the impact of pharmaceutical mergers on economic …
TRANSCRIPT
THE IMPACT OF PHARMACEUTICAL MERGERS
ON ECONOMIC AGENTS
by
ANNE MARIE MACY, B.A., M.A.
A DISSERTATION
IN
ECONOMICS
Submitted to the Graduate Faculty of Texas Tech University in
Partial Fulfillment of the Requirements for
the Degree of
DOCTOR OF PHILOSOPHY
Approved
Accepted
December, 1998
/ R'?2 ACKNOWLEDGEMENTS
I wish to express my appreciation to the members of the supervisory committee,
Dr. Eleanor T. von Ende, Dr. Klaus Becker, and Dr. Thomas Steinmeier for their
assistance in the preparation of this dissertation. A special note of gratitude goes to Dr.
von Ende for her guidance in this dissertation and throughout my Ph.D. program at Texas
Tech University. Thanks also goes to Dr. Don Ethridge for his help with the proposal.
Deep appreciation goes to my parents, Lowell and Jill, and my husband, Neil, for
their encouragement and devotion. Appreciation is expressed to the Texas Tech Graduate
School for the Dissertation Research Award. Many others have contributed in various
ways, for which I am grateful.
11
TABLE OF CONTENTS
ACKNOWLEDGEMENTS ii
ABSTRACT vii
LIST OF TABLES viii
CHAPTER
I. PROBLEM STATEMENT 1
1.1 General Issue 1
1.2 Specific Problem 5
1.3 Objectives 12
n. INDUSTRY ENVIRONMENT 14
2.1 Introductory Comments 14
2.2 Company Specific Considerations 15
2.2.1 Research and Development 15
2.2.2 Definition of a Market 20
2.2.3 Examples of Generations of Development within a Therapeutic Class 21
2.2.4 Marketing to Consumers 22
2.2.5 Levels of Dmgs 25
2.2.6 Generics 26
2.2.7 Over-the-Counter 27
2.2.8 Owners of the Firms 27
ni
2.3 External Considerations 28
2.3.1 Government Regulations 2 8
2.3.2 Other Societal Concerns: Piracy, Employment, and Sales 30
2.3.3 Consumers 32
2.3.4 Social Contact Patients 34
2.3.5 Insurance 34
2.3.6 Dmgstores 37
2.4 Role of Mergers 39
m. LITERATURE REVIEW 40
3.1 Introduction 40
3.2 Pharmaceutical Industry 40
3.2.1 Risks and Returns to Research and Development 41
3.2.2 Firm Size 44
3.2.3 Pricing Behavior 44
3.2.4 Intemational Considerations 46
3.3 Merger Literature 46
3.3.1 Theoretical Reasons for Mergers and Value Increases 47
3.3.2 Empirical Tests of Merger Activity 51
3.4 Uniqueness of this Study 54
IV. CONCEPTUAL FRAMEWORK 56
4.1 Objective of a Fum 56
4.2 Integration Considerations 61
iv
4.3 Returns to Economic Agents 63
V. METHODS AND PROCEDURES 66
5.1 Introduction 66
5.2 Returns to Stockholders 66
5.3 Operating Performance of the Firms 69
5.4 Data and Sources 71
VI. RESULTS 73
6.1 Introduction 73
6.2 Merger Descriptions 74
6.2.1 Bristol-Myers Squibb Horizontal Merger 74
6.2.2 Merck and Medco Vertical Merger 76
6.2.3 American Home Products and American Cyanamid OTC/BIO Horizontal Merger 78
6.2.4 Other Mergers 80
6.3 Event Study Empirical Results 81
6.3.1 Mean Adjusted Retum Model Results 82
6.3.2 Market Model Resuhs 88
6.4 Nonparametric Empirical Results 93
6.5 Regression Empirical Results 96
6.5.1 Model 96
6.5.2 Results 98
6.6 Anecdotal Evidence 103
6.6.1 Bondholders 103
6.6.2 New Molecular Entities for Consumers 106
6.6.3 Pharmacies 112
VII. SUMMARY AND CONCLUSIONS 114
7.1 Contributions 114
7.1.1 Firms Included in Study 115
7.1.2 Event Study Resuhs 117
7.1.3 Summary of Effects on Bondholders 119
7.1.4 Potential Wealth Distributions 120
7.1.5 Consumer Considerations 121
7.1.6 Operating Performance Results 123
7.1.7 Overall Assessment 125
7.2 Future Extensions of this Study 126
ENDNOTES 127
REFERENCES 128
VI
ABSTRACT
Mergers and acquisitions are methods of corporate growth. When internal growth
is not efficient or desirable, a firm will expand externally by acquiring another firm. In the
pharmaceutical industry, there were 21 major mergers between 1989 and 1994. These
mergers were a strategic response to the changing environment faced by the firms.
Consumers deshed better and more dmgs while managed care organi2:ations and the
government demanded cost control. The purpose of this study is to examine the effects of
three significant mergers in the pharmaceutical industry on concerned parties. Using a
case study approach, the Bristol-Myers Squibb horizontal merger, Merck-Medco vertical
merger, and the American Home Products-American Cyanamid horizontal merger are
examined. Returns to target and bidder stockholders along with the number and type of
new dmgs innovated for consumers are investigated. Typically, studies of mergers
evaluate the effects of the mergers on a short time horizon and only for stockholders.
These studies examine the effects of the merger announcements and not the actual merger
itself This study uses a tune frame of two years around each merger m order to examine
the actual returns of the mergers to economic agents.
vu
LIST OF TABLES
1.1 Historical Figures on United States Mergers 3
1.2 Inflation Rates, 1970-1997 7
1.3 Major Mergers in the Pharmaceutical Industry, 1989-1994 10
2.1 Growth in Research and Development, U. S. and Abroad, 1970-1994 19
2.2 Domestic U.S. Sales and Sales Abroad, 1970-1997 31
6.1 Mean Adjusted Retums—Bristol-Myers Squibb Merger 85
6.2 Mean Adjusted Returns—Merck and Medco Merger 86
6.3 Mean Adjusted Retums~AHP and ACY Merger 87
6.4 Market Model Retums—Bristol-Myers Squibb Merger 90
6.5 Market Model Returns—Merck and Medco Merger 91
6.6 Market Model Retums-AHP and ACY 92
6.7 Nonparametric Results 95
6.8 Regression Results—Retum on Assets 102
6.9 New Molecular Entities—Bristol-Myers and Squibb 108
6.10 New Molecular Entities—Merck and Medco 109
6.11 New Molecular Entities-AHP and ACY 110
6.12 New Molecular Entities~EU Lilly and PCS 111
Vlll
CHAPTER I
PROBLEM STATEMENT
1.1 General Issue
Mergers and acquisitions are methods of corporate growth. When intemal growth
is not efficient or desirable, a firm will expand extemally by acquiring another firm. Basic
finance teaches that the main goal of a firm is the maximization of stockholder wealth.
Therefore, the objective of an acquisition is to increase wealth. This goal may be achieved
by increasing sales, market share, assets, or research along with decreasmg costs. Many
firms and managers equate size with power. Mergers allow for an increase m critical
mass, which the firm and managers believe will give them increased power in the
marketplace. Mergers are a part of the business strategy of a firm and help create a
sustainable competitive advantage for the buyer firm through the addition of the positive
and desu^able attributes of the acquired firm.
A merger is the combination of two firms with the stockholders of both firms
jointly owning the new firm. A merger forms a new entity. An acquisition occurs when
one firm purchases the assets of another firm with the acquhed shareholders ceasing to be
owners. The acquired firm becomes a part of the buyer firm. A takeover is an acquisition
where the buyer firm is substantially larger than the acquired firm is. The definitional
differences are important for accountmg and regulatory purposes but have little economic
or financial meaning. Therefore, the terms merger, acquisition, and takeover are used
interchangeably.
Mergers in the twentieth century have come in waves. Mergerstat Review (1997)
denotes six main periods of merger activity. From 1893 to 1904, merger activity was
dominated by industry consoUdation leading to monopolistic entities. This was partly due
to the Sherman Antitmst Act of 1890 that outlawed collusion but not mergers. Between
1915 and 1929 the second wave of horizontal mergers formed oligopoUes. Mergers in the
1940s were caused by heavy estate taxes that forced small owners to sell as they retired.
Most of these mergers were friendly. The theory of diversification propelled the longest
merger wave lasting from the mid 1950s through 1969. Medium-sized firms acquired
other medium-sized firms in unrelated industries forming conglomerates. A firm
conducting business in several unrelated firms was believed to be less susceptible to the ill
effects of business cycles. This wave ended when the stock market dropped in the early
1970s. Starting in the mid-1970s, firms began divesting unrelated or unprofitable
divisions, opposite of a decade earlier. The 1980s saw a continuing of the disassembly of
conglomerates. The speed of takeover activity increased with the use of junk bonds. As
the 1980s ended, there was a slowdown in merger activity due to the stock market drop
and instability of financing from the use of junk bonds. The sixth wave started after the
stock market drop and increased with the rise in the stock market in the 1990s. Strategic
mergers have characterized this wave. Firms merge or acquire in order to gain specific
products, markets or skills. As shown in Table 1.1, 5,848 mergers, net of cancellations,
were announced in 1996. This figure is the highest in 27 years but below the 6,107
announcements in 1969. The percentage of merger deals with a value over $100 miUion
dollars has also increased during the last decade, indicating that the merging firms were
already large.
Table 1.1: Historical Figures on United States Mergers
Year
1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
NetM&A Announcements
4462 6107 5152 4608 4801 4040 2861 2297 2276 2224 2106 2128 1889 2395 2346 2533 2543 3001 3336 2032 2258 2366 2074 1877 2574 2663 2997 3510 5848
Total Dollar Value Paid
($ Billion) 43.6 23.7 16.4 12.6 16.7 16.7 12.4 11.8 20.0 21.9 34.2 43.5 44.3 82.6 53.8 73.1 122.2 179.6 173.1 163.7 246.9 221.1 108.2 71.2 96.7 176.4 226.7 356.0 492.9
1992 Constant Dollar Value
($ Bilhon) 157.4 81.7 53.6 39.3 49.9 47.2 32.2 28.0 44.8 46.1 67.2 78.7 73.3 125.0 76.6 99.9 161.0 228.5 214.8 197.0 286.8 246.5 115.6 73.2 96.7 171.9 215.9 330.9 446.9
Number of $100 Million Deals
na na na na 15 28 15 14 39 41 80 83 94 113 116 138 200 270 346 301 369 328 181 150 200 242 383 462 640
Source: Houlihan Lokey Howard & Zukin, Mergerstat Review, 1997, Los Angeles, CA: GDP Deflator: Economic Report of the President, Febmary 1996.
Mergers and acquisitions are part of the market for corporate control. The aim is
the right to manage the assets of the target firm. Successful management will lead to an
increase in shareholder wealth. However, principal-agent problems may exist between
management and the stockholders. Managers may undertake mergers to increase their
importance and make other decisions that maximize their utility mstead of stockholder
wealth. The decision to merge is optunally based on expected value created by the merger
and the sources of the value creation. Efficient decision-making regarding initiation of
mergers demands full information about the target firm.
The actual integration of the firms will determine success. The initial decision is
usually based on optimistic evaluations of the target firm in terms of its financial, strategic,
and organizational strengths. The weaknesses of the target firm and the difficulties of
actual integration are often overlooked or underplayed. Determinism, value destmction,
and leadership vacuum are three sources of integration problems (Sudarsanam, 1995).
