Analysis: Healthcare under the microscope

This week has seen several mergers and acquisitions (M&A) in the healthcare sector.

Roche, a Swiss-based drugmaker, today agreed to buy all the remaining shares in Genentech for $46.8 billion (£34 billion) in a takeover described as the largest in Swiss corporate history.

Earlier this week, Merck announced it was buying its rival, Schering-Plough, in a $41.1 billion deal, creating one of the world’s biggest pharmaceutical companies. The news comes three months after Pfizer’s $68 billion takeover of Wyeth.

There has always been a relatively large number of mergers and acquisitions within the sector, says Andy Smith, manager of the Axa Framlington Biotech Fund.

Smith says: “In the 1970s and 1980s, the classic blockbuster drugs were invented, drugs that sell over a billion dollar a year.”

He says that most of these blockbuster drugs – for example, antacids, cholesterol-lowering or antihypertensive drugs – have already been invented. “The main reason for a merger is cost-cutting, because it is becoming more and more expensive to develop new drugs,” Smith says.

He adds companies also hope to “bring together big research groups”.

In a statement, Severin Schwan, the chief executive officer of the Roche Group, said: “Roche and Genentech saw the potential of a pharma-biotechnology partnership early on.”

In Merck’s statement on its takeover of Schering, Richard Clark, the company’s president, said, “The combined company will benefit from a formidable research and development pipeline, a significantly broader portfolio of medicines, and an expanded presence in key international markets, particularly in high-growth emerging markets.”

Smith welcomes the latest sector developments: “It creates competition – although I don’t think it is going to be a lot tougher for other companies.”

He says that “all transactions go along with a halo effect”, but the real effects on the sector are difficult to predict.

“It is difficult because some people start to speculate which will be the next company to merge or acquire another company. It is very dangerous and impossible to predict. Fund managers should rather invest in those companies that are the best companies.”

Evan McCulloch, the manager of the Franklin Biotechnology fund, does not invest in Merck or Schering-Plough, but says other sectors that claim those two companies as clients may be negatively affected.

Merck shares lost 8%, while Schering-Plough shares gained 14%. McCulloch says the transaction was not entirely unexpected, because Schering-Plough was seen as a takeout candidate. He adds the move did not cause a rise in pharmaceutical and biotechnology stocks because of the inclusion of a new takeout premium.

McCulloch says the mergers highlight problems that large pharmaceutical companies face, such as weak pipelines, patent expirations and generating sustainable earnings-per-share growth.

As a result, these companies, with their large cash hoards and easy access to credit markets, may accelerate consolidation to strengthen their new product lines.

John Bowler, manager of the Retail Medical Discovery fund at Schroders, says that he held positions in Wyeth, Schering-Plough and Merck and the merger and takeover have helped his fund’s performance.

“I don’t think it will change things dramatically. Pressure on companies to increase their productivity and cut their costs will remain,” he says.

As at the end of January, the fund was 95.98% exposed to the healthcare sector.

For Americans, the year began with high expectations for the Obama stimulus plan and an anticipation of a recovery, including improvements to the healthcare system.

Tana Focke, manager of the Smith & Williamson North American Trust, says: “Over the last month, the only two sectors that showed growth were healthcare and utilities.”

With 17.7% of her £52.49m invested in the healthcare sector, it is her biggest asset allocation.

However, the hopes of early 2009 were dashed by confusion about what the stimulus package would contain. Focke says: “The Obama speech was not helpful because it frightened people when he said he was going to cut prices. But he didn’t say how. The healthcare stocks fell sharply, even those of low-cost producers.”

“One of my holdings, the pharmacy CVS Caremark, which is co-operating with the American government to develop ways people can get prescriptions cheaply and automatically, was marked down. Even though the company’s aim is to make healthcare more efficient and cheaper. Another holding Amedisys, a home nursing company, was also marked down.”

She says the situation was an economic paradox. “They should have gone up because they are working on ways to improve the healthcare system. But people panicked, because they feared every company’s margin would be squeezed.”