Sink or swim

By Marie Shields, Editor

The global financial crisis has prompted a rash of mergers, consolidations and layoffs in the pharmaceutical sector. Will the European industry stay afloat in these challenging times?

“Generic erosion will knock between 2% and 40% off the revenues of the top 10 companies between now and 2015”

This should be a good time for big pharma. The purchase of prescription drugs is usually non-discretionary – people need their medicines – and in the US, backed by insurance. Many companies have large cash reserves, which should be enough to see them through the downturn.

Some companies do seem to be doing all right. In January, Swiss drugmaker Novartis reported a 25 percent jump in 2008 net profit and forecasted a record year for 2009. Novartis said its profit had reached €6.2 billion euros and that sales had increased nine percent last year, driven by vaccines, diagnostics and consumer health products, and a revival in its core pharmaceutical business. The company also boasts the largest cash reserves among the big players – €11.4 billion.

US-based Merck & Co. also beat profit expectations when it announced in February that it had earned $1.65 billion in the final quarter of 2008. However, this was not achieved through increased sales – in fact, the revenue from two of the company’s top drugs, Zetia and Vytorin, fell by 26 percent after questions were raised about their effectiveness, and overall revenue fell from €4.7 billion to €4.57 billion.

Instead, Merck shored up its profits by eliminating more than 10,000 jobs in the last three years, and it has said it will cut 7,200 more by 2011.

UK-based GSK cut 850 research jobs last year as part of a restructuring plan that began in 2007, and in February, it warned that it might be forced to cut its workforce further in an effort to reduce costs by €2 billion a year over the next two years. At the same time, AstraZeneca said it would cut 6000 jobs, and 20,000 jobs are also due to go in Pfizer’s merger with Wyeth.

Cut your losses
Many of these job cuts involve US companies. So what’s going to happen in Europe? Will we feel similar effects of the downturn?

According to Jo Pisani, a partner in PricewaterhouseCoopers Strategy’s pharma group, we have at least one advantage: it’s harder to cut jobs in Europe than it is in the US. “It’s easier to lay people off in the US because of the nature of the employment contract, and then the next easiest would be somewhere like the UK,” Pisani says. “In countries like France, Germany and Belgium it’s more difficult, because of stronger unions and the period of consultation involved. Unfortunately at the moment, distressed companies will go for the countries where it’s easy to downsize first.”

Pisani also points out that many companies are spinning off their non-core activities. “This is part of a general shift within pharma to a business model of focusing on core therapeutic areas. For instance, Pfizer recently came up with a business unit structure where they’ve got six core business units and they’re actively out-licensing 100 compounds that don’t fit its therapeutic area focus. Similarly, AstraZeneca early last year sold off its cardiovascular franchise to a joint consortium of private equity and venture capital.” As many of those non-core activities happen to be based outside of the US, this could mean a boost for non-American specialist companies.

Downsizing, outsourcing, restructuring: these are the kinds of things that go on all the time in any industry, especially one facing the challenges of patent expiries and the death knell of its main cash cow, the blockbuster. It’s hard to tell how much of the recent activity in the pharmaceutical sector is a reaction to the financial downturn, and how much would have happened anyway.

One thing that does seem to have been prompted by the credit crunch is the sudden vogue for mergers. The big news in January was Pfizer’s €52 billion acquisition of Wyeth, which will give it access to its rival’s vaccines, consumer health and animal products. The move was widely seen as an attempt to boost Pfizer’s pipeline in advance of Lipitor – the cholesterol drug that the company nearly €9 billion last year – losing patent protection in the US in 2011. In all, 38 percent of Pfizer’s current sales will face competition from generics by 2013.

The merger will create a massive player in the industry, with more than 15 products with €750 million each in annual revenue, allowing the company to move away from its dependence on blockbusters.

In March, Merck & Co. agreed to buy Schering-Plough for €31 billion, in order to extend its pipeline and diversify its portfolio, while Swiss-based Roche finally took control of Genentech in a deal that valued the US biotechnology company at €35 billion.

Both of these deals are interesting, for different reasons. The Merck/Schering buyout will be enacted through a reverse merger, with Schering, renamed Merck, remaining as the surviving public company. The reason for this rather complex manoeuvre seems to be aimed at avoiding the loss of the rights to Remicade, a lucrative rheumatoid arthritis drug that Schering markets internationally under a joint agreement with Johnson & Johnson.

