BUSINESS
09/15/2011 08:39 am ET Updated Nov 15, 2011

Insight: Why Swiss medicine men swallow a strong franc

By Katie Reid and Ben Hirschler

BASEL (Reuters) - In recent months, a red-hot Swiss franc has made Switzerland an expensive place to buy a slice of pizza, let alone run a business. Swiss-based Roche, the world's biggest maker of cancer medicines, and its cross-town rival Novartis have felt the pain along with Switzerland's other exporters.

Yet the medicine men of Basel, who have spent 500 years pioneering drugs on the banks of the Rhine, insist it will take more than a currency crisis to dislodge them. In fact, they are stepping up investment in the Alpine nation.

Roche already uses Basel as the center for its non-U.S. production of the $6 billion-a-year biotech cancer treatment Avastin. Now it has started work on a 550 million Swiss franc ($626 million), 178-meter tall office tower that will dominate the city's skyline. Novartis says it will spend 2.2 billion francs by 2014 to transform its main riverside site into a state-of-the-art campus for researchers and top management. The firm's plans call for further expansion that could double the number of buildings by 2030.

A strong currency is supposed to force manufacturers out -- and indeed, a majority of Novartis's and Roche's routine drug making is now done in cheaper countries. But for the really important stuff, the big drug companies say Switzerland's advantages -- a mix of rich skills, intellectual property and low taxes -- outweigh both its high costs and its runaway currency, up almost 40 percent over the past three years. It's the same lesson German precision tool companies and Japanese carmakers have learned: a strong currency does not have to mean the end.

"Basel is our home. This is where we were born," says Novartis CEO Joe Jimenez, a former Heinz executive who joined the group in 2007 and took the top job in 2010. "It is a very important city to Novartis and we are treated very well here, so unless that changes, either if there are restrictions in governance or if the tax regime were to change, then this is where we are going to be."

Chris Stirling, European head of chemicals and pharmaceuticals at KPMG, says the Swiss franc exchange rate has taken the shine off the Basel story and some smaller Swiss businesses in the sector are being "murdered in the marketplace." Novartis and Roche are not immune -- but neither are they as vulnerable as purely local firms.

"This is hurting them because they have got a lot of people in Basel who are now very expensive because of the increase in the exchange rate," Stirling says. "Clearly, it is not nice for them, but it is not nearly as bad as for smaller companies because their cost base is much more distributed."

DEEP ROOTS

Basel's cobbled streets and pretty old-town houses certainly seem an anachronism in the modern, globalized world. Tucked away in a corner of Switzerland right on the French and German borders, Basel, with a population of just over 190,000, is the antithesis of the modern mega-cities that supposedly drive the world economy.

Novartis and Roche, whose sales rank second and seventh in Big Pharma globally, according to IMS Health, have headquarters on opposite sides of the fast-flowing Rhine. Fritz Hoffmann-La Roche set up the business that bears his name in 1896. Novartis, in its present form just 15 years old, traces its origins to three companies dating back as far as 1758.

Roche has been manufacturing Avastin in a seven-storey glass-and-steel building in the heart of the city since 2009. Novartis has a key manufacturing plant in Stein, another pretty town 20 minutes up the Rhine, which makes products for the crucial launch phase of new medicines worldwide.

The company's deep roots are captured by the sometimes gruesome exhibits in the city's Pharmacy Museum, tucked away in a 16th-century house a short walk from the marketplace. Jars of pickled scorpions, pulverized earthworms and antique enema syringes from the 17th and 18th centuries give way to glass vials of Hoffmann-La Roche strychnine and cocaine from around 1900.

It was in this building that Theophrastus von Hohenheim -- a Renaissance alchemist, astrologer and physician more commonly known as Paracelsus -- pioneered the use of chemicals in medicine. Later, Basel brought the world chemical riches from Valium to LSD.

To companies whose memories run back hundreds of years, the latest gyrations of the foreign exchange market are a hiccup.

"Imagine being in a country where it is not politically stable, or where it is not possible to rely on the supply chain or a regulatory framework," says Roche Chief Executive Severin Schwan. "We would never go there."

STRIPPING OUT COSTS

Being based in Switzerland, though, means a significant share of a firm's costs are in Swiss francs. For Novartis, 13 percent of expenses are paid in the currency. Roche says 17 percent of its operating costs are in francs.

The currency's strength has taken a bite out of operating income at both companies. The strong franc cost Novartis, which reports in dollars, 3 percent of its profits in the second quarter. Roche, which gives its results in francs and does not report detailed quarterly figures, suffered a bigger 15 percent currency hit in the first half.

Worries about franc strength have fed through into the stock prices of both companies, although in comparison with other recent stock market casualties the sell-off has been muted. The firms' share prices have fallen by 10-12 percent since late May.

