Pharmaceutical Mergers: What’s the Rush?

Villanova University
College of Commerce and Finance Spring, 2001
MBA 8439 – Contemporary Topics in Finance Dr. W.L. Dellva

Darren Snellgrove

Pharmaceutical Mergers: What’s the Rush?

Drivers of Recent and Future M&A Activity

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TABLE OF CONTENTS

i) Executive Summary

ii) Introduction

iii) Industry Structure

iv) Reasons for Recent M&A Activity

v) Analysis of Two Recent Mega-Mergers

– Glaxo Wellcome / SmithKline Beecham

– Pfizer / Warner Lambert

vi) Do Drug Mergers Really Work

vii) Possible Future Mergers

viii) Implications of Biotechnology & Genetic Mapping

ix) Conclusions

x) Bibliography

xi) Appendix

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i) Executive Summary

OBJECTIVE: Explain what social-political-economic factors are driving the recent step-up in
pharmaceutical merger activity, and determine whether or it makes sense.
METHOD:
 Analyze industry data, focusing on the recent pressures that explain recent merger activity.
 Consider general research and two recent mergers to see whether they are likely to succeed.
 Assess whether this trend will continue.

Industry Stage / Structure

 Relatively mature, and yet constantly changing industry. Complex financial challenges.

Reasons for Recent M&A Activity

 Major drug reimbursement issues, political pressure and concerns over pricing.
 Patent expirations / generic competition.
 Profitable industry, but growth slowing.
 Sales growth issues / global expansion.
 R&D pipeline gaps / R&D synergies.
 DTC campaigns / sales rep. coverage / channel access.
 Biotechnology / Gene Mapping.
 Management greed / agency factors.
 Changing M&A accounting regulations.

Analysis of Two Recent Mergers

 Overall, results are mixed. Portfolio balance and strategic fit are the key success factors.
 Glaxo / SmithKline - likely to achieve some success through pipeline synergies and cost savings.
 Pfizer / Warner-Lambert - the most likely to succeed due to strategic fit, operating efficiencies,
pipeline synergies, and the fact that this was a hostile purchase.
 Size may be good up to a point, but some of these mergers may be going too far:

Advantages of size: Disadvantages of being too big:

– Clinical trial economies of scale
– Sales rep. Coverage
– Regulatory / filing power with the FDA
– Lobbying power (political and with
wholesalers etc.)
– Balance risk in pipeline / product portfolio
– Diseconomies of scale / control issues
– Lack of focus
– R&D / commercial disconnects
– Loss of entrepreneurial environment
– May not deal with emerging areas
(biotech and genomics)

Conclusions
 Size and growth are being used to defend against increasing industry pressures, i.e.
Reimbursement, political pressure, patent expirations, growth issues, R&D pipelines, ad. economies.
 It is not clear that merging is the answer. Evidence to date suggests only minimal success, & a
temporary solution. Can’t “guarantee” discovery. Size issues e.g. R&D/commercial disconnect.
 Biotechnology and genomics pose both an opportunity and a potential threat – these areas may
provide better solutions to industry issues than the mega-merger solution.
 There is a multiplier effect as firms seek to retain/regain industry status.
 Although not necessarily the best solution, big consolidations in the pharmaceutical industry look set
to continue.

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ii) Introduction

Mergers in the pharmaceutical industry are not new, however, in recent years we have

seen increases in the level of pharmaceutical merger activity and more firms are using strategic

partnerships and joint ventures to develop and market new products. In this paper I will explore a

variety of social-political-economic issues in an effort to understand why pharmaceutical firms

are increasingly convinced that bigger is better. Specifically, I will seek to explain what factors

are driving the recent step-up in pharmaceutical merger activity.

During the course of the paper I will consider two recent mergers to see whether or not

they are likely to succeed. The mergers I will consider are Glaxo Wellcome’s merger with

SmithKline Beecham, and Pfizer’s hostile takeover of Warner-Lambert. I will assess the financial

implications of these mergers, and will also assess the driving forces behind recent mergers, the

existence of synergies, and whether value was created, destroyed, or simply transferred. My goal

with this analysis is to see whether big mergers really are the solution to some of the challenges

pharmaceutical companies currently face.

Finally, I will take a brief look ahead to try and understand how recent developments in

biotechnology and genetics are likely to impact the pharmaceutical industry, and whether merger

activity looks set to continue. In this paper I will explore the notion that a need for size is the

overwhelming reason for recent mergers and acquisitions in the pharmaceutical industry, but that

this may not necessarily be the best solution to the current financial and economic challenges.

