Healthcare companies scale up

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This was a big week for the global pharmaceutical industry. First, rumors of one deal suggested a possible return to the industry’s old self-destructive ways. But then two other transactions were announced that signaled continuation of a newer trend that’s much healthier for shareholders.

On Monday, it was reported that New York-based Pfizer Inc. (NYSE: PFE) had been in talks to acquire AstraZeneca PLC (NYSE: AZN), headquartered in London, for over $100 billion. The companies apparently broke off the discussions.

If such a transaction were to occur, it would be the latest in a long series of megamergers that characterized the corporate strategies of Pfizer, Swiss drug giant Novartis AG (NYSE: NVS) and others in the 1990s and 2000s. Back then, the aim was to acquire rivals in multibillion-dollar deals that broadened the buyers’ businesses to cover more diseases and new health-care areas.

The catalyst for this buying binge was the so-called patent cliff, in which some of the sector’s biggest drugs faced the loss of patents that protected them from competition, resulting in reduced revenues and earnings.

Since then, however, the patent cliff problem has waned because many of those patent expirations have already occurred. And the bigger, combined companies generally have come up short on development of new blockbuster drugs. Also, excessive diversification has brought weak competitive positions in some niches.

But the current industry trend is for companies to focus more on their core strengths instead of diversifying. Pfizer, Bristol-Myers Squibb (NYSE: BMY), Johnson & Johnson (NYSE: JNJ) and Abbott Laboratories (NYSE: ABT) have made such moves over the last few years in order to focus on what they consider higher-grow! th prospects.

Tuesday brought more of the same. Novartis and UK-based GlaxoSmithKline (NYSE: GSK) announced more than $20 billion in deals. Novartis is to sell its animal-drugs business to Eli Lilly (NYSE: LLY), a U.S. company, for $5.4 billion; and most of its vaccine business to Glaxo for $5.2 billion. Novartis also will buy Glaxo’s cancer-drug business for $14.5 billion.

Then on Wednesday came another announcement. Allergan (NYSE: AGN) is the target of an unsolicited takeover offer. The suitor is Valeant Pharmaceuticals International (NYSE: VRX), which has teamed up with activist investor William Ackman. If successful, the $46 billion deal would create a global giant in the eye-care and skin-care drug industries.

Montreal-based Valeant’s core strategy is to buy companies for their products, cut away research spending and then boost revenue by moving the products through Valeant’s sales force. This approach focuses more on cost savings and tax benefits than on seeking growth through scientific advances. Valeant said it sees this deal producing at least $2.7 billion in cost savings. The combined company also would benefit from a much lower tax rate than Allergan currently pays.

Before the announcement, Ackman’s Pershing Square Capital Management built a 9.7 percent stake in Allergan, valued at about $4 billion. Pershing Square is expected to maintain a stake in the combined company for at least a year. Unlike the week’s first deal, California-based Allergan is expected to oppose the offer and try to seek other alternatives. So it’s uncertain whether the transaction will occur and how long it will take.

But Valeant’s proposed deal and those involving Novartis, Glaxo and Lilly share a key theme: Focus on specific sectors where you believe you have the size and expertise to generate significant sales growth, be a market leader and build economies of scale.

Yet another healthcare deal that was announced on Thursday also emb! races tha! t approach. Zimmer Holdings, Inc. (NYSE: ZMH) agreed to buy privately held Biomet Inc. for $13.35 billion in cash and stock. Both companies are leading providers of  orthopedic, surgical and dental products. The deal strengthens Zimmer’s hold in the global hips and knee market, while placing it second in the overall orthopedic market to Johnson & Johnson. Achieving synergies from this transaction will be aided by the fact that both companies are headquartered in Warsaw, Indiana.

This trend in the healthcare industry of “scaling up” is expected to continue as companies deal with expected price pressures from the Affordable Care Act and other factors. This may well prove a plus for shareholders. But with fewer players and less competition, drug development and other medical innovation could suffer.