Seeking Alpha
Value, long only, growth at reasonable price
Profile| Send Message|
( followers)  

Summary

  • PFE is unsuccessfully courting AZN to the tune of $100 billion and may soon invest in a hostile bid.
  • R&D productivity is declining for the pharmaceutical industry in general and is worse for larger than smaller companies.
  • Consolidation is a common strategy to stave off slowing growth but is seen to further decrease R&D productivity.
  • PFE's acquisition of AZN will result in large tax savings but will also stifle innovation, which is the chief driver of growth.

Innovation is the main driver of profit in the pharmaceutical sector. Innovation is behind scientific breakthroughs made in research laboratories, drugs and medical treatments created from basic scientific knowledge, and novel manufacturing processes to mass-produce treatments. But, the process of innovation has evolved over time within the industry. As in other industries where complex innovation is paramount (e.g. commercial aircraft sector), new product introductions were made primarily by large pharmaceutical companies. However, with the discovery of genomics and biotechnology and improvements to imaging and stem cell technologies, there are many more small entrants in the pharmaceutical sector. Innovation has shifted from occurring within a few, large companies to within complex networks involving academia and both large and small pharmaceutical companies. In addition, consolidation amongst the large players that has accelerated over the last 15 years is also affecting innovation. This association between innovation and consolidation will be discussed below in light of the potential $100 billion mega-acquisition of AstraZeneca (NYSE:AZN) by Pfizer (NYSE:PFE).

R&D Productivity is Declining Over Time

How has the pace of scientific discovery changed over recent time? The answer depends on how scientific discovery is measured. If you look at the number of biomedical publications over time, the trend indicates a linear increase over time as shown below. This is likely possible due to several factors including: 1) higher R&D investment made at a global level; 2) more scientists working on evermore specialized problems under increasing pressure to publish; and 3) advances in technology that allow for easier data collection.

(click to enlarge)

Source: Pubmed.

However, another way to measure scientific discovery is by the number of new molecular entities (NMEs) approved by the FDA per year.

The above graph shows a different story: the number of NMEs that gained FDA approval normalized to the amount spent on R&D has steadily decreased over time due to reduced R&D efficiency. The declining R&D efficiency in the pharmaceutical industry is more apparent when compared to other industries like the communication and computer industries as shown below.

(click to enlarge)

Source: CBO study on R&D in pharmaceutical industry.

What is causing this troubling decrease in R&D productivity in the pharmaceutical industry? While some have blamed this on a more stringent regulatory environment, the FDA's approval rates have not changed much over time suggesting that this is not a major culprit. Similarly, another oft mentioned culprit is the disappearance of any "low-hanging fruits" (i.e. all the easy discoveries have already been made). But, the pace of science is accelerating and the number of new drug applications filed to the FDA has been relatively constant over time.

Instead, decreasing efficiency may come from poor R&D strategies. This includes an expansive R&D strategy that covers many different therapeutic areas but is too unwieldy to manage efficiently. Also, lack of innovation in-house may not be easily supplemented by licensing agreements and M&A activity that are expensive. Moreover, incorporating new M&A companies can be unproductive for the companies involved.

Lower R&D Productivity for Big Vs. Little Pharma

The below figure shows that the top 10 pharmaceutical companies, which account for nearly 50% of worldwide pharma sales, have a shrinking contribution to the worldwide drug pipeline (25% in 1997 and 15% in 2002) than the remaining pharmaceutical companies.

Source: Nature Reviews on 'Drug Discovery'.

Despite exorbitant in-house R&D budgets, big pharma is less productive than little pharma. In order to stave off the patent cliff, big pharma is looking for innovation externally via M&A and licensing agreements. When analyzing the above M&As, it is found that following M&A activity, R&D expenditures grew more slowly than those of comparable firms that did not undergo M&A suggesting that M&A activity may initially divert resources away from R&D. Productivity post-M&A activity was also lower in companies that underwent M&A as measured by patents filed.

As shown below, both the number and value of licensing deals is increasing over time in the pharmaceutical industry. However, most licensing deals have been late-stage, which are more expensive and less efficient than early-stage licensing deals.

(click to enlarge)

Source: Mergers and Alliances in Pharmaceutical Industry.

Consolidation in Big Pharma Yields R&D Downsizing

The pharmaceutical industry has changed considerably over time from being centralized around a few, large companies to being fragmented with many more new entrants in the industry. Starting in the 1990s, big pharma became larger through a wave of consolidation such that by 2002, the 10 largest drug companies accounted for 48% of pharmaceutical sales worldwide from only 20% in 1985. Pfizer is one of the biggest proponents of this 'acquire to survive' mantra in the industry: in 2000, it acquired Warner-Lambert for $112 billion; in 2003, it acquired Pharmacia for $60 billion; in 2009, it acquired Wyeth for $68 billion. Over this time frame, Pfizer also focused aggressively on cost cutting-partly by shutting down R&D facilities including those in Kalamazoo, MI, Ann Arbor, MI, Skokie, IL, and Sandwich, United Kingdom resulting in the loss of jobs for thousands of scientists.

The motivation for the wave of M&A activity is clear and include: 1) increasing in size to achieve economies of scale in R&D and other activities; 2) expanding into more therapeutic areas; 3) enhancing research productivity by bringing more technologies and talent; and 3) increasing growth rate. For instance, Pfizer's acquisition of Warner Lambert and Pharmacia brought in expertise in oncology, endocrinology, and ophthalmology. However, as stated above, it also resulted in much cost-cutting in R&D and resulted in an R&D budget of about $7 billion, which may be too unwieldy to manage efficiently.

Pfizer's Bid for AstraZeneca

Pfizer is currently the third largest pharmaceutical company in the world (after Johnson & Johnson and Novartis) with a market cap of $190 billion, while AstraZeneca is valued at about $100 billion. PFE initiated a bid for AZN for about $100 billion but so far, AZN has rebuffed PFE's offers claiming that they are undervaluing the company. For PFE, the acquisition will lead to about $11 billion in tax savings as PFE would move its headquarters to Britain and consequently pay a lower corporate tax rate than in America. With a recent earnings report showing a 15% fall in earnings due to the patent cliff it is facing with Lipitor and Enbrel, PFE is also under pressure to acquire growth and a drug pipeline externally. Part of AZN's reluctance to the deal is that PFE has shown a willingness in the past to engage in 'destructive synergies' by closing R&D facilities and shutting down the drivers of innovation. A large acquisition like this would make PFE the largest pharmaceutical company in the world and the subsequent organizational changes may distract from achieving productive innovation.

Conclusion

PFE desperately needs to find a way to increase R&D productivity and increase earnings growth, which stands at an estimated 2% annual growth rate over the next 5 years. Its bid for AZN may make sense from a financial standpoint because of the tax savings involved; however, AZN is in similar trouble and is expected to have negative growth over the next 5 years. Growth projections may change unexpectedly if there is a new blockbuster drug so innovation is the key to growth in the pharmaceutical industry. Instead of fostering growth via internal R&D, PFE has a history of looking externally. However, as discussed above, consolidation stifles R&D productivity. This is being recognized by other players in the industry like Eli Lilly whose CEO, John Lechleiter, has publicly stated his opposition to large-scale M&A. The CEO of Merck, Kenneth Frazier, echoes this sentiment and has pledged to focus on investing in drug development as the primary means of growth.

Source: Pfizer And AstraZeneca: Innovation Will Not Follow Acquisition