Distortion And Inflation In Measuring Pharma M&A

Five companies in big pharma’s top 20 have come through mergers in the past 10 years or so that changed them significantly. As measured by standard financial performance parameters, the processes at Takeda and Teva (and to some extent, at Allergan) seem relatively smooth and productive. Those at Pfizer and Merck don’t. But it depends on how you look at the numbers.

• Numbers can be deceiving when assessing the value of pharmaceutical mergers and acquisitions.
• Does M&A build larger, richer companies? Pfizer and Merck employed 105,000 fewer people in 2015 than their component companies did in 2006, and Allergan's net assets are higher than Pfizer's.
• Intangible "goodwill" represents 23% of the assets of top 20 pharma companies and 29% of those involved in relatively recent mergers.
• It's time to abandon conventional financial parameters in favor of more flexible ways of determining whether M&A has served shareholders, employees, customers and patients.

Mergers and acquisitions propel some of the more dramatic shifts in pharma, an industry characterized by constant change. This article examines the financial performance between 2006 and 2015 of five companies in pharma’s top 20: two serial mergers – Teva Pharmaceutical Industries Ltd. and Allergan PLC (Actavis) – and three companies where mega-mergers in the relatively recent past seemed to serve a more tactical purpose – Takeda Pharmaceutical Co. Ltd., Merck & Co. Inc. and Pfizer Inc.

Given the requirements to meld international operations in highly regulated markets, no merger in the pharmaceutical industry will ever be entirely straightforward. However, on paper at least, some are easier to understand than others.

As an example of a company where accounting for mergers is transparent, take Teva Pharmaceutical Industries. Teva has undertaken serial merger and acquisition, and its process appears to be rather ordinary, at least as judged by financial performance parameters.

Teva’s M&A activity has been driven by two ambitions: first to consolidate its position in the generic drugs market and second to build a higher-margin specialty drugs business alongside its generic effort.

In a series of deals that started in earnest with the acquisition of Ivax Corp. in 2006, Teva went on to combine its business with Barr Pharmaceuticals Inc. in 2008 (Barr had acquired the Croatian generics company Pliva DD earlier that year), with Ulm, Germany-based ratiopharm Group in 2010 and (adding a touch of biotechnology glamour) with Cephalon Inc. in 2011. Also in 2011, Teva expanded in Japan with the acquisition of Taiyo Pharmaceutical Industry Co. Ltd., and it completed its $39 billion acquisition of Actavis Generics from Allergan in August 2016.

Between times, Teva spiced up its offering further with smaller acquisitions such as those of hearing therapeutics specialists Auspex Pharmaceuticals Inc., and neurobiology company Labrys Biologics Inc. in 2014.

Teva’s acquisitions, largely speaking, have been additive and smooth. (See Exhibit 1.) They have provided both new product lines and strengthened distributions channels for existing lines. Monopoly regulators have required the divestment of a number of product lines but that has not markedly affected Teva’s path to growth.

Exhibit 1

Contrasting Progress At Teva And Pfizer

Note: The lines show data (indexed to 2015 = 100%) for drug sales, headcount and net assets. Orange lines are companies’ reported data between 2006 and 2015. Green lines are aggregates from the subsidiaries that came to make up the two companies. Teva’s numbers rose to their 2015 level, while Pfizer’s fell to it.

Scrip100 data (compiled from company reports)

As Exhibit 1 shows, Teva’s drug sales have increased at each acquisition and then grown beyond that. A stand-alone Teva in 2006 sold drugs worth $8.4 billion, a figure that grew to $19.7 billion in 2015. In 2006, the companies that came together to make Teva (including Teva itself) sold drugs worth $13.8 billion. Teva has captured its acquisitions’ sales and expanded upon them.

Furthermore, the number of employees at Teva has increased over time. Despite the churn that is typical of pharma, Teva in 2015 employed roughly the same number of people as its component parts did in the past. And those employees were more productive: in 2006, drug sales per employee stood at $320,000: in 2015, that figure was $460,000.

In Teva’s case, then, M&A builds the company’s sales and workforce, with its asset base expanding roughly proportionately. When Teva buys a company, it incorporates most of the assets and people associated with those assets into the fabric of its organization. That straightforwardness, as the pattern of Pfizer’s metrics suggest, is quite atypical. More on that later.

