In the pharmaceuticals industry, bigger doesn’t always mean better: the largest companies haven’t necessarily produced the highest long-term returns, and pharma remains one of the least concentrated of major global industries. Nonetheless, its largest players recently initiated a spate of mergers that created a new class of heavyweight with annual drug revenues of more than $20 billion. Despite the claims of the executives who cited the benefits of size as part of the rationale for making these deals, financial markets frowned on many of the combinations when they were first announced.
Yet for the largest drug companies—"Big Pharma"—size could bring advantages in several critical areas. Size provides an edge in launching blockbuster drugs, which can individually generate $1 billion or more in annual revenues; increases the number of bets a company can place on new technologies; helps it complete clinical trials more quickly; and increases its desirability as a licensing partner. Moreover, the biggest companies tend to back the most promising products, to enter key markets most quickly, and to deploy large sales forces to launch and market products most effectively.
Although becoming the next giant isn’t a pharma company’s only possible strategic path, remaining competitive will increasingly mean capturing the advantages of size through mergers or creative alliances. But realizing these benefits will force companies to manage this kind of scale carefully and to depart from current industry practice in organization and other important areas.
To assess the value of size in the industry, we analyzed and compared the performance of the 15 companies with the largest ethical-drug sales in 1999 and categorized these players into three "weight" classes (see sidebar, "The players"). Tapping industry databases for information about R&D projects, alliances, and the effectiveness of sales forces in promoting different drugs, we assessed the value of scale in several key areas, such as discovery, development, licensing, global launches, and sales. In addition, we synthesized the perspectives of dozens of industry experts, including McKinsey consultants who have broadly served the industry.
Why size didn’t matter . . .
Our research suggests that there is little long-term correlation between size and returns to shareholders (Exhibit 1). Since the late 1980s, pharma companies have consolidated to broaden their geographic reach and to enter new therapeutic areas, but the relative success of these suddenly larger entities depended on factors other than size. Throughout the 1990s, success was more closely related to the development of blockbuster drugs and to a strong presence in the US market. Three companies with significant growth in blockbuster sales in the past five years managed to outpace the industry: Pfizer, with its impotence treatment, Viagra; Warner-Lambert (now part of Pfizer), with its anticholesterol drug, Lipitor; and Schering-Plough, with its allergy drug, Claritin (Exhibit 2).
At first glance, it might seem that consolidation led to greater concentration of market share. The top 10 companies of 1999 held 46 percent of the worldwide market for ethical drugs, up from only 28 percent a decade earlier. But this comparison ignores the fact that 23 companies eventually merged to form the top 10 of 1999, and those 23 commanded 49 percent of the market in 1989. Between the years 1989 and 1999, their annual growth rate was 18.2 percent, trailing the industry average of 19.3 percent. The implication: a number of pharma mergers were anxious responses to the weak earnings outlook of one or both participants.
. . . and why size matters now
Although no guarantee of success, size is becoming more and more beneficial in several areas. One is the process of discovering drugs. Emerging technologies—involving bioinformatics, greater automation, and new screening approaches for genomics—may help "industrialize" drug discovery. But first, pharma executives must figure out which technologies to bet on, the amounts to wager, and how to balance the cost of investments against competing R&D needs.
Take genomics (see "Splicing a cost squeeze into the genomics revolution," on page 15 of the current issue). Should a company try to "own" a disease area by, for example, acquiring the intellectual-property rights to all of the biological targets identified through the unraveling of the human genome? What about investing heavily in the development of new screening techno-logies and thereby gaining exclusive access to them? Or would it be smarter to piggyback on the investments of others?
In fact, companies with enough resources to keep their options open and place a number of bets have an advantage. Interviews with R&D executives in the pharma and biotechnology industries suggest that companies may have to spend at least $100 million annually even to play a conservative game in these emerging technologies. Spending at the most aggressive level might require a $300 million annual investment.
