The Buy vs. Build: Challenge to Drug Makers’ Performance

During recent years, there has been a significant shift in market capitalization between the larger biotechnology companies and large pharmaceutical companies. Biotech market capitalization has grown at a much faster rate than that of Big Pharma over the last five years. An interesting strategic question is whether these changing value dynamics are accurately predicting a long-term power shift – biotech vs. Big Pharma – in the drug industry or simply represent episodic behavior by the speculative investment community. What are the implications for m&a activity? To gain insight into a possible answer, I examined the capital markets behavior and corporate characteristics of the current top 10 biotech and Big Pharma companies (see Table 1). I looked across a five-year timeline, roughly from May 1999 to May 2004, and evaluated four broad dimensions: equity returns, strategic decisionmaking, m&a intensity, and scientific risk performance. I searched for anecdotal evidence of broad sector trends, company-specific activity, or deal intensity as key forces shaping market capitalization. The project was aimed at these basic questions: Do smart m&a activity and insightful strategic management lead to superior shareholder returns? Or is good performance simply a function of the luck that one finds in the labs? Biotech and Big Pharma Universe At the dawning of the modern biotechnology era in the mid-1970s, the industry was composed of R&D-driven enterprises that devoted the majority of their funds to scientific discovery and development, while investments related to marketing and commercialization paled by comparison. Implicit in this business model was the assumption that core competencies lay in the discovery of biologically derived therapeutic drugs and not in dealing with medical regulatory bodies, developing marketing initiatives, and distributing drug products to the patient and medical community. Registering, selling, distributing, and supporting drugs was supposed to be the province of Big Pharma with their armies of drug reps, well-developed distribution systems, and clinical testing relationships with the academic medical centers and the medical community. As the scientific innovators, the biotech company simply would develop clinical and marketing alliances with the integrated Big Pharma players as a means of extracting value from their research. In addition to a unique business model, the underlying science approach of biotech was highly differentiated. While their initial stages of R&D were similar to that of a traditional drug company – focused on understanding biological pathways and proteins that were prevalent in health conditions – the follow-on stages were novel. Identification of drug targets was based on biological understanding and drug molecules would be designed by assembling naturally occurring biological materials. This technique enabled the scientist to encode the unique gene sequence of the molecule. Using the sequence as the basic drug molecule design, he or she could insert this genetic material into a biological production system (e.g., microbes or certain mammals) to efficiently and precisely produce volume quantities of the drug molecule. This design/production technique was in contrast to the “chemical synthesis” approach that a traditional drug company would use. As biotech companies achieved scientific and manufacturing success and saw their Big Pharma alliance partners share in the commercial value of their inventions, they became more sensitive to the economic benefits of establishing integrated scientific, clinical, and commercial operations. With their scientific success throughout the 1980s and 1990s came greater capital markets access and financial flexibility, which generated funds for investing more heavily into the concept of integrated operations. The model of integrated operations – science, clinical development, and commercial activities – is now characteristic of the biotech universe. These companies may still have Big Pharma alliances in place, but the partnership structure tends to deliver the majority of the value and the decisionmaking authority to the biotech innovator. As biotech’s business model evolved, Big Pharma went through some degree of change as well. These companies developed relatively substantial biotechnology science capabilities as they witnessed the scientific and commercial success of their biotech alliance partners. Despite this increase in internal science capability, Big Pharma’s track record for discovering and developing biotechnology-enabled drugs has been dwarfed by the biotech players. The resultant impact has been modest since Big Pharma’s internal R&D commitment remains highly skewed to the chemical synthesis approach to drug design. Today, the universe of 20 biotech and Big Pharma companies that I have identified all have integrated science and commercial operations and an average market cap of approximately $60 billion. As can be seen in Figures 1 and 2, the capital markets have provided much higher returns for the biotech shareholder than its Big Pharma counterpart. Perhaps the most telling single statistic is the five-year average annual market cap growth of the two groups – 22% for biotech vs. -1% for Big Pharma. Dimension 1: Strategic Management Because of huge investments in science and commercialization, short-term capital markets pressures, and relatively long-term return horizons, managing for sustained value in the drug industry is challenging. The types of managerial decisions that one looks for in this context are: Focusing on the core – A drug company operating correctly will establish its core capabilities and markets as a means of optimizing resource allocation and capital funding. In the case of Big Pharma, this meant a tighter focus on drug markets and initiatives to restructure out of diversified businesses such as: * Medical devices, e.g., the Bristol-Myers Squibb Inc. spin-off of Zimmer Holdings Inc.; * Agricultural life science, including sell-offs by Aventis SA, Wyeth Corp.; Novartis AG, AstraZeneca PLC, and Pfizer Inc., whose predecessor company, Pharmacia, spun off Monsanto Co.; and * Services, e.g. Merck & Co.’s spin-off of pharmacy benefits manager Medco Health Services Inc. For