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iii) Industry Structure

The pharmaceutical industry is a fascinating industry, filled with mergers, acquisitions,

strategic partnerships, join ventures, and licensing. The industry is highly regulated, extremely

complex, and filled with financial and economic challenges and points of interest. Finance

managers in the industry are faced with many issues including; managed care, insurance,

reimbursement, patents and generic competition, licensing, royalties, co-promotions, joint

ventures, co-marketing rights, high risk and high cost research and development, parallel import

issues, and international regulations. These issues will be explored in an effort to understand the

reasons for the industry’s current structure and how that structure is driving increased

consolidation through mergers and acquisitions.

The pharmaceutical industry is by most standards a mature industry. It is also highly

profitable (profit margins are about 16% versus 12% for the S&P 500) for those companies lucky

enough to develop blockbuster medical treatments which are patent protected for lengthy periods

to help companies recoup their research and development investments. Despite the fact that we

hear so much about the rising cost of drugs, sales in the industry have actually been growing at a

much slower rate in recent years. The 5-year sales growth rate for the industry is currently only

about 12% versus and S&P 500 growth rate of close to 17% (source for all financial data: Market

Guide.com). EPS growth rates have also been slowing and the current 5-year average is 16%

versus 20% for the S&P 500. When you combine this data with the current forces impacting the

industry and the fact that many companies are cash-rich the stage is clearly set for mergers.

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Although the industry is relatively mature, it is also an industry that is in a state of almost

constant change. In recent years, it has been faced with increasingly complex financial and

economic challenges including; intellectual property issues, patent expirations and generic

competition, managed care, insurance, and reimbursement issues, complex co-promotion, joint

venture, and licensing agreements, and an increasing array of research and development issues,

threats, and challenges.

The pharmaceutical industry has been under a great deal of scrutiny over the last few

years, and has become one of the top political targets. It is often claimed that prescription drugs

cost too much and that price’s are spiraling out of control – this is not true. While there is no

doubt that Americans are spending more on drugs, people often confuse more spending with

higher prices. Increased drug spending is almost entirely due to the fact that people are buying

more drugs. Ronald Bailey points out in an article written for Reason Magazine that “Between

1993 and 1999, overall inflation rose 19 percent while drug prices increased 18.1 percent… The

vast majority of the spending increase on drugs – some 78 percent – has occurred because

doctors and patients are taking advantage of more and better drugs that are now available.”

(Bailey, 2001).

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So why is the industry coming under so much pressure? Third-party payers are the main

culprits. As doctors prescribe more drugs to cure and ease the pain for their patients, health

insurers and managed-care providers have to spend more on drugs. Despite the fact that spending

on drugs does lower health care costs and increases the length and quality of patient’s lives,

insurers – from an actuarial perspective - actually prefer it when patients just die (or get cured)

because then they don’t have to pay for years of life-extending drugs. This is clearly a horrible

situation.

The structure of the pharmaceutical industry is often blamed for high prices. Patents

provide brand-name protection for new drugs, and allow pharmaceutical companies to achieve

average profit margins of 16 percent and up to 20 percent versus about 12 in most other

industries. The reason for patents and the need for high profit margins stem from the extremely

high and risky nature of pharmaceutical drug development. Between hundreds of molecules have

to be screened in order to make one successful drug and it can take as many as 15 years to bring

a drug through from discovery to launch. Many drugs developed never even make enough

money to cover their development costs, but pharmaceutical companies keep searching knowing

that eventually they will discover a blockbuster.

In 2000, legislation was passed allowing the re-importation of drugs manufactured in

America from Canada where drug prices are significantly lower mainly due to price controls.

The danger of this is that it will actually hurt Canadian’s as US pharmaceutical companies will

raise export prices to Canada in order to prevent profits being undercut in the US by re-

importation. Despite foreign price controls, many pharmaceutical companies do sell their

products abroad at a discount but the margins are low. This is a problem, for although they cover

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manufacturing and promotional costs, they do not generate enough profit from abroad to

adequately fund research and development. If the US follows the lead set by certain European

countries that regulate prices it could significantly hinder and most certainly slow the

development of new life-saving treatments.