Determinism refers to the conflict between the managers of the two merging firms. The
acquirer does not account for the uniqueness of the target firm and forces rigid mles and
programs on the new employees. If the managers and employees from the target firm
beUeve that they are bemg overlooked and ignored, they may act in ways to prohibit or
delay the mtegration, demonstratmg then- determinism. If the two sets of managers and
employees are not able to function together, the value of the new entity will be reduced
from the inefficiency. Friction between the two parties can cause communication lapses,
which reduces the productivity of the entire firm. A third problem is that a clear
leadership hierarchy is not always known, and the top management may not be involved in
the tedious aspects of integration. This lack of leadership further leads to integration
problems and a loss in wealth. Clearly, the three integration problems are variations of the
principal-agent problem. A successful merger must account for these potential problems,
which can delay the gains from the acquisition, and for the role employees play in the
actual merger outcome.
1.2 Specific Problem
In the pharmaceutical industry, there were 21 major mergers between 1989 and
1994. While this is during the period of somewhat reduced merger activity for the United
States as a whole, pharmaceutical firms were combining with other firms, insurance
providers, biotechnology, and over-the-counter firms for strategic purposes. A maintained
hypothesis is that the merger activity springs from the environment. In effect, mergers
were a response to the changing environment faced by the pharmaceutical firms. The
environment has two main components, intemal and external factors. These will be
introduced here but discussed more fully in the second chapter.
The industry revolves around the long and expensive research and development
process (R&D). On average, it takes over $300 miUion dollars to produce a dmg
innovation, while the process has a success rate of only 36% (DiMasi, Hansen,
Grabowski, and Lasagna, 1991). During the 1989-1994 period, consumers desked more
and better dmg innovations, cures instead of relief from diseases. They also expected the
pharmaceutical companies to be able to treat a variety of aihnents, many of which had
been previously considered genetic problems, such as Parkinson's Disease and baldness.
Some of the ailments from which patients wanted relief were caused by lifestyle choices of
the individuals, such as obesity and high cholesterol. The pharmaceutical firms were pitted
against each other to provide these new breakthroughs.
The industry also was under extemal attack. Managed care organizations (MCOs)
wanted more dmgs because dmg therapies are less expensive than most invasive
procedures, but demanded cost control as did the federal government. Currently, the
United States spends over thirteen percent of Gross Domestic Product (GDP) on heahh
expenditures. This figure is double the 1970 percentage and is a higher percentage than
the other major industrialized countries. However, domestic pharmaceutical expenditures
constitute only 1.2% of GDP, which is equivalent to those in Canada and less than those in
Italy, France, Germany, and Japan (PhRMA, Profile 1997). While pharmaceuticals
constitute only five to six percent of health care expenditures, the industry is an easy target
due to its size, availability, and recognizability. Physicians and hospitals are more
disaggregated around the country and harder to differentiate.
While domestic pharmaceutical expenditures appeared consistent with figures from
other industrialized countries, the price inflation of pharmaceuticals has been rising faster
than the overall rate of inflation. As indicated in Table 1.2, during the 1970s, the urban
consumer price inflation rate averaged 7.1%, whereas the prescription dmg component of
the CPI was only 3.6%. In the 1980s, the overall rate was 5.6%> and the dmg component
grew at 9.6%. From 1990-1997, all items averaged 3.3%, whereas the dmg prices grew
at 5.3%. Starting in 1981 prescription prices started to grow faster than the urban
consumer rate, and it has in each year since then except 1985. The dmg component of the
producers price mdex also exceeded the urban CPI for most of the 1990s.
Table 1.2: Inflation Rates, 1970- 1997
Year
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Average Average Average
70-79 80-89 90-97
CPI - All Items
5.7% 4.4 3.2 6.2 11.0 9.1 5.8 6.5 7.6 11.3 13.5 10.3 6.2 3.2 4.3 3.6 1.9 3.6 4.1 4.8 5.4 4.2 3.0 3.0 2.6 2.8 3.0 2.3
7.1 5.6 3.3
CPI - Dmgs
1.7% 0.0 -0.4 -0.2 2.3 6.2 5.3 6.1 7.7 7.8 9.2 11.4 11.6 11.0 9.6 9.5 8.6 8.0 8.0 8.7 10.0 9.9 7.5 3.9 3.4 1.9 3.4 2.6
3.6 9.6 5.3
Source: Bureau of Labor Statistics, various years.
Some pharmaceutical firms reacted to this changing environment by merging As
indicated in Table 1.3, three types of mergers occurred. Horizontal mergers were
transacted between firms of similar size. Examples of this type are Bristol-Myers and
Squibb, Glaxo and Wellcome, Upjohn and Pharmacia, Ciba-Geigy and Sandoz, and
Smithkline and Beecham. These mergers combined R&D facilities and staffs, sales staff,
geographic markets, and major products to increase critical mass and to facilitate
competitiveness in domestic and intemational markets. Because R&D staffs work in
teams, combining teams can actually enhance creativity. Research teams are also
expensive to produce so it is advantageous for some firms to acquire the existing staff of
another firm. Increasing sales staff generates wider exposure for all the dmg products.
Doctors tend to prescribe what they know. An increased marketing staff can better inform
physicians encouraging them to prescribe more. The time delay from the research and
development process has caused a need for a blockbuster or "wonder" dmg to be
produced by firms to sustain it over the long mn. Horizontal mergers increase the
likelihood of producing a blockbuster dmg through the combined resources.
Alternatively, vertical mergers between pharmaceutical firms and insurance
providers have been used to take advantage of the growing use of managed care
organizations in healthcare delivery. Pharmacy benefit managers are insurers who process
and review dmg prescriptions for managed care organizations. They influence the choice
of dmgs through formularies and dmg utilization boards. After the 1994 Eh Lilly-PCS
merger, the Federal Trade Commission established a fire wall to separate the management
decisions of owner pharmaceutical firms and their pharmacy benefit managers in order to
8
control collusive behavior. However, even with the fire wall, an easing of communication
between the entities may lead to a decrease in costs that may, in tum, encourage increased
use of the dmgs manufactured by the owner pharmaceutical firm. Other examples of this
type of merger are Merck's acquisition of Medco and SmithKline Beecham's acquisition
of Diversified.
Finally, pharmaceutical firms have responded to the changing industrial
environment by acquiring biotechnology firms and OTC firms. Typically, OTC firms
provide a steady cash flow that may be used to fund the long R&D process. OTC
products have a fairly steady demand and are relatively cheaper to produce than
prescription dmgs because of less stringent regulations. The research potential of
biotechnology has not yet been proven but is expected to payoff in the future by
revolutionizing the way in which pharmaceuticals are developed. Traditionally, research
has been conducted by looking for compounds and then determining if there are any
clinical applications. Biotechnology research looks instead at the disease or ailment and
tries to develop something to control or eradicate it. It involves knowledge of genes, cells
and entire systems. The increase in computer related technology is instmmental to this
process. By attempting to develop something explicitly for an ailment, it is expected to
increase success rates of innovated compounds, thereby decreasing costs and increasing
possible blockbluster innovations. An example of this type of merger is American Home
Products' acquisitions of A.H. Robins and American Cyanamid, with which they also
received Immunex.
9
Table 1.3: Major Mergers in the Pharmaceutical Industry 1989-1997
Year
1989 1989 1989
1989 1990 1990 1990 1990 1991 1991
1991 1991
1993 1993 1994 1994 1994 1994 1994
1994 1994 1995 1995 1995 1995
1996 1997
Bidder
Dow Bristol-Myers American Home Products American Cyanamid Pharmacia Boot Abbott Laboratories Baxter SmithKline American Home Products Sandoz Boehringer Mannheim American Cyanamid Merck SmithKline Sanofi Pharmacia Hoffinan La-Roche American Home Products EU Lilly SmithKline Beecham Glaxo Hoechst Upjohn Rhone-Poulenc Rorer Ciba-Geigy Roche
Target
Marion Squibb A.H. Robins
Praxis Kobi Flmt Damon Biotech BioResponse Beecham Genetics Institute
Systemix Microgenics
Immunex Medco Steriing Sterling Erbamont Syntex American Cyanamid
PCS Diversified Wellcome Marion Merrell Dow Pharmacia Fisons
Sandoz Boehringer Mannheim
Type of Merger
Horizontal Horizontal OTC
Biotechnology Horizontal Horizontal Biotechnology Biotechnology Horizontal Biotechnology
Biotechnology Biotechnology
Biotechnology Vertical OTC unit Rx unit - Horizontal Horizontal Horizontal Horizontal
Vertical Vertical Horizontal Horizontal Horizontal Horizontal
Horizontal Horizontal
Source: Mergers and Acquisitions, various issues
10
Mergers affect various groups associated with the mergers. While the mergers
were undertaken as a result of changes in the environment, the firms were not the only
stakeholders effected. Stockholders, to whom the managers of the firm are primarily
responsible, are an obvious stakeholder affected by the mergers. The firm has other
stakeholders who are also concerned with the outcome of the merger. Bondholders can
lose value if the firm undertakes additional debt or if the merger is unsuccessfiil.
Consumers' interest in the merger lies with the number, quality, and price of new dmgs
innovated. If the merger results in more products, consumers gain. Losses are possible if
the quantity or quality of production decHnes. The stakeholders are concerned not just
with the immediate effects but also the longer term effects of the mergers. Gains or losses
to the stakeholders may not be realized immediately. A longer time frame allows for the
inclusion of the integration process and its success or failure. While a successful business
earns net income and increases in the stock price, longer term success is interdependent
with the valuation of the firm by the other stakeholders. Therefore, each group has a
definition of a successful merger strategy.
The purpose of this study is to examine the effects of significant mergers in the
pharmaceutical industry on concerned parties. Using a case study approach, the Bristol-
Myers Squibb horizontal merger, Merck and Medco vertical merger, and the American
Home Products-American Cyanamid biotechnology/OTC horizontal merger will be
examined. Returns to target and bidder stockholders and bondholders along with the
number and type of new dmgs innovated for consumers and returns to the firm are
investigated.
11
Typically, literature and empirical studies of mergers evaluate the effects of
mergers on a short time horizon and only for stockholders. The event studies have used
data covering the time period immediately surrounding the merger announcement, usually
no longer than six months before or after. Though the rationale for this is based in
efficient market theory, with stock prices representing the discounted expected future
returns from an action or actions of the firm, the reaUty is that stock prices are rational but
not perfect. They are not able to immediately account for the actual returns of the merger,
which depend not only on synergies available but the success of the integration process as
well. Such a short time frame really examines the effects of the merger announcement and
the anticipated merger only, not the actual merger itself This study uses a time frame of
two years around each merger in order to examine the actual retums of the mergers.
1.3 Objectives
The primary objective of this study is to examine the effects of three specific
mergers within the pharmaceutical industry on industry stakeholders. The three mergers
are Bristol-Myers-Squibb, Merck-Medco, and American Home Products-American
Cyanamid. A case study approach will allow for an in-depth examination of the results of
each merger. The specific objectives are to determine the effects of the mergers on:
1. Bidder stockholders' retums.
2. Target stockholders' retums.
3. Firm operating performance. In particular, the effect on retum on assets is
investigated.
12
4. Other stakeholders: bondholders, consumers, and pharmacies. Specifically, what
happened to the firms' bond ratings after the merger; whether more dmgs and what
type of dmgs were innovated; and the use of short-dated dmgs by pharmacies are
discussed.
13
CHAPTER II
INDUSTRY ENVIRONMENT
2.1 Introductory Comments
The first step in analyzing a business action is to examine the environment the firm
faces. In a quick overview, pharmaceutical firms maneuver among various stakeholders.
The firms' first responsibilities are to the shareholders who are interested in retums on
their investments. The retums are generated from profits, which are created from the
difference between sales to customers (total revenue) and costs to produce (total costs).
