Merger & Acquisition in Pharmaceutical Industry - Dissertation Example

Running Head: MERGER & ACQUISITION IN PHARMACEUTICAL INDUSTRY Merger & Acquisition in Pharmaceutical Industry s Table of Content Merger & Acquisition in Pharmaceutical Industry 3 Introduction 3 Adaptive and defensive rationales 4 Combat increased profit pressures 4 Cutting infrastructure costs 5 Satisfy the market mandate to maintain earnings growth in the face of pipeline problems 6 Maintain competitive scale and scope 8 Defense against acquisition 9 Proactive and offensive rationales 10 Gain access to foreign pharmaceutical markets 10 Extend capabilities to new therapeutic areas 11 Achieve economies of scale and scope in R&D, sales, and marketing 12 Create a competitive advantage in R&D productivity 14 Fostering disruptive change 14 Findings and Conclusion 15 References 16 Merger & Acquisition in Pharmaceutical Industry Introduction The pharmaceutical sector trade literature suggests many of the rationales for M&A cited in the academic literature, but also some others. There is a clear sense from this literature that certain rationales are more adaptive and defensive in nature (particularly true for the earlier wave of M&As), such as combating cost pressures from buyers, cutting infrastructure costs, satisfying market demands for earnings growth, maintaining competitive size, and defending against acquisition. Other rationales reflect a more proactive and offensive thrust (particularly in later waves), such as diversification into new geographic markets and therapeutic areas, achieving scale and scope economies, developing competitive capabilities in R&D, and fostering disruptive change. There is also the clear sense that these rationales focus primarily on cost reduction and secondarily on revenue enhancement. Literature Review Adaptive and defensive rationales Combat increased profit pressures The first threat to pharmaceutical sector profits was the Waxman–Hatch Act (1984), which lowered the barriers for generic entry into the market (after patent expiration for the branded drug) but also extended patent terms for many approved drugs. The reality of increased generic competition placed a concrete limit on the life cycle of a product’s revenue stream and forced firms to search ever more vigorously for substantial sources of profits to replace those that were now being continually lost after patent expiry. One result of this pressure has been the increasing focus of firms on blockbuster drugs – drugs that could maximize economic return over the fixed life cycle of a drug’s patent protection – leading the R&D departments of major competitors to converge on similar targets and drug classes with blockbuster potential (e.g., lower-severity conditions treated by primary care physicians such as hypertension, arthritis, etc.). This convergence of pharmaceutical focus also resulted in an increase in the number of “me-too” drugs during the 1990s, as firms could observe and imitate their competitors’ R&D efforts. The branded drugs of pharmaceutical firms were thus confronted with increased competition from generic and therapeutically equivalent versions. Both sets of pressures served as an impetus for consolidation, which in turn reinforced the need to focus on larger, blockbuster products. The early 1990s also witnessed the consolidation of intermediaries into large, organized buyers – such as HMOs, PBMs, and GPOs – along the value chain in healthcare. From 1988 to 1996, for example, HMOs doubled their penetration of employer-sponsored health plans (firms with 200-plus workers) from 17 percent to 33 percent. (Martin, 2003) This growth placed additional pressure on pharmaceutical firm profits, as organized buyers negotiated large-volume discounts on drug prices, developed formularies of approved drugs, and pressured providers to prescribe generic versions or therapeutic equivalents of branded drugs whenever available. Pharmaceutical firms were also persuaded to hold down price increases during the early 1990s under the threat of the Clinton Health Plan in the United States and the proposed creation of large buying networks at state level. The period 1991–1995 saw a big decline in the price increases of pharmaceutical firms. (David, 2000, 48-56) The combination of these factors increased the perceived pressures on both revenues and life cycle durations of major branded drugs. In response, pharmaceutical firms merged in order to increase their negotiating leverage with HMOs and PBMs. Mergers may also have been designed to combat the large buying groups proposed by the Clinton Health Plan. In addition to horizontal mergers, pharmaceutical firms attempted to mitigate the threat of buyer power through vertical integration into the PBM business (e.g., Merck–Medco, Eli Lilly–PCS Health Systems, SmithKline Beecham–Diversified Pharmaceutical Services), although with disastrous losses in two of these deals.