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Pharma Mergers Make Sense

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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A wave of big mergers in the pharmaceutical industry is turning into a tsunami, with more than $100 billion in deals either announced or rumored this week. Oddly, this may be one of the rare cases where merger frenzy actually makes sense.

It all startedwith three big deals back in 2009: Pfizer acquired Wyeth, Merck bought Schering-Plough and Roche merged with Genentech. Now, activist investor William Ackman and Montreal-based Valeant Pharmaceuticals are bidding for Botox maker Allergan, worth about $40 billion. Novartis, GlaxoSmithKline and Eli Lilly have launched a complicated series of deals for a total of $25 billion. Novartis is trading its vaccine division for GSK's cancer drug business. Eli Lilly is acquiring Novartis's animal-health business. GSK and Novartis are also setting up a joint venture to produce and sell over-the-counter drugs, creating a global leader in that segment with brands like Excedrin and Panadol.

Then there are Pfizer's so-far-abortive efforts to buy the Anglo-Swedish AstraZeneca for about $100 billion. Some industry analysts believe Pfizer will make another approach, so Astra's share price has jumped as if the deal were already happening.

The feeding frenzy has two primary drivers: The "patent cliff," or the expiration oflucrative drug patents such as Pfizer's Lipitor, and Big Pharma's relative cash wealth and low debt levels. The median debt-to-capital ratio for the world's 20 biggest pharma companies is 22.7 percent, compared to about 37 percent for the S&P 500. The industry leaders are swimming in cash: Pfizer has accumulated $70 billion in its foreign subsidiaries, which it is better off spending overseas than repatriating to the U.S.

One aim of the mergers is to prepare for leaner years. Producing new hits is harder because of increased regulatory scrutiny. It's also costlier: The average cost of developing and launching a new drug has been estimatedat $5 billion in 2013, comparedwith $1.1 billion in the late 1990s. At the same time, expiring patents are driving the industry's revenue down. In 2013, combined sales reached $582 billion, compared with the 2011 peak of $610 billion. Consolidation is a way to cut costs and maintain profits.

Although huge deals are often a reflection of executives' Napoleonic ambitions, in the pharma industry they actually work. In a recent report, the management consulting firm McKinsey & Co. found that of the 11 pharma companies that have remained in the global Top-20 since 1995, seven have made acquisitions worth more than $10 billion each. "Median excess returns for megamergers in our sample were positive, showing returns 5 percent above the industry index two years after a deal's announcement," McKinsey wrote after analyzing 17 large deals that occurred in the industry between 1995 and 2011. "This is in contrast to large deals in other industries, which have had marginal returns relative to industry indexes, or, in the case of deals in the technology sector, sharply negative returns."

Big Pharma companies have demonstrated that, despite the inevitable disruption caused by the mergers, they end up better off. Given that history, the industry will keep consolidating to survive in a world where old cash cows are dying off, new breakthrough drugs are few and far between and time to market is longer and longer.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net