Sales are determined by consumer choice, which are influenced by physicians and
pharmacists. Firms can attempt to persuade choice through advertising and by providing
an array of products. Fums compete to produce the next wonder dmg. The research and
development process is the heart of the industry. This process is long and expensive,
demanding strong cash flows to support it. However, the winner of the process receives a
government patent, which can assist in controlling the marketplace for the firm. The
government is not just a regulator for the industry, but also a large buyer of
pharmaceutical products. Increases in the age of Americans and the rise of managed care
organizations have put pressure on the industry to produce more dmgs at a cheaper price.
This section examines the various fundamental components of the pharmaceutical industry
and its environment.
14
2.2 Company Specific Considerations
2.2.1 Research and Development
Success m the pharmaceutical mdustry is driven by a firm's abiUty to mnovate.
Society's desires for more dmgs and cheaper dmgs are, to some extent, mutually
exclusive. More and better dmg innovations cost money and time. However, consumers
rarely are willing to pay for the enthe discovery process and resuhmg dmgs. A new dmg
innovation costs over $300 miUion. The cost is high because many compounds are
unsuccessfiil. Fewer than 36% of all potential compounds survive the enthe research and
development process and make it to the market (DiMasi, Hansen, Grabowski, and
Lasagna, 1991). Not even the added incentive of a patent is by itself enough to induce the
risky behavior. A patent gives the holder the exclusive right to market the product for
seventeen years. However, the effective life of the patent is considerably shorter because
the patent covers some of the time during development. If the FDA is found to have held
up the approval of the dmg, the effective life can be increased by five years but not more
than fourteen years total. While a patent gives exclusive marketing rights to the holder, it
does not mean that there are no competitors. A patent is on the chemical composition of
the dmg not the therapeutic use. Therefore, several dmgs, all under patents, can be
competing in the same area. An example is the antiulcer market where Tagamet, Zantac,
and Pepcid all competed in the early 1990s while under patents. Currently, Mevacor,
Lescol, Pravochol, and Zocor all compete in the cholesterol lowering therapeutic area.
Therefore, the cost to mnovate a dmg is not necessarily offset by the barrier to entry
properties of a patent.
15
The length of the research process further compUcates innovations. DiMasi,
Hansen, Grabowski, and Lasagna (1991) discuss the costs and length of the eight steps in
the dmg development process. The first is the discovery stage, where a new innovation is
synthesized. The second stage is preclinical animal testing where evidence of safety for
human testing is gathered. During the third stage, the company files an investigational
exemption for new dmg. If there are no concems by the FDA, clinical studies can begin
after three months. On average, the first three stages take 42.6 months to complete.
The fourth through six steps are the clinical testing of the dmg on human subjects.
About one miUion people a year participate in such dmg trials. First, healthy humans are
tested to gain information on toxicity and safe dosages. Also, information on absorption
rates and ehmination patterns is gathered. This takes about 15.5 months. The fifth stage
is testing on subjects for whom the dmg is meant to help. Effectiveness and safety
information is gathered during the two-year process. WhUe 15% of aU new entities enter
the fifth stage, only 36% successfully complete this stage. Next, large-scale human testing
is done to gather more evidence on effectiveness and to look for side effects. Typically,
this takes another three years. WhUe the clinical trials are proceeding, long-term animal
studies are being conducted to determine the effects of prolonged exposure and the effects
on subsequent generations. FinaUy, after a successful completion of the above seven
steps, the company files a new-dmg approval appUcation.
The FDA reviews aU of the testing. Once the FDA approves the appUcation, the
firm can begin to market the dmg. FDA approval usuaUy takes over two years. OveraU,
the process takes about twelve years from start to finish. The overall time is less than the
16
sum of the mdividual steps because some of the steps can be completed concurrently. The
length of time of the development process coupled with the success rate of about one-
third illustrates the riskiness of the process.
Moreover, the approval of the FDA for a new dmg innovation does not mean that
the costs wdU be recouped. Grabowski and Vemon (1990) examined 100 new dmg
innovations from the 1970s. They found that only the top thirty dmgs covered the
average R&D costs with the bottom ten of this group only barely covering costs.
In order to encourage more innovations for lesser diseases, Congress passed the
Orphan Dmg Act of 1983. Orphan dmgs are dmgs that treat diseases that affect less than
200,000 people. Because the potential markets are so smaU, pharmaceutical companies
may not have an incentive to innovate for these markets. Under the Act, innovating firms
are eligible for tax credits to cover part of the development process and are given
exclusive marketing rights for seven years. From 1984 to 1993, one in three new dmgs
approved were considered orphan dmgs.
In order to assist the FDA in reviewing dmg applications, the Prescription Dmg
User Fee Act of 1992 (PDUFA) and its successor, PDUFAII were passed. PDUFA is an
agreement between the industry and the FDA where firms pay fees to have their dmg
innovations reviewed by the FDA. The user fee money allows the FDA to hire more
reviewers and cover expenses to increase the speed of the review process. Between 1992
and 1997, dmg companies paid over $327 mUUon in user fees. The FDA hired over 600
additional reviewers and decreased the average dmg review time to 15.5 months from
29.2 months. The speed has aUowed the FDA to approve 53 new innovations in 1996
17
compared to 26 dmgs in 1992 (PhRMA, 1997). However, with the current recaU of
several diet and cardiovascular dmgs and deaths from Viagra, concems are being voiced
about the speed and depth of the revised review process.
Overall, U.S. firms conduct 36% of world pharmaceutical research and
development. Japan accounts for 19%, foUowed by Germany (10%), France (9%), United
Kingdom (7%), and Switzeriand (5%). The total doUar figure of pharmaceutical R&D in
the U.S. was $11 bilUon in 1994 and is expected to be over $19 billion in 1998.
Conversely, the entire research budget of the National Institutes of Heahh (NIH) for 1997
was $13 bUUon (PhRMA, 1997). Pharmaceutical research represents only a part of the
NIH's research program. As shown in Table 2.1, domestic R&D expenditures have
grown faster than expenditures abroad in almost every year since 1981. The growth in
domestic expenditures has been steadier than foreign expenditures. This is partly due to
the R&D process. The quality and quantity of research technology and personnel induce
firms to conduct their research in the United States. Also, the FDA requires that the
majority of clinical testing occur in the United States.
Not only does the R&D process affect firms by providing products and profits, it is
a drain on cash flow. Cash flow represents what the firm can spend on R&D, other
intemal projects, or extemal distributions. The need for a steady cash flow encumbers the
firms to produce dmgs to feed the cash flow. The firm can not spend profits, only cash.
Firms must manage their flows in order to fiind aU viable projects in one time period,
which will fund the next projects in future time periods.
18
Table 2.1: Growth m Research and Development, U.S. and Abroad (1970-94)
Year
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Domestic R&D-U.S. and Foreign firms ($mU)
566.2 626.7 654.8 708.1 793.1 903.5 983.4
1,063.0 1,166.1 1,327.4 1,549.2 1,870.4 2,268.7 2,671.3 2,982.4 3,378.7 3,875.0 4,504.1 5,233.9 6,021.4 6,802.9 7,928.6 9,312.1 10,477.1 11,101.6
Annual Percent Change
—
10.7% 4.5 8.1
12.0 13.9 8.8 8.1 9.7
13.8 16.7 20.7 21.3 17.7 11.6 13.3 14.7 16.2 16.2 15.0 13.0 16.5 17.4 12.5 6.0
R&D Abroad -U.S. firms only ($mU)
52.3 57.1 71.3
116.9 147.7 158.0 180.3 213.1 237.9 299.4 427.5 469.1 505.0 546.3 596.4 698.9 865.1 998.1
1,303.6 1,308.6 1,617.4 1,776.8 2,155.8 2,262.9 2,347.8
Annual Percent Change
- - -
9.2% 24.9 64.0 26.3
7.0 14.1 18.2 11.6 25.9 42.8
9.7 7.7 8.2 9.2
17.2 23.8 15.4 30.6
0.4 23.6
9.9 21.3
5.0 3.8
Annual Total ($niil)
618.5 683.8 726.1 825.0 940.8
1,061.5 1,163.7 1,276.1 1,404.0 1,626.8 1,976.7 2,339.5 2,773.7 3,217.6 3,578.8 4,077.6 4,740.1 5,502.2 6,537.5 7,330.0 8,420.3 9,705.4
11,467.9 12,740.0 13,449.4
Percent Change
—
10.6% 6.2
13.6 14.0 12.8 9.6 9.7
10.0 15.9 21.5 18.4 18.6 16.0 11.2 13.9 16.2 16.1 18.8 12.1 14.9 15.3 18.2 11.1 5.6
Data from Pharmaceutical Research and Manufacturers of America, PhRMA Annual Survey, 1997.
19
2.2.2 Definition of a Market
The uniqueness of the pharmaceutical markets compUcates the R&D process for
research on one type of therapeutic area does not necessarily carry over to other
diagnostic areas. This encourages firms to specialize their research m certain therapeutic
areas and tends to mcrease market concentration beyond the effect from patents. One
resuh of the speciaUzation is that the government regulates the mdustry beyond the Food
and Dmg Administration.
A market is normaUy defined as the meeting of buyers and seUers and the
correspondmg exchange of goods and/or services. In a macroeconomic sense, aU
prescription dmgs constitutes a market. However, one aspect of a market is that the
goods are highly substitutable for one another. A consumer desiring a beta blocker wiU
not be satisfied with asthma medication. Therefore, the pharmaceutical industry faces
many markets defined by therapeutic classes. The therapeutic markets are designed to
include only those dmgs that treat a common disease or Ulness. The pharmaceutical
industry's four firm concentration ratio was 22 percent m 1987. However, the four firm
ratio within therapeutic markets ranged from 46% to 86%o m 1972 (Statman, 1983).
Santerre and Neun (1996) and Scherer (1993) beUeve that the ratios have changed Uttle
over the last twenty-five years. The concentration ratios increase in the therapeutic
markets because most firms speciaUze m several therapeutic areas or dmgs. SeUer
concentration ratios demonstrate this pomt. In 1992, the top three seUing dmgs for Glaxo
constituted 75% of sales for the firm. Pfizer, Upjohn, and EU LUly each depended upon
20
their three main dmgs for over 55%) of their sales. The firms pride themselves on market
share within a therapeutic area because it indicates market power.
Another characteristic is that the markets are not limited geographically. Most
firms sell their products internationally. Typically, what is a best seller in one country will
also be a best seUer in other countries. Because the intemational market is important, the
protection of patents is also a concern.
2.2.3 Examples of Generations of Development within a Therapeutic Market
Within a therapeutic market, dmgs of successive generations coexist in the
marketplace. A point investigated in this study is whether research is conducted on dmgs
that provide a significant gain in therapeutic value.
Cardiovascular dmgs have experienced four main phases of development. The
first three were considered breakthroughs. A breakthrough refers to a dmg that exhibits
an entirely new pharmacological action. The first step was the development of beta
blockers. These dmgs regulate and slow the heart rate by 15%). It is used on patients
with a rapid heart beat and/or high blood pressure. Examples are Tenormin and
Lopressor. The second generation was the calcium channel blockers. These dmgs dilate
the coronary and peripheral blood vessels and lower the blood pressure. They improve
patient compUance and efficacy through fewer dosages. Examples of these hypertension
dmgs are Calan, Procardia, Cardzeim, and Novasc. The ACE inhibitors are the third
generation. These dmgs lower the blood pressure by a different mechanism. They have
high efficacy for those patients who have had a heart attack. They may even prevent heart
21
attacks in patients prone to heart attacks. Examples are Vasotec and Accupril. The
current generation being developed is the second generation ACE inhibitors, which
improve upon their predecessors.