(http:/leda.law.harvard.edu) Cutting infrastructure costs Economic recessions, proposed governmental reforms, and price pressures from both payers (HMOs) and buyers (PBMs) placed pharmaceutical firms in a cost squeeze, which stimulated some of the early M&As. Pharmaceutical firms experiencing relatively large increases in operating expenses were more likely to be involved in pooling mergers (i.e., mergers of equals) in the 1986–2000 time period, perhaps as a means of cutting costs. (Patricia, 2004) Historically, pharmaceutical firms rarely had to worry about lean infrastructure spending, enabling firms that merged from a position of weakness with subsequent overcapacity to be in an even better position to realize cost synergies. Pharmaceutical executives believed that infrastructure cost-cutting between merged firms could provide bottom-line earnings growth for two to three years after a merger’s completion. In this manner, firms that historically were unable to take out costs used the merger to become more streamlined. Infrastructure cuts could be made in R&D (close, consolidate, or sell laboratories), manufacturing (close, consolidate, or sell plants), and marketing (reduce the number of sales managers). Such cuts could improve the productivity of the remaining assets. It should be noted here that R&D is targeted as a source of short-term cost savings, not as a source of long-term productivity improvements. By some estimates, up to 30–40 percent of the acquired company’s cost base could be captured as earnings through infrastructure rationalization. (William, 1996:110–119) Others put the estimated savings at 20 percent of the target firm’s sales. Satisfy the market mandate to maintain earnings growth in the face of pipeline problems Most alarmingly, pipeline productivity fell sharply in the late 1990s, with the total number of new molecular entities (NMEs) introduced each year staying essentially flat since 1990, even as spending on R&D and total revenue base more than doubled in the same time period. For instance, product withdrawals due to safety concerns wiped out years of anticipated profits from such firms as Wyeth (fen-phen), Bayer (Baycol), and Warner-Lambert/Pfizer (Rezulin). Late stage clinical failures also left major gaps in firms’ revenue projections. Pfizer suffered several late stage clinical setbacks bringing its blockbuster antibiotic Trovan to market, thereby restricting its ultimate value in the market; more recently, Merck lost two blockbusters in phase III trial failures (MK-0869 for depression and MK-767 for diabetes), leaving the firm in a precarious position for midterm growth. Such problems become reflected in the firm’s “desperation index” (i.e., declining values of products in the pipeline). (Matthew and Daniel 2004, 34-51) The combination of all of these factors has jeopardized the long-term stability and reliability of pharmaceutical firm revenue streams. Major gaps in revenue growth, either foreseen (e.g., patent expirations) or unforeseen (e.g., product withdrawals or pipeline failures), provide a critical challenge to management. The highly specialized sales and marketing personnel at integrated pharmaceutical firms become unproductive when patents expire and the R&D department is not able to deliver replacement products.(Andrew, 2004; C1-C4) To stay competitive in the future, most firms believe they need to maintain the scale of their sales and science spending, no matter how difficult the present earnings challenges. The problem with mergers is that they beget more mergers, turning the pharmaceutical firm into a “mass-mergerer” (i.e., a serial consolidator). Mergers set off leapfrog competition in a pharmaceutical sector that used to be stable with respect to who were the market leaders. Firms adopt a strategy of “not be left behind,” believing that those firms that fall in the size rankings are more vulnerable to takeover.(Elyse, 1995: B4) As companies get larger, the absolute value of revenues required to replace lost revenues from patent expirations and still generate double-digit earnings growth grows larger. By some estimates, the largest firms need to launch one to three blockbusters annually in order to maintain the pace of growth. So long as the pipeline productivity issue remains, satisfying the market mandate for growth will continue to require nonorganic solutions such as consolidation to help drive earnings forward.( Steve, 2003) M&As thus represent a short-term strategy and solution for firms with blockbuster drugs that are coming off patent and/or with an insufficient pipeline to replace the blockbusters. (Ravenscraft, 2000: 84-89) Increased size resulting from past mergers and continuing pipeline problems make this strategy less tenable over time. Maintain competitive scale and scope Common wisdom within the industry holds that sales force scale and the size and scope of R&D efforts create powerful competitive advantages for leading firms. For example, sales force size reportedly gives a pharmaceutical firm greater share of voice with the prescribing clinician and correlates with sales force productivity. Not surprisingly, sales force sizes skyrocketed in the 1990s; the top forty firms added 40,000 sales reps between 1992 and 2002. R&D budgets have followed suit, growing from 16 percent to 18 percent of sales between 1990 and 2000, with a peak of 20 percent in 1998. (PhRMA Touts Medications’, 2002, RX2) In the light of this accelerated spending on sales and scientific capabilities, and as leading firms consolidate, the gap in absolute spending between the first tier and the second tier has the potential to grow exponentially, threatening to leave smaller firms missing out on the consolidation trend behind for good. Firms mentioned the danger of being the “number 12” player in the industry in terms of not attracting the best scientific talent or strategic alliance partners. In response, second-tier players seeking a rapid way to achieve industry-leading scale have turned to consolidation, creating a series of leapfrog mergers in the 1990s with new firms setting the industry-leading standard for scale every few years. Pfizer (after the merger with Warner-Lambert) in 