A Season in Financial Hell

Pharm Exec's Finance Roundtable 2009, a hot ticket scheduled for March 3, was scuttled by a surprise snowstorm too treacherous for travel. Though we were disappointed to miss out on what is always a spirited debate, a weather-borne paralysis seemed all too appropriate at a time when the financial markets have collapsed like a house of cards (or credit default swaps). Alas, we had to make do with phone interviews of our 13 would-be guests, a diverse mix of professionals representing every link in the M&A supply chain—biotech heads and pharma business developers, experts in the strategy and execution of transactions, Wall Street analysts, and private equity firm investors—plus one Harvard Business School professor for critical mass. We asked this brain trust not only to identify trends in the increasingly complex science and art of drug industry dealmaking, but also to share their own strategies—and, of course, make predictions.

Which biotechs will survive the credit crisis? Can Pfizer get megamerging right this time around? Which businesses will which pharma gain or shed? What's the latest in risk sharing and alternative funding? These were just a few of the questions we asked our experts. And then, just as we were concluding the interviews, lightning struck twice more: the Merck-Schering and Roche-Genentech deals were announced, possibly changing the game entirely—and forcing us to bother our experts again.

As you might expect, there's no consensus on whether bigger is better. The one thing everyone agrees on is that between the financial crisis and healthcare reform, pharma is going to be acting—and transacting—as fast as it can.—Walter Armstrong, Senior Editor

Todd Davis

Co-Founder and

Managing Director,

Cowen Healthcare

Royalty Partners LLC

Todd Davis

It's no secret that pharmas have a number of challenges—patent expirations, getting drugs approved, drier pipelines, and payer pushback over prices. There is also a general feeling that they need to diversify. Consolidation gives the Pfizers and Mercks the ability to quickly address some of these challenges.

There is definitely a strong rationale for each of the three mergers. Wyeth provides Pfizer critical mass, especially in the area of vaccines, and allows it to shift its focus away from blockbuster primary-care products. Genentech gives Roche full access to its oncology portfolio and the ability to improve coordination on product development. Merck gets Schering's anti-clotting drug and its women's health and respiratory treatments clinical program, but also helps diversify its revenue with the 70 percent of Schering's revenue that comes from outside the US.

The three deal structures are different from the debt deals we've seen in the past. They all had a decent-sized equity component—Merck put up 44 percent in cash. This is a trend we expect to continue.

I think these three megamergers are just the tip of the iceberg. There are still a number of other pharma companies with a fair amount of cash on their balance sheets, and M&A is a logical path to pursue, as it's often cheaper to buy than build. You also don't want to be left out of the game—more companies will join forces to ensure they stay competitive.

Pricing pressures and healthcare reform will impact where pharma companies invest their money. Blockbuster drugs and primary-care products are likely to be under the most pricing pressure, forcing companies to diversify. This has already started to happen, as pharmas have started to move from big categories such as cardiovascular and lifestyle products into cancer, Alzheimer's, and obesity, where the needs are not well met. Even more important, real product differentiation in terms of meaningful safety and efficacy advantages will be the best defense against pricing pressure. "Me too" products will be the most vulnerable, even if they have strong patents.

Carolyn Buck Luce

Global Pharmaceutical Sector Leader,

Ernst & Young LLP

Carolyn Buck Luce

No two deals are alike—and that's the case with the three megamergers. Each deal was structured in a different way for particular strategic reasons—a straight merger, a reverse merger, and an unsolicited takeover that finally became friendly. However, once the deals are consummated, the strategic imperative becomes the same: how to execute the alignment and/or integration in a way that will capture value.

By creating three mega biopharma companies, the landscape of Big Pharma is transformed. Biopharmaceuticals are no longer a mid-cap game.

The collapse of the financial system makes this a great time for acquisitions in general; pharmas have a lot of cash, and biotech valuations are low. But when there is such a discontinuity in strength between buyers and sellers, it's more important than ever for pharma to ask, "Does this acquisition accelerate my ability to execute my strategy?" For companies that don't have their strategies straight, their ability to be successful in a major merger are reduced.

