Published On: November 2017
"United we stand and divided we fall" goes an old saying and the pharmaceutical industry seems to follow it by heart. Over the last 2 decades, many pharmaceutical companies have consolidated to gain more muscle which has led to diminished competition. Here, we analyse some of the objectives of the M&A and see if they have succeeded in achieving them and the risks and missing paradigms of the M&A strategy adopted and made popular by numerous large pharmaceutical players. The M&A’s have been aimed more at increasing revenues by using large cash balances on account sheets of many companies. Thus we will explore some solutions which will result in sustainable increase in the revenues against the fury of investment whose achievements are often short lived.
Economies of scale and cash balances
Many significant buyers create incentives for large companies especially those losing revenues from patent expiries to achieve future revenue potential. Another factor fuelling the M&A is the post-recession cheap interest rates which compensates the revenue loss from the loss of patented molecules. Thus, there is a fundamental difference between pre-recession and post-recession financial conditions. However the increasing risk in business has led to cautious investors and the fear of future business cycles.
Product diversification and development
The uncertainties in the drug development have also resulted in M&A being used as means to expand the business spectrum, especially the newly emerging therapies and segments. For example, in 2015, AbbVie acquired Pharmacylics for USD 21 billion with an intention to gain cancer and immune-disease focused business and intellectual property of the company. In a similar turn of events, Valeant took over Salix Pharmaceuticals, a gastrointestinal specialty company, for USD10.1 billion. In 2010, Novartis acquired Alcon, the world's largest eye-care company for an eye watering USD 39.3 billion with a product line comprising contact lenses and surgical products. Thus, traditional pharmaceutical companies are extensively acquiring medical devices companies to get a pie of the lucrative new segments such as medical devices market.
Patent losses and market development
Top 10 big pharmaceuticals are losing market share from an impressive 12% CAGR from 2000-2007 to a low 8% CAGR post 2012, while their market share has taken a hit from around 50% market share in the year 2007, to only 35% in the year 2015. Patent loses have been the major reason for the loss in market share which has resulted in lower market equity in the future resulting in increasing reliance on M&A for future growth. Companies have adopted M&A as a strategy to offset the revenue loss from loss of patents. For example, in 2000 Pfizer acquired Warner–Lambert with an eye on Lipitor and Pharmacia for Celebrex (2002).
Another goal of the M&A has been market development which is reflected by the acquisition of domestic formulations business of Primal Heath care by Abbott Laboratories for USD 3.72 billion. The acquisition was part of Abbot’s strategy of penetrating into new emerging markets and to reduce its overreliance on patented product business. Thus, Abbot here was seen as towing the lines of Teva which is the world’s largest generic drug company.
Core specialization and lean
Growing operating expenses are a case of concern for many pharmaceutical companies. Many companies have started to cut the fat by transferring or selling their noncore businesses to other companies having expertise in the concerned field. For example, Allergen decided divest its generic drug business to Teva for a sum of USD 40.5 billion in 2015 which enable Allergen to focus on its core business, while allowing Teva a larger foot print in its generic business – a win-win for both players.
M&A as a growth strategy? Will it work?
Mergers and acquisitions in pharmaceutical industry is a go-to strategy for acquiring business segments with high growth potential. These segments range from acquiring intellectual property, business segment such as devices or a particular portfolio. The million dollar question is which is the most attractive type of targeting?
Innovation is one activity where scale doesn't work and large scale may even be counterproductive. Innovation can't be manufactured and can only be nurtured and this reality has been the motivation for acquiring new compounds from a large global pool of smaller, specialized companies. Thus, acquiring intellectual property and molecules under development is seen as an attractive market equity gaining move.
Another line of thought behind M&A is achieving greater market sales by combining complementary skills and platforms of both companies. For example, achieving large market foothold by taking advantage of distribution chain and market platform of other companies to reduce the market lead time and reap maximum benefit before patent lifetime ends.
Diversification by buying companies, operating in high growth business segments such as fine chemicals, medical devices, and others is another approach to M&A. However, diversification brings larger complexities in managing the company and may be counterproductive to innovation due to management issues.
Another issue has been the risks involved in M&A’s, reflected by the short-lived association of Daiichi and Ranbaxy. Are Big Pharma becoming equivalent to Big Banks that failed? Allowing Big Pharma to indulge in misrepresenting the facts and the actual state of their operations and standards, and submitting false data suggest that M&A’s have their own fallacies and risks.
Current weakness in M&A strategies
Our analysis indicate that M&A while being productive in maintaining revenues will not be able to hold out in the longer run. Our analysis is based on some observations which include the growing cost and goodwill paid by the acquiring companies to buy other companies, the risks involved in M&A, opportunity cost of capital, growing operating costs and others. A brief analysis of M&A reflects that pharmaceutical companies have paid a lot more for acquisitions in 2016 and the value of deals almost double in comparison to 2015. This reflects a fundamental rule of finance — the returns on investment is a direct effect of the cost of assets acquisition and the risks assessment of the future.
Growing goodwill and acquisition costs will surely affect the future returns on investment and at the same time they stress out the balance sheets of companies due to rise in future liabilities of the company.
The reduction of operating expenses, especially the high sales distribution costs is a slow but long term measure any company can adopt. Partnership and outsourcing sales and distribution can lead to better efficiency in these activities. Although pharmaceutical industry will be driven by innovation, supply chain management is increasingly becoming important. Money saved is money earned! This converts directly in the analogy that cost saving measures such as supplier management and integration, proper selection of suppliers based on risk sharing business analysis, warehousing facility, supply flexibility are increasing in importance. Thus, pharmaceutical industry cannot afford to underperform on working capital management and needs to learn from the fast moving consumer goods industry.
An average pharmaceutical company holds finished goods inventories for a whopping 6 months as compared to 2 months for the consumer goods industry. Greater profit margin can no longer be an excuse when higher competition is putting pressure and is bound to drive prices down in the future. The pharmaceutical industry is also slow to adopt analytics and technology for product marketing. Logistics is another area where the pharmaceutical industry has paid scant attention. Pharmaceutical industry also lags in manufacturing technology which has been carried out in an inefficient, expensive, and poorly controlled batch mode as compared to the continuous manufacturing being carried out in other industries.
The pharmaceutical industry also focuses excessively on cost saving measures, rather than improving total cost of ownership and value-creation. Value creation has to be the prime objective of M&A with maintaining revenue relegated to secondary position. Low value creating activities should be outsourced while non-value creating activities should be eliminated rather than automated. Most M&A’s do not take into account the growing complexities in operations and focus excessively on revenue generation due to conventional financial theories and in an attempt to appease investors which is a cause of concern as lean manufacturing is the strategy of the future pharmaceutical industry as was demonstrated by Toyota in the automobile manufacturing industry. The pharmaceutical industry also lags behind in incorporating the principles of six sigma. In our analysis, nothing will inspire sustainable investor confidence as well as achieve efficiency than a permanent decrease in operating expenditures which is the primary hallmark of industry health and confidence. The pharmaceutical industry needs to take a sustainable approach to revenue generation rather than a quick fix to the issues facing the industry. Rather than targeting high growth, M&A should seek end value creation as its primary goal. Thus, splitting a company into segments depending on the specialized nature of the activity and its importance in core skill retention should also be explored as a viable strategy. Achieving efficiency will definitely take efforts and will involve some large restructuring charges, but will result in sustainable gains for years to come. To conclude it’s not the fast and the furious but the slow and steady that will win the race!