2000,(IMS Health, 2001) and GlaxoSmithKline (from Glaxo Wellcome and SmithKline Beecham) in 2001,(http://findarticles.com) each of which became the largest firm in the world at the time of the merger. The formations of Aventis (Alexandre, 1999) and AstraZeneca (Kerry,1999) created the second and third largest firms, respectively, at the time of the merger. Defense against acquisition Firms with relatively weak positions make attractive takeover candidates; solid products and R&D projects can be harvested, while redundant infrastructure can be cut wholesale. For such firms, improving performance through organic growth to sufficiently block such takeover attempts is too difficult, and too slow, to provide an effective defence. On the other hand, a merger with another firm allows a corporation to maintain some semblance of control over its destiny, despite the loss of autonomy inherent in a merger. Another attractive candidate for a takeover is a firm that is performing strongly, but which has not reached sufficient scale to become too large for a takeover. Sanofi-Synthelabo, a firm with above-average R&D productivity and a fairly strong pipeline, represented an attractive takeover candidate for larger firms looking for new growth engines. Sanofi’s merger with Aventis served several ends: to maintain Sanofi’s independence, to be a European champion, to consolidate Europe’s pharmaceutical sector, to be the new number three firm in the industry, and to serve France’s national pride (as well as leverage Sanofi’s attractive pipeline more effectively over more countries). (Peter, 2002: B2) In Japan, Yamanouchi Pharmaceutical Company agreed to acquire Fujisawa Pharmaceutical Company in order to battle foreign competition at home, to become the number two player in Japan, to fend off takeovers by larger global firms, and to avoid becoming a Japanese subsidiary of a foreign firm.(Kazuhiro, 2004: A2) In support of these efforts, countries like France (in the Sanofi-Aventis deal) and Japan are encouraging their domestic pharmaceutical firms to combine, increase their regional scale and dominance, and avoid being battered by foreign companies. (Peter, 2002: B2) (Of course, such encouragement can be misguided if it produces less competitive, merged firms that do not actively integrate to reduce costs or promote growth.) Proactive and offensive rationales Gain access to foreign pharmaceutical markets For much of the century, domestic firms dominated national markets by steadily building a sales and marketing presence and by forming strong relationships with regulators and local researchers. The difficulty in building these capabilities from the ground up as a foreign entrant to an established market presented firms with serious barriers to international expansion. At the same time, the increasing value and scale of foreign pharmaceutical markets in the USA, Europe, and Japan, combined with the universal marketability of pharmaceutical products, made expansion a strategic and economic priority. The fastest way to gain access to foreign markets, therefore, was to license or buy the capabilities of local firms. Examples of mergers partially driven by this rationale were typically US–European mergers, such as those between SmithKline Beckman (US) and Beecham (UK) (1989) or Pharmacia (Sweden/Italy) and Upjohn (US) (1995). US expansion was an important motive for non-US firms given the market size, high growth, and price realizations in the US. Mergers with Japanese firms, such as that between Roche (Switzerland) and Chugai (Japan) (2002), developed to foster entry to an important market where western firms have generally struggled; however, now most western firms have a strong base in Japan and do not need an acquisition.(Peter 2003: B4) In addition to building sales in new markets, pharmaceutical firms are also seeking to develop the image of a fast-growing and global firm. Global reach, combined with capabilities in rapid product launch, can also translate into a reduction of years to peak product sales and thus higher revenues. Extend capabilities to new therapeutic areas As firms grow, they have typically expanded the scope of their portfolio across a number of therapeutic areas. Most major pharmaceutical firms now have products in many major therapeutic areas (e.g., cholesterol, hypertension, depression, antiulcerants, diabetes, inflammation). However, this breadth results as much from the consolidation trend as from organic growth. For instance, Pfizer’s merger with Pharmacia in 2002 improved its presence in immunology (by capturing 100 percent of revenues from the comarketed rheumatoid arthritis drug Celebrex as well as the next generation Bextra) and added assets in oncology, endocrinology, and ophthalmology; these products complemented Pfizer’s existing strengths in cardiovascular disease, central nervous system, depression, and erectile dysfunction.