To be sure, some smaller companies have managed to place significant bets on emerging technologies: Bayer’s $465 million, five-year deal with Millennium Pharmaceuticals for hundreds of drug targets represents a significant investment in an unproven approach. But the price tags for such deals keep growing: Novartis recently signed an $800 million agreement with Vertex Pharmaceuticals for compounds generated through its proprietary chemo-genomics approach to drug discovery.
An average drug company spends about 25 percent of its R&D budget on discovery. An aggressive strategy would consume more than three-quarters of a middleweight company’s discovery budget but only one-third of a super heavyweight’s. As more and more of the human genome is understood, these stakes can only rise, further compromising the smaller players’ other important discovery activities, such as hiring more chemists to improve the efficacy of drugs further downstream. Unexpected research developments could intensify the challenge. If, for example, the genome’s secrets can be unraveled more quickly than expected, the advantage will go to companies that have the resources to respond rapidly.
Product development and in-licensing deals
Size may also help Big Pharma develop drugs more rapidly. The cost of development has leaped upward in recent years, since more drugs compete in the same treatment areas, regulatory scrutiny is tighter, and drug makers want to launch drugs with more indications. One result: more trials, as well as more patients in each of them, are needed. In addition, the cost of recruiting patients and investigators and of analyzing the results has gone up: the time needed to enroll patients, for example, now amounts to half the length of a trial.
The cost efficiency of trials doesn’t vary substantially with the size of the company conducting them. But larger pharma companies may succeed in building better networks of investigators who can cut the time needed to enroll patients. Such companies can also cultivate more intensive relationships with more and better clinical investigators, who are the source of patient referrals to clinical trials. Merck and Pfizer, for instance, are giants in the cardiovascular area, and they can be tough competition for any other company trying to find investigators and patients for that purpose.
Moreover, the growing pressure to find blockbusters means that more companies are in-licensing drugs that other companies have discovered or developed.1 And the biggest companies do better at gaining access to winning drugs. It is true that from 1997 to 1999, the middleweights in-licensed an average of six drugs, while the heavyweights in-licensed only four—a difference that held for both early and late-stage licensing. The heavyweights, however, licensed more of the top performers: the 100 drugs with the highest sales in 1998 and 1999. Of the 29 percent of these top drugs that were in-licensed, the heavyweights had the rights to four times as many as the middleweights did, and the heavyweights on average earned about 15 percent more revenue for each licensed product. This pattern suggests that heavyweights are regarded as the most desirable partners.
Operating on a global scale
In the global pharma marketplace, three key measures of competitiveness are the number of products launched, their value, and how quickly they enter top markets. In each respect, larger companies appear to exploit their scale to enhance performance. During the past three years, the heavyweights launched more products globally than did the middleweights: an average of 4.7 drugs to 3.5. Furthermore, the heavyweights collected more than twice the middleweights’ revenue, on average, for each product launched. In addition, the bigger drug makers entered the seven most important global markets faster than did smaller companies.
Finally, the large sales forces of the biggest pharma companies are essential in achieving the customer penetration required for a blockbuster. In general, the more sales representatives a company employs, the smaller their territories and the more numerous their contacts with each physician. This advantage translates into higher revenues resulting from stronger demand from physicians; we have observed a correlation between growth in the number of details and growth in revenue. The impact of the sales forces maintained by Big Pharma is particularly powerful during the critical six months following a launch, when contacts with physicians build large markets and sales momentum.
The challenge of mergers
Moving into the drug industry’s heavyweight class often calls for a megamerger, but companies caught up in one are vulnerable to the usual integration hazards. Integration is especially difficult for R&D operations, which are likely to have different degrees of risk tolerance, different scientific "tastes" reflected in portfolio decisions, and different approaches to governance and decision making. Companies distracted by integration often launch products poorly and miss licensing opportunities, and these failures jeopardize earnings and longer-term growth.