Exhibit 2

Takeda’s Acquisitions Boosted Sales And Headcount

Scrip100 data (compiled from company reports)

Takeda’s merger history contains fewer major events than Teva’s. In essence, Takeda has made just two significant acquisitions in recent years: Millennium Pharmaceuticals, acquired for its oncology portfolio in 2008 and Nycomed, acquired as part of Takeda’s efforts to extend its markets in Europe and emerging economies in 2011.

As Exhibit 2 shows, although the additions of Millennium and Nycomed helped boost drug sales at Takeda, the benefits have not been as marked as at Teva. Millennium was selling less than $300 million worth of drugs (Velcade [bortezomib], principally) at the time of its acquisition. And while sales at Nycomed were running around $4 billion annually when the company was acquired, they had already been in decline, partly from restructuring imposed by several years of private equity ownership and partly because of the OTC-heavy nature of the Nycomed business that Takeda acquired.

As Exhibit 2 also shows, perhaps as expected, the number of people employed at Takeda has risen as a result of the two acquisitions: in 2006, Takeda, Millennium and Nycomed had nearly 29,000 employees between them; in 2015, Takeda employed over 31,000 people.

At Takeda, then, the company appears to have the human resources to expand but not the growth products for its workforce to exploit.

Headcounts And Growth

Maintaining the level of employees from acquired companies is not always part of the deal in pharmaceutical mergers. Exhibit 3 shows employment numbers for each of the five big pharma companies created by relatively recent M&A. The left panel shows employment between 2006 and 2015 at the acquiring company (e.g., Merck & Co., or Teva), whereas the right panel shows aggregate employment at the various component companies that eventually merged (e.g., Merck & Co., Schering-Plough, Organon NV, Cubist Pharmaceuticals Inc., Adolor Corp., Inspire Pharmaceuticals Inc., Optimer Pharmaceuticals Inc., etc., in the case of Merck & Co).

Exhibit 3

Job Preservation And Destruction In Pharma M&A

Scrip100 data (compiled from company reports)

There are two distinct employment patterns among these acquisitive companies.

For Teva, Allergan and Takeda, acquiring a company adds employees. Following M&A, all or most of the employees from the acquired companies are incorporated into the new structure. The number of people employed overall remains much the same, even if the individuals change. The 2015 headcounts at Teva, Allergan and Takeda reflect the headcounts at the previously independent companies that they acquired.

Staff reductions at Pfizer and Merck go far beyond merely achieving efficiency in core corporate functions.

The pattern at Merck and Pfizer is very different. At these companies, headcounts spike on acquisition but then tail off with time. The headcount in the acquiring company is flat, but far fewer people retain employment at post-merger than were employed at its component firms.

Some of this will be due to divestment of operations that are no longer key to the company or that regulators demand it relinquish. But much of it is redundancy: while smaller firms can add market outreach as a result of M&A, larger firms may not. They are certainly not in business to maintain two or more parallel systems for central administration, finance, or legal or corporate affairs. However, the scale of staff reductions at Pfizer and Merck following mergers goes far beyond what would be necessary merely to achieve efficiency in core corporate functions.

For instance, the number of Pfizer employees in 2015 – 97,900 – was less than 60% of the number employed by the unmerged entities in 2006 (163,800). We know that around 10,000 people (6% of that 2006 headcount total) now have jobs at Pfizer’s animal health spin-out Zoetis Inc., but that fails to account for over 50,000 other jobs, mainly in pharma.

Similarly, the companies that came together to become the Merck & Co of 2015 employed around 110,000 people. Merck in 2015 employed 68,000, around 62% of its earlier aggregated headcount.

Asset Inflation And Goodwill

One of the curious things that sometimes happens to company accounts around a merger is that the asset profile of a company changes in odd ways. The relatively consistent manner in which the value of a company’s assets and liabilities have been assessed up until that point seem to be revamped in accounting for the merger.

In 2008, the year before Merck acquired Schering-Plough, for instance, its accountants and auditors had written in total assets for the company of around $47 billion, consistent with earlier years; its total liabilities were $28.5 billion. Their counterparts at Schering-Plough had valued their company’s assets at $28 billion in 2008 and had attached liabilities totaling $17.5 billion.

