What's Really Driving The Pharma M&A Frenzy

Forbs | David Maris

What is it with pharma and M&A?  It is hard to tell whether the deals announced (or attempted) by pharma companies in recent weeks are a sign of the early stages of a pharma feeding frenzy or simply a blip in an otherwise consolidating sector.

In just the past couple weeks, the acquisition market has heated up:

• AstraZeneca announced it is buying Ardea for $1 billion
• Roche abandoned its $7 billion bid for Illumina
• Glaxo got rebuffed from Human Genome Sciences in a $2.6 billion bid
• ISTA Pharmaceuticals accepted a $380 million takeout offer bid from Bausch & Lomb after turning down a bid from Valeant
• Pfizer announced the $12 billion divestiture of its infant nutritional business to Nestlé
• Watson Pharmaceuticals announced it will be buying European generic company Actavis for approximately $5.6 billion, to make the 3^rd largest generic company

Also, J&J’s brand new CEO stated that despite being days away from closing on its $21 billion acquisition of Synthes, they too will continue to look for deals.  While it is easy to think that this spate of news is part of a new change, it is part of a longer-term trend of a consolidating drug sector and one where a premium is being placed on innovation and growth.

There are a number of factors that are going into the continued consolidation of the drug industry.

In part, it was originally fueled by the consolidating buying groups – the rise of hospital chains, HMO’s, and chain pharmacies – made the selling activity more concentrated.  Through the years, as the large drug companies consolidated (Pfizer and Warner Lambert, Merck and Schering-Plough, Astra and Zeneca, Novartis and Alcon, Glaxo and Wellcome, Sanofi and Genzyme), their size alone made maintaining growth rates difficult.

But for now, the top reason for increased consolidation and partnering is that drug companies have a host of blockbusters going off patent at a time when the industry is facing fewer drug approvals.  With slowing sales, most drug companies are looking for growth by buying the companies that have solid pipelines that will deliver growth.

Peter McDougall, a noted pharmaceutical analyst who runs top-tier boutique pharmaceutical investment research firm DRUGANALYST in the UK, even went so far yesterday to write a humorous letter to AstraZeneca’s CEO with a prescription of whom they should partner with to fix their pipeline and growth woes: Abbott and Amgen.  In his letter, he implores:

“Please, please don’t continue with the comments such as I am reading this morning: “we are neck deep in deals”, “we are sticking with small deals”, these aren’t helping me. I assure you that there are no deals of around a billion or two dollars that will ever make a pennyworth of difference.”

But will it continue and will it be mergers-of-equals or small company deals that large drug companies pursue?  One biotech CEO who had sold his first company for several hundred million dollars, who is now on his second, with half a dozen pharma partners signed for his new technology put it this way to me:

“Large pharma can’t develop drugs any more.  They are too slow.  They make decisions for political reasons.  Their hurdles are too high.  They have to keep buying companies like us just to stay innovative.”

While this conclusion of drug companies not being able to develop new drugs and get them approved is clearly an overstatement, it is a sentiment shared by a lot of institutional investors.  And he is right about one thing: large pharma keeps tapping the speed, inventiveness, and entrepreneurial talent of smaller drug companies.

But there are many other factors that are driving the continued consolidation of the drug industry, including:

• Opportunity for cost cutting earnings boost – the most obvious way for two large drug companies to “create value” was to merge, and fire a lot of people.  While some costs are unavoidable, others are duplicative.  There are still a large number of deals done for this reason, and this reason alone. With the lower number of approvals, especially for large-market, general practitioner drugs, the large selling organizations have capacity.
• The rise of the emerging markets – with China now the second largest drug market, and with China and other emerging markets growing 2 – 3 times faster than the US, large drug companies are finding it necessary to have a meaningful presence in countries that before were on the back burner.
• Focus on biologics.  Biotech drugs are not subject to the same risks of generic drugs as regular small molecule drugs, so their commercial life tends to be longer.  Drug companies are looking to monoclonal antibodies not just because of their advanced science, but because they can get paid for the innovation.
• Buying a salesforce – sometimes companies that had historically partnered away their drugs to different territories, are looking to capture more of the value chain – or own more of the distribution.  If a company has a hot new product soon to be approved in the US, for example, buying a company with a salesforce is one way to avoid having to out-license.   This is among the least attractive reasons to acquire a company in my opinion, as it is often done because a purchase hits the balance sheet, while actually hiring the salespeople and bringing them on hurts reported earnings in the short term on the income statement.  Companies often wrongly overpay just to avoid an income statement impact.

While investors are focused on acquisitions, partnering is a far greater trend in pharma than the one-off acquisitions, and this is a trend that is accelerating.  Several drug companies spending more than 20% of their budget on partnered product R&D.  Just last week, Merck announced a $1 billion deal to in-license a cancer drug from EndoCyte, with $180 million of the deal paid up front.  These deals are far more common, but get little attention from investors.

The scope of the partnerships is wide and the sheer number of partnerships at drug companies is staggering.  Merck, for example, has listed on it website more than 75 partnerships with drug companies and academic institutions – and these are only the publicly announced deals, with scores of others are yet unannounced.  Lilly has over 100 active partnerships, according to the company.  Glaxo has a whole unit, the Academic Discovery Performance Unit, whose whole focus is to partner with academic researchers to bring their discoveries to market.   Based on publicly available data including company websites, it seem like each large pharma company is now managing over 100 R&D and commercial partnerships.

I have seen many investors chase overvalued companies on the prospect that another company just has to buy them only to see the stock price collapse.  One good example of this (and there are many) is Cypress Biosciences (CYPB) which at $17 had a new drug approval, a partnership with drug company to market the drug and a steady stream of analysts pushing the idea that someone would buy them.  When that didn’t happen, the stock eventually dropped to $2.50 before later being acquired for $6.00 by a hedge fund.

So will we see more consolidation within the pharmaceutical sector? Yes.  It is inevitable.  But who is next?  Investing by trying to pick which drug company will be next to be acquired is not investing, but speculation and foolhardy in my opinion.  Attractiveness as a takeout candidate is only one part of what makes a good company – the key for healthcare investors is to look for innovative pipelines and potential for commercial success at an attractive valuation, then takeout or not, one has increased the likelihood of a winning investment.