Last week, Pfizer announced the $160-billion acquisition of Allergan, an Ireland-based pharmaceutical company.
Mergers and acquisitions, even big-ticket ones, are not new to the drug industry. A Pricewaterhouse study released in October 2015, put the total number of deals in the quarter ending September at 59, up from 46 the previous quarter. The deal value too was higher, at a little over $72 billion compared with $67 billion. The study spoke of nearly 110 such deals in the pipeline awaiting completion of commercial and regulatory formalities. Even by the standards of an industry that has seen some really big-ticket deals in the past, the latest records beats earlier ones by some margin.
The largest acquisition till date goes all the way back to 1999, when Pfizer put in a successful bid to acquire Warner-Lambert for a consideration of $87.3 billion. Adjusted for variations in stock market valuation during the relevant period, the latest buy dwarfs the earlier record for such deals.
The S&P 500, a benchmark index of stock values, was ruling around 1,250 back in 1999. It is now marginally short of 2,100 as of Friday’s close at the New York Stock Exchange. An adjusted valuation of the Warner-Lambert deal would place it at around $150 billion, a good $10 billion short of the latest announcement.
Why the obsession?
What explains this obsession with deal-making in the pharmaceuticals industry? More specifically, how has it altered the industry structure? Has it become more monopolistic in character? Such large acquisitions notwithstanding, the overall structure of the pharmaceutical industry hasn’t changed all that much over these years. It is a still a tightly contested market globally as well as in the US, with a few large players and a large number of relatively smaller players existing side by side in most markets.
Of course, this is as it should be. If a merger or an acquisition fundamentally alters the market structure, you can be sure the competition authority — in this case, the US Fair Trade Commission — would have stepped in to stop the deal from going through. All this raises a more basic question: if it hasn’t resulted in concentration of pricing power for the acquirer, why is the company going through with it? A few things stand out. Some of these are specific to the industry while other factors are attributable to the overall business environment.
The points
The first basic problem for this industry is that it is unable to come up with product innovations with the same ease as it has been able to do in the past or as other industries are able to do now.
Take the auto sector. It can roll out any number of new models in a year and hope that some, if not all, gain customer acceptance and boost revenues and profits. For the drug industry, this has been extremely hard to come by. New drug launches have to cross a lot more regulatory challenges than a new car model is required to do. All claims at every successive stage of drug discovery have to be validated by two sets of professionals, who cannot even accidentally meet each other as that would compromise the objective of independent verification of drug efficacy, in the regulator’s eyes.
That is how elaborate is the process of drug discovery approvals are. It need hardly be said that all of that adds to the cost of bringing a new drug to the market.
There’s a way
But all this can be managed if one can come up with genuinely path-breaking research that leads to curing of cancer; or a permanent relief from diabetes. Unfortunately, the pipeline of such promising active pharmaceutical ingredients is practically empty. It may be just around the corner but, as things stand, a cure for cancer is proving just as elusive as ever.
It is not uncommon for pharmaceutical companies to set aside as much as 15 per cent of their gross revenues in R&D expenditure. If that isn’t translating into new streams of cash-flows, it is hard for the management to justify to the investment community its contribution to shareholder wealth creation.
The pharmaceuticals industry has to contend with the spectre of cheap ‘copy-cat’ drugs (generic versions of a proprietary medicine) once the patent protection on an existing drug runs out. At a time when India modified its law on intellectual property, promising the innovator ‘product’ patents as opposed to ‘process’ patents that the country granted until then (to make it compliant with the WTO stipulations), it was estimated that 90 per cent of drugs enjoying protection would go off patent by the year 2020. The industry has thus been experiencing steady erosion in profit margins as more and more drugs have been going off the patent list, at least in the key markets such as the US.
What industry has done
Of course, the industry has not been passive. It has been lobbying with respective Governments to extend patent protection for existing drugs by making marginal improvements. Once the marginal improvements are recognised and patent granted, the existing version of the drug too will enjoy similar protection as it would be seen as not significantly different from the new version that has been granted patent protection.
You can see their point of view. It is extremely challenging to come up with new blockbuster drugs. Yet profit margins have to be protected. Otherwise, retribution from the stock market is swift and often brutal. So the shelf-life (patent protection) of the existing drugs has to be extended so as to be able to extract premium pricing for the available portfolio of patented drugs.
The US pharma industry has been particularly successful in this regard. The USPTO (United States Patents and Trademarks Office) has been rather accommodative of the industry’s concerns. In one instance, a company which enjoyed a patent protection for an anaesthetic medicine (Propofol, the drug which became even more famous as the medicine that killed Michael Jackson) was able to get extended patent protection by innovating on the rubber stopper used in the container through which it is administered.
In another case, the incumbent beneficiary was able to get an extension of patent protection for the drug by demonstrating a capacity for ‘oral disintegration’, as opposed to absorption in the stomach (superior absorption) and additionally, introduced a change in its physical characteristic (speckled appearance… ta da!).
Why it’s not a good thing
Yet this has had unintended consequences. From a situation where the pharma industry was merely looking for temporary cash-flow relief through regulatory capture, it has now turned into an argument against committing fresh money for research. If profits can be sheltered by tweaking the patent law regime in its favour, why would the CEO of a drug company commit more money for research?
From here, it is but a short step to saying: “Let somebody else come up with a research finding, then the business can be taken over by paying top dollars”. Or so the argument goes. Thus the stage had been set for more mergers and acquisitions.
The only difference is that the target is not a seasoned listed entity, but a start-up that has achieved a breakthrough in research. Through other external factors like a benign tax regime in one country vis-à-vis another, the case for more mergers and acquisitions becomes even more compelling. In the instant case, Allergan as a target for acquisition had become doubly attractive by the fact that the corporate tax rate in Ireland is lower than in the US.
Hence a merger involving an Irish company and a US parent can well become a case where the Irish company ends up being the acquirer. The exact mechanics, of course, (called ‘tax inversion’) are a matter for the lawyers and accountants to work out.
But, anyway, the end result is more mergers and acquisitions.