Then there’s the ongoing saga of Roche/Genentech. The two companies have been linked since the 1980s, when Genentech licensed one of its first drugs to Roche. In 1990, Roche and Genentech merged, with Roche acquiring 60 percent of its smaller rival’s shares. At the time, it purchased an option to buy the remaining shares at a pre-set price – an option it exercised nine years later. Roche then brought Genentech back into the market twice in the next year, keeping a 58 percent stake in the company.

Roche eventually agreed to pay the equivalent of €35 billion – or €72 per share – for the cancer treatment specialist, which represents a premium of 26 per cent above Genentech’s closing share price at the time. The price is well above the €67 a share that Roche initially bid.

Old news
Mergers and acquisitions in the pharmaceutical industry are not new, and we probably haven’t seen the last of them. In the opinion of Shabeer Hussain, Program Leader in Pharmaceuticals for Frost & Sullivan, “Plagued with R&D challenges, patent expiries, generic competition and high drug attrition rates, pharmaceutical companies have resorted to various crisis management strategies to stay afloat during trying times. One of these strategies is M&A activities. With Pfizer taking a strong and bold step in this direction, there may be other companies to follow.”

AstraZeneca, Eli Lilly & Co., GSK, Novartis, Pfizer and sanofi-aventis all have patents on major drugs due to expire in the next three years. Wyeth, so eagerly snapped up by Pfizer, faces a tricky situation of its own. Its two biggest selling drugs, Effexor for depression and Protonix for heartburn, will lose patent protection in 2010 and 2011. In addition, generic erosion is predicted to knock between two percent and 40 percent off the revenues of the top 10 companies between now and 2015.

One strategy for coping with this massive loss of income is that exemplified by the Pfizer/Wyeth deal: swallow up your rivals, slim them down by radically cutting staff, and take over their pipelines in the hope that, even if they don’t produce the next blockbuster, you will at least add some diversity to your portfolio and gain enough to prop up your bottom line in the short term.

The crucial phrase is ‘bottom line’. Such mergers are often nothing more than a quick fix, aimed at making companies look good for shareholders and investors. But how well does this work? When news of the Pfizer/Wyeth merger broke, many analysts and industry leaders were skeptical. Michael Rainey of Accenture commented that nine out of ten of such big deals created no value or negative value. Bain’s Charles Farkas called the deal a half step forward: “Wyeth’s assets will buy Pfizer some time but will not be enough to replenish its research pipeline or replace Lipitor.”

PwC’s Jo Pisani argues that: “It should be more about creative collaboration and strategic collaboration than mergers. McKinsey research has shown that 60 percent of mergers and acquisitions don’t create value. Add to that the period of paralysis that companies often go through while the deal’s uncertain, a lot of those big deals won’t close for another six months.

“Against that backdrop, though, you’ve got the fact that pharmacies have an awful lot of cash – there was an FT article a few months ago that said the top companies have something like $100 billion (€76 billion) between them all. And then you had the Pfizer/Wyeth deal in which they put up $22 billion (€16.6 billion) in cash, and the rest they raised through financing. It’s a quick fix solution: if you have the cash, you can suddenly buy a pipeline or buy your entry into biologics.”

As Shabeer Hussain points out: “As blockbusters fall off patent, organic growth has witnessed major hits. Pharma companies have resorted to inorganic growth through M&A. However, this growth cannot form a sustainable business model for long. This is a stop-gap arrangement, to satisfy investors.

“Though Wyeth’s Prevnar and Enbrel are expected to benefit Pfizer by softening the loss incurred due to the Lipitor patent expiry, the deal may not add the expected value as imagined by Pfizer. This expensive acquisition is unlikely to bring in great dividends. In fact, expanding the business will make it even more difficult for Pfizer to handle its enormous empire. Growing a huge business of that size is a tall order.”

Like attracts like
So far much of the merger action has been confined to the US-based pharma giants. Is this just coincidence, or can we expect to see more of the same on this side of the Atlantic? Jo Pisani believes it’s a question of cultural fit. “Pfizer and Wyeth have a similar sort of culture, and that would be the same if you had European to European consolidation. Many people are saying that GSK must buy AstraZeneca, that it has to be the next one. It would make sense because they are culturally similar, plus there would be synergies in smashing together the two head offices in the UK.” Pisani believes that cross-continental consolidations are less likely – the Roche/Genentech deal being the obvious exception.

