Merger Mania--Faith or Folly?
Executive Summary
Has the $72 billion worth of acquisition activity in the past two years actually created companies who deliver higher value for their shareholders? Companies that didn't participate in the merger craze fared just as well, and may even have done better than those that did.
A look at how market caps for selected companies have fared over the past seven years suggests that the drug industry’s high- profile mergers have delivered little in the way of shareholder value.
<Body>by David Cassak, Roger Longman, and Antonio Regalado
- Between 1989 and 1996, drug company valuations for selected companies followed a consistent pattern of rise-slump-rise, despite company size or strategy.
- Correcting for mergers by creating pro forma market cap histories for merged companies, the data indicates that companies that participated in the merger trend did no better—and often worse—than the rest of the industry, including those companies who stayed independent.
- Even hostile takeovers, with their slash-and-burn approach to driving efficiencies, have yet to generate superior returns over earlier, friendly deals.
The US pharmaceutical industry has experienced a second major wave of mergers and acquisitions in less than a decade. Following the blockbuster deals of the period 1989-1991—which created Bristol-Myers Squibb Co. , Marion Merrell Dow Inc., Rhone-Poulenc Rorer Inc., and SmithKline Beecham PLC—the drug industry has seen a series of transactions, beginning with Roche ’s purchase of Syntex Corp. in November 1994 and culminating most recently in the merger of Ciba Ltd.and Sandoz Ltd. Just in the two years 1994 and 1995 the industry has seen $72 billion woth of acquisition activity. Even if the trend were suddenly to end tomorrow—and few industry executives believe it will—the scope and size of the merger activity has been a formative influence on the industry over the past seven years.
But has it actually done what it intended: create companies who deliver higher value for their shareholders? Our data suggests not. Indeed, a look at the history of market capitalizations over the past seven years for a handful of companies suggests that the earlier high-profile mergers did little to increase company valuations. It seems the companies that didn’t participate in the merger craze fared just as well, and may even have done better than those that did. In turn, the bets made by companies involved in the second wave of merger activity seem risky at best. Thus the larger debate within the industry about the value of mergers continues—legitimately.
Segmenting the Sample
Beginning with the assumption that the primary rationale for any merger or acquisition is to increase shareholder value, we compared year-end market capitalization figures in the period 1989-1996 for selected companies within three distinct groups: those who had done mergers in 1989; those who merged in the 1994-95 period and those who remained independent. For the years prior to the acquisition, when the now-joined companies operated independently, we created combined pro forma market caps of the two then-independent companies to provide a basis for comparison to the later, merged performance.
The point was to create a rough apples to apples comparison. For instance, American Home Products Corp. ’s market cap growth from 1989 to 1996 was 127.7%. But the acquisition of American Cyanamid Co. gave it a dramatic boost—without accounting for the shareholder cost of the transaction. To provide a rough approximation of this cost, we thus added the Cyanamid market cap to the pre-merger AHP market cap, which takes AHP’s pro formagrowth in the ‘89-‘96 period down to 71.6%. (Nonetheless, we also included in the chart of growth rates, p. 8, the numbers figured both ways—on a pro forma and “real” basis). For the ‘94-‘95 merger group, we also figured pro forma caps for points one month before the takeover announcement (before the takeover target received the share-price boost such an announcement always brings), one week after the announcement, and the day after deal closing.
The companies we selected from the 1989 merger group were SmithKline Beecham and Bristol-Myers Squibb as they were full mergers of parties that were primarily drug companies. Marion Merrell Dow and Rhone-Poulenc Rorer, in contrast, were partial acquisitions, where the larger company merged a non-public drug unit into the acquired company. For example, Dow Chemical merged its Merrell Dow unit into Marion Labs as part of the compensation for its 67% share of the new company.
For the group that merged in the 1994-95 period we chose Roche’s acquisition of Syntex, Glaxo Holdings’ acquisition of Wellcome PLC and AHP’s takeover of Cyanamid. We also compiled data for Pharmacia & Upjohn Inc. and Ciba/Sandoz, but didn’t include them in the analysis. For P&U, market cap data on Pharmacia isn’t available prior to 1993 (as Kabi Pharmacia, it was consolidated within the Procordia Group). The Ciba/Sandoz merger hasn’t closed yet. We included no data or analysis on the Hoechst AG acquisition of Marion because Hoechst’s market cap reflects far more than its relatively small drug component.
And for the independent companies we selected Merck & Co. Inc. , Pfizer Inc. and Warner-Lambert Co. Merck and Pfizer seemed good choices because their stock was never seriously affected by any speculation that they were takeover candidates, unlike Eli Lilly & Co., Schering-Plough Corp., and Warner-Lambert, which we did choose precisely because it was a frequently-cited takeover target.
A Consistent Pattern
Our analysis, therefore, looked at 11 companies that became eight. All of them shared the same basic valuation pattern. In the 1989-91 period, their valuations reflected strong investor faith in the industry, culminating in the annus mirabilisof 1991 when some companies did spectacularly. Merck grew over 80% that year, Pfizer over 100%.
In 1992-93, the industry hit the skids. The Clinton adminstration’s high-profile focus on health care reform scared away investors, as did the sudden stall of drug prices, which had previously seen steady annual increases. The pricing problem was seen as a long-term threat: Clinton-style reform, it was believed, would greatly increase the speed and scope of the changes managed care would bring to health care. Coming on the heels of the 1991 battle over Medicaid rebate pricing (which the industry lost when it failed to block passage of the Pryor bill), and the emergence of large national customers such as group purchasing organizations, the promised changes threatened the drug industry’s historic high profitability and scared away investors. The PBM acquisitions by Merck, SB, and Lilly, the first of which was announced in the summer of 1993, were a reflection of the downturn, not a cause. Indeed, throughout this period, Merck’s valuation moved consistently in the same direction as those of other companies in our group. The Medco acquisition likely did cause its valuation to dip deeper than either Pfizer’s or Warner-Lambert’s—but the former was growing fast and the latter was an object of takeover rumors. Still, even with the skepticism about Medco, Merck’s valuation model remains consistent with that of the rest of the industry.
