With big pharmaceutical players hitting the limits of scale, it's extremely risky to buy into the bad mathematics behind renewed merger mania.

The merger tom-toms are beating again in the pharmaceutical industry; just Friday, for example, there were press reports of talks between GlaxoSmithKline and Bristol-Myers Squibb. But it's not a beat to which Big Pharma can dance. Additional mergers will feel exciting for a while, but they will only mask the sector's deeper problems. And you can bet on one thing: Investors won't exactly be dancing, either.

So what cramps the style of big pharmaceutical companies such as Bristol-Myers, Glaxo, Schering-Plough and Pharmacia? The problem is this: precious few new drugs in their pipelines to drive long-term growth. Even those turning in great earnings—as Glaxo did when it announced its first-quarter results in late April—are getting big frowns from investors.
In a sector that made up about a quarter of the value of last year's 50 largest-cap companies, the problem is aggravated by confusion about the real cure.

Sure, the merger option looks attractive—the top two drug makers today have no more than 7% of world markets apiece. And Big Pharma's top executives certainly hear all about the advantages from their investment bankers.

But if they really want to delight investors again, they have to think and act very differently, not only in how they create new drugs, but also in how they market and sell them.

The big producers agree they need to pump out more than three new drugs each per year if they are to hit 10% annual growth. But they're averaging just over half that rate.

The better approach calls for reorganizing internal research efforts, licensing more compounds more often and focusing on integrating R&D, sales and marketing efforts around a few therapeutic franchises.

A study by our company estimates that the net present value—the incremental cash a company could have today from the lifelong proceeds of a successful drug—could be nearly five times higher for a tightly focused company than for a typical Big Pharma company.

Why all the current merger rumors, then? Put it down to Big Pharma's bad math.

Two years ago, the industry's leaders swore that bigger must be better. But if the recent merger mania has proved anything, it's that joining two businesses that have little in the laboratories is nothing but a pick-me-up.

Sure, 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 problem is that the big players are hitting the limits of scale.
On one hand, their organization models, structured strictly around functions, are centered on research labs that sow pharma molecules across a wide swath of disease categories and count on serendipity to produce breakthroughs. On the other, Big Pharma labs are not discovering more blockbuster compounds by merging with each other and building broader product portfolios.

In fact, the record shows that "serendipity" worked best where it coincided with a drug company's strongest suit. About 70% of blockbuster drugs created from 1970 to 2000 occurred in therapeutic franchises where companies already had more than $500 million in sales from one or more drugs.

Some pharmaceutical companies get the picture and are trying to refocus.
GlaxoSmithKline has restructured R&D around six centers of excellence in drug discovery. Each is autonomous, accountable and entrepreneurial, as in a discovery-biotech company. But GSK's efforts are fragmenting discovery rather than focusing the company on a few promising franchises.

Instead, GSK needs—as do many other large pharmas—to integrate commercial and development functions into mini-businesses. Each business should be assembled around a therapeutic category, such as central nervous system disorders, or a customer segment—clinical specialists, for example.

Run by a general manager, each unit would handle clinical development, sales and marketing. Each would control global P&L, would have its own sales force and would be free to license promising compounds—tapping the abundant innovation in outside labs or in 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 discoveries that don't fit the company's needs, which would boost revenues as well as researchers' morale.

Some industry executives argue that such a tight focus would put all the eggs in one basket.

We argue that it's far riskier in the long term not to concentrate in such a manner—and it's riskier still to buy into the bad mathematics behind renewed merger mania.

Ashish Singh is a vice president at Bain & Co.'s Boston office. James L. Gilbert and Jochen Duelli are based in Munich, where Gilbert is a director and Duelli a vice president. All three are leaders in Bain's global healthcare practice.

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