Envisage

The Calm Before the Storm

by Mark W. Anderson

January 2008

Speaking to analysts earlier this year after his company had just announced strong earnings for the first half of 2007, Franz Humer, chief executive of Roche Holdings AG, made an interesting announcement. Referring to the 15.6 billion Swiss francs (US$13 billion) in net cash the company had available, he said the Swiss drug giant would continue to hold the cash pile in reserve instead of buying back shares or offering a one-time dividend. The reason? Potential mergers and acquisitions (M&A). “It is important for us to be able to make acquisitions when we decide [to do so],” he said at a post-results meeting in London. “To have the flexibility to be able to react quickly when the opportunities arise is something important.”

Humer was speaking, of course, of the need for pharmaceutical and biotechnology companies to move quickly in an era of continued industry consolidation that shows little sign of slowing down. In fact, M&A activity in the pharmaceutical sector is on the upswing: in the last three months of 2006, seven M&A deals in the biotech sector occurred for a total value of approximately US$12 billion. More than US$55.7 billion in M&A activity took place in the total pharmaceutical sector in 2006, down from a high of US$200 billion in 2000 but up from the 2005 total of US$42.7 billion, and 2007 is expected to close at a similar pace to last year.

Roche hasn’t picked up a company since its 2005 acquisition of glycosylation technology developer GlycArt. Its rivals, however, are more active. Since 2003, for example, Pfizer has purchased five biotechnology companies. In the same period, AstraZeneca and Johnson & Johnson had four buyouts apiece. All told, there were more than US$481 billion worth of transactions in the pharmaceutical sector since 2002, according to health care business intelligence provider Windhover Information.

Ever since the early 1980s, consolidation has been a fact of life in the industry. In fact, the top five drug companies today all were created as the result of mergers. So, is the industry primed for another round of consolidation?

The Diseconomies of Scale

Many of the forces driving today’s activity are familiar: the spiraling cost of drug development, the need to fill poor performing pipelines and an industry flush with cash. But there also are new challenges and opportunities. Big profits create their own set of problems. A lot of companies are looking at their assets and realizing they must put them to work to satisfy investor calls for increased shareholder value. “Pharma is like any other industry: as you get bigger and larger, it takes a whole lot more to make growth happen,” says Mark A. DeWyngaert, Ph.D., managing director of the health care practice at Huron Consulting Group, in New York, N.Y., USA. “If you’re a US$10 billion company, to get 10 percent growth, you’ve got to come up with US$1 billion in sales. That’s not easy to do once or year after year.” So, buying another company puts those new resources and products to work in a way that stock buybacks or increased dividends can’t.

For some companies, size is a problem. “What has changed in recent years is a recognition that, on the research and development (R&D) side, there simply do not seem to be big economies of scale” available to larger companies that merge, says Patricia Danzon, Ph.D., professor of health care systems, insurance and risk management at the Wharton School, University of Pennsylvania, in Philadelphia, Pa., USA. “The optimal size of a firm for [economies of scale] in administration or marketing may be a huge multinational [corporation], whereas the optimal scale for doing research may be a very small company.” That means big companies have to act like little ones, she says, at least when it comes to drug discovery.

At a time when the industry is facing a wave of patent expiries, poor performing in-house R&D may appear to be a liability. The proof is in the pudding: Since 1995, total annual spending on R&D has more than doubled, to US$31 billion, while the number of new molecular entities approved by the FDA has fallen from 53 in 1996 to 18 in 2006. For that reason, mergers and acquisitions can look attractive to larger firms seeking to capture the R&D advantages of fast, nimble and entrepreneurial start-ups.

The Biotech Boom

The problems facing huge companies come at a good time for biotechnology firms, especially those looking to sell. Initial public offerings of biotech companies have fallen out of favor with investors in the past few years, which means being acquired has turned into a viable exit strategy for smaller and mid-sized firms. Windhoven Information reports the top 15 pharmaceutical companies worldwide have purchased 33 biotechnology companies worth more than US$162 billion since 2003.

“Many of the larger pharmaceutical companies would like to have a higher percentage of their revenues and their science coming from biotechnology,” says Robert Esposito, partner and national sector leader for KPMG’s transaction services, pharmaceutical practice based in Princeton, N.J., USA. “In many cases, they’re buying into biotechnology companies that have a very healthy pipeline including existing product, late-stage Phase II and III potential drugs, and potentially lucrative early stage R&D programs in development. That’s very much been the predominance over the past two years.”