Within the antibiotic therapeutic market, macrolides have experienced three
distinct generations but not the therapeutic gains like in the cardiovascular therapeutic
market. Erythromycin is the first generation and a breakthrough in treating bacterial
infections. Biaxin, the second generation erythromycin, reduced the number of dosages
per day but offers little therapeutic gain. The third erythromycin analog, Zithromax,
requires only one dosage a day, but again no therapeutic gain over the original
erythromycins.
A potential societal concern is that R&D moneys are spent on innovations that
provide little therapeutic gain. The Food and Dmg Administration ranks innovations
based on their scientific advances.
2.2.4 Marketing to Consumers
Patients are the final consumers of pharmaceutical products. The firms realize this
and now market their dmgs directly to consumers along with the traditional marketing to
physicians and pharmacists. Before becoming available in the marketplace, new dmg
entities are tested against the diseased state and a placebo. The FDA reviews the data and
determines its efficacy, safety, and stability and then makes the decision whether or not to
grant a patent. As stated above, the patent is on the chemical composition and not the
therapeutic use. Therefore, several dmgs all treating the same ailment can be on the
22
market simultaneously each under its own patent. Patients are not familiar Avith the
pharmacological differences among the dmgs and are unable to choose or ask for the best
one for them. The decision to prescribe is left to the physician. The physician may not be
well versed in the pharmacological differences and must consequently rely on dmg studies,
FDA reports, past experience, and marketing to detect the differences. In order to
maximize the utility of the patient, the best dmg should be chosen. Determining which
dmg is the best is diflficuU. Studies are conducted on people, but individual characteristics
can alter the outcome of a dmg experience. In the absence of complete information,
patients often infer quality by a dmg's price, presuming the more expensive dmg to be
better. Patients may also exhibit a preference for newer dmgs, which are assumed to be
better dmgs since they seemingly encompass the latest technology. This has become
problematic with patients. A ten-day supply of amoxicillin costs $8, whereas an equivalent
dosage of Duricef costs $80. Even though ten patients can be treated with amoxiciUin for
the same cost as one patient with Duricef, patients prefer the Duricef, believing it is better.
Many doctors fear discrimination suits with welfare patients and will prescribe the more
expensive dmg.
Due to the lack of comparative dmg statistics, firms are relying on advertising to
increase sales; however, the nature of this advertising has shifted radically in recent years.
In the past firms typically advertised to pharmacies, physicians, and hospitals. Now firms
are increasingly targeting consumers directly through television and magazine ads. This is
to inform patients of dmg attributes, to encourage patients to ask for a certain dmg, and
to pressure managed care organizations to include a firm's dmgs on its formularies. The
23
Food and Dmg Administration has recently become concerned with this practice.
Advertising can assist consumers in managmg their own care, which tends to lower the
cost of health care. On the other hand, deceptive advertismg may mislead patients into
beUeving facts not entirely tme, which may increase costs both to patients and to
physicians. Certain patients may be particularly sensitive to claims of cures or
revolutionary approaches to a disease. Informative advertismg may promote competition
by reducing the barriers to entry and by helping customers make better choices. However,
persuasive but misleading advertismg may decrease consumer utility by encouragmg faulty
decisions that may also increase barriers to entry. Large pharmaceutical companies who
hold significant market share in the particular therapeutic market do the majority of dhect-
to-consumer advertising. In order to receive the benefits of advertismg, firms provide the
health information only when they are able to associate their product with the information.
A new type of marketing tool used by some manufacturers is a switch program. In
a switch program, physicians are asked by pharmacists working for pharmacy benefit
managers to switch their patients from one medication to a competmg medication in order
to reduce costs. Many of these pharmaceutical benefit management firms are alUed with
dmg manufacturers. The recommended medication is often a product sold by the aUied
manufacturer. Switching medications can have large cost savings through the substitution
of lower cost dmgs. However, the relationship between the pharmacist, the
pharmaceutical benefit management firms, and the manufacturer is not always disclosed to
the physicians. This endangers the mdependence of the decisions by physicians and
patients in choosing medications based solely on the best interests of the patients.
24
2.2.5 Levels of Dmgs
Another aspect of marketing to consumers is the type of dmg developed. Dmg
innovations are classified as breakthroughs and me-too 's. A breakthrough is an entirely
new way to treat an iUness, a new therapeutic class wdthin a therapeutic market. Me-too's
are dmgs for which other dmgs in a therapeutic market already exist.
Dmgs can also be classified into three levels based on the type of ailment they
treat. The first level includes dmgs that treat life-threatening diseases or chronic ailments,
where the individual did Uttle to contract the ailment. Examples of these types of aihnents
include malaria, polio, arthritis, and some cancers. The second level are dmgs that treat
conditions where the lifestyle led by the patient contributed partially to the contraction of
the ailment. High cholesterol from a poor diet, hypertension from stress, lung cancer from
smoking, and AIDS from unsafe sexual practices are some examples. The third level are
dmgs that are meant to enhance the quaUty of life. Weight reduction dmgs, impotence
dmgs, and mood enhancing dmgs are aU examples.
The levels are not completely distinct because the contraction and progression of
an ailment can be attributed to a variety of factors. The distinction among the levels is
important because the different levels provide varying amounts of utiUty. Individual
patients and society may rank the benefits of each level differently. A sUghtly obese
individual with no other health concems may value the weight reduction dmg and the cash
spent on its development more than society, which would have preferred that the money
be spent on research and development on cancer. A concern from world health
organizations is that the pharmaceutical mdustry develops dmgs for patients m
25
industrialized countries who have higher incomes rather than for patients in developing
parts of the world who can not pay as much for the dmgs.
2.2.6 Generics
Proprietary dmgs manufactured by the firms face competition from generics after
the patents expire. The prevalence of generic substitution and the ease at which a generic
can receive FDA approval after the Waxman-Hatch Act has increased the market share of
generic dmgs. In 1984, generics controlled 18.6% of the domestic dmg market. By 1990
it was 32.9% and 41.6% in 1996 (IMS America, 1997). Typically, the generic dmgs also
quickly gain market share. Within one year of generic entry, generic dmgs control an
average of 61% of the market. The expected rapid loss of market share reduces
predictions about the proprietary dmg's overall retum. This puts fiirther pressure on cash
flow and research and development. A new dmg innovation costs around $350 million r
doUars, whereas a generic dmg costs only $1 million to bring to market (PhRMA, 1997).
To enter the market a generic dmg must only demonstrate bioequivalency to the
proprietary dmg. In response to this phenomenon, many pharmaceutical firms now have
their own generic houses in order to market both the proprietary and generic versions of
their dmgs. Eli Lilly's Apothecon division markets generics of Lilly's dmgs along with
generics of its competitors. To counter the increase in generics, proprietary firms
advertise that bioequivalent does not necessarily mean equal and encourage patients to
resist substitution. The FDA has discouraged such statements but acknowledges that the
major firms have not Ued in their campaigns (FDA, 1996). However, research has not
26
shown a significant efficacious difference between generics and most pharmaceuticals'
(FDA, 1997).
2.2.7 Over-the-Counter
In addition to prescription dmgs, many pharmaceutical firms also develop and
market over-the-counter (OTC) dmgs. Patients choose and self-medicate themselves with
OTC dmgs, many times without any professional input. Therefore, for a dmg to be
allowed to be marketed as an OTC, it must be extremely safe and the probability of an
overdose or a severe side effect must be very small. OTC dmgs do not provide wide
margins for the dmgstore or manufacturer, but their sales tend to be steady and positively
correlated to advertising. Hence, many firms now use OTC dmgs to provide a stream of
cash to fund R&D. Bristol-Myers Squibb efficiently uses OTC dmgs and cosmetics such
as Bufferin, Comtrex, and Miss Clariol to finance its innovation process.
2.2.8 Owners of the Firms
Ultimately, the firm's management is responsible to the stockholders. The major
pharmaceutical firms are publicly traded on the New York Stock Exchange including the
major intemational firms. Throughout the 1990s, analysts have promoted the health
industry and pharmaceuticals, in particular, as stocks of choice. The reason for this is
two-fold. The aging of the U.S. population has increased the demand for health services.
Pharmaceuticals are a natural beneficiary of this trend. Because it is more difficult to
invest in physicians' practices and hospitals, pharmaceuticals are a simple solution for
27
investors wanting exposure to the heahh industry. Second, the demand for
pharmaceuticals is not cyclical; therefore, these stocks are a good counter to the more
volatile technology stocks in an investor's portfoUo. The retum to a stockholder is based
upon the trading price. The demand for pharmaceuticals has helped to keep industry stock
prices strong.
2.3 Extemal Considerations
2.3.1 Government Regulations
The government has the largest impact on the industry because aside from being a
large buyer of pharmaceuticals, it determines which products can be sold, their labeling
requirement and conditions for doing business. The Food and Dmg Administration
through various laws regulates products of the pharmaceutical industry. Currently, for a
dmg to be sold in the United States, it must exhibit three characteristics: safety, efficacy,
and stability. In 1906, the Food and Dmg Act was passed. Its original purpose was solely
to prevent multibranding of dmgs. It was not concerned with safety or efficacy. In 1912,
the Shirley Amendments were added. They did not change anything but merely explained
the law in greater detail. In 1938, The Food, Dmg, and Cosmetic Act was passed. This
was the first time safety measures were introduced, but the Act was not concerned with
efficacy. Dmgs that had been marketed before 1906 were grandfathered. The 1951
Durham-Humphrey Amendments dealt with classification and procedures but not with
efficacy or safety. In 1962, the Kafauver-Harris Amendment addressed efficacy for the
first time. All dmgs marketed between 1938 and 1962 and aU subsequent introductions
28
were required to exhibit efficacy and safety. Dmgs marketed prior to 1938 were
grandfathered. Also in 1962, the National Academy of Sciences - National Research
Council Reviews (NAS-NRC) began. This study was meant to review the safety, efficacy,
and stability of aU prescription dmgs. The study was extended to cover over-the-counter
dmgs in 1972. Ex-Lax and Quinine are two dmgs which had been grandfathered
originally but have since been deemed unsafe unless by prescription. The Orphan Dmg
Act of 1983 was intended to encourage firms to innovate dmgs for rare diseases. The
Dmg Price Competition and Patent Term Restoration Act of 1984, more commonly caUed
the Waxman-Hatch Act, extended the maximum effective life (time in market after FDA
approval) by five years but the total cannot exceed fourteen years of effective life. As
discussed previously, this law also made it easier to produce generics.
The federal government has also passed laws and set policy concerning the pricing
behavior of dmgs. The laws have a great effect because the government is a large
purchaser of pharmaceuticals through the Veterans Administration and
Medicare/Medicaid. The Omnibus Budget ReconciUation Act of 1990 began providing
federal matching fimds to state Medicaid for prescriptions covered under a manufacturer
rebate agreement. The rebate is calculated as the difference between the average
manufacturers' price and the lowest price paid by any buyer. There is also a minimum
rebate of about \5% of the average manufacturing price. The Veterans Health Care Act
of 1992 began requiring that the dmg manufacturers enter into pricing agreements with
the Veterans Administration, Department of Defense and Federal Supply Schedule in
order to do business with the federal government. Currently, the dmgs purchased under
29
this Act can not exceed 76%) of the nonfederal average manufacturing price of the most
recent year. Moreover, price increases are strictly limited by increases in the urban
consumer price index. The 1996 total rebate was approximately $2 bilUon, up from $553
million in 1991 (PhRMA, 1997). A partial resuh of this rebate is a shift of costs from the
government to private insurers and individuals who do not receive rebates and, therefore,
must pay the fiiU amount for each dmg.
