.927.636 20.927.636
200
Exhibits
Exhibit 8.2. American Call Option Decision Tree
201
Bibliography
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Master Thesis

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THE AARHUS SCHOOL OF BUSINESS

MSc in Finance and International Business

Authors: Alfredo Galletti Carsten Wong Iversen

Academic Advisor: Tom Aabo

THE VALUE OF MANAGERIAL FLEXIBILITY IN PROJECT APPRAISAL

A CASE STUDY ABOUT THE EXPANSION OF NOVO NORDISK IN LATIN AMERICA

AARHUS, September 2004

REAL OPTIONS .................................................................................................. 5

INDUSTRY OVERVIEW ............................................................................. 10

THE DIABETES MANAGEMENT INDUSTRY..................................................... 24

THE LATIN AMERICA OVERVIEW.........................................................30

BRAZIL ............................................................................................................ 34 MEXICO ........................................................................................................... 42

NOVO NORDISK GROUP .......................................................................... 51

THE EXPANSION IN LATIN AMERICA .................................................62

BIOBRS S.A. ................................................................................................... 65

THE INVESTMENTS OPERATIVE BUDGET .......................................70

THE BASE OPERATIVE BUDGET ..................................................................... 90

THE DISCOUNTED CASH FLOW EVALUATION.................................94

7.2 7.3 7.4 7.5

THE VALUE OF THE REAL OPTIONS ..................................................118

8.3 8.4 8.5

THE VALUE OF THE EXPANSION OPTION (CALL OPTION) ..........................126

CONCLUSIONS ......................................................................................... 139

Alfredo & Carsten

Alfredo Galletti Carsten Wong Iversen

Alfredo Galletti Carsten Wong Iversen

III Scope and Limitations

SCOPE AND LIMITATIONS

Alfredo Galletti Carsten Wong Iversen

Alfredo Galletti Carsten Wong Iversen

Appraisal Methods Used NPV IRR PBP ARR Combined methods

% 13.7 10.3 6.8 3.4 65.8

Alfredo Galletti Carsten Wong Iversen

The Net Present Value and DCF Methodology

Alfredo Galletti Carsten Wong Iversen

Alfredo Galletti Carsten Wong Iversen

Including Uncertainty in Projects Valuation

See Schmidt (2003). Alfredo Galletti Carsten Wong Iversen

Source Schmidt (2003), authors elaboration.

Figure 2. Option Replication

Alfredo Galletti Carsten Wong Iversen

Figure 3. Value of a Call Option

Source: Brealey, Myers (2003), authors elaboration.

Alfredo Galletti Carsten Wong Iversen

See Schmidt (2003). Alfredo Galletti Carsten Wong Iversen

Source: Schmidt (2003).

See Schmidt (2003). Alfredo Galletti Carsten Wong Iversen

Alfredo Galletti Carsten Wong Iversen

The Pharmaceutical Sector

Figure 4. Pharmaceutical Sales by Geographic Region, 1999 2003 (US$ billion)

Source: IMS Health (2001), (2002a), (2003b), (2004b), authors elaboration.

Source: www.Quicken.com, authors elaboration.

Alfredo Galletti Carsten Wong Iversen

Table 3. Healthcare Spending as % of Gross Domestic Product, 1998

Alfredo Galletti Carsten Wong Iversen

Factor Price Regulation Price Regulation Approval Time Approval Time

Type of influence Negative Negative Negative Negative

On Market Size R&D Expenditures Market Size R&D Expenditures

Parallel Imports 14% 11% 7% 2% <1% <1% No parallel imports 1.4 %

Alfredo Galletti Carsten Wong Iversen

Figure 5. Global Pharmaceutical and Biotech Alliances by Party, 1990 - 2002

Source: Rasmussen (2003), authors' elaboration.

Alfredo Galletti Carsten Wong Iversen