Being the partner of choice is not something pharmaceutical companies are known for. Their ability to be flexible, to grow based on other people's innovations versus their own, and to understand how to create a win/win has been limited. The partnership has been defined as "what I need" at a point in time.

We're seeing the start of a marriage between private capital and the pharmaceutical industry, in terms of financing business activities in which one partner is willing to take the scientific risk and the other is willing to take the financial risk. Recently, there was a very interesting partnership among Lilly, TPG-Axon, a private equity partnership, and NovaQuest, a joint venture created by TPG-Axon and Quintiles. It's an example of how pharma can be part of someone else's grand strategy as opposed to having to create the grand strategy themselves.

Right now, the entire revenue stream for a pharmaceutical company is based on what it makes, not what it knows. Content and research and benchmarks about the product are monetized only through sales. At the same time, pharma companies educate consumers and doctors so that they are more effective and efficient in their choices—and they give that away for free. The future involves moving from a product-only company to a product-and-service company in order to have a long term revenue-generating relationship with customers.

Gino Santini

Senior Vice President, Corporate Strategy and

Policy, Eli Lilly and Company

Gino Santini

You'll never go find a merger between two large pharma companies that has gained market share. That doesn't mean the Pfizer-Wyeth or Merck-Schering mergers will destroy market share, but it does tell you why they merged in the first place. A merger can help you become more efficient and cut a lot of cost, but do not expect to see more innovation or big growth.

For Lilly, the acquisition of ImClone—besides being very interesting because of Erbitux and other products in the pipeline to substitute our patent expirations and complement our oncology franchise—also had the element of the biologic capabilities. We see our portfolio in the future split approximately 50/50 between biologics and small molecules, and ImClone will help us achieve that.

We need to become a lot more productive to decrease the cost of bringing one molecule to market. At Lilly we set our goal at a one-third reduction—from $1.2 billion to $800 million. We believe we are already half way there. We spun out all our in vivo toxicology to Covance, We think they can actually run their operation more efficiently than we can, so we've done a lot to decrease our costs through a better percentage of variable versus fixed costs.

We're experimenting with a lot of pilot programs, trying to establish a network of partnerships to develop many of our molecules. There is an element of risk sharing, because they take the risk of the development cost; if the molecule is successful, we have an option to buy it back, but at more than we paid for their costs. We've done a few arrangements with external investors on some of our more expensive internal development projects. The expected return that a financial investor requires is a lot less than what a fellow big pharma does.

At Lilly, the targeted therapy approach is a top priority, and virtually every program in development has a biomarker strategy. That really justifies having a very high market share in that group of patients, because your drug is absolutely better than the alternative, and its value justifies the price.

The days when pharma just came in and paid a biotech to give up its program are gone. The smart biotechs and pharmas both realize that they need each other, and there's a very positive, mutually beneficial overlap around mid-stage development—as opposed to arm's length transactions.

Jason Rhodes

Vice President, Business Development,

Alnylam Pharmaceuticals

Jason Rhodes

Evolution is often hastened by cataclysmic events, whether a meteor strike or an ice age. The equivalent here is the economic crisis combined with a very challenging regulatory environment, where the hurdle for products is very high. At the same time, the need for innovation has never been greater. Big Pharma has had to evolve beyond the small-molecule platform. The three new megamergers are a response to all of that.

It's an even more Darwinian period for the biotech industry. But I think most of the companies that have compelling technology and intellectual property will make it through. And on the other side, there will probably be somewhat less capital, but that capital will probably be focused on a smaller set of stronger companies.

This isn't the first time. I remember going to BIO in 1998, and people thought it was the end of the industry. It can be a desert, and every once in a while it rains and flowers bloom and people say, "Gosh, now we've entered this verdant new world." And then we go back into the desert.

The absence of capital may have lowered the prices of biotechs somewhat, but it's not like pharma is on some kind of shopping spree. They aren't buying things that they wouldn't have bought otherwise. They're very disciplined. They recognize that moving into a non–small molecule world is a long game, and they're asking what kinds of companies can we work with in order to position ourselves to be a winner.