biotech, focusing on the core generally meant a tighter focus on specific therapeutic areas. An exception, however, was Millennium Pharmaceuticals Inc., whose aggressive business transformation took the company from a genomics tool-kit platform to an integrated drug company model. One would think these types of “focus” decisions can impact the stock as they’re often announced well before execution. Driving top-line growth – Sales emphasis is anything but trivial in the drug business due to the mix of competing forces that drive growth, namely pricing, which is loosely regulated in some countries; patent expiration; scientific success or failure, which impacts the launch of new products; and compliance with rigorous manufacturing and quality assurance regulations. In particular, patent expiration and the encouragement of generic competition by most countries put tremendous pressure on incremental annual growth. Driving efficiencies across all operations – The culture of drug companies has, up to a point, tended toward the belief that they could grow their way to greater incremental profitability. Organizational downsizing always has been viewed as the last resort to solving profitability gaps, much like an inertial force – with the drug company often resolving to sustain short-term profitability disappointment as a trade-off for maintaining morale in a scientist-dominated workforce. Industry consolidation through m&a has provided the greatest excuse or impetus to realign organizational costs across both biotech and Big Pharma. The other inertial force to reckon with when managing costs in a drug company is the “sanctity” of marketing expenditures – particularly after the mid-1990s FDA environment that permits direct-to-consumer advertising of drug products. In many ways the promotional budgets of Big Pharma have become as impenetrable as those associated with large consumer packaged goods companies like Procter & Gamble Co., PepsiCo Inc., and Coca-Cola Co. The marketing productivity challenge has become one of assessing the impact of more sales reps versus media-driven consumer promotion – they both cost money. Containing risk – Logically, the lion’s share of risk in a drug company should be located in the lab. By definition, experimental failure does occur and should occur in drug R&D activities. The management art is ensuring that failure occurs early on with relatively few downstream surprises in latter stages of clinical development. Within the past few years, however, a new type of risk has become prominent in the Big Pharma universe – legal risk and scandal. From Schering-Plough Inc.’s and Eli Lilly Co.’s well publicized FDA manufacturing violations to the SEC travails of Schering-Plough and Bristol-Myers, to Wyeth’s diet drug litigation, which has forced the company to book more than $13 billion in reserves to pay claims, a host of issues have challenged management’s integrity and resolve to maintain focused performance. Exploiting deal opportunities – Depending on the type and structure, deals should offer an opportunity to fill out a product portfolio, establish a better market presence through alliances, diversify R&D risk, or refocus operations – following a divestiture or spin-off – to core markets. Given the event risk and pace of change inherent in the drug industry, it’s critical that a company view deals as a method for executing strategy – everything else being equal. Dimension 2: Transaction Intensity – Typical Structures The following types of deal structures have been prevalent in the drug industry: * Mergers of equals * Large enterprise acquisitions * Bolt-on acquisitions * Product-level alliances * Restructurings, including divestitures, spin-offs, and equity carve-outs Dimension 3: What is Success in the Lab? The only externally measurable variable for scientific success is regulatory approval for marketing a drug product, such as an FDA clearance in the U.S. Depending on the stage of clinical development, i.e., Phase I, II, or III, experts have estimated that the likelihood of success ranges from roughly 15% to 90%. Failure in early stages of clinical testing is disappointing but failure in latter stages at times can be devastating to a company’s credibility in the capital markets. The Data Never Lie As a starting point to laying out the evidence, let’s review the summary information shown in Table 2. During the five-year period ended May 2004, the average annual returns for the benchmark indices were: -1% for the DRG index (large drug companies), 10% for the NASDAQ/Biotech index, and -3% for the S&P 500. Within the Big Pharma universe, AstraZeneca, Aventis, Lilly, Novartis, and Pfizer had higher returns than their peer index (DRG). Within the biotech universe, Amgen Inc., Biogen Idec Inc., Celgene Corp., Chiron Corp., Genentech Inc., Genzyme Corp., and Gilead Sciences Inc. all exceeded returns within their peer index (NASDAQ/Biotech). The common thread across both groups of companies with higher returns was adequate or better scientific success. Additionally, except for Lilly, none of these companies had any extraordinary risk issues to manage. Deal intensity seemed to be less of a compelling factor. While nine companies in our select group experienced substantial m&a activity, several companies of note did not – namely, Celgene, with a 58% average annual equity return, Genentech with a 42% return, and Lilly. Across the companies that did not exhibit higher-than-average sector returns, common themes were heightened scientific risk and, with one exception (Millennium), clearly documented strategic management issues. Transaction intensity seemed not to be a factor in this laggard group of eight companies. Only three had substantial m&a activity. The high-return biotech group had much better returns than that of the high-return Big Pharma group. The most likely causal factor is that each of the seven high-return biotech companies enjoyed torrid annual sales growth during the five-year survey period – 39% on average. The last five years have delivered a robust harvest of newly launched, highly effective drug therapies from these companies. By contrast, the Big Pharma companies have had to grapple with myriad patent expiration issues for major drug products (e.g., Prozac, Claritin, Augmentin) and are extremely challenged by the