M&A in the Pharma and Biotech industries has often been driven by 1. Purchasing molecules that were considered “underpriced” or 2. To optimize taxation structures via a Tax Inversion. In recent months, the former has turned into a PR nightmare for Pharma and the latter was made more difficult and less profitable. These changes however shouldn’t stop Pharma M&A – it may just slow it down a little and ensure there is a deeper strategic advantage than unpopular price hikes and tax restructuring.
I remember taking a deep dive into an investor presentation deck of a rapidly growing Pharma company. The deck walked through all of the “value” that was created by the company’s M&A activity. The presentation conveyed a compelling story with senior leaders walking through how the new company structure made them more efficient and effective at decision-making and also walked through all of their M&A deals to date. The deck showed how all of the company’s acquired assets were performing better post-acquisition than prior (higher top line revenue and lower SG&A). These examples were given in top line revenue rather than Rx volume because the truth is that Rx volumes (generally) hadn’t increased. Rather, the positive revenue changes came largely from price increases (some of which had to be explained in front of congress). The one exception was a “merger” (technically a “reverse takeover” if anyone was taking notes) of a foreign company. Following the acquisition, the foreign assets actually were performing more poorly under the new leadership. The huge win on the merger was from the tax inversion that (if I remember correctly) lowered the overall company’s effective tax rate to less than 5% (note that the US federal income tax rate of 35% previously applied to much of company’s revenue).
The investor deck effectively highlighted the two key areas that drove Pharma to be one of the most active sectors for deal making:
- Acquisition for the purpose of increasing molecule prices, and
- Acquisition for the purpose of tax restructuring
Over the past months, we’ve seen an overwhelming public outcry against the practice of drastically increasing the prices of in-market molecules. It has resulted in congressional hearings, but more broadly is a PR nightmare for the industry as a whole. The company whose presentation I am referring to has even said it will discontinue the practice (though its ability to take on debt might also be a key driver in its slowing of M&A activity).
Over the past weeks, we’ve also seen the Treasury try to enact changes that make Tax Inversion more difficult and less profitable, including the effective elimination of Earnings Stripping (the legal practice of lending money to entities in high tax jurisdictions for the sole reason of using interest deductions to move profits to jurisdictions with lower effective tax rates).
So with both price increases and tax avoidance potentially off the table, is M&A in Pharma dead?
The answer is clearly no- though M&A activity might appear a little sluggish compared to the past few years. Admittedly, I’m not an Investment Banker, but apparently not all M&A deals in the works currently are dead, as evidenced by Shire and Baxalta. This deal is is touted as creating a leader in rare disease biotechnology (though there were tax restructuring benefits that may or may not be realized at this point). So why will we continue to see Pharma and Biotech M&A activity in the future?
As seen with the Novartis GlaxoSmithKline (GSK) 2014, “swap” companies are looking to increase their focus in certain disease areas. In this deal, Novartis sold its Vaccine business to GSK and bought GSK’s Oncology business (Novartis also sold its Animal Health business to Eli Lilly). By leveling up in certain disease areas and increasing focus, companies can build trust and a strong reputation with certain HCP target groups. This is especially important at a time when rep access is decreasing and fewer HCPs want to see reps from every company. Being a therapy area leader (or even gaining critical mass) can often mean the difference between a rep getting access to a doctor, and ending up sitting in the waiting room. Increased focus also lets companies consolidate sales teams giving reps more products to discuss with HCPs, all while having smaller geographies to traverse and fewer physicians to call on. The hope is that this translates into a more effective sales force with less time travelling and deeper HCP relationships. The increased exposure in rare diseases that the Shire-Baxalta Merger creates is likely the sole reason the deal is still live without the guarantee of tax advantages.
With % of spend on SG&A being reported in the first few sentences of many M&A press releases, cost-cutting will remain a driver for some M&A activity. Some of this will occur with the reduction of sales teams (as mentioned in the Increased Focus section), as we know up to 90% of sales in any year are driven by previous years’ performance (carryover sales are caused by HCPs being slow to change prescribing practices). In other disease areas, sample drops are one of the most fundamental parts of a sales call, meaning reps can carry more products without the need to talk to all of them. Still other costs are saved at an administration and head office level. Cost cutting, as in other industries, will continue to be a driver of some M&A in Pharma and Biotech.
Capability building is in all sectors a key reason for M&A activity, but in Pharma and Biotech, there are specific reasons that this may drive increased transactions in the future.
Certain capabilities are not common to all Pharma/Biotech companies including:
- The ability to mass-produce complicated biologics,
- The ability to leverage new technologies,
- The ability to effectively spend R&D dollars, and
- The ability to bring a product to market in a cost-effective manner
Production capabilities can always be built or bought. For simple molecules, the technological prowess and physical set-up of a production plant is fairly simple compared to that of complicated biologics. In some cases, companies choose to build anew to increase capacity of Biologic Production (ex. Roche announced a large investment to increase biologic production capacity in 2013), while in other cases it is easier to buy the capabilities from others who have access capacity (ex. AstraZeneca purchased and refurbished Amgen’s Colorado biologics manufacturing facility in 2015). In some cases, capacity building may turn into a reasonable reason for M&A as branded biologics lose exclusivity, opening up manufacturing capacity for some companies while others are in need to ramp up production quickly. (Note that the extra capacity may be muted with most branded biologic manufacturers also creating unbranded equivalents – Roche/Genentech being the largest exception.)
New technologies continue to drive innovation in biotech and we seem to hear more and more talk of the promises of CRSPR, Car T-cell therapies and RNAi (to name a few). In short, some of these technologies may yield short-term wins while others may only show true patient benefits (and commercial promise) over far longer time horizons. Some technologies will no doubt be licensed while others will drive M&A.
Decreasing returns on R&D spend is a growing trend in Pharma that has created a shift from building pipeline to buying pipeline (decreased R&D spend in proportion to top line revenue). There are two possible reasons for this, the first being that smaller organizations may in fact be more efficient at R&D. Some large Pharma companies have even broken their R&D teams into smaller units in an attempt to gain efficiency. The assumption here is that the premium paid in purchasing Phase II or Phase III molecules is less than the risk/cost of failure of internalizing the function completely. The other possible reason for this shift is that the markets simply don’t value early stage R&D spend and therefore, in an effort to engineer shareholder value, it is better to purchase later-stage molecules than invest in R&D. Either way, we will no doubt see a continuation of Pharma purchasing pipeline as internal R&D spend continues to decrease.
On the other side of the coin, there will always be pre-commercial organizations that are structured around R&D. These organizations can be exceptional at R&D, but often find themselves in a situation where they have trouble raising funds to complete a Phase III trial. Or if they can, they often don’t have the resources to bring the molecule to market.
The establishment of a sales force, marketing team, market access group, etc. is expensive and takes a very different set of core competencies that many R&D focused organizations do not possess. The organizational transformation required to commercialize a single molecule is often not a feasible business plan if there aren’t fast following products. Fortunately, these companies are actively pursued by commercial organizations that are looking to buy pipeline- driving a continuous stream of acquisitions.
Overall we should expect to continue to see M&A in Pharma and Biotech over the years to come – not just for the reasons above, but also a need to increase market access or market share (Takeda and Nycomed), increase portfolios or move into new space (Sun Pharma and Ranbaxy) and a variety of other reasons common in other sectors. It’s still an exciting time to watch the Pharma world, as companies will continue to keep their eyes open for strategic acquisitions.