Many European countries have government healthcare systems, hence the strict pricing

controls. In the US, the insurance companies rule and can have a big impact by deciding what

and how much gets covered. US controls are currently limited to “best price” for Medicare and

Medicaid, although there are a number of proposals currently under consideration such as

prescription drug coverage for seniors that would more than likely see an increase in government

control over prices.

Price Controls in Europe:

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The following table highlights some of the restrictions that apply in the some of the biggest

European markets:

France Germany Italy Spain UK

Cross Country Comparison

Internal Reference

Negative List

Positive List

Price Cuts

Price Freezes

Profit Control

Rebates

Reference Prices

Applied price control system

Source: Managed Care in Europe, 1995

In the next section, I will explore the impact that these factors are having on the

pharmaceutical industry – specifically I will discuss the fact that uncertainty is increasing the

level of merger activity. Size and growth are now a necessity in the pharmaceutical industry.

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iv) Reasons for Recent M&A Activity

Although consolidation in the pharmaceutical industry is nothing new, the recent

increases in merger activity reflect an increasing number of financial and strategic challenges

now facing the industry. These often-unique financial challenges have made size a desirable

objective. There are seven main reasons why the pharmaceutical industry has been consolidating

in recent years: 1) drug reimbursement issues, 2) political pressures and growing concerns over

drug prices, 3) patent expirations / generic competition, 4) sales growth issues, 5) R&D pipeline

gaps / synergies, and 6) the increasing use of direct-to-consumer (DTC) campaigns, and 7) recent

developments in biotechnology and the mapping of the human genome. The last reason will be

explored later in a separate section. There are also two other reasons that may help to explain

merger activity, namely agency affects and recently proposed changes to merger accounting

regulations. In this section I will explore these issues in more detail. Before doing so, it is

interesting to compare 1995 industry rankings based on revenue to the ranking list in 1999.

1995 Rank and Pharma Revenue 1999 Rank and Pharma Revenue
$ Billions $ Billions
1. Glaxo Wellcome $10.5 1. Pfizer $20.9
2. Merck $8.4 2. Glaxo SmithKline $20.7
3. BMS $7.8 3. Merck $14.2
4. HMR $7.5 4. AstraZeneca $13.5
5. J&J $7.1 5. BMS $12.1
6. AHP $7.0 6. Novartis $11.8
7. Pfizer $6.8 7. Aventis $11.4
8. Roche $6.8 8. J&J $11.1
9. SmithKline Beecham $6.0 9. AHP $9.3
10. Sandoz $5.0 10. Pharmacia $9.1
SOURCE: Evaluate Pharma – Database of
pharmaceutical company information

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The previous table highlights how mergers and different product blockbusters have

changed the pharmaceutical rankings in recent years – although the issues identified above are

the underlying drivers of growth through acquisition, the importance of status within the industry

as a driving force should not be ignored. It is also interesting to note the change in size of these

companies. In 1995, the number one company was Glaxo with revenue of $10.5 billion. In 1999,

Pfizer topped the list with double the revenue at $20.9 billion. Clearly, there is a drive for size.

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Throughout much of 2000, the pharmaceutical sector was filled with concern. During the

election there was a great deal of discussion about rising drug prices. Many thought the federal

government would pass new laws aimed at slashing prices. However, the arrival of a Republican

White House and an evenly split congress put an end to many of these fears. IMS Health (a firm

which tracks pharmaceutical sales and usage) now expects global sales to grow 8.8% to $385

billion in 2001 (Business Week, Jan 8, 2001). Despite these projections, there may still be

demands to pass a Medicare prescription-drug benefit. Currently, the government plan provides

reimbursement for pharmaceuticals taken in hospital but not for the large number of drugs

seniors now take at home on a regular basis. How this will affect the industry remains to be seen,

but undoubtedly bigger will be better in an era of price-cutting. One of the biggest threats to

pharmaceutical firms over the next few years will come from generic competitors. “SG Cowen

Securities predicts that between now and 2005 patents will expire on products with annual sales

of $34.6 billion” (Business Week, Jan 8, 2001). In 2001, drugs like Prozac, which generates

annual sales of $2.5 billion for Eli Lilly, will come off patent, as will AstraZeneca’s Prilosec with

sales of $6 billion. This is one of the main reasons that drug manufacturers are anxious to merge.

Companies in the industry have shown sustained periods of double-digit sales growth, and don’t

want this to stop.

