Pharma mergers have hardly brought runaway success. Yet, judging from industry CEOs' public pronouncements, on the horizon is another merger and acquisition wave that will challenge both participants and spectators. The M&A game of the future may diverge drastically from strategies of the past, as multiple acquirers begin to target specific therapeutic franchises rather than whole companies.
Companies that take the merger route will have to handle a gamut of issues, from selecting the right partner-especially as the number of attractive prospects diminishes-to persuading increasingly skeptical financial markets of the transactions' value and wringing real benefits from them.
Urge to MergeThe pharmaceutical industry has consistently displayed one of the lowest levels of market concentration of any major industry. But that is changing. The market share of the largest pharma company doubled from Merck's 4 percent share in 1994 to GlaxoSmithKline's 8 percent today. And the combined share of the top ten pharma companies has increased by 40 percent. According to Deloitte Consulting's analysis, that trend will continue, and the combined market share of the top five pharma companies could easily increase by 85 percent, from the current 22 percent to 40 percent by 2005. That is likely to occur through five to ten major transactions during the next five years as the top ten pharma companies race to solidify their positions and snatch up the remaining attractive acquisition targets. Those transactions will be based on the following criteria:
Apart from company rivalry, what is the economic rationale for pharma mergers and acquisitions? The most frequently cited sources of value include
Although analysis suggests that none of those arguments is particularly persuasive, it is worthwhile to review the evidence for and against them.
Product portfolio expansion. Adding to the argument for this classic strategy, the merged entity will amass a fuller portfolio of leading products across a larger number of therapeutic categories, enabling it to increase its penetration of managed care formularies. In that case, the merger would create tangible financial value for shareholders. But analysis shows that few pharma company transactions during the last decade have increased the market share of the combined entities.(See "The Billion-Dollar Pyramid," PE, August 2000.)
But it is possible that the overall scale of R&D activity required to gain access to the full panoply of industry technologies and the concomitant investment requirements have increased as a result of new scientific advances. That would support the value of spreading the costs and risks of those technology investments over a larger base--a bigger R&D budget or aggregate revenues--thus favoring mergers. That the benefits of those new advances have yet to translate into increased R&D productivity or effectiveness supports that theory.
Sales force. Pharmaceutical sales forces have grown significantly during the last decade. The combined United States-based sales force of the top 40 pharma companies has more than doubled, from 38,000 sales reps in 1996 to 80,000 in 2000. Given that increase, it is questionable whether further sales force expansion will result in sales increases, especially considering that most physicians are too busy to see reps in the first place. In fact, the number of sales calls has increased at a fraction of the growth rate of rep employment, seriously raising doubts about the benefits gained from combining sales forces.
Cost reductions. When well executed, mergers create opportunities to cut administrative costs and to consolidate manufacturing. But the sheer magnitude of a transaction is an insufficient reason to justify doing it, and pharma companies have unimpressive track records for maximizing a merger's value.
Catching onto that trend, Wall Street has begun to take a less sanguine view of pharma M&As. Whereas earlier deals enjoyed an immediate rise in market capitalization, the financial markets reacted negatively to the three most recent mergers, reducing the combined valuations of the participating companies by 10-20 percent. The message seems to be that investors are unwilling to give management the benefit of the doubt at the time of announcement, so management must persuade the markets that it has a solid plan for creating value through the transaction.
In evaluating transactions and communicating with financial markets, pharma companies need to recognize that the accounting rules for M&A transactions in the United States have changed. The "pooling of interest" method of merger accounting, in which the acquired company's value is based on depreciated cost rather than market price, is now dead. Companies will be required to use the "purchase" method, under which the difference between market and book values is designated as an increase to the book value of acquired tangible assets, in-process research and development, intangible assets, and goodwill--which can make up as much as 60 percent of the pharma purchase price.
The new accounting rules' earnings-per-share implications are less favorable than the "pooling" approach but less onerous than the old purchase accounting, which required annual amortization of all goodwill and intangible assets. The new rules require intangible assets with a finite useful life to be amortized. They also subject goodwill and intangible assets with an indefinite life to an annual impairment test that requires assets' book value to be reduced from cost to fair market value.