As the world battles with COVID-19, the life sciences sector has never been more important. The sector will play a large role in forming and implementing social policy around the world, and as a result will come under increased scrutiny.
The KPMG Investor Insights team recently asked some investors and analysts what they thought about the way listed companies in the sector reported financial performance and KPIs at a recent event. This audience was also asked what they thought auditors need to pay attention to when auditing listed pharma companies.
Below are some of the key highlights from the discussion - you can access the slide deck Pharma and Healthcare.
Key value drivers – unlike other sectors
Investors rely on a number of valuation drivers that feed into the metrics and methods they use to assign value to life sciences companies. Our audience made a few key observations, listed below.
- A focus on drug development over the long term sets the life science sector apart from others from an investor perspective. Investors’ valuation models often cover 10-20 years at a high level of granularity (vs 3-5 years in most other sectors). Companies are spending heavily on drug development but – due to the way that spend is accounted for – investors note that balance sheets are ‘tiny’ by comparison. This can make it hard for them to see how well the money has been spent.
- Research and development (R&D) productivity is seen as a key factor but can be very hard to measure. It is seen as a ‘black box’ by some, with companies not being seen to be offering sufficiently granular disclosure.
- Differences in accounting treatment can hinder effective comparison of companies with similar business models. For example, some R&D spend is expensed and some capitalised. Investors are also reliant on valuation multiples based on ‘core’ measures, which often show companies’ performance in a highly favourable light.
- Capital allocation decisions and cash generation are key. It’s important to investors to know how decisions are taken on how much cash is spent – e.g. on investment in R&D or acquisitions and partnerships – vs how much is returned to them in the form of dividends and share buybacks.
Transparency on ‘core’ performance measures
The sector is highly reliant on adjusted (or ‘core’) performance measures, which strip out many items identified by companies as ‘non-cash’ or ‘non-recurring’. Our audience discussed the need for better transparency and granularity on these core measures.
Investors had questions over whether financial reporting on a ‘core’ basis truly reflects the costs of drug development. For example, R&D costs (or acquired R&D assets) are often capitalised at inception but also excluded from ‘core’ performance measures when they are amortised or impaired, which conceals the true total cost.
A key question from investors was whether auditors are ‘holding management’s feet to the fire’ on disclosures. Our investor audience encouraged auditors to keep a watchful eye on how items in the financial statements related to COVID-19 are presented by companies. They highlighted the potential for asymmetric treatment of such items – e.g. companies might identify COVID-19 related costs (e.g. additional implementation costs of remote working and physical distancing, purchase of personal protective equipment) as unusual items to be excluded from core measures, without treating COVID-related financial benefits (e.g. higher sales of pharma products, lower travel expenses) in a similar way.
Timeliness of financial reporting
Members of our audience highlighted that the granularity of disclosure they require to assess companies in sufficient detail is only contained in the annual report, which is often released more than three months after the year end. They find it hard to explain why some large pharma companies publish the full annual report in January, while others in the sector wait until April.
In the same vein, KPMG in the UK continues to encourage listed companies to consider their investors’ needs and speed up the publication of their annual report. (Our policy on preliminary announcements aims to deliver the auditor’s insights on the financial statements to investors earlier when significant challenges to quicker publication of the annual report exist.)
Financial KPIs tied to executive remuneration
Our investor audience shared their thoughts on financial KPIs that are tied to remuneration. They noted that – although such measures are useful for determining which metrics are on the minds of management – there are some areas which deserve further investigation.
- Investors rely on management to ‘do the right thing’ for the whole business – at times, management are seen to be heavily incentivised to raise a particular financial KPI rather than take a more holistic view.
- Some investors take the view that management teams are often seen to focus heavily on top-line growth and margin expansion – often achieved through deal-making – and not necessarily enough on returns on invested capital.
- Non-financial KPIs are growing in importance: environmental social and governance (ESG) factors are of growing importance to investors, who are increasingly requesting extended assurance over companies’ ESG disclosures.
From our discussion, we gathered that investors want:
- Life sciences companies to take a long-term holistic view of how they create value in their businesses, focusing more on returns on invested capital over revenue and margin growth;
- Financial KPIs and management incentives to better reflect that long-term holistic view;
- Core performance measures that better reflect total recurring income and expenditure over the entire product lifecycle; and
- Auditors to be alert to investors needs and provide appropriate challenge to management when auditing companies’ disclosures in these areas.
About KPMG Investor Insights
Our pharma and healthcare roundtable session with investors and analysts was held on 3 June 2020. It is one of a series of investor outreach events we hold to discuss and share perspectives on how corporate reporting, auditing and assurance, and stewardship can evolve to meet investors’ needs today and in the future. Visit our Investor Insights page to find out more.