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Firms are also merging in order to exploit cost savings and benefit from economies of

scale and scope in R&D. Research and drug development in the pharmaceutical industry is

extremely risk, expensive, and time consuming. Many companies also have significant gaps in

their development pipelines. This has profound implications for a pharmaceutical organization in

terms of future sales growth. Finance managers in pharmaceutical companies spend a lot of time

analyzing the corporations product portfolio and have to make tough decision to make sure that

the company has the right balance of risk and return, and early and late stage opportunities.

Companies need to invest carefully given the fact that development programs are so expensive

and time consuming. It also takes time to recruit and train scientists and it is extremely inefficient

if you have to keep hiring and firing because you do not have a balanced pipeline and workload.

Although there are economies of scale associated with R&D activity (primarily associated with

the development side in terms of trial capabilities and the use of contract research organizations)

executives are constantly trying to manage the use of size while at the same time providing an

entrepreneurial environment that will encourage drug discovery.

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Scale is also increasingly important now that direct to consumer advertising has been

made more accessible. Pharmaceutical companies are now able to use television advertising to

market their products directly to consumers. Many have argued that this is a bad idea, however,

pharmaceutical companies counter by arguing that increasing consumer awareness is a good

thing because more patients than ever are now recognizing symptoms and actively pursuing

treatments with their doctors. Another associated reason for size relates to the intense selling

infrastructures that many large pharmaceutical companies like Pfizer now have. Firms have to

grow in order to compete against these marketing powerhouses, which are increasingly locking

up distribution channels.

An additional reason that should also be mentioned as a reason for merger activity is

management greed. It is almost impossible to eliminate agency affects from a business, and as a

result managers will undoubtedly do what is in their own best interests. Clearly mergers can offer

significant benefits to management whether it be via increased job security, golden parachutes,

poison pills, stock awards, etc. This is not a new phenomenon however and does not explain the

recent flurry of merger activity.

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During the last year, there were also moves by the Financial Accounting Standards Board

(FASB) to eliminate the pooling method of accounting for merger transactions. Companies were

concerned that they would have to account for all transactions using the purchase method which

requires any premium over and above fair market value (known as Goodwill) to be amortized

over 30 years. More recently, FASB issued a limited exposure draft stating that although the

pooling method would still be eliminated, goodwill would not have to be amortized and would

simply remain on the balance sheet. The only time firms would have to expense any costs to the

income statement would be if the asset became impaired in any way. Although this recent move

appears to have eliminated many of the concerns regarding future mergers, concerns over

possible FASB rulings undoubtedly contributed to some of the increased merger activity in the

pharmaceutical industry.

In some ways it would appear to make sense for pharmaceutical companies to merge.

Investors have come to expect that pharmaceutical companies will always deliver double-digit

growth, but as patents begin to expire and generic competition increases this is becoming harder

to achieve. Recent combinations of giant firms like Pfizer and Warner-Lambert and Glaxo

Wellcome and SmithKline Beecham puts pressure on those remaining to do the same in order to

stay competitive. Pharmaceutical companies are merging for size in order to maintain growth.

v) Analysis of Two Recent Mega-Mergers

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In order to explore the issues identified in this paper further, and to see whether mergers

have actually helped corporations, two recent mega-mergers will be considered. The

merger between Glaxo Wellcome and SmithKline Beecham, and Pfizer’s hostile

takeover of Warner-Lambert following an initial announcement that Warner-Lambert

would be merging with American Home Products.

Glaxo Wellcome / SmithKline Beecham

The shares of SmithKline and Glaxo declined immediately after the deal was announced. The

combined corporation won approval from the FTC in December. In 2000, the company recorded

702 million pounds in one-time items related to the merger and restructuring costs as well as

gains from disposals. Key products include: Paxil, Wellbutrin, Augmentin, Seroxat/Paxil.

Avandia, a diabetes drug, recorded $702 million, and Seretide, an asthma drug, posted $316

million. Consumer healthcare division only grew 3% and will more than likely be divested in

order to create a more pure-play pharmaceutical company (GSK press release Feb 22, 2001).