Dealing with the complexities of size itself may be even more difficult than navigating the pitfalls of M&A and integration (Exhibit 3). Managing an enormous number of discovery and development programs is a formidable task, and so are maintaining a heavyweight’s strategic vision, steering a large number of marketing initiatives, and running huge sales forces. The biggest pharma companies can prepare to meet the challenge by reconsidering their organizational structure, their processes for making decisions and allocating resources, and their accountability and incentive systems.
About the Authors
Sumit Agarwal and Arjun Oberoi are consultants in McKinsey’s New York office; Sanjay Desai is a consultant in the New Jersey office; Michele Holcomb is an associate principal in the Los Angeles office.
The authors wish to thank Roy Berggren, a director in McKinsey’s New York office, and Rajesh Garg, a principal in the New York office.
Notes
1See Murray Aitken, Sunitha Baskaran, Eric Lamarre, Michael Silber, and Susan Waters, "A license to cure," The McKinsey Quarterly, 2000 Number 1, pp. 80–9.
McKinsey Report: An Interview Transcript
Riding the pharma roller coaster
In an industry in which many mergers have failed to create value, Fred Hassan has used them to take Pharmacia into the pharmaceutical big leagues. Here he explains how.
Catherine George and J. Michael Pearson
2002 Number 4
Leading in the global pharmaceutical industry means mastering a hugely expensive game of trial and error. A company might discover a winning protein that could someday deliver a blockbuster drug but face expenditures of as much as $500 million for testing and trials before it could do any good. For the biggest companies, annual R&D budgets can run to more than $5 billion, a sum that has fueled an ongoing process of mergers, many of which have done little to boost long-term growth. Scientific and technological breakthroughs continually stoke investors’ expectations.
This is the demanding environment in which Pharmacia’s chief executive, Fred Hassan, has made his name by pulling off a series of unlikely turnarounds. Hassan, a 56-year-old chemical engineer born in Pakistan, took the reins of Pharmacia & Upjohn in 1997, two years after the merger of Sweden’s Pharmacia AB and Michigan’s Upjohn created the company (then headquartered in England), which was plagued by declining sales, profit warnings, and raging turf battles. Hassan restructured operations, moved the headquarters across the Atlantic to New Jersey, installed a new management team, and generated several promising new drugs.
Two years later, he engineered a merger with Monsanto when the St. Louis-based drug and agricultural company was under broad attack as the standard-bearer for genetically modified foods and other agricultural products. In the new Pharmacia Corporation, Hassan created a core pharmaceutical business and turned the agriculture business into an autonomous subsidiary to be spun off. Along with Monsanto’s Searle unit came Celebrex, one of a new class of Cox-2 antiarthritis drugs and Pharmacia’s first true blockbuster. With 2001 sales of more than $3 billion, Celebrex put Pharmacia in the industry’s big leagues, with peers such as Pfizer, Wyeth, Eli Lilly, and Merck.
In mid-July of this year, Pharmacia agreed to an acquisition by Pfizer, thus creating the world’s preeminent pharmaceutical company, for about $53 billion in stock. The acquisition is scheduled to be completed by year-end. It is expected that Hassan will initially serve as Pfizer’s vice chairman after the closing of the transaction. In an interview conducted at Pharmacia’s headquarters, in Peapack, New Jersey, prior to the merger announcement, Hassan spoke to Katy George and Mike Pearson of McKinsey about his view of the pharmaceutical industry, the lessons he has learned from his experience with mergers, and his thoughts on maneuvering in such a risky landscape.
The Quarterly: In today’s challenging pharmaceutical environment, how can companies best create value?
Fred Hassan: By finding a flow of innovative medicines that answer the needs of doctors and their patients. The companies that will succeed in the long term are the ones that best sustain this flow.