2.3.2 Other Societal Concems: Piracy. Employment, and Sales
The government as a representative of society is also concerned with the impact
pharmaceuticals has on the economy. While the government regulates the pharmaceutical
industry and is concerned with the rate of prescription price inflation, the government
actively assists the pharmaceutical industry with the enforcement of intemational patent
laws through treaties and sanctions with countries not in compliance with the treaties.
According to PhRMA (Profile, 1997), for every three dollars eamed from exports, U.S.
firms lose one dollar to piracy. The loss in revenue is also a future loss in cash flow for
research and development. Four of the most troublesome countries are Argentina, India,
Turkey, and Egypt. Their piracy costs firms over $1 billion a year.
The pharmaceutical industry has been a steady employer since World War II. In
1994 the industry employed 195,015 people through 1465 different estabUshments and
had an annual payroU of $8,656,899,000 (U.S. Bureau of the Census, Country Business
Patterns, 1996).
30
As indicated in Table 2.2, sales of pharmaceuticals within the U.S. by domestic and
foreign firms has increased from over $11 miUion in 1980 to over $38 million in 1990 and
over $50 miUion by 1994. Pharmaceutical exports as a percent of total sales have been
steady over the decade at about 34% (PhRMA, 1995).
Table 2.2: Domestic U.S. Sales and Sales Abroad, 1970-94
Year
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Domestic U.S. Sales -U.S. and Foreign firms ($mil) 4,552.5 5,144.9 5,210.1 5,686.5 6,470.4 7,135.7 7,951.0 8,550.4 9,580.5
10,651.3 11,788.6 12,665.0 14,743.9 16,805.0 19,026.1 20,742.5 23,658.8 25,879.1 28,582.6 32,706.6 38,486.7 44,304.5 48,095.5 48,590.9 50,740.4
Annual Percent Change
—
13.0 1.3 9.1
13.8 10.3 11.4 7.5
12.0 11.2 10.7 7.4
16.4 14.0 13.2 9.0
14.1 9.4
10.4 14.4 17.7 15.1 8.6 1.0 4.4
Sales Abroad -U.S. firms only ($ mil)
2,084.0 2,459.7 2,720.2 3,152.5 3,891.0 4,633.3 5,084.3 5,605.0 6,850.4 8,287.8
10,515.4 10,658.3 10,667.4 10,411.2 10,450.9 10,872.3 13,030.5 15,068.4 17,649.3 16,817.9 19,838.3 22,231.1 25,744.2 26,467.3 26,870.7
Annual Percent Change
—
18.0 10.6 15.9 23.4 19.1 9.7
10.2 22.2 21.0 26.9
1.4 0.1
-2.4 0.4 4.0
19.9 15.6 17.1 -4.7 18.0 12.1 15.8 2.8 1.5
Total ($ mil)
6,636.5 7,604.6 7,930.3 8,839.0
10,361.4 11,769.0 13,035.3 14,155.4 16,430.9 18,939.1 22,304.0 23,323.3 25,411.3 27,216.2 29,477.0 31,614.8 36,689.3 40,947.5 46,231.9 49,524.5 58,325.0 66,535.6 73,839.7 75,058.2 77,611.1
Annual Percent Change
—
14.6 4.3
11.5 17.2 13.6 10.8 8.6
16.1 15.3 17.8 4.6 9.0 7.1 8.3 7.3
16.1 11.6 12.9 7.1
17.8 14.1 11.0
1.7 3.4
Data is from the Pharmaceutical Research and Manufacturers of America, 1995.
31
2.3.3 Consumers
Ultimately, the firms must satisfy consumer needs. However, the link between the
firms and the final consumers is not direct for physicians, pharmacists, and managed care
organizations are elements of the distribution chain. The demand for pharmaceuticals is
derived, first, from the demand for health and second, from the demand for health
services. The demand is fiirther complicated by the various agency relationships that exist
in the process of consuming pharmaceuticals. The physician chooses the dmg for the
patient. The insurer pays for the dmg. The pharmacist determines which version of the
dmg to dispense to the patient and provides additional information on the dmg. Each
agent works for the principal, but their decisions may be swayed by each other and the
pharmaceutical houses. The physician prescribes the dmg but does not pay for it or
consume it. The insurer, through various techniques to be discussed below, can influence
and Umit the choices from which the physician can make decisions. The pharmacist must
stock not only the dmgs that the physician prescribes but also those that the insurer will
reimburse the pharmacy. To influence the decision of the three agents, marketing
personnel from the pharmaceutical firms inform patients, physicians, and pharmacists
about the benefits of their dmgs. They also provide rebates, technical support, and other
incentives to encourage the sale of their dmgs.
Pharmaceuticals and heahh services differ from other products in that patients
believe that they deserve the highest quality pharmaceutical and health services unlike
other products. Individuals may want a Mercedes but they drive what they can afford,
which may not be the best car in terms of safety, gas mileage, comfort, and reputation.
32
With heahh care, individuals want to mamtain their quality of Ufe and demand the best
care. Patients do not usually know about the various dmg choices avaUable to them.
Instead, they rely on the coUective interaction of theh agents to make the best decision.
As discussed in the prior section on marketing to consumers, the best dmg is not always
known. Patients infer quaUty through price, newness, and advertising. The patient's and
the agents' experiences v^th the dmg also convey mformation about quaUty and reliability.
The decision of dmg choice is determined by the four players and by the attributes of the
dmg. Insurers and pharmaceutical firms attempt to modify the choice to their ovm benefit.
The idea of a "best" dmg becomes difficuh to quantify amongst the interests of the
players.
Managed care organizations are not only interested in the cost of pharmaceuticals.
They also increase the demand for pharmaceuticals by promoting dmg therapy as a
cheaper alternative to traditional methods such as invasive procedures, especially when
dealing with a chronic condition. A new field, pharmoeconomics, has been developed
which solely looks at the cost-benefit analysis of a new dmg and the corresponding
treatment versus the old treatment. Many times the benefit comes from the decreased time
spent in a hospital or from avoiding a surgery. Pharmaceutical firms realize that the firm
that is able to develop and patent a dmg to treat these aUments could earn millions of
dollars on that dmg.
Schweitzer (1997) presents an overview of the final consumers of pharmaceuticals.
He finds that the elderly, women, and Afiican Americans are more likely to use
pharmaceuticals. The demand is also influenced by diagnostic categories. Respiratory and
33
circulatory system diseases are associated with higher dmg use than gynecological and
nervous system conditions.
2.3.4 Social Contact Patients
As our society has aged, a new type of patient has emerged to the benefit of
pharmaceutical firms. Social contact patients are senior citizens who do not want to
tolerate the discomfort and uncertainty that comes with aging. They vish the doctor and
pharmacy frequently in order to be reassured that they are doing fine. Most have had a
heahh problem and desire this reassurance as part of their daily life. These patients also
tend to be the ones who are willing to take increased number of medications, new
medications, or different medications. While the medical community has advocated more
patient interest and responsibility in his or her own care, for social contact patients the
health problem becomes a preoccupation. The patients desire the comfort and the feeling
of importance from discussions with health care providers. The increased use of
advertising directly to patients has exacerbated the situation. This is time consuming for
the physicians, nurses, and pharmacists. However, the dmg manufacturers only receive
the benefits from increased sales and do not bear the fuU burden of costs associated with
this type of behavior.
2.3.5 Insurance
Insurance companies are a growing intermediary between firms and consumers.
This has forced firms to recognize their power and try to manage them. While dmg
34
purchases are only 1.2% of GDP, out-of-pocket expenditures on pharmaceuticals is 39.5%
of all outpatient dmg expenditures. This is higher than the 2.4% of out-of-pocket
expenditures on hospital services. Private heahh insurance pays 40%) of all outpatient
expenditures while Federal and State Medicaid pays over 17%) (Heahh Care Financing
Administration, 1995). Because of the disproportionate amount of out-of-pocket
expenditures, many consumers believe that prescription dmgs account for more than the
five to six percent of health care expenditures. The high proportion of consumer
expenditures is because fewer people are insured for prescription dmgs than for general
health care. In 1995, 85% of Americans had some form of health insurance but only 75%)
had insurance that covered prescription dmgs (U.S. Census Bureau, 1996). In addition,
co-payments and deductibles limit the extent of insurance.
The grov^h in managed care organizations and their emphasis on cost containment
has led to a variety of techniques to control dmg expenditures. Private third party
reimbursement of pharmaceuticals has increased from 29% in 1990 to 60% in 1996 (IMS
America, 1996). The first technique is the use of formularies, Usts of dmgs that are
approved for insurance coverage. Formularies can be open, in which coverage extends to
all dmgs with reduced co-payments for the use of particular dmgs, or they can be closed,
which restricts coverage to only listed dmgs. Dmgs are chosen based on therapeutic
value and cost. While formularies have reduced costs, an overly severe formulary will
encourage patients to use other medical services as a substitute.
Therapeutic substitution, the replacement of one dmg for another usually in the
same therapeutic class, is another technique to contain expenditures. Sometimes the
35
patient is unaware that he has been switched to another dmg. The use of substitution has
increased from 22%) in 1990 to 57%) in 1995. HMOs also switch patients from a
proprietary dmg to its generic equivalent. WhUe generics must be bioequivalent to its
proprietary dmg, some patients may not respond as weU to the generic. This is usually
because of fiUer agents in the dmg. FiUer agents are non-medicinal components of a dmg
used to shape, to add color or to enlarge the piU. The use of generic switching has
increased from 63%) in 1990 to 86%) in 1995.
HMOs also direct the care of patients. The use of step-care therapy, another cost-
saving technique, has increased from 27%) in 1990 to 49% in 1995. Under step-care,
physicians must follow a sequence of treatments starting with the cheapest and moving up
the cost scale if the prior step was ineffective in treating the ailment. In order to assure
compliance by physicians, HMOs also review the prescribing decisions of physicians. The
use of these dmg utilization reviews has increased from 47% to 83% (PhRMA, 1997).
Because dmgs are a basic component of health care, insurance companies,
employers, other managed-care organizations and Medicaid now use pharmacy benefit
managers (PBMs). The PBMs process and review the prescribing and use of dmgs.
Many PBMs also fiU the prescriptions through large maU-order businesses. PBMs
currently manage benefits for about 50%) of all Americans who have pharmaceutical
insurance coverage. Because of the importance of PBMs, the top three firms have been
acquired by major pharmaceutical firms.
36
2.3.6 Dmgstores
Dmgstores of the past were smaU stores who sold the firm's products at prices set
by the firm. Now, managed care organizations and government involvement have
dismpted the relationship between dmgstores and the manufacturers. Chain pharmacies
have gained power and chaUenge the pricing policies of the firms. This has forced the
firms to re-evaluate and re-estabUsh their relationship with dmgstores.
Dmgstores are the final link between dmg manufacturers and final consumers. In
1996, retaU pharmacies dispensed over 60% of aU domestic dispensed prescriptions.
Hospital sales accounted for 14%, whereas maU order pharmacies dispensed 10%) and
clinics and nursmg homes another 9%. RetaU pharmacies fill prescriptions for over 90%
of HMOs (IMS America, 1997). The dmgstores dispense the pills according to the
prescription and program with the third-party payer. The increase in third-party payers
and the use of electronic filling have been the most significant changes in retail pharmacy.