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The following analysis seeks to explore the Glaxo Wellcome / SmithKline Beecham merger

from a theoretical perspective in order to try and understand the transfer of value that took place
The Bargaining Area and Synergism - USD Millions

Acquiring Firm Target Firm

Glaxo Wellcome SmithKline Beecham
EPS (fully diluted) $ 0.92 $ 1.67
Annual Dividend 0.55 0.18
Dividend Growth Rate 5% 5%
Book Value per Share 3.80 4.00
Average Market Price per Share (Wa) $ 53.00 $ 62.19
Number of Shares (Sa) 3,254 1,179
P/E Ratio 57.54 37.32
Total Earnings $ 2,997 $ 1,965
Total Stockholder Wealth (W x S) $ 172,440 $ 73,344

Pre-Acquisition Wealth Positions: $ 172,440 $ 73,344

Post-Acquistion Value of the Combination: $ 61.63

Wab = O (Ya + Yb) / [Sa + (ER) Sb]

Expected P/E Ratio after the combination (O) 58 Average of current ratios
Total first period earnings (before synergism) Ya + Yb $ 4,962 Assuming no change
No. of shares of the acquiring company (Sa) 3,254
No. of shares of the target company (Sb) 1,179
Tentative Exchange Ratio (ER) 1.2 Acquirer price/ target price

Post-Acquistion Wealth Position of the Shareholders:

Acquiring company shareholders:

Will support the merger, if they expect Wab > Wa Yes this is the case, therefore accept

Target company shareholders:

Wb (1 / ER) $ 53.00
If the post acquistion price is greater, they will accept Yes this is the case, therefore accept

Maximum Exchange Ratio Acceptable to the Acquiring Company

ERa = [O (Ya+Yb) - (P/Ea)(Ya)] / [(P/Ea)(Ya)(Sb/Sa)] 1.81

Minimum Exchange Ratio Acceptable to the Shareholders of the Target Company

ERb = [(P/Eb)(Yb/Sb)(Sa)] / [O(Ya+Yb) - (P/Eb)(Yb)] 0.95

Post Combination Synergism

Value of the Enterprise after the Combination $ 285,795
Less:
Value of the Enterprise before the Combination $ 245,784
Total Synergism $ 40,011

Less:
Share of Synergism to Stockholders of A: $ 28,071
Share of Synergism to Stockholders of B: $ 11,940

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in the merger based upon the per-merger negotiating area. The framework used was developed

by Larson and Gonedes and is a popular technique for assessing corporate mergers (Clark, 1996).

Their framework requires the following assumptions:

1) The objective of the combination is to maintain or enhance stockholder wealth.

2) The price / earnings ratio captures the risk-return characteristics of the merging firms.

3) No synergism from increased earnings or efficiency gains will occur in the first year.

I gathered data from SEC documents (10-Q filings) for the periods prior to the merger to

complete this analysis. What we see is that the model expects the post-acquisition value of the

combination to be about $61 per share. Because $61 is greater than the acquiring company’s

current value of $53 per share, the acquiring company shareholders (Glaxo Wellcome) will

accept the merger proposal. The target company shareholders (SmithKline) will accept the

merger proposal assuming that their post acquisition wealth position is also greater. The

calculation is shown above Wb (1 / exchange ratio) = $53. Because $61 (the post-acquisition

value) exceeds $53 the target shareholders will also accept.

From the analysis we can see that the bargaining area for the deal was 0.95 (the minimum

acceptable level for the target shareholders) and 1.81 (the maximum acceptable range for the

acquirer). Generally the shareholders of the target firm extract more relative value from the deal

than the shareholders of the acquiring firm. This was true for this merger - although the absolute

value was lower, relative to the pre-acquisition wealth position SmithKline Beecham

shareholders extracted a higher percentage of synergism (16% versus 7%).

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Although this analysis provides some insight into the merger, the real key to

understanding the success / failure of a deal comes from looking at the post-combination

announcements, and the real driving forces behind the deal.

In the first earnings report since the merger, Glaxo Wellcome and SmithKline Beecham

reported a 13% rise in 2000 pre-tax profit, boosted by a 10% increase in pharmaceutical sales

and double-digit growth in key therapeutic areas. Pharmaceutical sales were $23.4 billion,

contributing 85% of total sales. Perhaps more impressive was the fact that new product sales

represented $4 billion or 17% of pharmaceutical sales, and grew at 60%. It’s pre-tax profit after

one-time items rose to 5.33 billion pounds ($7.71 billion) one a pro-forma basis from 4.71 billion

pounds a year earlier. Total sales rose 12% to 18.08 billion pounds from 16.16 billion (WSJ, Feb

21, 2001).