The days when pharma just came in and paid a biotech to give up its program are gone. The smart biotechs and pharmas realize that they need each other, and there's a very positive, mutually beneficial overlap around mid-stage development—as opposed to arm's length transactions.

At Alnylam, we think hard about how we monetize the value of our intellectual property and platforms, while retaining the opportunity to develop our own pipeline. We generally do large, non-exclusive platform partnerships or license out our products as they enter the clinic. Both involve up-front and milestone payments, and often shared royalties.

It's program funding that's highly rational and recognizes where relative skills lie. That's really the future, where companies learn to work together in long term collaborations.

Michelle Dipp, MD

Vice President, Head of US

CEEDD, Center for Excellence for

External Drug Discovery,

GlaxoSmithKline

Michelle Dipp, MD

When you look at the megamergers, you see two large pharmas looking for what one lacks and the other has. Some of the unintended consequences will be downsizing and the effects on biotech. If Pfizer and Merck are spending a lot of money on major acquisitions, they'll have less money to do other deals. Whether there will be more consolidation depends on the strategic vision of each company. At GSK, Andrew Witty stated publicly that we are absolutely not out to do public mergers. So where Pfizer may be focusing on products that are already on the market or close to it, GSK is looking a little bit more toward innovation.

The financial downturn is having a winnowing effect on the biotech industry. I think it's a good thing. We were in a bubble, where it was easy to raise money. Companies that have a clear, well-reasoned business plan and are working on good science will be the survivors.

In a biotech, you have to conserve cash and extend your runway, and the only way to do that now is to cut programs. But at the end of the day, forcing a biotech to focus on only one or two programs is actually the way to generate therapeutics.

This is an opportunity for pharma to really dip its toe into innovative science. The volume has increased a lot in terms of companies wanting to partner right now. At the CEEDD, we have about ten companies a day wanting to talk to us.

We're also seeing pharma downsize. At GSK, we've not only cut but also refocused our programs, so the entire R&D arm has been reorganized into smaller therapeutic groups. GSK has made a strategic effort to foster an entrepreneurial spirit, so we've taken large groups of 500 to 2,000 people and broken them down into groups of 60, 70, 80 people. You don't have to go to large committees and wait two weeks for information to proceed. You can get things done, and you're empowered to make decisions. It's like a biotech company, right?

Steve Holtzman

CEO, Infinity Pharmaceuticals

Steve Holtzman

To state the obvious, these are very hard times for the biotech industry. The financial downturn is dramatically affecting public biotechs that are, say, three to ten years old—in the past, their alternatives were partnering with pharmaceutical companies or accessing the equity markets. Now, with those markets closed, pharma has tremendous leverage.

In contrast to the many struggling biotechs, Infinity has a very aggressive investment in R&D over the next several years and a cash runway through at least 2012. We entered into a partnership with Purdue Pharmaceuticals, which is building a cancer franchise outside of the US. They made a $75 million equity investment in Infinity at a premium of more than 100 percent, and will invest another over $400 million over the next five years. They will market outside of the US, whereas we retain the domestic rights.

It's emblematic of the kind of win-win deals that are being struck between pharma and biotech. It provides us significant funding so that we can develop our later stage molecules and continue to fuel discovery without being turned into a contract research house with minor royalty rights.

In order to stretch their cash out, many young biotechs are cutting back on discovery efforts and focusing on their late-stage clinical asset. The cumulative effect could be to diminish discovery efforts across the industry. It also renders these companies very vulnerable—if you're reduced to betting on a single project, your probability of failure is higher. Even the companies that can preserve capital to get to the next set of data points are likely to end up having to sell to a pharmaceutical company and—having been reduced to a single asset—they will just be bought up and split up. The discovery platform will be gone.

An alternative would be for pharmas to find ways to work with biotechs, to truly take advantage of their innovative capabilities. We keep hearing about how Big Pharmas want to be more biotechlike. But becoming more like a biotech doesn't just mean getting smaller—taking your 1,000 R&D people, who have been trained and socialized in a certain environment, turning them into groups of 100, and now all of a sudden they'll act differently. There's a lot to be said for identifying high-quality biotechs, bringing them under your wing, and leaving them alone.