The third-party payers determine the co-pay that the customer pays and the amount that
wiU be reimbursed to the pharmacy. Because many managed care organizations use
formularies in determining which dmgs will be covered, the retail pharmacy must also
spend its time clearing the prescription through the MCO. RetaU pharmacies buy their
dmgs from wholesalers and distributors, who charge a variety of prices based on volume,
stock, and other buying characteristics. The acquisition price is the lowest price for which
the dmg can be purchased. The average wholesale price (AWP) is typically close to the
highest price for which the good can be purchased. Most third-party payers reimburse
pharmacies based on a formula. If the pharmacy is able to purchase the dmg at the
37
acquisition price, then the pharmacy earns a margin. However, if there is not a large
discrepancy between the prices, the pharmacy can lose.'* Reimbursement agencies revise
the prices frequently forcing the pharmacies to constantly be aware of price changes. The
unit price used in the equations is an average price. Therefore, some pharmacies'
purchase prices are greater, and they take a loss on some dmgs. For aU pharmacies a
positive margin only exists if the pharmacy is able to purchase the dmg for less than the
reimbursement amount. This is especially difficuh for independent pharmacies who are
not always able to purchase enough to qualify for volume discounts. Some of these
pharmacies have reacted by not filling welfare prescriptions.
Other than the effect of third-party billing on retail pharmacies, two other changes
in the last decade have had a significant effect. The first is that inventory costs have
skyrocketed for the local pharmacy. Many of the new dmgs that are introduced are
improvements over the last dmg simply by reducing the number of dosages. This is meant
to increase patient compliance. Consider erythromycin and Biaxin. One hundred and
twenty tablets of erythromycin can be purchased for $14.95, which is a thirty day supply.
Sixty Biaxin, which is the same thirty day supply, costs $195.59. Biaxin has been in the
top 50 dmgs prescribed since it was introduced. The number of Biaxin prescriptions is
about twice the number of Ery-Tab prescriptions. Therefore, the pharmacies must carry
the more expensive dmg on its shelves, increasing overhead costs.
The third major change has come from the huge influx in generic dmgs. Along
with the increase in dmgs has come the increase in generic dmg manufacturers. This has
further compUcated the purchasing decisions.
38
All three major changes have led to muUiple tier pricing within the industry. Each
dmg can be purchased for a wide variety of prices and sold at an even wider range
according to the payment method. This has led to an increase in time spent by pharmacies
to control their margins. While the total number of dmgstores has remained about the
same at around 70,000 stores, the number of chain pharmacies has increased in the 1990s
offset by a proportionate decrease in independent pharmacies (PhRMA, 1996). RetaU
pharmacists credit this change to the ability of chain pharmacies to receive quantity
discounts from manufacturers and wholesalers and therefore, able to maintain profit
margins.
2.4 Role of Mergers
Mergers represent a strategic response to intemal and extemal factors surrounding
the pharmaceutical industry. The increase in size may provide an answer for the firms.
The new, larger firms may be better able to produce dmg innovations, to market their
products, to deal with managed care organizations and the federal government, to increase
cash flow, and to increase power in the market place. The goal of a merger is to gain
control. For the pharmaceutical industry, the firms want to increase control not just of the
attributes of another firm but also to increase the ability to exert control over their
environment. Mergers are beneficial if they are weaUh producing for the economic agents.
This study wdU consider the effects of the mergers on these agents.
39
CHAPTER m
LITERATURE REVIEW
3.1 Introduction
This study is on the impact of pharmaceutical mergers on economic agents. While
extensive research has been conducted on the pharmaceutical industry, there are no prior
studies of pharmaceutical mergers. The majority of the research on the pharmaceutical
industry is centered on topics such as the profitability of the industry, the role of research
and development, the role of generics, and the impact of institutional influences. Research
on mergers is also extensive with topics focusing on the motivations for mergers and
empirical results of mergers. Therefore, to fiiUy understand the role of mergers within the
pharmaceutical industry, both sets of literature must be examined. Pharmaceuticals are
discussed in the first section, and mergers in the second section. Each section is farther
divided into subsections on different elements of each part.
3.2 Pharmaceutical Industry
The majority of the work on the pharmaceutical industry focuses on the role that
research and development (R&D) plays in the risk and retums of the firms. The first three
articles discussed consider the costs a known fact. It is not untU the Grabowski and
Vemon 1990 and 1993 articles and the DiMasi, Hansen, Grabowski, and Lasagna (1991)
article that quantitative measures of the current cost of R&D are studied. Other areas of
40
consideration for this study are the role of firm size in innovations, the pricing behavior of
the firms, and intemational considerations that may encourage mergers.
3.2.1 Risks and Retums to Research and Development
Comanor (1986) discussed the industry and presented a synthesis of prior work.
He analyzed the profitability of the industry first in terms of market stmcture. He noted
that while the industry may appear to be monopolistic, it is actually highly competitive.
The firms compete not in price competition but product competition. New products,
especially generics, are constantly entering the market forcing the existing products into
obsolescence. Comanor added that a second factor pressuring the firms is technology,
which is also rapidly changing and expensive. He viewed the research and development
process as lottery with winners and losers. The cost of the technology to innovate is so
expensive that Comanor recommended viewing R&D as a public good with financial
support from the government. After assessing for the various factors facing the industry,
Comanor concluded that the industry did not earn above average profits for a
manufacturing industry and may have eamed profits weU below what was needed to
compensate the firm for the risk of the R&D process. In his discussion of technology,
Comanor did not mention that increases in technology can lead to several discoveries
instead of just one, each helping of offset the cost of the technology. He also ignored the
role computer technology can play in the discovery process. His discussion lacked
empuical evidence, which weakened his argument on the expensiveness of the industry
and need for government assistance.
41
Writing during the time of the Clinton heahh care debate, Scherer (1993)
addressed the profitability of the industry. He promoted the R&D process as the reason
behind the high pharmaceutical costs that were being discussed in the debate. Unlike
Comanor, Scherer did not believe that generics were a concern to the firms and the R&D
process. Instead, he considered the federal regulation to be a serious threat. In a similar
conclusion to Comanor, he advocated less regulation and more assistance for the
pharmaceutical firms. Scherer discussed that the pricing pressures and lack of patent
protection around the world faced by the industry would lead to fewer innovations.
However, the fault for the decrease in production lies with the world governments not the
industry. The article was clearly written to assist in the formation of opinions at the time,
but it lacked empirical evidence to completely support his assertions.
Also critical of the federal regulation was a study by the Boston Consulting Group
(1993). This article presented evidence on the increased regulatory presence of the Food
and Dmg Administration (FDA) on the conduct of the pharmaceutical industry. The FDA
had increased the number of regulatory employees in the prior five year period, and the
number of pages of submissions to the FDA also increased during this time. The paper
hypothesized that between the increased regulation and pricing pressures by managed care
organizations, R&D expenditures would fall as would the intemational position of the
industry. The Group recommended that firms consider working with or merging with the
managed care organizations and improving relations with the FDA in order to maintain
marketing power. While this paper was sponsored by Pfizer, an American pharmaceutical
firm, which may cause the motivation for the study to be questionable, it does present the
42
concems of the firms at this time and addressed a potential role for mergers in the
industry.
The retums to dmg innovations were discussed by Grabowski and Vemon (1990).
They found that of the new dmgs innovated in the 1970s, only 30 of the 100 dmgs
covered average R&D costs with ten barely covering costs. The authors concluded that
the R&D process was very risky and costly. Unfortunately, the authors did not draw any
poUcy implications for the firms, such as the need for the firms to have a major success to
cover the costs of the research process.
Grabowski and Vemon (1993) continued their research and examined the retums
to dmgs in the 1980s. They found that the intemal rate of retum was 11.1% with a mean
net present value of $22 million. This figure is slightly less than the figure estimated by
the Office of Technology Assessment (1993), which found a net present value of $36
million. Grabowski and Vemon accredited the differences to accounting techniques. Both
studies concluded that the pharmaceutical industry was risky and needed government
support and not regulation in order to assure continued innovations.
DiMasi, Hanson, Grabowski, and Lasagna (1991) quantified the cost of R&D.
Examining 93 innovations in the 1970s, the authors found that a new dmg innovation cost
over $200 million in the 1970s, and the figure had increased to over $300 miUion for dmg
innovations in the late 1980s. The authors systematically examined each stage of the
research process and attributed a cost figure to each step. The amounts were then
discounted at the cost of capital of 9%). One drawback of the results is that the authors
make no distinction between development costs per therapeutic class. Also, since most
43
firms specialize in a few therapeutic areas, their costs may not be as high if a base amount
of knowledge already exists.
3.2.2 Firm Size
If innovation is the heart of the industry, a natural question is whether large or
smaU firms produce more innovations. Acs and Audretsch (1988) examined innovation in
firms of all sizes and industries. They found that while large firms produced more
innovations in total, smaller firms innovated more on a per employee basis. On closer
examination of their data, the pharmaceutical industry was prolific and required more
expensive labor to innovate than other industries like appliances and metals.
Greer (1992) specifically examined the pharmaceutical industry and found that the
smaller firms produced more innovations than the larger firms did because the larger firms
were mired in bureaucracy. Most of the firms Greer cites were biotechnology firms. A
drawback of this study is that Greer neglected to account for the strategic alliances
between many biotechnology firms and large manufacturers. It could have been that the
large pharmaceutical houses contracted out their R&D in order to decrease risk and costs.
3.2.3 Pricing Behavior
The pricing behavior of the industry relates to mergers by indicating the extent of
pricing power firms can exert in the marketplace. If firms have limited power, it may be
advantageous to combine to increase market power, or if generics limit the longevity and
44
profitability of dmgs, an increase in size may be needed to produce more dmgs to counter
the influence of generics.
The pricing behavior of the pharmaceutical industry during 1976-1987 was
discussed in Caves, Whinston, and Hurwitz (1991). They found that the average
proprietary dmg's price rose after patent expiration and then fell when generic products
entered the market but only by 4.5%). Generic products' prices tended to be 10%) less than
the proprietary dmg's price but gained little market share. Grabowski and Vemon (1992)
also examined pricing patterns of generics during the 1980s. They found that the entry of
new generics was positively related to the brand name profit margin. The uniqueness of
the Grabowski and Vemon study is their finding that generic products exhibited first-
mover advantages and pharmacists and physicians had quality perceptions about the
generics. The generics competed against each other and not just against the proprietary
dmg. Neither sets of authors discussed the role that managed care organizations could
have played in the usage and pricing behavior of generic dmgs during the 1980s.
Lu and Comanor (1994) examined the level of price competition among new dmg
innovations during the 1980s. They found that dmgs, which entered the therapeutic
markets where a dmg already existed, were priced lower to gain market share and then
were increased in price over time to match the price of the original dmg. The authors did
not address if the dmgs were profitable for the firm or if the price increases were an
attempt to recoup costs.
45
3.2.4 Intemational Considerations
Grabowski (1989) discussed that the intemational competitiveness of the American
pharmaceutical firms may be in jeopardy if pricing pressures continue by decreasing the
amount of funds available for research. He found that the domestic firms innovated more
dmgs and of higher therapeutic value than any other country. However, he wamed this
could end in the 1990s if generics and managed care organizations reduced profits.
Schweitzer (1997) examined this idea and found that the European firms were strong
competitors to American firms during the 1990s. He also found in countries, which had
extensive price controls on pharmaceuticals, total heahh expenditures were high as
consumers substituted other health services. He indicated that domestic firms needed to
compete more aggressively with their European counterparts or risk losing intemational
power. Both authors mentioned but did not expand upon the idea that merging into larger
firms was a way the domestic firms may be able to compete intemationally.
