Will the Glaxo-SmithKline Merger Be Good Therapy?

The proposed acquisition of SmithKline Beecham by Glaxo Wellcome – in a stock swap valued at $75.7 billion – may be creating the world’s largest pharmaceuticals company, but the question remains: Is it worth the effort?

Wall Street in general was clearly not enthusiastic about the deal. On Tuesday, January 18, the first business day after the announcement of the merger on Monday, both company stocks took a beating in London and the U.S. On the NYSE, SmithKline dove eight points to $61 5/16 a share, an 11% slide, and Glaxo fell 5 15/16 points to $54 1/16, a 9.9% decline – significant losses even in an era of volatile stock swings.

Wharton health care systems professor Patricia Danzon shares Wall Street’s lack of enthusiasm for the proposed new company, which would have 7.3% of the worldwide prescription drug business and an annual research budget of approximately $4 billion.

"The basic business of the drug industry is developing drugs and getting them to consumers and physicians," says Danzon, who has done extensive studies on the pharmaceutical industry. "Maybe a bigger company can do it more efficiently and faster, but whether that is a winning strategy remains to be demonstrated."

Danzon says that though there have been well-publicized mergers and near-deals among big pharmaceutical companies of late, there are not necessarily more of them proportionally than in other industries. But it is true, she adds, that drug companies have a peculiar relationship with Wall Street.

"The PEs (Price-earnings ratios) of drug companies are high, and Wall Street has high expectations for continued earnings growth," she says. "It puts huge pressure on them to continue to perform. If they are faced with the loss of patents on drugs that produce revenue, or if the drugs in the pipeline are not as successful as they might have hoped, one way to get short-term breathing space is to merge.

"Usually the first step for merged firms is to cut work forces and get cost savings that go immediately to the bottom line," Danzon says. "That gives the company some short-term breathing room to meet Wall Street revenue growth expectations. The longer-term hope is that the larger firm will get a bigger bang for the R&D spending because of economies of scale and scope."

While the initial reaction to the deal from investors appears to be that Glaxo and SmithKline won’t get that initial hit, Danzon isn’t so sure about the long term either. "The key question is, will the combined entity be more productive than the sum of the two parts separately? Will the sheer hassle factor of bringing two different corporate cultures together, consolidating two huge organizations, be worth it? Will the costs in time and money of integration eat up the initial savings? You could lose some of your best people because when employees hear that job cuts are coming, they look to move on before the cuts hit them. It’s an interruption of normal business practices, which can be really costly."

One immediate concern over this merger, say some analysts, is that the combined companies have not planned to make deep enough job cuts among their collective 107,000 employees worldwide to please investors. But this, some say, won’t necessarily sink the deal, at least in the long run.

"The jury is always out whether bigger is better, but in this case, I think it makes sense," says Jeffrey Chaffkin, a pharmaceutical analyst at PaineWebber. "The cost of developing drugs is way up, especially with the moves into genomics and gene therapy. We have seen five or six of these mergers now, like that of Astra and Zeneca. There needs to be critical mass for better research and development and a global sales staff for these important drugs."

Chaffkin does predict that larger companies will be loath to develop drugs that don’t make megabucks. "You can’t afford to do niche products when you are Glaxo," said Chaffkin. "You have to go for blockbusters. You have so much invested, you can’t be targeting smaller markets any more. I also worry whether the big company will have what it promises – a faster-growing model. The decision-making process for everything can really bog down in very big organizations. Yet you have to be global in scope in this industry, so you may just have to take that chance."

Management professor Harbir Singh isn’t worried about the integration aspect of this particular merger. "The two companies have relatively similar corporate cultures, and we’ve seen enough middle- and smaller company mergers in the last five or 10 years in the pharmaceutical business, so we can see how many work," he notes. Glaxo and Smithkline are "obviously looking for more scale in research and development," Singh adds. "Some companies in the industry are doing well; others aren’t. Glaxo hasn’t done so well lately. SmithKline has done all right. It could work, but it’s certainly not a sure thing."

Meanwhile, news reports out this week speculated that two articles in a medical journal this week – suggesting that SmithKline’s diabetes drug Avandia may have caused serious liver disease in two patients – could have contributed to the company’s stock decline. SmithKline’s response has been that the liver problems were not caused by the drug but by other aggravating factors.

In some ways, the outlook for a combined Glaxo SmithKline comes down to an issue of how big is big enough in the drug business. Danzon says that most of the bigger firms, such as Merck and Pfizer – both of which are smaller than the new Glaxo/SmithKline combination – already have a large enough research budget to get economies of scale. "Maybe Glaxo sees something in this acquisition that fascinates them that the rest of us don’t see," she says. "The most important aspect of a merger like this is making sure of the synergies, that things fit together long-term. We will just have to see whether this will work."

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