Peter Tollman

Senior Partner,

BCG, The Boston Consulting Group

Peter Tollman

The industry has been consolidating for a long time, and to some extent Pfizer-Wyeth, Merck-Schering, and Roche-Genentech are part of that trend. But it's still not a highly concentrated industry. If you look at the projection for 2010, the top 5 players represent about a third of the industry revenues, and the top 20 players about three-quarters.

Being bigger can be helpful in many ways. Your negotiating power with payers, especially powerful private or governmental institutions, is greater. Your global reach is greater. Your ability to access innovation is greater; your presence among suppliers, like CROs, and your ability to improve cash flow by managing costs are all greater. So both Pfizer and Merck have announced improved cost positions that are going to come about as a result their transactions. If you can gain $5 billion in cash flow a year at a P/E of even 10, that gives you $50 billion in market value.

But ultimately it's the ability to grow through innovation that's going to drive success, and it's very difficult to see any relationship between size and innovation either positive or negative.

The three mergers have shaken up the industry. If you want to compete at scale, a new level has been attained. There's now significant distance between Pfizer, Roche, or Merck and the rest. At the same time, there's a scarcity of targets the size of a Wyeth or Schering-Plough.

The biotechs have been picked over many times. At this point it's a buyer's market, but the buyers are finding few opportunities in their sweet spots—even among early compounds. So the force of the market is going to be played out, and a significant number of biotechs are going to go out of business.

The Big Pharmas have been progressing their own pipelines, and their drug discovery is more productive than it used to be. Even the biggest aren't able to fund everything they'd like to as compounds go through the clinic, so many are looking for creative ways of sharing the cost of development and/or the upside of the compound—from deals with each other to deals with private equity. This trend in exploring different risk-return trade-offs is only going to accelerate.

Despite the megamergers, the idea of the monolithic pharma company that discovers, develops, and commercializes all under its own roof is being deconstructed—and not just by biotechs.

Gary Pisano

Professor of Business Administration,

Harvard Business School,

author of Science Business

Gary Pisano

We've been down the megamerger road before, and it hasn't worked. I can't think of one company, other than Novartis, that was better off for having merged. The buyers always say the same thing—"there's synergy." But they rarely produce it.

Even Merck, which has avoided big acquisitions until now, went for it. Their merger was motivated by Schering's pipeline. But the market presumably values the pipeline reasonably fairly, so there's really no free lunch. In fact, we know that people tend to overpay for mergers, relative to their value. So you immediately put your own shareholders in the hole. They've already overpaid for stock that they could have bought at the market price, usually for 50 percent less. So now you've got to do 50 percent better, just to make your shareholders whole.

You can cut costs, but it's a one-shot deal. And everybody knows what that means: laying off a lot of people. So now everybody in the organization, at all levels, is thinking about how to keep or enhance their position. They're not thinking about "How do I develop a new drug?"

Now Pfizer has $70 billion in sales, which means it has to add, say, 10 percent annual growth. Think how many drugs Pfizer needs to launch to generate $7 billion in extra sales. Seven blockbusters—in one year. But these guys can't even do one or two.

The Big Pharmas should be acquiring companies that do things differently from themselves, not more of the same. If I were advising Roche, I would have told them to leave Genentech exactly as is with their 60 percent share, and take the $48 billion and go acquire a dozen innovative biotechs—one of which might be the next generation's Genentech.

I assume that Roche is aware that the gold mine at Genentech isn't just Herceptin and Avastin, but the management team that created all that value. The power of Genentech is that it's very well integrated among research, early development, clinical development, manufacturing, process development, and marketing. If Roche goes in and decouples, and starts saying, "Genentech, you're just going to be a research or early development group," they will destroy a lot of capability.

Sylvie Gregoire, MD

President, Human Genetics

Therapies Business,

Shire Pharmaceuticals

Sylvie Gregoire, MD

We can't avoid these three megamergers. It might become worrisome if the trend continues [to the point] that there will be just one big European and one big American pharma—like other industries where such large consolidations occur. Whether that's good for innovation is unclear.

