Mergers Can't Save the Drug Industry

Mergers Can't Save the Drug Industry

Virtually all the world's largest pharmaceutical companies are struggling to compensate for drug revenue poised to evaporate as pipelines empty and patents expire.

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Mergers Can't Save the Drug Industry

Bayer AG's layoff announcement last Thursday, in the wake of its withdrawal of one of its best-selling drugs from the market, is just the most recent gulp for air in a sector that needs rescue. Virtually all the world's largest pharmaceutical companies are struggling to compensate for drug revenue poised to evaporate as pipelines empty and patents expire.

The dearth of new drugs is hurting the long-term growth of Schering-Plough, Pharmacia, and Bristol-Myers Squibb, to name a few. Even "Big Pharma" firms turning in strong earnings numbers, as GlaxoSmithKline did last month, are disappointing investors. In a sector that made up about a quarter of the value of last year's 50 largest-cap companies world-wide, the problem is aggravated by confusion about the real cure.

Some, like Bayer, are cutting costs—7% of its payroll this round, after withdrawing its blockbuster anticholesterol drug, Baycol, after allegations associating it with more than 100 patient deaths. Other firms are trying to solve the problem by tapping into research-rich surroundings. Novartis recently declared it will put its global R&D HQ on the MIT campus—close to some of the world's best biotech and medical-research facilities. Others, like GlaxoSmithKline and Novartis, are rumored to be seeking merger partners, again.

But such moves won't save the situation. If the big pharma companies want to boost results for the long term, they have to think and act very differently, not only in how they create new drugs, but how they market and sell them.

The big producers agree they need to pump out more than three new drugs a year if they're to hit 10% annual growth. But currently they're only managing just over half that discovery rate. In other words, the big pharma companies don't have the new products or pipelines implied by their reputation as "growth" stocks. If they don't get serious about rethinking the way they do business, that reputation—and the lush earnings multiple it has afforded them—will be in jeopardy. This requires reorganizing internal research efforts, licensing more compounds more often, and focusing on R&D, sales and marketing around a few therapeutic franchises.

So why are many drug companies rumored to be seeking another round of mergers? Put it down to Big Pharma's bad math. Two years ago, the industry thought it had a fix for slow growth: bigger must be better. But if its recent merger mania proved anything, it's that joining two businesses with little in the labs is nothing but an adrenalin shot. Certainly, Glaxo Wellcome squeezed out millions in costs when it merged with SmithKline Beecham in December 2000, but it has been able to do little to deflect the pending loss next year of patent coverage on four drugs, including the popular antidepressant Paxil, that bring nearly $4 billion in U.S. sales alone.

The big drug companies are hitting the limits of scale. As they've gotten bigger, they've strayed from their core franchises, casting their research nets ever wider in search of the next blockbuster drug. But between 1970 and 2000, Big Pharma's biggest breakthroughs occurred where firms had longer, stronger experience—therapeutic franchises in which the companies already had more than $500 million in sales from one or more drugs.

Some pharmas are waking up. GlaxoSmithKline has restructured R&D around six centers of excellence in drug discovery. Each is autonomous, accountable, and entrepreneurial, much like a discovery biotech company.

But GSK's efforts are fragmenting discovery rather than focusing it on a few promising franchises. GSK, and many other large pharmas, need to integrate commercial and development functions into "mini-businesses," with each business assembled around a therapeutic category, such as central nervous system disorders, or a customer segment, clinical specialists, for example. Each unit would handle clinical development, sales and marketing, control global P&L and have its own sales force. Each would be free to license promising compounds, tapping the abundant innovation in outside labs or the company's own research division.

So where does that leave the R&D labs? For today's pharmas, it makes more sense to split R from D. Research will work better as a stand-alone organization, dealing at arm's length with the business units. A separate lab would increase discovery productivity. And its relative independence would let it license compounds that don't fit the company's needs to others who may be able to profit from them, boosting revenues—and researchers' morale. On this score, Novartis may be on the right track.

There's also the not-so-little issue of portfolio management. With the exceptions of Merck and Eli Lilly, few Big Pharma companies handle their product portfolios in truly disciplined ways. Usually, their portfolio reviews consist of project teams that come together ad hoc and disband after a product launch, which means no team remains accountable for results. A senior cross-functional team that oversees all the therapeutic franchises should decide on key tradeoffs, such as what to do with new compounds, which therapeutic franchises to focus on, which to enter, and which to exit.

Finally, some activities, such as manufacturing, and some new discovery technologies, such as genomics, will work better if they're set up as shared services, with prices negotiated with individual therapeutic franchise business units. The franchises that pay for shared services are more careful to make sure the services are managed in an entrepreneurial way, so resources go to the areas of highest return.

Although such organizational upheaval will cost plenty in time, energy and assets, the potential gains—up to five times higher net present value of new drugs compared to what Big Pharma traditionally has achieved—should more than cover the investment required. A stricter focus on therapies or customer groups can pay off in other ways too. It will accelerate R&D output, speed up market entry, and allow businesses to actively manage the closing phases of a drug's lifecycle.

Some industry executives argue that such moves pile all the eggs in one basket. But it's far riskier in the long term not to concentrate around selected therapeutic franchises. Cutting costs may boost earnings in the short run. Merging may hide Big Pharma's basic problem for a while longer by putting more drug discoveries under fewer logos. This time, though, investors won't be fooled.


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