Following the Megadeal Decade, Drug Makers Face a Rockier Road to Growth

While the megadeals that dramatically reconfigured the pharmaceuticals playing field in the past decade are noticeably lacking these days, followers of the industry expect the sector landscape to continue to change in smaller ways, with less-sizable deals, as drug makers persevere in their drive for growth. Other characteristics of pharmaceuticals dealmaking could change in the 21st Century as acquirers encounter increased competition from their biotechnology brethren, a dwindling supply of targets with promising products, and challenges in structuring revenue-enhancing deals in the post-pooling environment, and companies may need to adjust their m&a strategies in order to gain maximum benefit from their deals going forward. Most industry observers agree that the large-scale drug-company dealmaking of the past decade has probably run its course. And even though the market shares of the larger companies are still relatively small when compared with those of the market leaders in other industries, the current pharmaceuticals arena does reflect a good amount of consolidation, they note. Yet a lot of room exists for further consolidation in the field, many believe. In years to come, though, it is expected that the acquisition trail for drug companies will be a bit rockier than it has been in the past. Acquirers will be more selective in choosing targets that complement their core capabilities and start shifting their focus away from product-driven deals toward more technology-driven m&a in their quest for growth, industry analysts believe. In working with large pharmaceutical companies, Russ Hagey, managing partner in the Los Angeles office of Bain & Co., advises clients that there are limits to scale, that “just trying to get bigger has not been the path to better R&D efficiency.” “Companies will have to be very thoughtful about which therapeutic area they are going to focus on going forward. They will have to pick their spot for growth,” he adds. The value in building therapeutic depth Focus, he maintains, is especially critical for the large pharmaceutical firms as they screen acquisition candidates. “There will be huge value in building therapeutic depth in an area better than anyone else. That is one of the key themes that we would articulate to large pharmas.” Based on research that his firm has been doing on the value of being a focused player in the industry, focused firms realize returns that are about two times those of non-focused firms, Hagey states. Some industry followers say that the impact of the scrapping of the pooling-of-interest accounting method can not be underestimated when discussing pharmaceutical industry dealmaking. Big pharmaceutical deals generally had been accounted for on a pooling-of-interest basis, so the companies never recorded the fair value of the assets and liabilities on their books, notes Ray Beier, a partner in the Transaction Services Group at PricewaterhouseCoopers. As a result, those deals tended to be more accretive, he adds. Since pooling is no longer an accounting option, and since a significant portion of the asset base of a pharmaceutical company consists of product pipelines, patents, and other assets that must be identified under the new accounting rules, those assets will not be treated as goodwill, “so they won’t enjoy the goodwill amortization moratorium,” Beier says. “It is our view that the industry will suffer from more dilution. You can debate whether that dilution is economically driven or not, but notice, for example, it seems to have been a factor in putting the brakes on large deals.” Beier believes that “some inertia has been built into the system” because of the new accounting rules. “Companies are concerned about how the market will view them, and there seems to be a concern about being the first one out of the box with a new deal because of anticipated new dilution.” Acquisition options for leading pharmaceuticals firms seem to be diminishing, some experts say. There are not enough mid-sized drug firms to go around for the acquirers that want to scoop them up, they note. Additionally, an industry-wide shortage of products has caused buyers that have the cash to “bid deals up to astronomical levels,” says John Maddox, vice president and engagement director at Bogart Delafield Ferrier, a pharmaceutical and biotechnology strategy consulting firm based in Parsippany, N.J. “I think there is going to be a more difficult road for companies to follow going forward because the prices of the assets are getting higher and the availability of products is going to be more limited. I think people are a little concerned that perhaps all the products that are needed to sustain the industry are not available,” says Maddox. Today, many of the companies that have the cash to pay for deals are biotech firms, which are enjoying high stock valuations and favorable financing conditions at the moment. Some biotechs are trading at about 50 times forward earnings versus 20 or 25 times forward earnings for pharmaceutical companies, notes Stephen A. Greene, managing director in charge of Andersen’s health care corporate finance team in the U.S. Not only are biotechnology companies becoming more-able competitors for acquisition targets but they are not as eager to do deals with pharmaceutical companies since they now have the resources to build out their infrastructures and to self-commercialize, says Hagey. Larger pharmaceutical companies have not demonstrated the ability to leverage the larger R&D budgets that come as a result of their acquisitions, he adds. “When they’ve made acquisitions of small biotechs, they generally have not improved their ability to get products to market. So biotechs are saying, “We too can build scale and integrated business processes to bring products to market and don’t need to hook up with large pharmas to do that,” he states. “Acquisition of growth has become more competitive for large pharma so those companies are going to feel squeezed.” The perspective of some industry pros is that growth options for large pharmaceutical firms are decreasing, and that those companies do face challenges to their growth. Historically, a major portion of their earnings growth has come through the size, scale, and cost reductions gained through mergers and acquisitions, Hagey notes. “But they have not been able to get leverage or efficiency out of ever-increasing R&D budgets, so they are not able to drive growth with their product portfolios.” Going forward, Hagey expects there to be an increased focus on acquisitions of technology that would help drug makers create value in the industry, such as technologies that would help decrease the cost of drug discovery or help extend the patent life of drugs. “You’ll see a lot more technology-based m&a as opposed to product-based m&a, because people are trying to decrease the cost of drug discovery or extend the life of their product portfolios, not just trying to add new products to their portfolio.” He points to Johnson & Johnson’s acquisition of ALZA Corp., which specializes in drug-delivery systems, as a stratagem to lock up technology that might be able to extend the patent life or the efficacy of its products.