Post-merger, the newly combined Merck had liabilities not of $46 billion (a straight addition of the inherited figures) but of $57 billion. This jump of $11 billion is largely accounted for by the $8.5 billion in debt that Merck took on to pay for the acquisition.

However, the $37 billion jump in the valuation of Merck’s post-merger assets to $112 billion is more complex to explain.

Of it, $10 billion comes from an uptick in “goodwill,” an accounting line that can cover a multitude of possibilities, but that in this case, as Merck’s 10-k submission explains, “is largely attributable to anticipated synergies expected to arise.”

In the circumstances of a merger, goodwill can be used as a make-weight adjustment in accounting terms. Conveniently, Merck quickly adopted guidance issued in January 2009 from the Financial Accounting Standards Board (FASB) that outlined that “any excess of the purchase price (consideration transferred) over the estimated fair values of net assets acquired is recorded as goodwill.” When it acquired Cubist in 2015, by the way, the goodwill accumulated by Merck increased by $4.7 billion.

The other, nearly $30 billion excess of assets that appeared when Merck bought Schering-Plough in 2009 was attributed to Merck’s having gained a controlling interest in the Merck/Schering-Plough partnership in cholesterol-related treatments. In truth, the partnership was already in decline at that point; its sales in the year of the merger had fallen 20% since 2007. Merck attributed over $40 billion in intangible asset value to product rights, in-process R&D and trademarks acquired from Schering-Plough.

Exhibit 4

The Flexibility Of Asset Accounting

Scrip100 data (compiled from company reports)

This flexibility in asset accounting at Merck is illustrated in Exhibit 4, which shows a history of the value of net assets (total assets minus total liabilities). Pre-merger, the net asset value of Merck and Schering-Plough was $25.5 billion, of which Merck chipped in $17.5 billion. After the merger, the net asset value was nearly $59 billion.

As Exhibit 4 also shows, the king of asset flexibility is Allergan (Actavis/Watson before that). But for a change in US Treasury rules in April 2016, Allergan’s M&A trail might have reached an endpoint through a merger with Pfizer. (Also see " Pfizer, Allergan In Third-Biggest Merger Ever " - Scrip, 23 Nov, 2015.) (Also see "Pfizer-Allergan Merger: The End Is Nigh " - Scrip, 6 Apr, 2016.)

At the end of 2014, Actavis announced a definitive agreement to acquire Allergan for $66 billion, a deal completed in March 2015. Subsequently, Actavis adopted the Allergan name and brand.

One of the interesting aspects of that merger was the way the deal created value in the company. In total, Actavis raised $33 billion in new money through a combination of taking on debt and selling shares, and spent $37.5 billion to acquire various businesses (Allergan represented the lion’s share).

Value appeared to be created by the spontaneous emergence of assets in the merged company. Whereas the net assets of pre-merger Allergan plus Actavis were valued at $36 billion, post-merger Allergan in 2015 had net assets worth $76.5 billion, $40 billion more.

Allergan’s net assets are larger than Pfizer’s, a company with three times the people and three times the drug sales.

Some of that asset inflation arose in the form of goodwill. Post-merger Allergan boasted $46 billion worth of goodwill, nearly $20 billion more than the pro forma addition of the goodwill numbers from Actavis and pre-merger Allergan.

The $46 billion worth of goodwill looked less out of place when investors thought post-merger Allergan would merge with Pfizer, and the company’s market capitalization was north of $130 billion. After the Treasury Department’s block, however, $46 billion seems rather too large a chunk of Allergan’s post-Pfizer valuation of around $80 billion.

Another $67 billion of Allergan’s extraordinary asset total is attributed to product rights and other intangibles. Pre-merger Allergan attributed just $1.8 billion and pre-merger Actavis just $19.2 billion to product rights and intangibles.

Taken together, the two tricky-to-pin-down asset classes, goodwill and intangibles, account for $113 billion of Allergan’s assets, 93% of all the company’s assets not sold to Teva. Goodwill – the accountant’s reconciliation of the gap between the fair value of assets and what was paid for them – represented 38% of Allergan’s assets in FY2015. So almost 40% of Allergan’s reported assets are, in essence, the cumulative overpayments for acquired companies.

