Addicted To Mergers?
The pharmaceutical industry is hot. The cholesterol-lowering drug Lipitor, the new arthritis drug Celebrex, and of course Viagra, have generated the kind of buzz you'd expect to see on opening night of a Hollywood blockbuster. They've been a powerful tonic for corporate health--fueling revenue and earnings growth for many drugmakers. And the best is yet to come: New technologies are helping scientists unravel the mystery of the human genome, making possible impressive new drug innovations in coming years.
But if things are so rosy, what explains the drug industry's frantic urge to merge? Pfizer Inc. and Warner-Lambert Co. are now locked in a pitched battle in the wake of Pfizer's hostile bid for Warner. It's a warning sign of the growing pressures for the drug industry in the years ahead. The most obvious is the imminent expiration of patents on an unprecedented number of big drugs. When a patent on a drug expires, the drug's maker can lose as much as 80% of sales to generic knockoffs. The best way to combat that problem, of course, is to replace those drugs with new products. But while the industry is devoting big research-and-development dollars to pricey new genomics technologies, that is unlikely to yield a big payoff for years. At the same time, intense competition is sending marketing costs skyward. The result is that many pharmaceutical companies are going to feel a squeeze--at a time when Wall Street still expects big sales and earnings growth. Most companies, says Pharmacia & Upjohn Chief Executive Officer Fred Hassan, "are looking at a very difficult period."
The solution for many drugmakers will be to make a deal. Among the companies being watched closely are Glaxo Wellcome PLC and SmithKline Beecham PLC, which tried to consummate a merger last year. That deal collapsed largely because of clashes over which side would dominate the new company. According to one source close to Smith-Kline, CEO Jan Leschly will soon announce that he will retire in the first half of 2000, months earlier than expected. That move could pave the way for renewed deal discussions with Glaxo or another party. (A SmithKline spokesman notes that Leschly's contract does not expire until September, 2000, and declined to comment on whether he might retire early.) And as a number of drug industry chiefs, such as 66-year-old Bristol-Myers Squibb Chairman Charles A. Heimbold Jr., face retirement, they may view a major deal as a way to cement their legacy.
If recent history is any indicator, however, big mergers aren't necessarily a cure-all. While the deals yield cost savings for the first few years, they often don't deliver what they promise. The last round of mergers failed to produce the long-term rewards many investors expected. And while big budgets do allow companies to conduct cutting-edge research, there is little evidence that massive research spending leads to a better record in developing hot new drugs. "There is always a danger that size works against you," says Anthony H. Wild, president of Warner-Lambert's pharmaceutical operations. "After all, why is it that all of us go license products from small biotechnology companies?"
Small biotech companies will be getting more phone calls from big drugmakers as the massive wave of patent expirations continues. According to Lehman Brothers Inc., between 1999 and 2005, U.S. patents will expire on 178 drugs worth nearly $60 billion. That's likely to trigger a flood of cheaper generic versions. Among the companies with the biggest potential generic headaches are Merck & Co., which will lose U.S. patent protection on products such as the $2.3 billion antihypertension drug Vasotec, and Bristol-Myers Squibb, which is likely to face knockoffs of its $1.3 billion diabetes treatment Glucophage.
PRICE PRESSURE. Market challenges are building as well. Drugmakers have been able to hike prices at an annual rate of more than 4% this year, but Jay A. Istvan, a vice-president at Boston Consulting Group, expects pressure from managed care and debate about prescription drug costs in Washington to keep future price increases at more modest levels. At the same time, since companies have been able to shorten the time for developing a drug, breakthrough products encounter competition sooner than ever. While novel therapies used to enjoy years on the market before competitors arrived, the new $1.4 billion arthritis medicine Celebrex from Monsanto Co. faced a similar product from Merck within five months. "That compresses the profitability of the drug," says AstraZeneca CEO Tom McKillop.
EXECUTIVE ANGST. That sort of competitive heat, along with the patent headache, is creating real angst in the executive suite. The top 20 drug companies will have to launch more than three novel therapies annually for the next five years to meet Wall Street's low-teens earnings growth expectations, according to Boston Consulting Group's Istvan. He figures the drugmakers are on track to crank out the equivalent of only 1.6 new compounds each year.
One key reason for the shortfall is that drug companies are focused on complex diseases like Alzheimer's and diabetes. They involve a myriad of interconnected mechanisms in the body, and many aspects of the diseases are still poorly understood. Finding one molecule to correct them is going to be extremely tough, and the human trials to test such a molecule could take years.
Compare that process to developing an antibiotic, for example. Many infections both develop and can be stopped quickly, so results on antibiotics can be collected in a relatively short time. Genomics, which enables researchers to pinpoint the genes involved in a disease, has the potential to improve research productivity, but industry professionals figure a meaningful payoff is years away. "I don't think you'll see a big impact in less than five years," says Jurg Reinhardt, head of global development for Novartis' pharmaceutical operation.
