CNBC European Business | Pharma Goes To Market

Pharma Goes To Market

After a busy summer of mergers and acquisitions, Sarah Wachter asks where Big Pharma is going and why?

This may be a bad year for M&A overall, with global activity down 30% in the first half, but Big Pharma is bucking the trend big-time: pharma deals were up almost 48% by mid-August compared to the same period last year, $121.5bn and counting, according to analysts Dealogic, and seven of the 10 largest transactions were announced in July alone.

While this flurry of activity is only the latest in a series of waves of industry consolidations, dating back to 1996 - when Ciba-Geigy merged with Sandoz to create drugs behemoth Novartis - it also reflects the depressed stock market, which has hit riskier sectors, such as biotechnology. Biotech drugs are more complex to make than conventional ones, and typically more expensive.

Ian Oliver, head of Ernst & Young's healthcare division points out that during previous industry flirtations, such companies were valued at a 60% premium to net asset value. In July, Roche's $43.7bn bid for the remainder of the biotech leader Genentech it does not own - which would be the largest biotech acquisition ever - offered a premium of just 8%.

Technically, biotech might represent a risky investment, but for Big Pharma, grappling with how to secure future profits, it is a gamble it can't afford not to take. The pharmaceutical giants may currently be generating annual global sales of around $25bn from bestselling drugs, such as Pfizer's cholesterol-lowering drug Lipitor, but many of theses drugs' patents run out in 2012.

Simultaneously, new medicines are coming under far tougher regulatory scrutiny, says Aparna Krishnan, healthcare analyst with Global Insight. A recent example is Singulair, an allergy and asthma drug from Merck, for which the US Food and Drug Administration is currently seeking information from doctors and patients on side effects. This greater scrutiny is putting greater pressure on a company's total drugs pipeline, adds Krishnan.

As if that were not enough, Big Pharma is facing tougher competition from generic drug companies. A generic drug is identical, or bioequivalent to a brand name drug but is produced and distributed without patent protection. Emboldened by the Hatch-Waxman Act in the US, aimed at reducing healthcare costs, generic firms are becoming more aggressive and more litigious. "They are bringing suits under the act challenging Big Pharma's drug patents, which gives the first generic company to sell one of these drugs a six-month window of exclusivity," says Krishnan.

Biotech has had a better track record recently of drug development, with 80% of new biotech drugs reaching phase three clinical trials, the final phase before a drug gets approved for sale by regulatory authorities. The deal on the table to buy Genentech, a leader in biotech drugs to treat cancer, eclipses recent biotech transactions, including a slew of licensing and collaboration deals by Big Pharma, notably a drug licensing deal by GlaxoSmithKline with Actelion for $3.3bn, the $8.8bn price tag Japan's Takeda Pharmaceuticals agreed to pay to acquire Millennium Pharmaceuticals, and last year's purchase of Medimmune by AstraZeneca for $15.6bn.

In the short run, biotech acquisitions won't improve the balance sheet of Big Pharma, because, Oliver says, many biotech firms post losses and when these companies are consolidated into Big Pharma's results, they will have a diluting effect on earnings per share.

In fact, the business model is radically shifting towards more niche areas where small companies are able to establish and maintain robust growth, says Krishnan. "It is not so much about size anymore," she adds.

But to make these acquisitions work, analysts are in broad agreement that Big Pharma must, by and large, keep newly acquired biotech firms independent, so as not to tamper with the highly successful corporate cultures of innovation already in place.

The recent unveiling of GlaxoSmithKline's new strategy, says Oliver, shows how Big Pharma is addressing short-term needs to increase its new drugs pipeline. But it is also keeping its eye fixed on the long term, by acquiring or collaborating with drug discovery companies and reorganising its R&D structure to "effectively mimic individual biotech companies, with each scientific team acting as a standalone entity," says Oliver.

In parallel with acquiring companies to discover new drugs, Big Pharma must also embark on an intelligent strategy of diversifying into non-traditional businesses, believes Ton Gardeniers, global head of healthcare at ABN AMRO in Amsterdam.

This wave of diversification is well underway. Gardeniers cites two companies that are aggressively diversifying their activities: Novartis, which is developing businesses in eye care; and Bayer, which is developing its CropScience arm involved in everything from seeds to plant biotechnology. But the diversification wave is far from cresting, he says: "There's a lot more that can be done". Gardeniers also warns that diversifying pharmaceutical companies need to be careful not to pursue too many different activities.

Most important of all, analysts say, pharmaceutical companies need to move to the centre of the debate on healthcare, be central to the discussions on how to make it more affordable and how to better use information to make better decisions for managing patient health. Pharmaceutical companies have long become sidelined from the discussion, becoming mere purveyors of pills, not participants in this discussion, one European health care analyst said, requesting anonymity. Gardeniers adds: "The central question in pharmaceuticals and healthcare should be ways to make healthcare more affordable."

According to some of the worst-case scenarios, healthcare could end up costing 97% of GDP by 2080. To make healthcare more affordable and offer a steady stream of profits to Big Pharma, Gardeniers cites the emerging trend of biotech companies making generic versions of biotech drugs. What's more, affordable biogenerics will make it likelier that regulators will give the nod of approval for these drugs, he believes.

But drug companies must also move from the healthcare debate to offering new healthcare solutions. To do so, it is crucial that Big Pharma companies get involved earlier in the management of disease, and in prevention, Gardeniers says. This will include embracing diagnostics and personalised medicine, which involves the taking of genetic information from a patient to determine susceptibility to disease, and using it to develop preventive strategies or treatments.

A number of small companies are working in this new field of molecular diagnostics that has emerged in the past decade, which is in a ferment of innovation, Gardeniers says.

Despite the crossroads at which the pharmaceutical sector finds itself, a number of the drug giants are pursuing new business models: Roche, which has rebounded to become a 'pure play' of R&D productivity, integrating biotech into the larger business; Novartis, which has very solid general management of its overall operations; and GlaxoSmithKline, which is exhibiting leadership and an openness to consider 'everything'.

The pharma sector, says Gardeniers, represents good investment opportunities for the second half of the year, although the real answer to the conundrum of consolidation lies three to five years in the future. Only then can the true value of these recent deals be assessed, Gardeniers reckons. While pharmaceutical companies will continue to cut costs and outsource services, the next phase of consolidation will be more internal than external, he says.

"I don't think the market cares much about cost synergies from these mergers," Gardeniers says. "In the short run, these companies generally represent very good and safe investments.What the market does care about is the three- to five-year outlook, and what kind of growth strategy these companies develop. It's a terrible time to be complacent. Right now, you need to be light on your feet, look at new opportunities, and risk something."