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Mergers
and acquisitions
Introduction
Few people who read newspapers and listen to news broadcasts
– and certainly none who follow share prices - can be
unaware that the pharmaceutical industry is a hotbed of merger
and acquisition (M&A) activity. During 1999 deals worth
over $100 billion were completed, led by the mega-mergers
that created AstraZeneca (approximate value $31 billion),
Aventis ($22 billion) and Sanofi-Synthelabo ($11 billion).
This figure was then dwarfed within weeks of the start of
2000 by the proposed deals between Pfizer and Warner-Lambert
($80+ billion), GlaxoWellcome and SmithKline Beecham ($70+
billion) and Monsanto and Pharmacia & Upjohn ($25+ billion).
Behind these high-profile mergers lie hundreds of smaller
scale deals between companies further down the ranks of size.
This paper presents a brief analysis of the reasons for this
huge level of activity, taking into account the factors that
drove M&A in the past and the new ones that may be emerging
for the future. It pays special attention to one of the current
dominant themes – the urge to become bigger in order
to guarantee consistent performance over time in an R&D
driven environment – since this is both one of the most
hotly debated motivators of M&A at present and the driver
of the very high profile deals referred to above.
Strategic objectives
A major strategic move like M&A is a clear expression
of the overriding strategic intentions of any company. What
are the aims of pharmaceutical corporations?
Strategy in the pharmaceutical industry is developed against
a background of the risk/return equation that the market and
the technology involved bring with them.
The return offered by the market for a successful product
sold worldwide is enormous – within a few years of launch
a product can, in ideal circumstances, reach annual sales
of $2–5 billion, with margins of over 80%. Corporate
profitability is therefore often at levels very few other
industries can match. However, the risk inherent in the technology
is equally large – development timescales are commonly
10 years and usually cost hundreds of millions of dollars
(and escalating rapidly), while the probability that such
an investment will bring success is very low.
Against this background drug companies, like all other companies,
are seeking to enhance shareholder value. This normally requires
them to demonstrate both consistent improvements in earnings
in the short term, and a strategic position that gives shareholders
the assurance that results will continue to meet target in
the longer term. Traditionally, US and UK shareholders have
sought high performance on both of these criteria, with particular
emphasis on the short-term aspect, while those in Europe and
Japan have tended towards a greater emphasis on the long-term
aspect.
Because the returns in the industry can be so high –
and some comparator company somewhere is always producing
a stellar performance - shareholder expectations in the short
term are also very high. Frequently quoted earnings growth
targets for the larger companies currently centre around 13-15%
pa – implying, on the basis of the ratios earned by
average companies in recent years, an annual sales growth
target of about 10-12%. The task of management is to extract
this kind of high-level and, above all, consistent performance
against the dramatically fluctuating risk background of the
industry. This task becomes overwhelmingly daunting for an
individual company when the long time-scales of its own R&D
mean that nothing new will come on to the market, perhaps
for several years, to add to the top line at a point where
the bottom line is ceasing to match expectations.
Past drivers of M&A
In the search for improved performance companies have become
involved in M&A in the past for one or more of the following
main reasons:
Geography – Pharmaceutical products are very
difficult to create. Once this has been done they must be
exploited to the maximum degree. This includes ensuring that
they reach all relevant markets worldwide and are marketed
fully effectively there. Drugs companies have for many years
sought to develop their international reach by buying companies
with an established presence in target markets. Often in Europe
this included in the past the need to gain a foothold in a
national market where only domestic companies could gain full
pricing and reimbursement rights for their products. In Japan
there was a cultural block to fully effective operation for
anything but a local company - although acquisition of national
companies there has only recently become even feasible. Buying products – In an industry where performance
is so much driven by the top line (the sales generated by
its high-margin products) a common theme of M&A has long
been the search for new products to add to the existing range. Buying technology – specific skills often
underlie the ability to generate certain types of drugs. In
many cases these skills are accessed by means of license deals,
but on occasions a company has preferred to use the M&A
route. Cost savings – a favourite motivator in many
industries, the ability to put two companies together and
save costs, is also a factor in most pharmaceutical M&A.