I'm not sure that blockbusters will drive future growth in the industry. It might be personalized medicine and smaller total products—$300 to $500 million, not $3 to $5 billion. How you meld an extremely large infrastructure with focusing on niche products is also unclear.

The current economic crisis will have an impact on sales—for example, on which products get on the Medicare and Medicaid formularies and how much they cost. The uncertainty creates a lot of fear, from an investor's perspective, about what will happen to this industry, and you can see how we follow the trend in terms of stock price.

However, the worst part to this crisis is the fear that exists, and all the sources of novel products that have been completely shut down as a result. VCs are not investing in small start-ups. No one wants to take any risk. With the financial markets closed, it's harder for even midsize pharmas to raise cash in order to do a good acquisition. And that will contribute to the drying up of the industry pipeline, creating a further lull in the innovative cycle.

At Shire, we believe that the quality of the revenues and the risks associated with those revenues is better handled by diversifying, and therefore not completely dependent on a particular territory. If some reform occurs in the US and the majority of your revenues are from the US, that's an issue. That's why our goal is by 2015 to have 25 percent of our revenues coming from outside the US, Canada, and the big five European countries.

It's a time of global change and turmoil for our industry, but that was happening anyway, before the economy tanked. The added challenges force us to focus on doing it better. We should see that as opportunity, not the death of innovation.

Lori Hoberman

Principal, Fish & Richardson, P.C.

Lori Hoberman

Even in the current financial climate, the CV money is still there for early-stage biotechs that have a product or platform with blockbuster potential. That's what the venture capitalists are looking for: something with a big potential exit. But there's much less tolerance for risk because of the long term nature of the investment. The funds in that space have at least a two-year time horizon. Investors are getting a lot of pressure from limited partners who don't want to be writing checks to make their capital calls. The message to the biotechs is "Cut the burn rate with a smaller space, fewer employees—whatever you can do to minimize the time you need to go back to the trough for more money."

At the same time, the Big Pharma companies look to these startups as part of their own R&D and innovation. We're seeing a lot of joint collaboration, where the Big Pharma is bringing something in its portfolio to the table and relying on these small, much more nimble, early-stage companies to build it out or find another use for it. Then, at the end of the collaboration, there are some very interesting licensing arrangements—maybe the compound goes back to the Big Pharma, with significant royalties going to the early-stage, or certain exclusivities are given to early-stage versus Big Pharma in terms of marketing.

Back in 2001, the early-stage biotechs experienced a survival-of-the-fittest shakeout. I think that this is a deeper recession, and two-thirds of these companies may run out of money by the end of the year. There's a mindset change that needs to happen. Strategic acquirers and investors need to get away from the fear, and start to view things as opportunities. We need a shift away from those particular blockbuster-potential drugs to more niche plays, off of which you can still make decent profits.

The profit motive is at the heart of everything, but there are other reasons for drugs to hit the market. If the blockbuster profit potential shapes the market, it will absolutely be doomed.

Ronald Renaud

CFO, Idenix Pharmaceuticals

Ronald Renaud

Being in biotech is a risk-laden endeavor, and the risks just get magnified in a serious economic downturn. We have to pay attention to our balance sheet even more closely now than in a good market, and worry even more about how every decision is going to impact the return on investment. The notion used to be that biotech companies never go away, they just reinvent themselves. But now we are definitely seeing companies close up shop. The capital-raising window is mostly shut.

It's quite a shift, from talking about small biotech bankruptcies to Big Pharma megamergers, even though they're part of the same industry. The mergers are obviously about the need for products, as a patent cliff is staring these big companies in the face. But I don't think it's desperation as much as it is a sea-change in how Big Pharma is thinking about its own R&D productivity. There's the need to address low productivity at a very, very critical point in the industry's life cycle.

The 10 or 11 largest pharmaceutical companies are almost at $1 trillion in market cap. And, on average, they have from $10 to $12 billion in cash, with continued free cash flow. So there's a lot of capital to deploy for needed assets. With valuations where they are and the amount of cash Big Pharma has, the opportunity to aggregate smaller biotech companies with innovative drug discovery platforms, whether in inflammation, say, or virology, is more attractive now than in the past 15 or 20 years.