very large revenue bases from which their financial models must drive growth. To drive this last point home, the average trailing 12-month sales for the high-return Big Pharma group are approximately $25 billion. Can We Draw Conclusions? A number of anecdotal observations can be made on the sample that segue into some basic conclusions about the drug business: Stock prices and sales Market capitalization is highly sensitive to the sales prospects of new drugs and the sales performance of existing drugs. This is a products-driven market where the implied and articulated strategy is simply to develop, harvest, and launch a clinical development pipeline. It’s highly unlikely that a company can differentiate itself in any way other than through its R&D activity and commercial product sales performance. Mergers and acquisitions Acquisition activity, in and of itself, does not enhance capital markets performance. Only to the extent that acquisition activity brings competitive products into the portfolio should the shareholder logically be rewarded. There is no better example of a superbly performing company than Genentech, whose success is based almost purely on an organic model. Novartis, while possibly more inclined than some to pursue growth through acquisition (note its creeping equity stake in Roche Holdings AG), has largely achieved its success over the past five years by following an organic model. Bristol-Myers, on the other hand, has been more acquisitive than most but also one of the worst performing. In Bristol’s case, there remain questions about the quality of operations that were actually acquired and the price paid, as well as its well-publicized SEC and Imclone travails that no doubt have tarnished management’s credibility. Repeatedly, the corporate development question is not “do we grow through acquisition or organically?” but “are there assets to be acquired that are of a higher quality than those we might develop or sell organically?” These key questions are characteristic of an innovation-driven industry, not a maturing industry. Restructuring Restructuring activity that further focuses on the core drug business may be helpful but not a sufficient catalyst in the capital markets. The efforts of Wyeth, AstraZeneca, Novartis, Merck, Pfizer, and Bristol-Myers to shed their non-drug businesses are probably viewed favorably by the capital markets. However, the upside in any capitalization is likely related more to the performance of the company’s core drug business. Anecdotal support for this thesis is that AstraZeneca, Novartis, and Pfizer – all higher-return Big Pharma companies that have restructured down to their core drug businesses – have had solid pipeline and commercial product performance. Conversely, Wyeth, Merck, and Bristol-Myers – restructured companies with lagging returns – have experienced unpleasant scientific surprises and intense commercial product challenges. Managing for results It is likely that strategic management and scientific success are the primary drivers of shareholder value. That may sound trite but our evidence supports the notion that effective R&D performance and high-quality management garner the best returns in the capital markets. Biotech surge The biotechnology sector clearly is becoming a more powerful force in the drug industry. While the Big Pharma group still has the larger balance sheets, the biotech group has grown far more rapidly over the last five years and Big Pharma’s balance sheet advantage is waning. Biotech’s sales growth has resulted in much more financial flexibility and managerial experience; in many ways, these companies have grown into adulthood. Large biotech companies have tasted R&D success, are comfortable with transactions of all types, and have experienced the challenges of managing rapidly growing resources to exploit explosive growth. The industry power pendulum is undoubtedly swinging in the direction of the biotechnology industry. The only question is “to what extent.” Future Role of Drug Industry Deals Mergers and acquisitions activity likely will be driven by product and pipeline attractiveness. Within Big Pharma, while its lackluster capital markets performance, looming patent expirations, and a certain loss of managerial credibility might create a desire for a merger, finding the right merger partner and structure will be challenging. Deal activity will be characteristic of an innovation-driven industry, not a maturing one, i.e., a balance favoring organic development over dealmaking. Antitrust issues and the desire for postmerger growth synergy also contribute to making the list of possible combinations quite short. Within the biotech sector, bolt-on acquisitions are more likely than mergers due to relatively high capital markets performance and fairly independent growth cultures. Again, as with Big Pharma, m&a activity will be driven by the opportunity to acquire innovations, not simply to foment consolidation. The interesting question to ponder is whether there will be significant crossover m&a activity between Big Pharma and biotech. While Big Pharma’s greatest competitive advantage is its financial strength, proxied by hefty balance sheets and large cash flows, over time this will be offset by a paucity of late-stage pipeline activity and increasing branded and generic product competition. Given biotech’s growth curve, a legitimate question to ask is: Which industry sector will be the aggressor? As an illustrative irony, consider the linkage of Genentech and Roche Holdings. Biotech giant Genentech, with a $66 billion market cap, is 55% owned by Roche – a structure that evolved to maximize Genetech’s entrepreneurial independence. There may be a day in the not distant future when Genentech’s enterprise value overtakes that of Roche. Indeed, there have been cases in technology spaces where investee companies wound up with larger caps than their “parents.” And remember when Microsoft Corp. and Intel Corp. took shape as niche technology suppliers to IBM Corp. Sound familiar? Jan S. Wolpert is President of Wolpert Associates Inc., a strategic management consulting firm based in Chatham, N.J. He previously had been a senior corporate development executive at several health care and life sciences companies. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com