The prospects for this merger are not fully clear. It seems likely to add some value to

shareholders but mostly through cost cutting as well as some pipeline synergies. However, the

strategic value is less clear. Dr. Jean-Pierre Garnier, CEO has high expectations for the newly

combined firm. In February the company unveiled it’s strategy for growth, claiming that 2002

EPS would accelerate dramatically, and that over a hundred new chemical entities (NME’s) were

currently in development, 117 of which are already in clinical studies. There are new plans to

increase R&D productivity, and planned cost savings of at least 1.6 billion pounds sterling were

confirmed. Dr. Tachi Yamada, Chairman R&D pointed out the complementary nature of the

R&D portfolios that the merger brought together. The plan is to take advantage of economies of

scale, while at the same time promoting an entrepreneurial environment – no easy task.

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The benefits of the merger and the performance of the business have led the company to

forecast EPS growth of 13%+, despite the fact that the combined corporation will dispose of

certain assets. Such divestments are commonplace in pharmaceutical mergers due to regulatory

and FTC issues as well as the obvious overlaps that occur with such mergers.

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Pfizer / Warner Lambert

Pfizer purchased Warner-Lambert for $70 billion in June of 2000. Unlike the merger

between Glaxo Wellcome and SmithKline Beecham, this was a hostile takeover.

Warner-Lambert had announced a friendly merger with American Home Products,

however shareholders seemed wary of the motives for this merger as the press reported

that the merger was less about real value and more about retiring executives trying to

make a name for themselves.

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Despite some initial publicity issues, Pfizer’s takeover has been very well received. Most

industry analysts and many people within the pharmaceutical industry expect this to be

one of the few mergers that will really work. The merger represents a superb strategic

fit, and provides Pfizer’s incredible sales and marketing infrastructure with a great R&D

pipeline. Analysts currently project earnings growth of about 24% for the quarter, as the

company continues to squeeze out better than expected cost savings from the merger.

The company currently has strong prescription growth on products such as Lipitor,

Neurontin, and Viagra. One of the biggest drivers of the Pfizer merger with Warner-

Lambert was Lipitor, Warner-Lambert’s blockbuster cholesterol-lowering drug. Alone,

Pfizer booked nearly half the revenues as a result of a co-marketing arrangement. The

drug is set to be the world’s best-selling medicine, surpassing Merck’s Zocor and

AstraZeneca’s Prilosec. With the deal complete Pfizer sales of Lipitor would exceed $7

billion by 2002 according to a large number of analysts. Pfizer appears to be serious

about cutting jobs and costs as part of the consolidation and the fact that this is a hostile

takeover makes it all the more probable. Warner-Lambert’s New Jersey headquarters

will be combine into Pfizer’s in New York. Current estimates project 10% workforce

reductions. Pfizer hopes to save $1.6 billion in operating costs in as little as 18 months

(corp. PR, 2000/01). Pfizer told analyst’s that overall savings will be $2.5 billion within

3 years. Many actually believe that Pfizer is being conservative. There are a number of

reasons why these companies can save so much. Pfizer makes Norvasc, a pill for high

blood pressure that’s expected to generate $3.5 billion in revenues this year, and

Warner-Lambert makes Accupril, a $600 million blood-pressure drug with a different

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mechanism of action. After the merger, a slightly larger Pfizer sales force can sell the

two drugs at once, since doctors may prescribe both to patients with hypertension.

Integration on the research side will also work well as any overlaps are minimal. The

combined firm will have a presence in almost double the number of disease categories.

Pfizer has long been known as a sales and marketing powerhouse so the fact that it will

now have Warner-Lambert’s R&D will improve Pfizer’s performance as it currently

sells a lot of other company’s drugs. There are other strategic reasons for the merger for

example the combined firm will have more than 10% of sales in the domestic

prescription-drug market. The Pfizer / Warner-Lambert merger is truly a strategic

merger. Pfizer’s large market share will give it more influence over contracts with

wholesale drug buyers - just the influence a drug company needs in an increasingly

hostile environment.

iv) Do Drug Mergers Really Work?

With regards to the mergers analyzed in this paper. The newly formed GlaxoSmithKline

is likely to achieve some success through pipeline synergies and cost savings, but whether or not

this merger will truly add value for shareholders remains to be seen. Given the industry

challenges ahead, size alone should add at least some value. Pfizer’s acquisition of Warner-

Lambert seems highly likely to succeed due to strategic fit, operating efficiencies, & pipeline

synergies. All of the issues discussed in this paper as reasons to merge are addressed by this

merger. Pfizer now has Warner-Lambert’s pipeline and will be a tough competitor to beat

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In general, the evidence as to whether a merger adds value or not has been, at best,

mixed. Merger premiums are typically in excess of 40% according to data from the Merrill

Lynch Mergerstat Review, and it takes a lot of strategic benefit to recoup these premiums (Clark,

1996).