Goodwill and other aspects of asset inflation in accounting provide a distorted or, at least, an “interesting” characterization of Allergan’s financial position relative to other companies in pharma’s top 20. (See Exhibit 5.) They allow Allergan to be represented as a much bigger company than it is.

Exhibit 5

Goodwill And Other Resources At Merging Pharma Companies

Company	Pharma Sales ($bn)	Assets ($bn)	Liabilities ($bn)	Net Assets ($bn)	Goodwill Sbn	Goodwill as % of Assets	Employees
Pfizer	45.5	167.5	102.7	64.7	48.2	29%	97,900
Allergan	15.1	135.8	59.3	76.6	46.5	34%	31,200
Merck	36.2	101.8	57.0	44.8	17.7	17%	68,000
Teva	19.7	54.3	24.3	29.9	19.0	35%	43,000
Takeda	14.9	31.6	15.0	16.6	6.9	22%	31,328

Scrip100 data (compiled from company reports)

For instance, although Allergan’s pharma sales for 2015 are about the same as Takeda’s, Allergan generates those sales from an asset base that is around 4.3 times as large. Even when Allergan’s liabilities are offset against its assets, the picture changes little: Allergan’s net assets are 4.6 times those of Takeda. Indeed, they are larger than Pfizer’s, a company where drug sales are three times those at Allergan and that employs over three times as many people.

For FY2015, Allergan had assets worth $34 billion more than Merck and was also carrying more liabilities than Merck.

Goodwill is a device used broadly in accounting for merger valuation reconciliation in pharma. As Exhibit 5 shows, goodwill accounts for over 34% of Allergan’s assets in FY2015 but also for 35% of Teva’s and 29% of Pfizer’s. Incidentally, at Sanofi, goodwill accounts for 39% of the company’s assets (not shown in Exhibit 5): most of this originated when Sanofi and Aventis Pharma AG merged in 2004. Across the top 20 leading companies in pharma, goodwill accounts for at least $288 billion worth (22%) of asset value.

Post-Truth Analysis – Choosing How You See Mergers

A company is a multifaceted object, the performance of which is measurable in many ways. In a post-truth environment, it is time to set aside judgments based on conventional parameters such as earnings, revenues or net assets in favor of more flexible ways of assessing whether M&A has served stakeholder groups such as shareholders, employees and customers/patients.

The next few paragraphs illustrate that in the case of Pfizer. (See also Exhibit 1 for trends in Pfizer’s figures.)

Exhibit 6

Pfizer Change, Plus C'est La Même Chose …

	2006	2015	Change
Drug Sales ($bn)	45.1	45.5	0.8%
R&D Spending ($bn)	7.6	7.7	1.2%
Operating Profit ($bn)	13.0	9.0	–31.2%
Net Profit ($bn)	19.3	7.0	-64.0%
Assets ($bn)	115.5	167.5	44.9%
Liabilities ($bn)	44.2	102.7	132.5%
Net Assets ($bn)	71.43	64.7	–9.3%

Scrip100 data (compiled from company reports)

Those who take a long view of company performance could hardly fail to be impressed by Pfizer. Since Ian Read took over as CEO in 2010, the price of the firm’s stock has more than doubled. Furthermore, the company’s dividend payments increased from around 75 cents a share in 2010 to around $1.10 in 2015. In addition, not only has Read overseen a $50 billion increase in Pfizer’s market capitalization but also, through its various share buy-back arrangements, the company has returned around an additional $40 billion to shareholders since 2010 (and $57 billion since 2006). Dividend payments add another $38 billion that Pfizer has returned to shareholders since 2010 ($68 billion since 2006).

Read’s money machine generated nearly $500 billion in pharma sales between 2006 and 2015, investing $80 billion of that in R&D, and generated $115 billion in net profit, while continuing to employ nearly 100,000 people. All this despite Pfizer's loss of exclusivity on the world’s biggest-selling drug ever, Lipitor (atorvastatin), at the end of 2011. Amazing!

