The pharmaceutical-biotechnology industry has become increasingly consolidated over the past 15 years; in 1985 the 10 largest firms accounted for about 20 percent of worldwide sales, whereas in 2002 the 10 largest firms accounted for 48 of sales. Much of this consolidation is the result of mergers. The value of M&A activity in this industry exceeded $500 billion during the 1988 to 2000 period. A commonly cited rationale for this consolidation by proponents of these mergers is the existence of economies of scale in research and development (R&D) and in sales and marketing. However, despite rising R&D spending the productivity of the pharmaceutical industry, as measured by the number of compounds approved by the Food and Drug Administration (FDA) have deteriorated since 1996.
Furthermore, the number of new drugs entering clinical trials has declined since 1998, which calls into question the effectiveness of mergers and the scale economies hypothesis more generally. Moreover, several of the largest pharmaceutical firms have been trading at significantly lower price-to-earnings ratios than many of their smaller rivals, indicating investors believe the larger firms will experience lower growth rates.
Prior to merger with Pfizer, Wyeth was a multinational corporation consisting of four reportable segments: Wyeth Pharmaceuticals, Wyeth Consumer Healthcare, Fort Dodge Animal Health and Corporate. Corporate was responsible for audit, treasure, tax and legal operations of the Company’s businesses (could have potential synergies with Pfizer). All four reportable segments were being managed separately since they developed, manufactured, distributed and sold district products and services requiring different technologies and marketing strategies. Exhibit 1 describes principal business operations and product categories for the main business segments, depicts pharmaceuticals that have been the main source of revenue for Wyeth, representing 83% of the total, in 2008. Furthermore, Exhibit 2 provides a breakdown by business segments based on their revenues.
The combination of Pfizer and Wyeth was characteristic of a horizontal merger (a merger between competitors on the same rung of the industry value chain), which is often rationalized by economies of scale and scope.
In pharmaceuticals, scale economies is most pertinent to the volume that can be sold since manufacturing isn’t a substantial chunk of the cost structure once the drug has been developed. A bigger portion of the fixed costs can be attributed to research & development, about 18% of sales in pharmaceutical, generally highest among all industries and marketing and promotion.
Scope economies is the ability to increase efficiencies in sales and distribution activities by expanding (or reducing) the “scope” of the product portfolio, such as bundling complementary products in a single sales call, or diversifying inventory risk with multiple products. This is more relevant in the pharmaceutical industry. If a company with excess sales force capacity merges with another company selling products in a similar category, sales force can be trimmed and yet potential revenue per sales person can increase since customers now have a wider product offering. Similarly scope economies can be achieved when a company selling an injectable device or drug delivery system merges with another company offering different products in the same category by streamlining manufacturing and distribution.
Large drug makers tend to make strategic bets in the various key therapeutic areas by shepherding a drug compound in each of them. When companies merge, the cumulative pipeline can be winnowed down so that the R&D war chest is devoted to the most promising drugs from each company. Yet to achieve scope economies from M&A activity, companies must be cognizant of their capabilities and how that...