In response, their accountants are going through costs; routine or clerical operations are now often outsourced. Roche is currently doubling to 600 the number of data managers working in India, for instance.

But, the companies insist, core activities will stay firmly rooted in and around Basel.

Novartis' Jimenez says the Stein plant is "critical." Basel-based know-how is central because getting new products right is essential. Like all drug companies, Novartis has to plan for a product life-cycle that means a drug's profitability collapses when its patents expire; every month in that countdown to the loss of exclusivity can be worth millions of dollars. "We cannot jeopardize the launch results by trying to offset the currency appreciations," Jimenez says.

And even if the companies' shares have slipped, investors do not anticipate a rout. Novartis and Roche remain the world's most valuable pharmaceutical companies by market capitalization. The companies' shares trade at around 10 times next year's forecast earnings, attracting investors prepared to pay more per dollar of their profit than for U.S.-based Pfizer or France-based Sanofi. For the top 10 drugmakers globally, investors pay on average 9.3 times forecast earnings.

Sell-side analysts still rate the Swiss companies' shares highly, with 27 "buy" or "strong buy" ratings for Novartis out of a total of 36 recommendations, while Roche has 22 out of 34, according to data compiled by Thomson Reuters' Starmine.

IT'S THE TAXES

There are other reasons to stay rooted in Basel. One is the product pipeline and the local culture of drug discovery. In recent years, the city has established a fast-growing biotechnology sector that is now one of the strongest in Europe, and boasts the continent's biggest biotech success in Actelion. Like several other firms in the Basel area, Actelion has strong links with Big Pharma, since its founder and CEO Jean-Paul Clozel honed his skills during 12 years at Roche.

Rudolf Minsch, the chief economist at Economiesuisse, an umbrella organization for Swiss business, calls Basel a "Silicon Valley of pharmaceuticals," noting its specialized products are a lot less price sensitive than run-of-the mill manufactured goods.

The tax regime is also a big help. Switzerland's federal corporate tax rate is just 8.5 percent. After regional and local taxes, that rises to an average 21.2 percent, against more than 30 percent in France and Germany and 25 percent in the Netherlands, according to the Organization for Economic Cooperation and Development.

Novartis and Roche pay markedly less tax than most of their Big Pharma peers. In the second quarter of 2011, Novartis's effective tax rate was 16 percent, while Roche had a first-half tax rate of 21 percent.

Switzerland's tax regime also encourages companies to hold their intellectual property (IP) in the country -- a boon for patent-rich businesses like drug makers. Multinationals can minimize the tax on profits from such assets. It's an advantage that has encouraged such firms as McDonald's, Kraft Foods and Nissan, to locate their main European offices in Switzerland.

Added to this, both Roche and Novartis have the advantage of global presence, making them better-placed than smaller local firms to weather the currency storms.

"The big difference between them and smaller manufacturing companies in Switzerland is that they have a natural hedging because they have affiliates all over the world," Minsch says. "This helps them a lot."

STAID BUT INNOVATIVE

The companies' size has another advantage: it boosts their clout with authorities. Switzerland's pharma industry accounted for 31 percent of the country's exports last year, giving the biggest drug companies the ear of lawmakers and other officials. Novartis Chairman Daniel Vasella even had the Swiss border crossing with France moved a few years ago because the road leading to it cut across the company's research campus.

This month the Swiss National Bank reaffirmed a long-term strategy and threw its weight behind local manufacturers by saying it was "prepared to buy foreign currency in unlimited quantities" to curb the franc's rise. That may be a tall order, but the direction suits exporters. A day later, Switzerland was again ranked No. 1 worldwide in the World Economic Forum's global competitiveness report, ahead of Singapore, Sweden, Finland, the United States and Germany.

Switzerland's position on the list, the Swiss-based WEF said, reflects key strengths in innovation, intellectual property protection, research collaboration between academia and industry, labor market efficiency and excellent infrastructure, as well as rock-solid government finances that mean the risk of unpleasant tax shocks is miniscule.

The WEF didn't mention Basel's geography. The city is institutionally removed from the euro zone, but close enough to the Swiss border with Germany and France to allow people who work in Basel to live in euros and be paid in francs. That means some employees are smiling all the way to the supermarket. Around 35 percent of the staff working on the Novartis campus live in one of the two neighboring countries, where their salaries go a lot further.

Basel's nightlife may be staid and locals may complain about the amount of building work. But the daily commute is usually just minutes, and it is a good place to raise a family. A rich arts life and opportunities for adventure sports such as river swimming and even water-skiing help keep creative scientific staff happy.

"For us at Roche, the life blood is innovation and innovation is linked to talent," says Schwan. "If we don't get new innovative medicines and diagnostic tests developed we can switch off the light in 10 years from now. It is as simple as that because then the last patent will have expired."

With such a long horizon, a strong currency is just one factor among many.

(Edited by Sara Ledwith, Simon Robinson)