Earnings from 1996 to 1998 were very strong for the industry because faster approvals kicked in at the US Food and Drug Administration via the Prescription Drug User Fee Act, and much of the new-drug application inventory that was in the system was released into the market. What used to be a 24- to 36-month review time shrank to 10 to 20 months. The stock market reacted, and maybe there was an overreaction. Since then, we have seen a correction. After the extra new-products inventory had worked itself out of the system, our industry was back to introducing 20 to 30 new chemical entities a year—which is the same rate, more or less, as in the mid-1980s. However, in the absence of a commissioner, the FDA has been more conservative and the approval rate has slowed.
When it comes to R&D, we must recognize that many of the good opportunities have been picked off already and that the new opportunities are increasingly hard to find and very risky. This will be perhaps the biggest challenge for our industry in sustaining product flow.
The Quarterly: Investor expectations for pharmaceuticals are high—in some cases as high as 20 percent year-on-year earnings growth. How do you drive that kind of growth?
Fred Hassan: I think this 20 percent number was always too high for the industry. I even question 15 percent for the total industry. When the total economy is growing at 6 percent—and profits also, over the long term, are growing at this rate after inflation—it becomes a challenge for any industry to grow by more than double that rate year after year. We are also facing some major challenges as the payers for health care in the developed economies face economic constraints combined with rising health costs. They are targeting medicines for savings. But longer term, I am convinced that societies will see the special value and benefit of pharmaceutical innovation. We’ll be a healthy, vibrant industry for the future.
The Quarterly: What needs to happen to improve productivity in the industry?
Fred Hassan: We must find new ways of discovering drugs and improving our pipeline flow. We know there’s a need for new drugs, but we still haven’t found how to validate targets quickly and conclusively and then get the right chemical molecules that work. We still don’t know how to eliminate that research risk. At Pharmacia, we had sonepiprazole in our R&D pipeline for schizophrenia and it looked promising. But later-stage trials found some problems and we had to stop. Meantime, another company’s "piprazole" does appear to work. We don’t know why one works and another doesn’t. So in spite of all these discovery tools, you still have to invest a lot of money to find out if the drug works or not. The industry has to keep working at improving its R&D batting average.
The Quarterly: R&D budgets run at $2 billion to over $5 billion a year for some companies. Turning a discovery into an eventual product can cost $500 million or more, and it still might not work. You can view this industry as a series of very expensive high-risk bets. Doesn’t that argue for even more merger activity?
’It’s true that consolidation was needed in recent years so that R&D budgets for the big players could get past a billion dollars’
Fred Hassan: It’s true that consolidation was needed in recent years so that R&D budgets for the big players could get past a billion dollars or more. This was because of the point that you make: individual bets can grow to half a billion dollars or more. You’re also dealing with demands for very expensive outcome trials from various regulators as well as from managed-care administrators. Individual trials can cost $50 million or even $100 million. So there’s a barrier to entry in terms of research and development at approximately the $1.5 billion-a-year level. But you do need a certain mass to be able to remain in the Big Pharma group for the long term. In the United States, a great deal of consolidation has already occurred. I can see potential for significant further consolidation in Europe and also Japan, where there are a number of companies that lack the necessary critical mass.
The Quarterly: What lessons have you drawn from your experience in managing mergers?
Fred Hassan: I think there are always two questions that you ask about a merger. First, of course, is it a good idea in terms of creating added value? Second, if you do it, then how well can you execute the merger? Both questions need to be asked, and the only way to truly validate a merger is to see what happens afterward—that is, to have some kind of a measurement point and make an evaluation. I think that in pharmaceuticals, since you’re looking at very long new-product cycle times, you can have an early evaluation point—say, 18 months after a merger—to see how the business integration process is proceeding and whether the expected cost synergies have been achieved. But the real validation can only occur five to ten years out, when the productivity of the merged business can be assessed by the level of new-product flow.
The Quarterly: This suggests that as you are integrating, you are at the same time focused on meeting immediate financial-performance measures and trying to keep your eye on the long term.
