Glaxo Smithkline: Powerful Medicine

Glaxo rocks the drug industry, but could this deal be too big?

It was a global drug reaction. The news that Glaxo Wellcome PLC and SmithKline Beecham PLC were in merger talks has sent shock waves through the pharmaceutical industry. It's not just the prospect of a new giant in the market--a global behemoth that would have combined revenues of about $19 billion a year. The more frightening prospect is that the combination of the No.1 and No.10 drugmakers would produce a competitor that can pump more than $3 billion a year into developing new drugs--three times what Novartis, the closest rival in research spending, is shelling out.

While it is far from certain that the talks, which began in late January, will result in a deal, they reflect a tremendous shift in the global drug business. The advent of technologies such as genomic sequencing and advances in the development and testing of new chemical compounds are giving companies countless leads for new drugs. But capitalizing on those leads requires massive spending. At the same time, sales and marketing expenses are ratcheting upward as companies battle for share.

BUREAUCRATIC BLOB? The bottom line: Companies with bigger research and development budgets and more marketing muscle stand to dominate today. "Anyone who is going to remain competitive is going to need an enormous amount of resources," says Alan M. Sebulsky, an executive vice-president at Lincoln Capital Management. "It puts a lot of pressure on other companies to consider consolidation."

Despite the imposing research and marketing power of a merged Glaxo and SmithKline, there are questions about how a drugmaker of such proportions would function. Making this deal work will require exceptional management--to keep up with the pace of the industry and ensure that the company doesn't become a bureaucratic blob. Just to achieve respectable growth, the new company will need to produce a slew of hot new products. "It takes a huge quantity of meat to feed the beast," says Samuel Isaly, a partner at pharmaceutical research firm OrbiMed Advisors. "And this would be one enormous beast."

So could this be too big a deal? A recent study by consulting firm A.T. Kearney Inc. tracked the economic return--the cash generated by a company, adjusted for the cost of capital--of drugmakers such as American Home Products, Bristol-Myers Squibb, and Glaxo, all of which have done major deals in the past decade. Kearney found that the economic return for most drug companies declined in the first few years following a merger or acquisition.

Kearney's findings are hardly unique. A study by Barrie G. James, a consultant at Basel-based Pharma Strategy Consulting, showed that virtually every drug company formed by a merger in the past 30 years ended up with less market share than the two companies had before the deal. The biggest reasons: Culture clashes can undermine productivity, as in the case of Pharmacia & Upjohn Inc. And management may become so preoccupied with integrating the deal that they lose focus on the core business. "Two plus two doesn't always equal four or five," warns Barrie. "Sometimes it equals three."

RESEARCH PAYOFF. Clearly, Sir Richard Sykes, chairman of Glaxo, and SmithKline chairman Jan Leschly believe that a combination of their companies would be an example of the former. In a joint statement disclosing their merger talks, the executives described the possible deal as a "compelling strategic opportunity." For one thing, cost savings from combining the companies could be substantial. Salomon Smith Barney analyst Kevin Wilson figures axing up to 15,000 positions and consolidating operations could save nearly $2 billion over three years.

The biggest potential payoff, however, stems from the complementary research skills of the two companies. Glaxo has invested heavily in technology to automate the chemistry of developing drugs, including its $500 million acquisition of Affymax. That enables it to design and test massive numbers of compounds as potential drugs.

SmithKline, on the other hand, is a leader in genomics. Through well over 100 biotech alliances, including its $125 million investment in Human Genome Sciences Inc., the company has amassed massive data on the roles of genetics in disease, giving the company many more ways to try to develop new drugs. But that means SmithKline has more drug-development opportunities than it can handle alone. As Leschly himself acknowledged in January at a San Francisco conference: "It's very difficult to analyze what we should invest in and who we should work with" without the resources to explore every promising drug prospect.

Most drug deals haven't produced the synergy Glaxo and SmithKline are hoping for, however. The most successful, such as American Home Products Corp.'s acquisition of American Cyanamid Co., have been cost-cutting plays. "I don't recollect any deals that have been done predominantly to gain more R&D clout," says Cowen & Co. analyst Stephen M. Scala.

WEAKER PIPELINE. The discussions between Sykes and Leschly are forcing companies across the pharmaceutical industry to reassess their positions. "It does change things for competitors," Monsanto Chairman Robert Shapiro said at a conference in Davos, Switzerland, on Feb. 3. Cowen's Scala figures that midsize companies such as Schering-Plough, Warner-Lambert, and Zeneca may end up seeking partners. And industry watchers don't rule out a bid for SmithKline by another suitor. One frequently mentioned possibility: F. Hoffman-La Roche Ltd.

The Glaxo move puts particular pressure on Merck & Co. With a number of patents expiring after the turn of the century, Merck Chairman and CEO Raymond V. Gilmartin will need to deliver a steady stream of hot new products. Independent pharmaceutical analyst Jack Lamberton doesn't think that Merck's pipeline is strong enough to completely offset lost sales from those drugs. He expects the company's sales growth to dip in the next several years. That prospect, analysts believe, could force Merck to consider its merger options--though Gilmartin says he has no intention of doing a major deal.

Even if companies such as Merck sidestep the big deals, they will nonetheless be looking for ways to expand their pipelines. So they'll be striking more partnerships with biotech players and stepping up efforts to license drugs from other pharmaceutical companies. With new technologies accelerating drug discovery, pharmaceutical companies need to churn out more hits than ever to keep up with rivals. It's hardly the sole determinant of success, but sheer scale is becoming more important than ever.

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