In the wake of American Home Products’ friendly bid for Warner-Lambert and Pfizer’s $80 billion (or $74 billion, depending on who’s counting) hostile counter-offer (click here to read an “Explainer” on hostile takeovers), expectations are growing that we’re going to see a wave of mergers in the pharmaceutical industry. Novartis, Glaxo, Monsanto, Schering-Plough, Merck: Everyone is either on the block or shopping. Whether all this buying and selling makes economic sense seems somehow beside the point. After all, they don’t call it merger-mania for nothing.
The most perplexing thing about the goings-on in the pharmaceutical industry, though, is not that drug-company CEOs would rather run $70 billion companies rather than $30 billion companies. Nor is it that Pfizer’s bid–which, remember, it could have made long before American Home Products came a-courting–seems driven as much by the “if you want Warner-Lambert, then I want Warner-Lambert” impulse as anything else. These, after all, are the basic ingredients of many, if not most, mergers which has something to do with the fact that most mergers destroy, and don’t create, economic value.
No, the most perplexing thing about all the merger talk is the reaction of investors, who have driven up the prices of pharmaceutical stocks pretty much across the board. Since acquisitions almost universally occur at a price above the current market price, and since bidding wars (of all kinds) tend to drive prices far above fair value, investors have jumped into the drug stocks, assuming that merger-mania has to be good for them.
Here’s the problem, though: There are no outside bidders for these companies. The only company that’s going to buy a Glaxo is another drug company. So, there isn’t any flood of outside capital coming into the drug industry. If a wave of mergers gets touched off, all that’s going to happen is that capital will be redistributed from certain companies’ shareholders to other companies’ shareholders. But the total amount of value in the industry as a whole will remain the same.
In bidding up the prices of all these drug companies, then, investors are essentially saying that if you divide a pie up into four slices, it’s more valuable than if you divide it up into eight slices. But the pie is the very same size. It just looks different.
It’s true that it’s better–all other things being equal–to own one of the four slices rather than one of the eight. But all other things aren’t equal, since for Pfizer to become a $70 billion company, it’s going to have to spend huge amounts of money to acquire Warner-Lambert. The possibility of a merger wave may make the stock of the potential acquirees more valuable. But it should make the stock of the potential acquirers equally less valuable.
The other possibility is that there really will be synergies in the new giant companies that will make them more profitable together than they are apart. But it is hard to see what these are, and empirically, synergies are next to impossible to realize.
What that means is that the determinants of value for the industry as a whole–free cash flow, return on invested capital, and future growth prospects–will remain unchanged after the merger wave is done. And that means the stock price of the industry as a whole–if there were such a thing–should remain the same.