For the acquiring company, there are advantages to such a model. First, the cost of bringing a drug to market—estimated by some as between US$800 million and US$1 billion—can be reduced, making the asking price for a biotech or other developing start-up seem minimized. Also, by waiting for a smaller company to bring innovation to the point in clinical development where the risk is substantially reduced, there is the potential for developing a higher ratio of drugs brought to market by the acquiring company. Plus, if the development of new molecular candidates is accelerated, there is more upside in terms of the patent life, enabling longer periods to successfully market the drug. “Pharmaceutical companies are taking a hard look at the numbers and comparing the cost of having a lot of late failures and the cost of something that may be likely to succeed,” DeWyngaert says. “While there’s always been investment between big pharma and biotech, in the past it’s generally been in the early stage.” Now, he says, many companies are being bought later in the process, after a lot of the risk has been offset.

Besides filling in pipeline, buying a smaller biotech firm also offers entry for a larger company into a newer specialty or therapeutic area. “What a number of companies are doing, because of the long lead times it takes to fill in the pipeline, is to fill in the gaps with specialty drug candidates outside of the realm of primary care drugs,” says Stewart Adkins, a London-U.K. based pharmaceutical industry analyst for Lehman Brothers for 23 years before starting his own firm, Stewart Adkins Advisors Limited, in 2006. “And specialty drugs include biologicals.”

New and Different Risks

But go beyond the problems of diseconomies of scale—beyond the coming wave of patent expiries and the need to utilize spare cash or even the problems filling in the pipelines—and you’ll find other, equally compelling reasons why the industry may be primed for an accelerated wave of consolidation.

“What we’re seeing within the pharmaceutical industry today is a confluence of many factors that are creating a kind of ‘perfect storm’ environment,” says Ken Getz, a senior research fellow at the Center for the Study of Drug Development at Tufts University in Medford, Mass., USA. “Some of those factors relate to the economics of drug development, but others relate to the changing risk dynamics of pharmaceutical development.”

Getz says that in addition to the breakdown of the traditional business model for larger pharmaceutical concerns, external factors such as regulatory environments, public advocacy and increased globalization is putting even more pressure on companies to find new ways to create value. That means the risk profile of the current operating environment has intensified dramatically due to a lot of external risk factors that typically weren’t present in the past.

“I think we’re seeing dramatic shifts in the industry’s sense of invincibility,” Getz says. “Companies are becoming a little bit more squeamish, and they’re looking for a hedge against shrinking profit margins and public sentiment turning more negative.” And one of the ways to do that, he says, is through partnerships with companies offering innovation expertise, contract development services and public outreach.

And, as always, rapid globalization continues to affect the industry in new and different ways. Multinational alliances, outsourcing and off-shoring, and global mergers no longer are novel experiments; they’re commonplace. Such cross-border pollinations likely will lead to greater awareness of opportunities around the globe and could represent yet another driver in the move toward more consolidation. “Globalization could drive the M&A activity in another direction than the one we anticipate, however,” Adkins says. “I think Western pharma companies understand the opportunities in India, China and elsewhere, but they’re still a long way from making lots of money there.” As a result, he says globalization could result in more opportunity for companies in developing countries—such as Indian generic drugmakers, for example—to move into the northern hemisphere and approach fully developed markets via the means of mergers and acquisitions.

The Cost of Doing Business

So what does that bode for the future? Cash-rich companies, diminished pipelines, blockbusters drugs increasingly facing competition from generics, a changing regulatory environment, and the relentless march of globalization—these are conditions conducive to increased consolidation.

“Many pharmaceutical companies are trying to break the traditional business model by moving into other areas, like biotechnology and vaccines,” says Barath Shankar, an analyst with research company Frost & Sullivan, in San Antonio, Texas, USA. “[That means deals] are starting to get more expensive for the buyers, because there is more competition for the assets. So you see three or four or five bidders [on some deals], and the only real challenge is the money needed to go after these companies.”

Send us Your Comments

Name		Remember
E-mail
Website
Message

Web Exclusives

Statistical Advantage

Gary Shorter, director of biostatistics for Quintiles, talks to Envisage editor Adam Istas about the growing importance of incorporating biostatistical analysis into all stages of drug development.

Measure for Measure

A proposed Health Care Comparative Effectiveness Research Institute in the United States may force the biopharmaceutical industry to emphasize patient outcomes and quality of life issues when developing a new medicinal product.

Articles

• Spotlight
• Development
• Management
• Commercialization

• Sitemap
• Privacy Policy

© 2008 Envisage Magazine