Beginning in 1994, in fact, the industry saw a comeback, gradual in the first two years, more dramatic in the last two years, 1995-1996, as health care reform died in Congress and the threat of managed care grew less frightening.
Nearly all companies in our analysis fit this pattern, regardless of individual strategy or size—big or small, PBM acquiror or no: a sharp upward slope to 1991, a dip to 1993 and then a gradual increase to August 1996. (The only exception was Roche, whose ‘91-’93 market cap increased in the period during which all other companies’ were declining. And Roche’s valuation rose dramatically— by 137%. But it is worthwhile noting that Roche only began to trade ADRs in the US in 1992.)
And within the basic outlines of the pattern, an analysis of individual company performances, which did vary, suggests that the mergers didn’t help the new companies outperform the market. Of the four ‘94-‘95 acquisitions we examined, only the merger-of-equals that became Pharmacia & Upjohn actually saw an increase in market cap from 1993-1996 that rivaled (and exceeded) the performance of the independents: the pro forma P&U market cap grew 128% during this period. The pro forma performance of the other three merger companies all lagged the independents’ performance, averaging about 45%. Meanwhile the independent group averaged about 100% growth over the period.
A View Over Time
This brief analysis begs an important question: have the mergers of ‘94-‘96 had enough time to realize their true potential? Glaxo Wellcome, Roche and American Home executives would clearly argue that they have not—and even P&U executives, happy as they must be at the run-up in their post-merger value—believe they can do much better.
But looking at the two older mergers in our sample which clearly have had enough time to wring out consolidation’s advantages, the data indicate no benefit from the merger. Neither company was particularly insulated from the 91-93 downturn—both fell 30-35%, comparable to the independent companies and the industry overall. Nor did they rebound more quickly in the period 93-96. In fact, while SB’s 93-96 growth was topped 100%, in line with Merck and Pfizer, BMS dramatically underperformed the other companies, scoring 49% growth.
It could be argued that had these companies not merged, their performances would have been drastically worse. But the consistency across the industry, undercored by Warner Lambert’s performance, makes it just as likely that Bristol or Squibb or SmithKline, alone, would have followed the same pattern. Moreover, this argument might also be turned around to suggest that the acquirors who were unable to create post-acquisition market value might better have been acquisitions themselves.
Admittedly, the companies doing deals in the second wave have seen more fluctuations in their market caps—reflecting investor speculation in the deals. Most saw the acquiror’s market cap fall and the acquired company’s valuation rise after the announcement. By the time each of the deals closed, however, the combined company’s valuation was well below the pre-announcement pro forma market cap—except in the case of Pharmacia & Upjohn, in which in a friendly merger-of-equals, both companies’ market caps rose after the deal was announced and was even higher after the deal closed.
Thus, as of August 28, 1996, the merged companies by and large still lagged the performance of those that remained independent and the industry in general and appeared to have delivered no greater benefit to shareholders than the first wave of deals. Some industry executives note that comparisons between 89-91 and 94-95 are complicated by the fact that many of the latter represent a very different kind of deal than the megamergers of the late 1980s, i.e., hostile deals.
In fact, many argue that hostile deals will generate higher value, on the assumption that the acquiring company will quickly pay off the extra premium through particularly brutal cost cutting. Since the acquiror incurs none of the obligations to protect the acquired company, as it would in a friendly acquisition or a merger of equals, it can be as thorough in driving efficiencies as it needs to be.
But the evidence suggests that hostile transactions do no better, and arguably worse, than friendly deals. P&U, our only obviously successful deal, was a friendly merger of equals, while Glaxo and American Home have underperformed. Roche-Syntex, a nominally friendly merger, looks in retrospect—in terms of the wholesale cutting of Syntex’s infrastructure—more like a hostile transaction.
Indeed, notwithstanding the new pressures drug companies are under today, the fact is the drug industry doesn’t really do hostile takeovers. Both Cyanamid and Syntex were valued for the drugs or drug candidates they brought with them, rather than as fully operational businesses with a strong future. Thus they were more a play to strip away assets than to merge two fully operational organizations.
What Value in A Merger?
Admittedly the data is preliminary and subject to a large number of qualifications. For one thing, looking at market valuation from the narrow perspective of mergers denies the impact other factors have on valuation—the patent expiration of products, clinical delays, the launch of a major product, other types of deals (such as vertical integration).
Second, the sample we used is admittedly small. To make comparisons more valid on a face value, we selected out companies who might have disproven our thesis if they could have been analyzed along the lines of market cap. Adding the histories of more companies, such as Lilly, Schering-Plough, Ciba and Sandoz, might have painted the picture differently or revealed broader patterns.
Even within our small sample, there are, despite general trends, significant outliers—such as P&U or Roche, whose market capitalizations defied the growth-slump-growth model of the industry overall—that can be explained by extenuating factors but at the same time potentially undermine the conclusions.
Finally and most importantly, acquirors could argue that creating pro forma market caps unfairly penalizes their true growth rates. It would be a more accurate measure of corporate market cap growth, they could reasonably argue, to simply use the market cap of the acquiror alone. Market cap, after all, is market cap. How growth in market cap was achieved is irrelevant.
The caveats are important. But based on this one simple analysis method, it is clear that the newly merged companies have neither outperformed the rest of the industry nor been particularly insulated from downturns. As industry executives continue to explore new alliances, the compelling case for mergers appears far from made.