3.3 Merger Literature
Relevant merger research is divided into two main areas: theoretical reasons for
mergers and empirical studies of the effects of mergers on stockholder value. The articles
on theoretical reasons are mostly presentations of ideas with no empirical context. No
single explanation encompasses all merger activity. Instead there exists a variety of
motivations. The empirical articles use event studies to test the various theories and
examine trends in merger activity. Most of the event studies examine price changes with a
short time frame centered around the date of the merger announcement.
46
3.3.1 Theoretical Reasons for Mergers and Value Increases
Agency problems and efficiency gains are the two broad categories of merger
theory. If agency problems motivate a merger, managers act in their own interest with the
possibiUty of financial harm to the firm's stockholders. The total gains to a merger under
this circumstance tend to be nonpositive. Mergers may also be undertaken for possible
synergy gains. In this case, the merger gains wiU be nonnegative. The two categories are
not competing theories but instead provide a framework in which to analyze a merger.
Jensen (1986) credited agency problems and the lack of free cash flow payouts as
the cause for mergers. Managers are the agents of stockholders and are charged with
acting in the best interests of those stockholders. Free cash flow is the cash available in
excess of the cash needed to fund profitable projects. Payouts office cash flow to
stockholders reduce the fiinds available to managers, which reduces the power of
managers because they have less cash under their control. Hence, managers are reluctant
to payout funds. Managers could use the money to fiind projects that are not profitable at
the current discount rate, but this could reduce the stock price. A solution to this problem
is to spend the free cash flow on acquisitions, which can be value-enhancing for the firm.
Firms with large cash reserves are more likely, according to Jensen, to acquire other firms.
Shleifer and Vishny (1988) have expanded upon the agency conflict idea. They
charged that the managers of acquiring firms do not always act in the best interest of their
stockholders. Instead, mangers use the extra available cash flow to buy new projects.
This behavior may actually reduce the value of the firm at the same time it satisfies the
utility of managers, who now are part of a larger company or a company newly invested in
47
an up and coming field such as technology. This causes retums to shift from the bidder
stockholders to the bidder managers. The bidder firm may overpay for the target firm.
This shifts gains from the bidder stockholders to the target stockholders.
The agency theory espoused by the prior two articles is problematic. If the agency
theory offered a comprehensive explanation, one would expect more hostUe takeovers
than currently occur as firms try to dump excess cash. Also, if gains are always shifted to
target stockholders, eventually bidder stockholders would realize this and no would want
to be the bidder. While managers may not always make decisions in the best interest of
stockholders, efficient market theory teUs us that a manager who would make decisions in
the best interest would receive funds from stockholders fed up with inefficient
management. A lag may occur as stockholders determine efficient management, but
eventually retums should go to the efficient firms and managers.
The winner's curse or hubris hypothesis is derived from the agency conflict
hypothesis. RoU (1986) discussed that the winner of a takeover bid is willing to pay more
for the target firm than any other firm would pay. This is because the winning bidder
overestimates the value of the target. In essence, the winner's hubris leads to the curse.
Even without competition for the target, RoU suggests that bidders overestimate and
overpay during the acquisition process. Capen, Clapp, and CampeU (1971) also found
that winners are cursed by overpaying for acquisitions. A shortcoming of this theory is
that its proponents have looked at a very narrow time frame, usuaUy six months before the
offer to six months after the offer, in their discussions of gams to stockholders. Modem
finance theory dictates a longer-mn view of mergers. It may take years to reap the
48
benefits of a merger. While stock price fluctuations around the merger offer reflect fiiture
expectations about the merger, acttaal gains and synergies may not be realized for years.
Efficiency gains from a merger may occur from a signaling or information effect.
Weston, Chung, and Siu (1998) discussed the idea that a takeover offer signals to the
market that the bidder sees more value in the target than the market currently does. If the
market agrees with the undervaluation, the target's stock price will rise. Bradley, Desai,
and Kim's (1983) analysis indicated that the information from a takeover bid could
encourage the target's management to undertake activities to increase efficiency regardless
of the outcome of the takeover bid. Takeover offers can indicate a firm that is not living
up to its potential. The gains in stock price go to the target shareholder for the market
recognition of the firm's undervalue or inadequate performance. Share prices of targets
that received unsuccessful bids did not fall back to preoffer levels for several years.
The q-ratio hypothesis relates the market value of a firm's securities to the
replacement costs of the firm's assets (Weston, Chung, and Siu, 1998). When this ratio
faUs below one, it is cheaper for the firm to buy an operation as opposed to building its
own. This is one possible cause for mergers in the 1970s. The q-ratio provides an
explanation for mergers between firms conducting the same type of business within an
industry. The q-ratio is more relevant for industries that rely on technology and
equipment instead of human capital.
Fama and Jensen (1985) noted that mergers that diversify a firm allow a decrease
in risk for undiversified stakeholders. It is questionable whether mergers for
diversification are helpful for diversified stockholders, who can diversify on their own.
49
Managers and employees may benefit, and the benefit may be transferred to stockholders.
Theories of management teams imply that employees and managers who work together
develop certain efficiencies and skills. If the team is divided, the efficiencies are lost. If
the team is transferred to a new operation, the team skills remain intact. This benefit can
resuh in lower costs and increased efficiencies, which can translate into higher retums to
stockholders.
The main theories on merger value rely on synergy as the improvement
mechanism. Synergy is caUed the "2 + 2 = 5 effect." The sum of two parts is greater than
the two parts alone. Weston, Chung, and Siu (1998) discussed that many horizontal
mergers occur because it is believed that the two firms make a good fit and complement
each other. The merger can compensate for deficiencies in each of the firms. Operating
synergy may result in managerial economies from all parts of the firm including
production, research, marketing, and finance.
Operating synergy can also occur from vertical integration. Arrow (1975), Klein,
Crawford, and Alchian (1978), and Williamson (1975) each discussed the value from a
vertical merger. The combination of two firms at different stages of production or
distribution of a product can decrease the cost of communication. The increase in
coordination allows for a smoother function system, which potentially creates efficiencies
and profits.
The synergy theories are rooted in the belief that the firms are not initially
operating efficiently. If the firms are inefficient, then the merger represents a gain not only
to stockholders but also to society. The concern over concentration is moot for mergers
50
are weahh increasing. Synergy theories also assume that economies of scale exist over all
parts of the cost curve or at least for the area of concern. If this were tme for all firms,
then it would be desirable for aU firms to condense into one.
None of the theories is fully able to explain aU merger motivations. However, the
fundamental ideas lay the groundwork for an examination of merger activity.
3.3.2 Empirical Tests of Merger Activity
Positive retums to targets are well documented in the literature. Jensen and
Ruback (1983) reviewed thirteen studies of merger performance. Target stockholders
averaged retums from 20% to 30%. JarreU, Brickley and Netter (1988) studied 663
tender offers from the early 1960s to the mid 1980s. They found that retums to targets
ranged from 19% to 35%. The resuhs from the Bradley, Desai, and Kim (1988) study
mirrored the results of JarreU, Brickley and Netter.
While retums to target shareholders are positive, retums to bidder shareholders are
not as clear. Jensen and Ruback (1983) found retums to bidder stockholders ranged from
zero to four percent. JarreU, Brickley, and Netter (1988) and Bradley, Desai, and Kim
(1988) obtained similar results. However, a weakness of these studies was the length of
time period used to generate these results. All studies used windows of less than two
months to determine the retums. With such a small time frame, the studies are not
necessarily looking at retums to stockholders from a merger but returns to stockholders
from a merger offer. The retums from a merger may not appear or be known
immediately.
51
The method of payment used in a merger may also influence the retums to
stockholders (Myers and Majluf, 1984). The use of stock sales to pay for an acquisition
implies that the stock is overvalued. Debt financing implies undervaluation of the stock.
Wansley, Lane, and Yang (1983) studied mergers in the 1970s and found that target firms
received a higher abnormal retum when cash was used instead of stock. They did not
look at debt financing. Travlos (1987) estimated retums for bidders and target
stockholders. His resuhs indicated that retums to target stockholders averaged about
12% for stock transactions and 17% for cash transactions. Bidder stockholders received
negative retums in stock transactions and less than one percent in cash transactions.
Unfortunately, a major drawback to the Travlos research is that he used a two day
announcement period as the time frame for analysis. Clearly, results based on a two day
announcement period are simply not dynamic enough to capture the full impact of
mergers.
Berkovitch and Narayanan (1993) tested for total retums with different merger
theories. They found that the correlation between target retums and total retums was
positive and significant for mergers that exhibited total positive retums. The correlation
between positive target retums and positive bidder retums was not significant. The
authors attributed this to the hubris theory. Concerning the mergers that resuUed in
negative total retums, the authors found that target gains were negatively correlated with
the negative total retums and with the bidder retums. The authors pointed to the agency
theory to explain the negative total retums and bidder retums, but believed that the hubris
theory explained the positive gains to targets. Seventy-six percent of the mergers
52
examined exhibhed positive total retums. The authors concluded that the agency and
hubris theories may have accounted for the distribution of retums among stockholders but
the mergers occurred because of synergy.
Healy, Palepu, and Ruback (1992) analyzed the postmerger performance of fifty
large mergers. They examined operating, investment, and employment variables. The
authors found that employment decreased and operatmg measures increased. The
investment variables did not change significantly. Agrawal, Jaffe, and Mandelker (1992)
studied over 1000 mergers that occurred in the 1970s and 1980s. They found that
acquiring firm stockholders realized a 10%) loss in weahh over a five-year period foUowing
the merger. Unlike most other studies, the authors adjusted for size and risk due to the
large variety of firms in the study.
Industry effects are another important consideration in the analysis of merger
activity. Dess, Ireland, and Hitt (1990) noted the need to account from a management
viewpoint for industry effects and a longer time period. Mitchell and Mulherin (1996) and
Subramanian, Mahmoud, Thibodeaux, and Ebrahimi (1992) each accounted for this effect.
Results from Mitchell and Mulherin found that most mergers in the 1980s were in
industries that had experienced noticeable shocks such as deregulation and changes in oil
prices. They also discussed the role foreign competition and innovation have in
interindustry patterns and concluded that typically the industries reacted to broad
economic and financial shocks instead of industry-specific shocks.
Subramanian, Mahmoud, Thibodeaux, and Ebrahimi analyzed the food and kindred
products industry. They looked at firms from a homogeneous industry in order to look at
53
mergers from a more microeconomic scale and to compensate for industry effects. The
authors also used a wider time frame, five years before and after the merger
announcements, primarily to look at retums to bidder stockholders who may not have
received retums immediately. Resuhs suggested positive retums to the stockholders and
improvements in operating performance. While focusing on a specific industry over an
expanded time frame has benefits, the empirical resuhs of the study are limited because
they are based on only ten years of annual data. The use of monthly or quarterly data
would have dramatically raised the power of their empirical resuhs. A drawback of the
longer time frame is that the data may have been influenced by extemal factors not related
to the merger (Lubatkin and Shrieves, 1986). Therefore, a trade-off exists between
characteristics of data and the quality of the measure of performance.
3.4 Uniqueness of this Study
Current economic and finance theories examine mergers over a wider time frame
than do the current empirical studies. This study combines the event study process of the
current studies with the longer view of the current theory. This is accomplished by solely
examining the pharmaceutical industry, which will remove any industry effects, and by
using a time frame of two years, which captures the full effects of the integration process
and decrease the effects from extemal factors. The data is monthly to increase power.
Synergy was the stated objectives of the mergers by the firms: the horizontal
mergers allowed for increased research and development and marketing, while the vertical
mergers allowed for some influence over prescription insurance choices and pricing. The
54
mergers were presented by the firms as a strategic move to counter the pressures of R&D
risk and extemal cost controls. By increasing firm size, the manufacturers wanted to
increase control over their environment and increase their ability to service their
stakeholders. This research attempts to infer whether the stated objectives for the mergers
were realized. The absolute value and sign of the retums to various stakeholders infers
the existence and magnitude of synergies or of agency problems. Efficiency gains are
shown by nonnegative results whereas nonpositive outcomes indicate agency problems or
imperfect information regarding potential synergies.