Because the top line is so important, it is however rarely
a primary driver, except in cases where there is a desperate
need to improve earnings in the short term – more often
a motivator than managements are ready to acknowledge. Expansion into new business areas – there
have been periods in the past when the pharmaceutical industry
has become concerned about its future, or has perceived attractive
opportunities in more or less related fields to apply its
expertise to new ventures outside the creating and selling
of drugs. The record is not a happy one, a recent example
being the move via acquisition into Pharmacy Benefit Management
in the USA by three companies at a time when President Clinton’s
reforms seemed to be threatening the future of the industry.
Large amounts of money were lost in two of these cases at
least. Similar experiences have been had in the generics field.
The most recent trend has been in the opposite direction,
with companies merrily disposing of animal health, cosmetic,
pharmaceutical generics, agrochemical, fine chemical and other
activities in order to focus on the currently unparalleled
margins available in pharmaceuticals. Defence – while most M&A activity is aimed
at building strong positions for the future, this often involves
an element of ensuring that others do not get the chance to
take the same opportunity. The most obvious and high profile
example of this is Pfizer’s aggressive acquisition of
Warner-Lambert with whom it had very significant collaborations
in the market place, but which was close to a merger with
American Home Products. Doing something – when all around are girding
themselves for the M&A fray it is hard for a management
to sit tight and say they have confidence in their company’s
ability to sustain itself by its own efforts and to refrain
from becoming involved. All sots of things can cause management
to want to join in – can they be quite sure that a cherished
development project will not fail and leave the company exposed?
Promises have been made to shareholders that the company would
remain fully competitive, but how is this to be demonstrated
when you chief competitor just got twice as big? In any case
what manager wants to suddenly find himself managing company
number three rather than number one? Isn’t it very useful
to be able to muddy the corporate waters for a couple of years
to get off the treadmill of consistent annual growth, and
start from a new point? What about getting rid of a few troublesome
or underperforming executives in the inevitable organisational
turmoil of implementation? What about personal rivalries between
individual CEOs at the top of the industry? Few would deny
that these factors have also been behind involvement in the
M&A marketplace. Getting bigger – although virtually all M&A
means getting bigger, in recent times this has become the
primary motivator behind some of the biggest deals of all
– as described above. This element is examined futher
in the next section.
Have these strategies of the past been
successful? Academic studies regularly demonstrate that only
about half of all acquisitions (in any industry) are successful.
In the case of the drugs industry, this seems to depend on
the reason for the M&A. On the whole geographic expansion
by acquisition has been effective, as has the acquisition
of products and sometimes technology (although this can lead
to restrictions on the exploitation of the technology as the
acquiring company becomes its only customer, as happened with
Ciba Geigy and Alza). Expansion into new fields has not worked,
but that is because the strategic aim was flawed rather than
because the M&A did not work. Pfizer’s defensive
move in buying Warner Lambert will probably pay off.
On the other hand, simply the number of companies that have
merged and then gone on to need to merge further (the list
of no longer existing companies included in the merger of
Glaxo Wellcome and SmithKline Beecham is revealing) suggests
either that it doesn’t always work or it is an inevitable
process, driven by the dynamics of the sector. In generous
mood the author inclines towards the second opinion –
that the forces at work on the pharmaceutical industry are
such that the need for major strategic change to ensure consistent
performance is endemic - while recognising that pharmaceutical
industry management has on occasion not shown itself to be
outstandingly competent, and has certainly sometimes sought
to solve its self-generated problems by M&A, which it
then mismanaged.
Size
Perhaps the biggest topic in M&A today is the value of
size, or scale. The industry is plagued by the fear of losing
revenues from one or two key products and not being able to
replace them with revenues from new products, because they
can never be sure what their R&D will produce and when.