There's a lot of diversity now in the way pharma is structuring deals. At Idenix we just completed a $450 million licensing deal with GlaxoSmithKline for one of our three HIV compounds. We get an up-front payment, and the rest is contingent upon our successfully meeting milestones. We also get royalties if the commercialized product meets sales milestones. Both sides win in that kind of deal. There's a very natural synergy compared to the slash-and-burn approach to M&A that we've been accustomed to.

There used to be an assumption that hostile takeover attempts didn't happen in biotech. You can't say that any more. They happen up and down the range of market caps—you have Roche and Genentech, Astellas and CV Therapeutics. If you're a small company, it makes you more vigilant about who owns your stock.

Les Funtleyder

Healthcare Strategist,

Miller Tabak, co-author of

Healthcare Investing

Les Funtleyder

Pharma has been a consolidating industry forever, so it's not like these three megamergers mark a radical change. But the Pfizer-Wyeth merger did change the environment, and triggered the expected strategic responses as seen in the Merck/Schering deal—with probably one or two others to come.

In all three deals, people more or less agree that the price was within the ballpark of fair. So we're starting to get a better sense of the valuation parameters setting floors and ceilings of what the top pharmas can cost. But value is in the eye of the beholder and rests on assumptions that either will or will not be met.

Can Pfizer do this merger differently? If some innovative drugs come out of the combined pipeline in, say, 2013 and beyond, then spending $65 billion on one acquisition may have been worth it.

The Merck-Schering deal has better odds because their portfolios are more complementary and their pipelines are both in decent shape. But Merck has little track record at big consolidations, and I wouldn't predict that its process-driven culture will increase innovation when it's 50 percent bigger.

Roche and Genentech probably stand the greatest chance of success, if only because Genentech has such blockbuster products and Roche has proven that it can manage Genentech at arm's length. But whether Genentech's scientists, who are among the best in the industry, will want to stick around is the trillion-dollar question.

I think we're going to see a lot of deals this year, of many different kinds. The small- and mid-caps also need new products—the game is grow or go. Even though it's a very successful company, Gilead swept in and bought CV Therapeutics because it wants to grow beyond its HIV/HCV core into a new line, and CV has one or two cardio drugs.

It's unclear how pricing pressures will play out. With healthcare reform, drug reimportation, comparative effectiveness, and other proposals that have been talked about for years, things are going to get less favorable for pharma. There may be an advantage of scale for a megapharma when negotiating with payers. In the end, companies that get on board with improving access and quality and controlling costs stand a much better chance of creating value.

Dean Slack

Vice President, Strategic

Advisory, Leerink Swann

Dean Slack

Mergers and acquisitions have been a regular part of our industry for many years. Now we're seeing some major consolidation. The drivers are particular growth products, scale, and, increasingly, continuity of revenue and profit in the face of patent expirations.

While being large can help a pharma with securing preferred access for its medications, the benefits of R&D and commercial scale have been difficult to capture. Being large also makes continued growth much more difficult. But I don't think that having fewer, larger pharma companies will stifle innovation. Some pharma companies are adopting decentralized approaches, while others are using external R&D for de-risking.

The rout in the stock market has created many good values in the biotech community. Recently, one-third of the biotechs were trading at values below their cash-on-hand. Striking a deal with pharma validates the biotech and can increase valuation. Traditionally, alliances have been done with licensing and royalties. But now, to extend their months of cash-on-hand, biotechs are newly open to all sorts of cash-inducing arrangements with pharma—even being acquired.

Many pharmas' share prices are depressed right now, despite strong earnings, so there's still an emphasis on gaining efficiencies, improving operations, and driving growth and earnings. Cost cutting need not require a bloodletting of reductions in the work force. There are many ways to work smarter, empower people, and create more efficient processes. In one case, we saw a marketing organization face 63 steps—many removable—in carrying out the tactical implementation of its strategy. Companies need to be cognizant of doing business better each planning period.