Those who take a long-term view of company performance could hardly fail to be disappointed by Pfizer. On a stand-alone basis, the company’s revenue and drugs sales figures in 2015 ($48.9 billion and $45.5 billion, respectively) remain almost exactly where they were a decade ago in 2006 ($48.4 billion and $45.1 billion). So does its investment in R&D ($7.7 billion in 2015 vs. $7.6 billion in 2006). (SeeExhibit 6.) General US inflation over that 10-year period was 17.6%, making Pfizer’s flat performance in sales and R&D investment a de facto contraction. According to an April 2016 QuintilesIMS study, Medicines Use and Spending in the US: A Review of 2015 and Outlook to 2020, the US pharmaceutical market grew 37% in that same period, putting Pfizer’s flat performance even further behind an average industry performance curve. The operating profit in the company’s pharmaceutical division in its two most recent full financial years was half that of a decade ago, and less than a third of its operating profit in 2011, Lipitor’s last year of patent-protected sales.

Those who take a long-term and broad view of company performance could hardly fail to be appalled by Pfizer. It’s not just that the results that the firm has reported since 2006 have, as mentioned, been flat and lagged general and pharmaceutical inflation. It's also that modern Pfizer in 2015 (and 2017) isn’t just Pfizer, it is an aggregate of several major noble entities: in the last decade, those principally include Wyeth, King Pharmaceuticals Inc. and Hospira Inc. plus such minnows as Encysive Pharmaceuticals Inc., Javelin Pharmaceuticals Inc., Redvax GMBH, Anacor Pharmaceuticals Inc., Bamboo Therapeutics Inc. and, most recently (although, like other 2016 acquisitions, not included in this analysis) Medivation Inc.

Taking M&A activity into account, Pfizer’s star dims further. Back in 2006, the component companies that made up Pfizer had revenues of $73.3 billion, sold drugs worth $65.7 billion and invested over $11 billion in R&D. From this 2006 baseline, and without accounting for inflation in any way, revenue at Pfizer of 2015 was down 33%, drugs sales were down 31% and R&D spending was down 30%. Pfizer-2015 employed just 60% of the workers that its constituent parts did in 2006.

Pfizer’s shifting balance sheet provides yet another dimension to the analysis of its performance. On a stand-alone basis (only Pfizer Inc. and not its early component parts) in 2015 the company generated $48.9 billion in revenue from $167 billion in assets (revenue 29% of assets), which is substantially less efficient than its 2006 generation of $48.4 billion revenue from $115 billion in assets (revenue 38% of assets). However, this may be misleading: while the value of assets at Pfizer increased between 2006 and 2015, so too has the value of its liabilities. The company’s net assets in 2015 were just 91% of those in 2006, suggesting that revenue generation at Pfizer Inc. has become more efficient since 2006. However, Pfizer Inc. is less efficient than its pre-merger components: back in 2006, Pfizer, Wyeth, King and Hospira generated $0.82 million in revenue per $1 million in net assets. By 2015, that number had fallen to around $0.75 million per $1 million.

Numbers can yield two different views of Pfizer. In Exhibit 1, orange are the data for Pfizer Inc., a company with a stable number of employees reflecting relatively constant drug revenue and R&D efforts. Acquisition has increased its assets, although its liabilities have also grown yielding flat net assets.

In green are the same parameters for what might be called Greater Pfizer, the elements of the earlier pharma universe that have subsequently found shelter under the Pfizer umbrella.

Pfizer found a way to offset reduced sales from its patent-expired products while continuing to reward shareholders. It aggregated companies, dispensed with their less profitable parts and cut R&D spending 30%. Between 2006 and 2015, Greater Pfizer lost 40% of its employees and 30% of its drug sales. Pfizer’s pre-merger elements had significantly higher sales ($20 billion more), higher R&D spending ($3.5 billion more) and many more employees (66,000 more) than the Pfizer of 2015. Its assets in 2015 have the same dollar value as in 2006, but it liabilities increased by 50%.

Everyone can agree that, despite obvious difficulties, the last decade of Pfizer’s financial performance has been amazing. Or disappointing. Or simply appalling.

In a post-truth world in which maintaining influence depends on nurturing rather than challenging deeply held preconceptions, having a variety of sets of performance data allows you to choose the interpretations that fit most comfortably with your preexisting emotional attachments and irrational biases.