Fred Hassan: One has to commit to and meet certain short-term financial requirements in order to convince shareholders to support the merger and satisfy the Street’s expectations. But in the long term, the challenge is to develop that special strength that will make the difference. I’ll give you an example: The merger between Pharmacia & Upjohn and Monsanto created extraordinary strength in the area of inflammation. Pharmacia & Upjohn made a conscious decision in 1997, after I arrived, to exit inflammation as a therapeutic area. We shut it down because we had failed to bring out new products. With Monsanto, not only have we leveraged the Cox-2 platform that came from Searle; we have assembled world-class talent that will allow us to sustain and expand Pharmacia’s global leadership in the area of inflammation.
The Quarterly: As you considered executing the merger with Monsanto, what were some of the key personnel and organizational issues you looked at to get this focus?
Fred Hassan: Of course there are the usual things: the waves of implementation, the structure, and knowing who’s in charge. But we saw that we could have enormous impact by going directly to our frontline managers: the people who manage the people who do the work. In the first days of this merger, we had all the district managers of both sides in one place, with my management team and me talking to them. Right there, that’s merger integration in progress. You cannot afford to miss even a day when it comes to certain sales and marketing operations, and district managers are the key to getting it done. So we had a big meeting in Chicago and a big meeting in Berlin, and we covered probably 70 percent of the revenue flow right there. We had a more formal meeting, and then we broke up so that people from the same country could meet informally at the same table—so that the Searle and the Pharmacia people could get to know each other. Within the first week, we had the machinery in the field reasonably aligned and a good sense of direction and faith in the new management. Our market share numbers kept climbing right through the merger.
The Quarterly: What is the CEO’s role in driving that kind of integration?
Fred Hassan: I think the CEO has to set the right tone through personal leadership and trust-building behavior. One important way to make this happen is to select a management team that reflects your values and standards. Visible personal leadership is also important. For example, I developed a relationship based on trust with Monsanto’s chairman and chief executive, Bob Shapiro. He welcomed my visits to Monsanto’s headquarters, in St. Louis, and to the Searle operations in Skokie, Illinois, even before the merger was finalized. I spoke with the Monsanto and Searle people in agriculture and pharma to give them some insight into my leadership style. Through this process, they were able to make a judgment about who I was as a person and to become comfortable with the new leadership of the new company we were creating.
The Quarterly: What was your personal focus in handling the merger of Monsanto-Searle and Pharmacia?
Fred Hassan: My primary concern was to make sure that the driving functions in the business stayed in good shape. In our business, that means R&D and marketing and sales. Searle was a smaller company that had run into difficulties in the early ’90s but had come back very nicely in the late ’90s with the Cox-2 platform and with strong and inspired R&D leadership. After a very successful initial launch of the antiarthritic Celebrex in the United States, Searle found it was yielding market share to Merck’s Vioxx at an unacceptable rate. So the merger benefited Celebrex because that rapid share erosion slowed, then stopped, as Merck faced a larger company that had a strong, aligned sales and marketing team. Instead of the continual market share growth by Vioxx that many observers expected, the new Pharmacia regained headway. We have established a major lead over Merck in the Cox-2 inhibitor marketplace globally. This was almost unimaginable before our merger.
The Quarterly: How did you do this?
Fred Hassan: For example, in certain European markets there was a product launch for Celebrex in April 2000 at lower prices than Vioxx. We moved quickly to correct that strategy and instead focused on the value attributes of Celebrex. This strategy has worked as we—along with our promotion partner, Pfizer—came from behind Merck and overtook it in Europe.
The Quarterly: What do companies need to conclude a merger agreement successfully?
Fred Hassan: Transparency, to create trust and enable a quicker understanding of the key business drivers, coupled with prudent risk assessment and decisiveness. That’s because the biggest problem is that much of what you would like to know is not known before agreeing to the merger, for a number of reasons. You are usually in a competitive situation, which means that if you take too long, you’ll probably lose the opportunity. Also, in order to keep the process quiet and confidential to limit interlopers or premature market reactions, only a limited number of people can be involved, as was the case with the merger of equals between us and Monsanto, so you don’t get a chance to do the kind of due diligence that you would see in a textbook. This takes some courage, combined with good judgment.
