E&Y: As Big Pharma falters, Big Biotech helps fill a $100B M&A firepower 'gap'

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For years now Big Pharma's deep pockets have provided the big bucks needed to drive multibillion-dollar deals in biopharma--and quite a few of the smaller ones as well. But as the industry's dealmakers flock to San Francisco for the annual JP Morgan confab, Ernst & Young's life sciences team has weighed in with a new report that highlights an important tilt taking place in the balance of financial firepower among the most influential players on the field of deals. 

Industry pros will be familiar with the fundamentals: Facing a daunting patent cliff crisis, the biggest pharma companies--E&Y looked at the top 16--have been buying companies to help build revenue as top blockbusters get blasted by generic competition. They've also been forced to prop up stock prices with share buybacks, beefed up dividends and opted to turn to emerging markets as pricing pressures flattened revenues in developed countries. 

In the process, though, the formula hasn't quite worked as well as planned. Now the emerging-market strategy is flagging as Big Pharma's pockets thinned, a trend helped by the added debt the industry took on. Collectively, the world's biggest pharma companies' growth rate has slipped behind the market's trajectory, which will create a $100 billion "growth gap" by 2015. And despite a surge in stock prices last year, an overall decline in values over the past 6 years has further eroded Big Pharma finances, leading to a 23% decline in the kind of "firepower" it needs to do M&A deals.

E&Y's charts show that Big Pharma accounted for 85% of the industry's dealmaking firepower in 2006. But while they've maintained much of their heavyweight financial punch, that figure shriveled to 75% last year. And while specialty pharmas and generic companies have helped fill the gap, Big Biotech has done the most to step in to compete for deals.

The shift has significantly altered the landscape for deals. Only a handful of companies can still pull off a $60 billion megamerger, but now more players are stepping in to the industry sweet spot for high-profile deals in the $5 billion to $20 billion range.

Ernst & Young, of course, is in the business of advising companies on strategies, so it's no surprise to see them offering some advice on how the big companies can maintain their reserves. But their experts believe this is one trend that is likely to stick around for a few years.

"You could foresee it," says Jeff Greene, the global transactions advisory services leader in E&Y's life sciences group. High margins couldn't continue indefinitely with all the restraints being applied. "You could see that would become more and more constrained." Now Big Pharma has begun to "hit the wall over the past year or two." And that in turn has helped turn the heat up on cost-cutting.

E&Y's Andrew Forman notes that while financial pressures have been mounting in pharma, the top biotech companies have been growing at a much faster pace, and they have a long-term advantage in the longer arc of patent protection available for biologics. 

"On conference calls, you don't hear about mega-deals," he says. "You hear about bolt-ons. No one is telegraphing that they want to do more than $20 billion, in part because they can't." But don't rule it out.

Longtime Ernst & Young biotech analyst Glen Giovannetti thinks it's likely that a Big Pharma company or two in search of added product revenue will go on the hunt for one of these Big Biotechs. And as for a merger of Big Pharma equals: "I wouldn't rule out that there couldn't be another mega-deal.

Regardless, $5 billion to $20 billion buyouts represent the industry's sweet spot now, and those deals are likely to go for higher premiums with more companies elbowing their way to the auction block

Greene believes it's likely that the gap in firepower will be influential for the next three to 5 years. But there are variables to consider, he adds. Some Big Pharmas are more constrained than others and they may look to sell off some noncore assets to give them the money they need to pull off a big deal. Some players more also look to do deals in specific geographies, like China and India and Israel. And don't forget Japan, the world's second biggest pharma market, where more consolidation is likely.

Here's a link to E&Y's release.You should check it out. -- John Carroll, Editor-in-Chief. Follow me on Twitter and LinkedIn.