This seems to be the season for mergers and acquisitions in Pharma. What is the motivation for these transactions. One possibility is that if structured correctly, a merger or acquisition can be a no-lose proposition for accounting purposes and a no-win proposition for stockholders.
How can this happen. Consider Company A which is slowly losing patent protections for its products and cannot get replacement products approved quickly enough to replace them. Given the massive profitability of many pharma products and the enormous landscape of potentially successful development projects, Company A must be relatively poorly managed. However, Company A can find Company B that has income producing products and acquire it. What is the cost to Company A? The cost is minimal because the money Company A spends to acquire Company B is counted as an investment. Company B’s assets are simply a replacement for the money Company A spent. Over time, Company A will have to depreciate these assets but this depreciation can often be spread over many years. So, the cost of acquisition is low from an accounting point of view. Just a lot of lawyer payments.
If the cost is low, what’s the benefit. Well, that’s easy, the net income of Company B is added to the income of Company A. So, profits go up automatically. In fact, profits can go up even more if Company A fires as many people in Company B as possible. Of course the firing should concentrate on people who don’t add immediately to the current income of Company B. This maximizes the amount of Company B’s income that is available to add to Company A’s bottom line. Who will be the first targets for firing? The R&D group is prime. R&D doesn’t contribute to current profits. R&D generates future profits and a good R&D group can be extremely valuable. But, in the short term, R&D is a cost. So, getting rid of R&D makes short-term sense. It makes many mergers and acquisitions a no-lose proposition, at least on paper.
But what about reality? Firing all the people responsible for generating future profits means there will be no future profits. All the value locked in the R&D organization is lost. So, the value of Company B is greatly reduced. However, this loss is probably not recognized for accounting purposes. The value of Company B is still carried at close to its cost.
Thus, an acquisition can, for accounting purposes, be a no-lose transaction. However, over time, the profits from Company B must decline because their future revenues are limited by the loss of R&D. So, in due course, the slow depreciation of Company B that must be recognized year after year, will overtake the rapidly declining revenues. This is when reality starts to set in. Now Company A may have to start recognizing losses from the acquisition.
What to do? Another acquisition will fill the bill. Of course, it must be larger because the income from newly acquired Company C will need to cover the losses from depreciation of Company B in addition to the depreciation of Company C. So, the acquisitions must get bigger and bigger.
That’s just what we are seeing. Larger and larger acquisitions but sluggish growth or declining profits, except for a few years following the acquisition.
I’m not sure how something like this will end. But, he size of acquisitions cannot grow to infinity.