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.
Those that decide to remain independent will face a different set of challenges. They will need to remain competitive with
merged rivals that have expanded product portfolios and increased marketing and R&D budgets. To avoid being caught by surprise,
they will also have to decide how long they can afford to sit on the sidelines. (See "Pay Attention," page 54.) Will they
take the leap if their relative size and ranking fall below a certain threshold? Will they counter if one of their R&D or
marketing partners becomes a takeover target? Will they jump in if the opportunity to break up a company and acquire an attractive
therapeutic franchise presents itself?
This article describes how M&A activity in the pharma industry is likely to unfold during the next five years, examines the
underlying rationale for that activity, reviews the financial perform-ance of past deals, and poses a novel approach to pharma
M&As, regardless of current attitudes toward 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:
- the extent to which product lines and R&D pipelines complement each other
- strategic intent
- sustainability of going it alone
- cultural compatibility
- R&D or marketing partnerships and alliances
- organizational structures-functional versus business units
- geographic proximity.
Those factors have the greatest impact on the success of mergers and their effect on value creation-or destruction. Companies
that fail to use them to evaluate potential acquisition targets and merger partners do so at their peril. (See "Where It Goes
Apart from company rivalry, what is the economic rationale for pharma mergers and acquisitions? The most frequently cited
sources of value include
- expanded product portfolio and replacement of products whose patents have expired
- increased scale of R&D in the face of new scientific developments
- increased size of sales forces, leading to increased sales
- elimination of overlapping manufacturing and administrative functions.
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
R&D productivity and scale. Analysis of the relationship between pharma R&D expenditures and the number of new molecular entities or regulatory filings
fails to confirm the presence of econ-omies of scale, regardless of time period. So there is no reason to believe that the
increased size resulting from combined R&D groups will magically increase productivity. In fact, a merger could reduce R&D
productivity if it increases the operation's complexity, which is almost inevitable if the combined company ends up with more
R&D locations. Historically, pharma companies have been reluctant to move or consolidate R&D locations because they fear losing
valuable and hard-to-find talent.
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.