The Quarterly: What about the pace of change?
In a merger, ’you simply cannot do everything right away. Instead, you must have waves of change that are specific to each situation’
Fred Hassan: People can only take a certain amount of change before they start to lose their bearings. The merger process between Pharmacia & Upjohn and Monsanto was immense in terms of the number of people involved and the business units affected. My philosophy is different from what many textbooks recommend, which is fast, across-the-board change. The reality is that you simply cannot do everything right away. Instead, you must have waves of change that are specific to each situation. With the Monsanto merger, we did not make sales territory changes immediately, because we saw how important it was to sustain customer relationships. We waited two years to implement our new sales territory strategy, changing up to 30 percent of customer contacts at that later date. Had we made more significant changes earlier on, we probably would have lost Coxib market leadership to Vioxx. We built our number-one status with Celebrex by staying focused on our customers and making all our organizational changes with careful preparation.
The Quarterly: Is it a principle of yours that existing management typically isn’t up to the task of handling the complexity of a merger?
Fred Hassan: Management has to rise to the task of handling the new complexity, which grows geometrically. As the scale goes up twofold, your competency has to be four times better in terms of everything you do. This is the basic concept we are embedding in the behavior of our people. Some people enjoy the demands and therefore are successful and satisfied in the combined company. Other people prefer a different environment. We now have a strong management team at Pharmacia. But not everyone who was part of the former Pharmacia & Upjohn or the former Monsanto and Searle has stayed with us. When you foster the right behavior combined with the right talent, you have the qualities it takes to become a superior-performing company.
The Quarterly: Why has your focus been on creating a "best-managed company" rather than something else, such as being number one in the pharmaceutical industry or number one in a certain area?
Fred Hassan: It’s a business imperative because it’s the key to producing results. We have not aspired to be the biggest company in the industry. We have instead focused our people on working to build the finest company in the industry—one that strives to be the best in delivering innovation in health care. We have challenged our people to put us in the forefront in innovation and to make us a trusted partner for health and wellness. We have attracted people from all the major companies in our industry, as well as from other industries. Pharmacia has become known for a certain boldness in our vision and quality in our execution. And we do strive to lead in the arenas where we have our key product drivers.
’A high standard of integrity is a critical aspect of our vision of being a best-managed company’
Becoming a best-managed company has been a means to two goals for us. It has been the means of becoming the best at providing new treatments and products for our customers and patients—maintaining an innovative product flow. By doing this, we have set a foundation for generating upper-tier shareholder returns in the long term. We also have wanted to link certain high-performance goals to being well managed. For example, we have said that cost-consciousness can be further enhanced in our culture. It’s easier to be a low-cost company if it’s simply another aspect of being a best-managed company rather than being a special cost-cutting program coming from the CEO. So if people can see that limiting expenditures is part of the overall goal, they tend to identify with it and own it more fully.
Similarly, we have been very consistent in telling our people that a high standard of integrity is a critical aspect of our vision of being a best-managed company. This approach has allowed us to link personal action to the vision. It has allowed us to build internal strengths so we can apply very high standards to everything we do.
The Quarterly: What about your own role—what has been the balance of your time and interest?
Fred Hassan: Lately, I have been putting the greatest part of my time into the product flow area, which, as I noted earlier, is the most important value driver in the business. I have looked very closely at R&D. I have also looked at licensing opportunities, where, in my opinion, the personal involvement of the CEO to demonstrate commitment and build trust is often what leads to a handshake. Building trust is the key. I have seen it as my job to be an ambassador for the company when it comes to bringing products into the pipeline. In Big Pharma, about half the pipeline is brought in from other labs. So that’s a very important job for the CEO.
About the Authors
Katy George is a principal and Mike Pearson is a director in McKinsey’s New Jersey office.