Firepower and Growth Gap Report 2014

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The shifting balance of firepower

A year ago, consensus was that 2013 would be a busy year for acquisitions by big pharma companies as they sought to fill their “growth gaps” — the additional revenue they need in order to keep pace with the overall drug market. But, big pharma companies executed only a handful of small bolt-on deals, and their share of M&A transactions fell to a new low.

To explain this seeming paradox — and, more importantly, to understand what might lie ahead for M&A in 2014 — we updated the EY Firepower Index (defined in the box below) that we introduced last year.

Understanding the changing dynamics of pharma M&A requires that we look at three factors:

  • Pharma’s growth gap
  • Pharma’s firepower (its capacity to conduct M&A)
  • The relative firepower of big biotech and specialty pharma (unless otherwise specified, specialty pharma includes generics).

The EY Firepower Index measures companies’ capacity for conducting M&A deals. A company’s firepower is diminished as its market value, cash and equivalents fall or as its debt levels rise. For more details on the methodology and assumptions behind the Firepower Index, see the Appendix in the PDF version of this report.

Key findings

Big pharma was largely absent in the M&A market in 2013 despite a persistent revenue growth gap that is expected to reach US$100 billion by 2015. While big pharma’s “firepower” to conduct deals increased in 2013, in 2014 they will face dual challenges of higher valuations for attractive assets and relatively less purchasing power when compared to big biotech and specialty pharma valuations.

Big pharma was largely absent on the M&A front in 2013

Big pharma executed only a handful of small (less than US$5 billion) bolt-on deals. Three likely factors behind this lackluster M&A activity are:

  • Shareholder returns remain strong, despite weaker top-line growth
  • Replenished pipelines are improving organic growth prospects
  • More competition exists for more expensive M&A targets

Big pharma’s growth gap remains

Yet, despite strong shareholder returns and improving pipelines, big pharma’s 2015 growth gap remains essentially unchanged at US$100 billion. This is due to both a lack of significant M&A and slowing sales.

Revised third-quarter guidance indicates that aggregate 2013 sales are expected to decline by about 1%. Causes of this slower growth include continued patent cliff impacts, weak new product adoption, decelerating growth in emerging markets and slower adjacent business growth.

While big pharma’s firepower is up...

High equity levels in the stock markets have helped big pharma build its firepower, which increased by nearly US$100 billion, or about 15%. While healthy cash balances or lower debt levels are often key factors in building firepower, 90% of big pharma’s increase in firepower was due to changes in the stock market.

...the balance of firepower is shifting

In this report we look at two corollary measures to gauge the shift in balance of firepower and effects of increased competition:

  1. Share of firepower. Despite an overall increase, big pharma’s share of firepower – its portion of the combined firepower of big pharma, big biotech and specialty pharma – fell significantly from 85% in 2006 to 75% in 2012 to 70% in 2013 (see Exhibit 3). This means the valuations of big biotech and specialty pharma, many of which are in the sweet spot as potential acquisition targets, outpaced those of big pharma.
  2. Relative firepower. While big pharma’s firepower rose in absolute terms, the relative firepower of big pharma (i.e. adjusted for higher target prices) has actually declined by more than 20% over the last year.

Big pharma will likely face heightened competition for deals in 2014. Big biotech and specialty pharma have already proven to be significant competitors for assets, accounting for more than 80% of M&A activity by announced deal values in 2013 (see Exhibit 4).

 

Exhibit 3: Big pharma's share of firepower has fallen steadily

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Exhibit 4: Big pharma M&A share falls below 20%

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Implications for 2014 and beyond

We are cautiously optimistic about the prospects for continued M&A growth in the sector overall. Big pharma’s re-emergence on the M&A stage will ultimately be determined by how boards and senior management teams realign strategic priorities in response to core business performance, R&D results, competitor moves and investor expectations. Their M&A litmus test is likely to be influenced by the following:

More competition for assets

  • In 2014, the best assets will likely command higher prices and challenge returns on investment

Acquisitions are likely to hedge the pipeline disappointments seen

  • Likely acquirers in 2014 are companies with growth gaps who are looking to hedge potential disappointments in product launches and R&D

Companies may use divestitures to pursue growth targets

  • Companies with large growth gaps and the ability to divest non-core assets could turn to divestures in order to boost their firepower.
  • EY estimates approximately 12 divestures by big pharma – principally from non-core businesses - could be worth up to US$100 billion in incremental firepower that could be redeployed for M&A.

Use it or lose it

  • Companies whose firepower is expected to remain the same or decrease in value may feel pressured to use their firepower while they still have it.

Transaction execution self-confidence required

  • To undertake large-scale acquisitions or divestitures, management groups need to ensure they have the right capabilities, resources and process onboard. Elevated target prices coupled with rigorous investor scrutiny mean there is little room for error.