If mergers were to succeed anywhere it would seem that the pharmaceutical industry

offers the greatest chances for success. Operating economies, including the elimination of

overlap in R&D, production and marketing, can produce meaningful cost savings, however a

number studies have shown that merged firms have not performed better over the long-term than

drug makers opting to go it alone such as Merck. Many combined firms have also lost market

share in key therapeutic categories. The shares of SmithKline and Glaxo declined immediately

after their deals was announced. SmithKline and Glaxo investors were apparently disappointed

by less than expected projected cost savings, questions over revenue growth and likely initial

dilution of EPS.

Although size may be good up to a certain point, some of these mergers may be going too

far. The main advantages of size for pharmaceutical companies include:

– Clinical trial economies of scale

– Enhanced and more utilized sales rep. coverage

– Additional regulatory and filing power with the FDA

– Increased lobbying power (both political and with wholesalers)

– Balanced risk in terms of the company’s pipeline and product portfolio

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However, many of these benefits are only temporary, particularly given the current rate of

consolidation within the industry. Furthermore, there are potential significant disadvantages

associated with being too big. These include:

– Diseconomies of scale and control issues

– A lack of focus

– The potential for disconnects between R&D and commercial (leading to investment

in sub-optimal projects from a commercial perspective)

– The loss of an entrepreneurial environment that encourages and rewards discovery

Finally, and perhaps most importantly, these mergers may not deal with some of the most

important emerging areas in pharmaceutical development, namely biotechnology and genomics.

Although, many of these mega-mergers do seek to address the industry issues outlined earlier,

merging may not be the best long run solution. Biotechnology and genomics, which will be

discussed in the next section look set to be the future of drug development, and investments and

development in these areas, would probably be a better solution. In spite of these factors and the

mixed success of mergers, pharmaceutical firms continue to merge in an effort to provide some

level of security in an increasingly uncertain industry.

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vii) Possible Future Mergers

The following chart depicts the current state of the pharmaceutical industry, but more

importantly it highlights a series of possible future mergers:

WW Rx Rev. Rx Share Market Cap

1999 1999 12/00 Act.
$ Billions $ Billions $ Billions

• Pfizer 21 7.1 290

Giant
• GSK 21 7.0 178

• Merck 14 14 218
Large
• AstraZeneca 13 13 59
• BMS 12 12 146
• Novartis 12 12 116
• Aventis 11 11 68
• J&J 11 11 146

• AHP 9 3.1 83
Midsize 79
• Pharmacia 9 3.1
• Roche 9 3.0 71
• Lilly 9 3.0 102
• Abbott 8 2.6 75
• Scher-Plough 7 2.5 84
• Bayer 6 2.0 38

SOURCE: SEC 10-K’s / Annual reports.

As you can see from the chart above, Pfizer and GlaxoSmithKline are now clearly the

largest pharmaceutical companies in the world, with revenues of over $21 billion. Behind

these giants, we can see a group of about six large companies, many of which were

former giants prior to recent mergers followed by a midsize group of firms all of which

are likely to be acquisition targets as the large firms seek to regain their super-size status.

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viii) Implications of Biotechnology & Genetic Mapping

Almost all the big pharmaceutical companies have strategic / financial partnerships with

biotechnology companies. In the past these partnerships have been a good fit. Biotechnology

firms frequently lacked the cash to fully develop their products independently, and even if they

had cash for R&D they lacked the resources to compete with the big pharmaceutical companies’

sales and marketing efforts. On the flip side, pharmaceutical companies are continuously looking

to fill gaps in their product pipelines and leverage their existing sales force structures.

Partnerships with biotechnology firms are very attractive to pharmaceutical firms.

Increasingly, however, biotechnology firms are making it on their own. Capital has been much

more accessible in recent years, and some firms such as Amgen, Biogen, and Genentech have

been able to fulfill the dream and go from biotech start-up to fully-fledged biopharmaceutical

firm.

