May 13, 2014

No Special Rules for Pharma


From an economic and investment perspective, there are no special rules for the pharmaceutical industry


Some recent proposed transactions by pharmaceutical companies show that industry reconstruction is far from being complete. The usual concerns have been expressed, including lost jobs, closed facilities, and reduced R&D slowing the development of new drugs. The larger proposals include:

  • Pfizer’s proposal to acquire AstraZeneca;
  • Bayer’s agreement to buy Merck’s consumer care business for US$14.2 billion (€10.4 billion);
  • Valeant Pharmaceutical teaming up with an activist investor in a bid for Allergan; and
  • Novartis acquiring the GSK cancer drug portfolio, GSK acquiring the Novartis vaccine business (excluding flu vaccines) and the two companies merging their consumer health businesses into a jointly-owned subsidiary.

Question: are there sound economic principles behind these transactions?

The argument for mega-mergers is that some companies have not controlled costs and that overhead, sales, marketing and R&D can all be rationalized. This reasoning can be applied to mature companies in any industry. It is difficult to determine whether these transactions have any long-term industry-wide impact since the pharmaceutical industry, while mature, is also rapidly evolving.

The pharmaceutical industry is extremely heterogeneous and actually composed of many smaller industries:

  • Every therapeutic indication is a small industry;
  • Every type of cancer is a small industry; and
  • Every biological target could be considered a different small industry.

This leads to a situation where there can be extreme heterogeneity among the companies and their corporate strategies. In this type of environment, there are two economic strategies which appear to conflict with each other – reducing risk through diversification and optimizing resource utilization through focus. The argument for diversification is justified by different growth rates and both different and low new drug success rates in the various therapeutic classes. The argument for focus is the critical mass and optimal resource utilization needed to be the best in a therapeutic class.

Conclusion: Yes, there are sound economic principles applicable to all industries, including the pharmaceutical industry, which are behind these proposed transactions.

The pharmaceutical industry is not special because it provides products which are essential – the same argument can be made for food, energy and many other products. The pharmaceutical industry is somewhat unique in a few ways, such as the level of government and regulatory control, lower level of direct purchasing by the end-consumer and the political and social impact of a story about an individual seeking treatment for a specific medical condition.

There is no economic rule which states that X% of investment capital must be invested in medical industries. Investors put their money where they think they can make the best profit from lending capital or making equity investments (capital gains and dividends). Investment capital is always balancing:

  • risk and reward;
  • trading and long-term investment;
  • cash, debt and equity; and
  • governments and industries.

The pharmaceutical industry must convince investors that it deserves their capital investment.

Investors are also balancing the term of their investments, which creates problems in industries with long product or project development cycles. The natural resources industries have mining and processing projects which are similar in length to the time required for clinical development of a novel drug. Short-term investors, with investment cycles of days up to perhaps 2 years, have completely different expectations. These transactions appeal to investors, C-level management and boards of directors which all have a short-term focus on revenues, income, share price and dividends.

However, the pharmaceutical industry has to balance this short-term profitability focus with the long-term growth objectives, which require risk-taking investment in new product development. Mature pharmaceutical companies must invest in R&D but the level and type of investment can vary widely with the therapeutic focus. While some companies will choose to have internal R&D programs for specific therapeutic classes, other companies will choose to buy or license their new products.

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