That reality is one reason for Pfizer's aggressive move against Warner-Lambert. While Pfizer has enjoyed robust sales and earnings growth the past few years, the company's new-product lineup isn't particularly strong, partly because of setbacks in development, including a poor showing by Alond, a drug to treat certain diabetes complications. But acquiring Warner would give Pfizer Lipitor, which many analysts expect to become the largest-selling prescription drug in the world within the next decade.
Nabbing Warner would bring other benefits as well. After all, if the drug pipeline isn't flush, a splashy merger can always turbocharge earnings for a few years. Consider the merger of Ciba-Geigy Ltd. and Sandoz Ltd. in 1996 that formed Novartis. By the end of 1998, the company had been able to cut $1.2 billion out of its cost structure, in large part through savings in administration and overhead. So while 1998 sales were up just 2%, net income climbed 16%, to $4.2 billion. Although few pharmaceutical chief executives admit that near-term cost savings are a big motivation to dealmaking, Dr. Joseph Zammit-Lucia, president of Cambridge Pharma Consultancy, insists: "Those savings have largely driven deals to date."
The big question is whether those newly merged companies get more than a few years of cost savings out of the deal. Here the track record isn't so great. Barrie G. James, president of Basel-based Pharma Strategy Consulting, has studied the market share of companies that were formed in deals vs. those that remained solo. He found that nearly all merged companies had less market share in the years after the deal than the two companies had enjoyed prior to the transaction (chart, page 85). James figures, for example, that independents Pfizer and Eli Lilly & Co. increased their market shares 81% and 28%, respectively, between 1990 and 1998. In contrast, his research shows that the market share of Glaxo Wellcome in 1998 declined 15% from the combined market shares of Glaxo PLC and Wellcome PLC in 1994, the year before their merger.
A key reason for that underperformance may be that drug company mergers are often driven by desperation. When SmithKline Beckman Corp. struck a deal to merge with Beecham Group in 1989, SmithKline's near-term drug pipeline was weak, and earnings were slipping as big products, such as the anti-ulcer drug Tagamet, lost market share. And Glaxo's move to buy Wellcome in 1995 came as the company was seeing a slide in sales of its own blockbuster ulcer drug Zantac--with even more pressure looming when the Zantac patent expired in 1997. "Historically, these deals were done by companies that were suffering," says J.P. Morgan Securities Inc. analyst Carl Seiden.
R&D DISRUPTION. Another obstacle to making these megadeals pay off is the difficulty of putting two large research organizations together. At Novartis, for example, the company was able to cut nearly 10% of its research and development costs by eliminating overlapping functions such as testing whether drug candidates were too toxic. Further savings came from paring the number of drug development projects from 75 to 53 now. While those savings were pumped back into R&D in part to finance emerging technologies, it is hard to avoid at least a short-term disruption in research productivity.
In the long term, pharmaceutical CEOs are betting that bigger will be better when it comes to drug discovery. But proof is hard to come by. Boston Consulting Group's Istvan says his firm looked at 40 large and small pharmaceutical and biotechnology operations between 1992 and 1997, studying a slew of measures, including new drug candidates per scientist or per dollar spent. It found that, on average, the big companies were no more productive than the smaller operations. That's one reason large drug companies are devoting larger chunks of their R&D budgets to outside collaborations with companies that provide new technology and possible new drug leads (sidebar, page 90).
Going forward, however, the benefits of size could become more important. Understanding the genetic differences between people, for example, will ultimately lead to medicines that are custom-designed for individual people. Already, Herceptin, the breast cancer drug from Genentech Inc., works by blocking the protein produced by a gene found in about 30% of breast cancer patients. Warner-Lambert's Wild says that while companies used to develop one blockbuster drug for a specific disease, in the future they could develop a series of smaller products for one ailment, each designed for people with a different genetic makeup. Here, he figures, size and efficiency in testing and rolling out many new products will be critical.
But there's no doubt sheer muscle matters in marketing. Drugmakers have been on a hiring binge in that department for the past several years, with the top 40 drug companies almost doubling their U.S. salesforces from 36,500 in 1995 to more than 62,000 currently, according to market research firm Scott-Levin. "Does bigger make you better?" asks Istvan. "In sales and marketing it does."
Take the case of Lipitor, the $3.7 billion cholesterol-lowering drug at the heart of the battle for Warner-Lambert. The company launched that drug in 1997, when Merck dominated the market with its cholesterol product Zocor. Lipitor had an edge in being more potent, but most patients did well on Zocor. Analysts weren't expecting Merck to take a major hit; however, what they didn't count on was the massive sales offensive mounted by Warner and its marketing partner Pfizer. In 1998, for example, representatives from those two companies paid an estimated 81,000 visits per month to U.S. doctors to sell Lipitor, according to market researcher IMS Health Inc. Marketing Zocor on its own, Merck was able to make only about 57,000 monthly calls. The outcome is that Lipitor now holds the top market share in the lucrative U.S. cholesterol-lowering market.
For companies like Merck, the cost of fighting that sort of marketing war is mounting every day. Throw in patent expirations and rising drug development costs, and it's obvious why drug company executives have their own Y2K problem. A hasty marriage of two troubled players, however, may only make the patient sicker.
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