Another interesting difference between US-based and European-based pharmacetuical companies is that several of the European companies are family-owned rather than publicly quoted. German company Boehringer Ingelheim, the number 15 company in the world, is one of these. In a previous conversation with Andreas Barner, Boehringer’s Vice Chairman, he told me, “It allows us to be more stable. We are less affected by the stock market, very obviously, and can continue to follow our long-term vision.”

Barner isn’t exaggerating: Boehringer has invested €1.73 billion in research and development in the last year, adding 400 new employees, to bring its global headcount in R&D to 6400 people, in a time when other companies are cutting back.

One of Boehringer’s German competitors is also majority privately owned: 30 percent of the Merck KGaA’s total capital is publicly traded, while the Merck family owns an interest of about 70 percent. Bernhardt Kirschbaum, Executive Vice President of R&D for Merck Serono, the pharmaceutical arm of Merck KGaA, points out that, “It means we don’t have to look every day, every minute at the stock price; instead we can think in somewhat longer periods. The Merck family has invested a lot in this company. It’s not like with some other families who might invest here and there and when the one business suffers they pull their money out and put it into something else. That’s not the case with us, which brings additional stability.”

Jo Pisani confirms this. “It does help to insulate them from the flucuations in the market. Certainly you haven’t seen many of those privately held companies become as distressed as the others. And if you look at the strategies they’re pursuing, they have a lot more freedom.”

Of course, being family owned can go wrong as well. Witness German billionaire Adolf Merckle, who threw himself under a train in January, after losing billions speculating on the stock market. Merckle had taken over his grandfather's business, creating Phoenix Pharmahandel, Germany's largest drug wholesaler, and starting generic drug maker Ratiopharm.

One other change in the financial markets that has affected pharmaceutical companies is the loss of private equity investors. When debt was really available, such investors could raise up to $100 billion, which meant that even the top pharmaceutical companies were within their sights. But the current conditions have left those players unable to raise debt, which has cut off a potential exit route or source of income for capital for organic growth for pharma compnaies.

Bad for research
Whichever way you slice it – mergers, layoffs, spinning off elements of the business – none of these do anything to drive the engine that has kept the industry going for decades – innovation in research. Mergers, for example, usually result in bigger companies with more layers of management, something that tends to stifle research, rather than encourage it.

Says Shabeer Hussain, “Innovation is not the primary focus at the moment, and these activities are just crisis management measures. Such short-term arrangements enhance their stock prices and are purely business-oriented, not innovation-oriented.”

According to the latest PwC report, Pharma 2020, Virtual R&D, Which path will you take?, this ‘innovation deficit’ has enormous strategic implications for the industry as a whole: “Pharmaceutical companies need to decide what they want to concentrate on doing and identify the core competencies they will require, a process which may involve exiting from some parts of research and development.

“But even those that regard research and development as a core element of their business will have to make fundamental alterations in the way they work. They may, for example, have to focus more heavily on specialty therapies, since most of the diseases for which there are currently no effective medications or cures are not amenable to mass-market treatments, as well as reducing the time and costs involved in researching and developing such medicines to ensure that society can afford them.”

The truth is, no matter how much the public loves to hate big pharma – much as we love to hate any powerful industry with a major impact on our lives – the world needs the pharmaceutical industry. Without the innovative research and development it funds and carries out, many serious diseases would remain untreated.

So what’s the answer? Companies – whatever side of the Atlantic they find themselves on – need to take a different approach. Instead of gorging themselves on their rivals, then going on a ruthless job-cutting purge, they need to slim down from within, stay focused on vital research, find themselves a niche. Accept that the days of big blockbusters are over. Build a portfolio of mid-performers – then if they lose one drug to generic competition, it won’t smash a meteor-sized hole in their profits.

Smart companies, the lucky ones with strong enough cash flows to ride out the recession, will target emerging markets or focus on core competencies or rare conditions with high unmet need. Combined with the stability afforded by private ownership, this could mean that the European pharmaceutical sector will emerge from the financial downturn relatively unscathed.

Companies with the biggest cash reserves
Novartis    €11.4 billion
Roche    €10 billion
Johnson & Johnson    €9.7 billion
Merck & Co.    €7.5 billion
GlaxoSmithKline    €7 billion