(Rajesh, 2001: 78–83) Achieve economies of scale and scope in R&D, sales, and marketing Economies of scale are believed to exist in some portions of the pharmaceutical value chain (e.g., sales and marketing) more than in others. Industry executives believe that larger commercial scale has continued to demonstrate positive marginal returns, though the magnitude of those returns has rapidly diminished. For example, “more sales representatives can call on more doctors more times,” or “more representatives can sell more drugs to more doctors leading to more scripts.” Larger scale may also facilitate faster product launches across larger markets, leading to higher revenues. Many observers speculate that instead of increasing returns to scale there is a “critical mass” of research spending – a threshold level at which a minimum efficient scale is attained. This threshold level of spending allows companies to acquire key technologies and place the requisite number of bets across fixed research assets in order to achieve an adequate return on investment (ROI). (Melanie, 2004: 76–82) This critical mass would also allow companies to adequately fund both early stage research as well as expensive, later stage development without making trade-offs between short-term and long-term spending priorities. There are other presumed benefits of mergers that involve economies of scale. Increased scale from a merger may allow a firm to spread the costs of acquiring any future technologies or biotechnology firms across a larger base. (Higgins, 2006) Larger firms may also be better able to leverage the technology, R&D, and skill sets of these future target acquisitions. Finally, pharmaceutical firms may make strategic acquisitions of firms operating in a specific therapeutic area in order to gain scale and thereby compete with larger firms who devote a lower proportion of their R&D to this area (e.g., Eli Lilly and Novo Nordisk’s efforts in diabetes). Analysts suggest that scale economies exist within (but not across) therapeutic areas, and those pharmaceutical firms can leverage knowledge across multiple states within the same disease family (narrow but deep focus).( Kearney, 1999) If mergers are a way to achieve optimal scale in the pharmaceutical sector, then one would expect smaller firms to be involved in more M&A activity than larger firms. Large firms apparently believe that there are advantages to growing even larger.( Danzon, 2004) All the same, after fifteen years of consolidation, pipeline productivity continues to decline, and the extent of scope advantages for merging firms is difficult to estimate. This may be due to the fact that merging firms often cut out large groups of development projects that cannot satisfy new criteria for high potential sales; one analysis showed that postmerger firms had almost a third fewer projects in development three years after merging as their premerger baseline. (Troubling Numbers for Big Pharma Consolidation, 2000, 2) Create a competitive advantage in R&D productivity Long-term improvements to R&D productivity, as opposed to short-term cost savings and earnings boosts, are often cited by executives at the time of a merger. Mergers are heralded as the beginning of a new research engine to drive organic growth in the future. Consistently, these same companies have returned to mergers again and again in order to shore up weak pipelines and gaps in market portfolios. It may take more time than expected to assimilate the new technologies and firms acquired. In the short term, the combined earnings stream of the merged firms may provide a more consistent flow of internal funding for R&D to offset the volatile cash flows from blockbusters.( Jeffrey, 1999) Fostering disruptive change As noted above, M&As are often pursued for defensive reasons to correct underlying weakness and decline in the combining firms. Mergers provide an external impetus and logic for restructuring each firm’s assets that might otherwise encounter greater internal resistance. In this manner, the two firms can “start with a clean slate,” conduct a companywide review, reallocate assets to more productive areas, reengineer processes, reduce head counts, and undertake changes that neither firm could do prior to the combination. (Lawrence,1998: 2–10) Indeed, the merger event serves to justify the enormous disruption costs.(Ravenscraft, 2000) In this manner, merged firms may achieve the economies of scale and savings that individual firms cannot, or take out costs that the individual firm cannot. Findings and Conclusion The above review suggests that M&As can be motivated from multiple sources. This conclusion is supported by industry surveys of pharmaceutical firms who report having multiple M&A goals: grow the core business, realize cost synergies, acquire new technologies, gain competitive advantage, generate fiscal advantage, and so on. Such a phenomenon is not unique to pharmaceutical firms; firms in other industries typically have multiple objectives in pursuing M&As. It is possible, of course, that many positive aspirations are voiced to disguise underlying motivations for cost synergies (i.e., reductions). The problem with multiple rationales noted in these other industries may also pertain to pharmaceuticals: the lack of a clear focus in the merger and the presence of conflicting agendas. In the presence of multiple goals, the intentions of the two firms (particularly if one acquires the other) are likely to diverge, if not conflict. Moreover, there may be a simultaneous (and confusing) effort to cut costs and pursue growth. Other problems that stem from multiple rationales concern the merger implementation effort – for example, the difficulty in mapping out the implementation steps due to the need to accommodate a variety of potentially conflicting interests and directions. Multiple rationales may thus prove dysfunctional during the merger transition and lead to unresolvable conflicts. Industry analysts argue that one party in clear control, with a dominant economic rationale, a simple program, great communication, and excellent execution, is the critical ingredient for M&A success. 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