Pharmaceutical firms are finding significant problems associated with licensing

agreements, co-marketing arrangements, joint ventures and other strategic partnerships. Although

such arrangements reduce costs as firms share the burden of development, they also limit

revenue if and when the drug becomes successful. As a result, a number of pharmaceutical firms

have launched their own biotech efforts, or are buying or attempting to buy out the biotech

partners. However, it is not just partnership issues that are driving pharmaceutical interest in

biotechnology. There are significant benefits associated with biotechnology related drug

development. In general, biotechnology products can be brought to market quicker due to higher

specificity versus their small molecule counter-parts. In addition, biotech products frequently less

immuno-genecic effects due to the fact that they are derived from human cell-lines.

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On the surface, it would appear that no force is changing the pharmaceutical landscape

more than biotechnology and the mega-mergers discussed earlier, except perhaps genomics.

Pharmaceutical firms are desperately trying to understand the implications of a scientific

revolution known as genomics, which has the potential to change a company’s entire business

model. The term genomics refers to the effort to exploit the all the scientific information now

available in gene databases around the world. Although most big pharmaceutical company have

some genomics expertise, some companies like GlaxoSmithKline are now trying to make it

central to their discovery and development efforts. Others are developing external partnerships

with new companies like Millennium Pharmaceuticals and the Celera Genomics Group. The

opportunities in the area of genomics are immense. Scientists have huge opportunities to find

new ways to attack disease. Merck & Co. has already used genomics to identify a gene linked to

common form blindness. BMS has a number of compounds derived via genomic research to treat

cardiovascular ailments and rheumatoid arthritis, and SmithKline Beecham as uncovered new

targets to help treat osteoporosis (Business Week, Jan 8, 2001).

How does genomics fit with big pharma? Drug makers have massive libraries of

compounds. Matching their database of compounds with the genomic database of disease targets

should dramatically improve the speed and efficiency of drug development – so don’t be

surprised to see a significant increase in partnerships and merger activity between drug makers

and genome specialists. In fact, this is in my opinion a better solution to the current industry

pressures than the more traditional pharmaceutical mergers that we have seen of late.

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ix) Conclusions

In spite of mixed evidence, pharmaceutical firms continue to merge in the hope that size

will help them to deal with uncertainty and ever increasing industry pressure. Size and growth

are being used to defend against increasing industry pressures including reimbursement issues,

political pressure, patent expirations, growth issues, R&D pipeline gaps, and advertising

economies of scale.

It is not clear that merging is the answer. With regards to the mergers analyzed in this

paper, GlaxoSmithKline looks likely to achieve some success through pipeline synergies and

cost savings, but the strategic benefits are less certain and the announcement was not well

received by the market. Pfizer’s acquisition of Warner-Lambert is more likely to succeed given

the fact that it was a hostile takeover, and that there was a good strategic fit. However, Pfizer had

to pay a significant premium in order to make the merger happen due to the planned friendly

merger between AHP and Warner-Lambert.

In general, evidence to date suggests only minimal success and given the current rate of

consolidation any benefits gained through increased size are only likely to be temporary.

Operating economies, including the elimination of overlap in R&D, production and marketing,

can produce meaningful cost savings, however a number studies have shown that merged firms

have not performed better over the long-term than drug makers opting to go it alone such as

Merck. Many combined firms have also lost market share in key therapeutic categories.

Further, you cannot guarantee drug discovery, and there are size issues associated with

big mergers. These include diseconomies of scale and control issues, a lack of focus, the

potential for disconnects between R&D and commercial (leading to investment in sub-optimal

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projects from a commercial perspective), and the loss of an entrepreneurial environment that

encourages and rewards discovery.

Finally, and perhaps most importantly, these mergers may not deal with some of the most

important emerging areas in pharmaceutical development, namely biotechnology and genomics.

These areas are improving target identification and will ultimately help to reduce costs. They

have the potential to revolutionize the drug discovery process, if drug companies can match their

databases of compounds with the genomic database of disease targets we should see some

dramatic improvements in the speed and efficiency of drug development. Biotechnology and

genomics would appear to offer potential better ways to deal with current industry pressures than

simply merging traditional companies in order to gain some synergies and perhaps some

additional lobbying power. They offer the potential to redefine the industry, to actually deal with

some of the pricing issues, sales growth, patent, and pipeline issues without consolidating

already large companies which simply makes your base for growth even bigger. Even with the

mounting financial evidence and growing number of arguments against these mega-mergers the

current industry trend looks set to continue. Although not necessarily the best solution, big

consolidations in the pharmaceutical industry look set to continue.

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x) Bibliography

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