The reaction has been to use M&A to create larger companies,
spending more on R&D - and therefore producing more products
in a more regular pattern. The question this raises is whether
this is just a dog chasing its tail - the faster you run,
the faster you have to run, still without reaching your goal.
To examine this, the author created a complex simulation model
of the industry to look at what happens to companies of different
sizes over many years given a range of assumptions, based
on current experience, about their R&D spend as a proportion
of sales; the productivity of this R&D (and the way that
productivity changes over time and as companies grow); the
in-market performance of the resulting products; the background
market growth and the performance of the existing underlying
products. In each case the company was dependent entirely
on its own resources to provide future growth. It could not
enhance its product range through acquisition or licensing.
No such model is a substitute for the real world, but this
one provides some intriguing insights. In none of the company
scenarios (ranging from current sales of $2 billion to $40
billion) did the average company at each revenue level sustain
sales growth at over 8% pa in the longer term, even if it
spent 25% of sales on R&D. The average $2 billion company
completely failed to maintain growth, and the $5 billion companies
performed weakly. The best performers had sales in the range
of $ 10-20 billion sales. Significantly, above that level
performance began to slip again, as is shown by the mean sales
performances in the graph below.
This clearly suggests that up to a point size brings advantages
in terms of sheer growth of sales for the average company.
But what about companies which were not average in performance?
Could small companies who outperformed their group do better
than large ones? In general yes. While there was a consistent
trend to greater predictability of results as companies grow
bigger, bringing the advantage sought in the recent mega-mergers
of beginning to eliminate the vast fluctuations in performance
that industry dynamics force on companies, it comes at the
price of reducing the possibility that a big company will
do as well as high-performing small ones. This is illustrated
in the chart below, which shows that a $40 billion company
has a 75% chance of reaching or exceeding an average growth
of 8%, while a $5 billion company only has a 38% chance of
doing that. However if target growth is at least 10%, then
both have about an equal chance (about 17%) of getting there,
and both have been overtaken by a $10 billion company, which
has a 30% chance of achieving 10% or more.
A $10 billion company has a 20% chance of multiplying its sales by a factor of at least 2.5 over
10 years, $30 billion and $40 billion companies only have a 6% chance of doing so.
On the basis of this analysis a company with current sales below $5 billion has very little
chance of achieving acceptable growth rates over time if it relies on its R&D for future products.
The optimal size is in the range $10 to $20 billion sales, because at this level average performance
is better than that achieved by bigger or smaller companies and it is also fairly consistent without
excluding the possibility of a period of outstanding growth. Above $20 billion performance becomes
increasingly stable, falling within a narrower range of possibilities, and on average is less good.
In other words the conglomerators are right to think that merging to increase size is good - but only up to a certain point.
The future
Some of the factors which have driven M&A in the past will continue to be valid.
For example geographical expansion will continue to take place, particularly in Japan
and other Asian countries, perhaps also in South America as patent legislation comes into
force, and acquisition to gain access to products and technologies will certainly continue.
New factors will however also enter into the equation. The pharmaceutical market environment
of the past has been one of trial and error and serendipitous inefficiency, with the patient as
the least influential component. In the future the processes of product development and marketing
will become more predictable and efficient, and the patient will move closer to the centre of things.
This past environment created the crude era of blockbuster drugs, developed by trial and error and
also used in patients by trial and error, generating enormous and largely unpredictable rates of risk
and return. The inevitable result was the creation of the blockbuster company, through the mechanism
described in the size analysis above. The future environment will be more sophisticated, targeted and
predictable, with a lower rate of both risk and return, and will favour again smaller, nimble companies.
This pharmaceutical market pressure will be matched by others - the increasing bite of anti-trust legislation,
public dislike of global mega-corporations, new approaches to employment and the work-place, the flexibility
offered by collaborations rather than acquisitions, the difficulty of managing creativity, focus, motivation
and efficiency in mega-companies - to eliminate the need for mega-mergers.
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