55
CHAPTER IV
CONCEPTUAL FRAMEWORK
4.1 Objective of a Firm
A basic premise of economic analysis is that a firm seeks to maximize profits.
Profits are defined as total revenue minus total costs. Total revenue is determined by sales
and the sales price. Total cost is the product of average total cost and sales. Therefore, a
firm seeks to make the difference between total revenue and total costs as large as
possible.
However, static profit maximization does not necessarily provide the proper
guidance to managers (Keown, Petty, Scott, and Martin, 1998; Brigham and Gapenski,
1993; Moyer, McGuigan, and Kretlow, 1990). This is because profit maximization does
not include a time component. It provides no way to compare short and long term
decisions and benefits. Managers must examine the trade-offs between short-mn and
long-mn retums to determine in which profit-maximizing opportunities to invest.
The second shortcoming of profit maximization is that no consistent definition of
profit exists. Accountants can alter the counting of costs and revenues in the calculation
of profit. This leads to hundreds of possible figures even if standard accounting mles are
foUowed. Even if a clear definition of profit is determined, whether the goal of the firm
should be to maximize total profit, the change in profit, or earnings per share is still
undetermined.
56
SimpUstic profit maximization also does not account for risk differences among
projects. Two projects may provide identical expected cash flows, but the risk of the
future flows may differ between the two projects. The risk can be from the timing of the
project, the financial risk of the investment, or the business risk of the investment. A firm
can increase the retum from an investment by leveraging it; however, the increase in
earnings per share causes an increase in financial risk. An efficient market will recognize
that the leveraged project entails more risk and value it accordingly.
Because static profit maximization does not provide enough guidance, managers
instead attempt to maximize the market value of stockholder weahh. Stockholder wealth
is the market price of a firm's stock. The market price represents the discounted future
retums from owning the stock, which can come from dividends or price changes. It is the
market value and not book value of the stock with which investors are concerned. The
book value is a historical concept and is not indicative of future earnings potential. The
market value is the price at which the stock trades in the marketplace.
Three main attributes of a firm's cash flow determine the market value of a share
of stock. The first factor is the amount of future cash flows expected to be generated for
the benefit of stockholders. The greater the expected flows are, the greater the value.
The second factor is the timing of the cash flows. The third factor is the perceived risk of
the cash flow. As always, the longer the time needed to receive the cash flow and the
more uncertain the cash flow is, the higher the retum must be to compensate the
stockholders. In determining the value, the flows are discounted at an appropriate rate
called the discount rate. The discount rate represents the opportunity cost of the
57
investment. It takes into account the retums that are available from altemative
investments opportunities during the specific time period.
Cash flow is the determming factor because it can be spent, whereas net income
can not be dispensed since it does not reflect the actual inflows and outflows of cash.
Cash flow is concerned with the tme cash generated by the firm that can be used to
acquire assets, make expenditures, and be distributed to investors. Cash flow can be
raised extemaUy or intemally. Extemal cash flow comes from equity and debt. Intemal
cash flows come from operations and the sale of assets. Initially, the cash flows are used
to acquire assets that are used in the production of products. The production should
result in funds for remvestment and for distribution to creditors and owners.
Capital markets act as an overseer to control the system and enforce efficiency. A
firm's stock price is its single comprehensive index of success. It reflects the investors'
best evaluation of the firm's tme earning power. The process is prospective; it discounts
the firm's fijture prospects into the current market value of the stock. It is comprehensive
by considering aU corporations and rendering judgments about the quality of the current
and expected performance. The stock markets conduct a widespread, rapid, continuing
process of evaluation. The evaluations reflect choices, hence they are comparative,
realistic, and comprehensive.
If a pharmaceutical firm's decision to merge was correctly based on efficiency
gains and not agency problems, the merger should have a positive effect on cash flows.
Initially, the integration process may require a cash outflow. However, once the synergies
are realized, cash flows should increase. An efficient market wUl recognize the gains and
58
stock price retums should reflect the value-increasing merger. Cash flows may decrease
due to agency problems or not be as large if the potential synergies were overestimated.
Cash flows that are less than expected should cause stock price retums to decrease.
Stockholder weahh has been defined as the retums from owning the stock.
However, stockholders are not the only people interested in the financial success of a
company. The creditors are also concemed with viability. For this reason, a better goal
would be the maximization of a firm's total market value, which equals the market value
of the equity plus the debt. Usually actions that increase the value of equity will also
increase the value of the debt. However, this is not always the case. Consider a situation
where an action by the firm causes the value of the debt to fall but the stock price rises.
This action has caused some of the value to be transferred from the creditors to the
stockholders. This behavior is considered unethical and should be avoided. All fliture
debt obligations will take into account this prior action through higher interest rates or
more restrictive bond covenants. If after a pharmaceutical merger, the valuation or rating
of the target and bidder firms' bonds decreases, retums have been shifted away from the
bondholders to other stakeholders. A merger that exhibits efficiency gains will partially be
demonstrated in bond ratings that increase or are unchanged.
Customers are another important stakeholder. More and better products increase
the choices available to the utility maximizing consumers. Customers determine part of
the success of a merger. If the new integrated firm produces products demanded by the
consumers, the new firm's value should increase. For pharmaceutical firms, sales are
determined by the interaction of final consumers and their agents. Few final consumers
59
determine product choice. Instead, the agents determine which dmg, which manufacturer,
and at what price the patient may consume. The manufacturing firms reaUze the power
the agents have over sales and market share. Therefore, in order to maximize stakeholder
wealth, the dmg manufacturers must consider the opinions and actions of physicians,
pharmacies, hospitals, and managed care organizations to the merger.
Employees of the firms constitute the fourth stakeholder. They seek job security
and increases m pay. While the stockholders own the firm, the employees are the ones
who carry out the day to day operations and make most of the decisions. As is weU noted
m the industrial organization Uterature, principal-agent issues can arise when the owning
and decision making processes are separated. After a merger, it is the employees who
undertake the mtegration process. The pharmaceutical firms must reaUze the employees'
role in turning potential synergies mto actual gams. Because employees are instmmental
to the success of a merger, their actions and opinions must be considered by the
pharmaceutical firms in order to realize wealth gains.
A fifth stakeholder would mclude the government and society in general. They are
interested in an increase in the overaU wealth of the country. Wealth can be described as
choice. A society may become wealthier if it has more choices, and a firm promotes
wealth if it provides more choices. However, social welfare does not always rise when
choices increase because the opportunity cost of the increase may offset the benefit of
more choice. Hence, an mcrease in choice can but not always mcrease social welfare.
Society also wants the general standard of Uvmg to increase. For the pharmaceutical
industry, this can come from better dmgs that produce a healthier Ufe along with strong
60
financial retums, which provide income to owners, creditors, and employees. Society may
be interested in dmgs that cure aihnents that afflict a few people and for people who can
not afford dmgs. Therefore, pharmaceutical mergers that mcrease concentration may be
acceptable if the firms innovate new dmgs at affordable prices. Because the government
can prohibit the merger, the firms must note society's deshes.
The stakeholders are tied together m the valuation process. The consumers along
with their agents determine sales. Employees partiaUy determme costs and product
choices. The government regulates the mdustry and can pressure the firms into
conducting business as it wishes. These three stakeholders affect the cash flows for the
firm, which determine the stock price and bond value, and which links them to the
stockholders and bondholders. When two firms are considering a merger and throughout
the integration process, the opinions and actions of aU stakeholders need to be considered
for they aU affect the new firm's wealth. However, the concems of the stakeholders may
not evenly weigh in the firm's decisions. But under an assumption of efficiency, the firm
that makes the best decisions should see its value increase m comparison to its
competitors.
4.2 Integration Considerations
The main reasons for mergers are to achieve efficiencies and to take advantage of
monopoly-related conditions. Efficiencies come in two forms: technical savings either
physical or organizational, and reduction in transactions costs. The monopoly mcentives
can be from raising the barriers to entry and vertical squeezes. The net social effects of a
61
merger include achieving a balance between net economies gained by a merger that could
not be obtained by direct growth or long-term contracts and possible anti-competitive
effects such as from raising barriers to entry. For the pharmaceutical industry, the benefit
of the mergers may come in the form of increased products and decreased costs. These
benefits must exceed the costs of increased concentration and possible increased pricing
power to net a positive social gain.
However, mergers that increase concentration do have benefits. Competition can
be shaUow and myopic. Instead of focusing on the long mn, firms focus on a series of
short term contests. Firms become pressured by short-term financial success, which can
be in conflict with long-mn objectives, if all of the effort is put into just surviving and little
is left for creativity. One of the reasons espoused by the pharmaceutical firms for merging
it that it aUows the firms to have a less myopic view of business because of increased
research staffs and cash flow from the increase in critical mass.
Some mergers may cause pecuniary economies, which provide money benefits
without improving the use of real resources. Merged firms may be able to get lower input
prices, which is a possible result of the vertical mergers between pharmaceutical
manufacturers and pharmacy benefit managers. The newly combined firm may also
receive promotional advantages from the increased marketing power since sales networks
are transferable. Merged pharmaceutical firms can combine detaU forces and market more
goods. However, if no new innovations or improvements are discovered or no decrease in
price, the benefits of an increase in concentration are limited for consumers.
62
Mergers may increase diversification through product extension (new product),
geographic extension (same product, new location), or pure diversification (no relation to
firm's products). Product extension and geographic extension diversification may be
beneficial to aU stakeholders. However, the benefit of pure diversification is questionable
for stockholders and creditors. It may be more efficient for investors to seek
diversification by investing in different firms instead of one firm investing in different
areas. Employees are unable to diversify on their own and clearly benefit from
diversification. Because pharmaceutical firms typically specialize in several therapeutic
areas, a merger can expose a firm to new markets. The pharmaceutical firms also tend to
have strong ties in various countries. After a merger, existing products have potential new
geographic markets.
The total effects of a merger require time before they are realized. Firms may not
immediately gain from the extemal growth, but instead only after a successful integration.
The success can then be passed on to employees, consumers and other stakeholders in the
form of more and better products, lower prices, and higher wages. Therefore, this study
will use a wider time frame to analyze the mergers.
4.3 Retums to Stockholders and the Firm
The success of the merger can be judged in two ways. The first is the retum to
investors. The stockholders'return is calculated as R = {Pt + Dt) ^ Pt-\ where,
R = retum on a stock
Pt = selling price in time period t
63
Pt-\ = purchase price in period t-1
Dt = dividend per share in period t.
If the owner did not buy or seU the stock during the time period, the retum is found by
estimating the arithmetic mean of the high and low price per share in period / and in period
t-J. The retum over several time periods is found by taking the geometric mean of each
period's return. The geometric mean is used because it is a more conservative average
and better suited for outiiers. The retum is dependent upon the dividends received and the
change in price or potential change in price. If investors believe that the merger is
advantageous, they will bid up the price until the discounted expected future retum equals
the current selling price. After the merger occurs, the price will continue to increase if the
retums from the merger are greater than expected. If the price faUs, this indicates that the
views of the benefits of the merger were overzealous. If the price remains the same, the
merger accomplished what investors expected.
The price of the stock is a flmction of the earnings of the firm. The earnings are
dependent upon sales and how well the firm satisfies consumer utilities. This again
demonstrates the intertwined nature of the stakeholders.
An additional consideration involving the merger is the abnormal return. The
abnormal retum is the difference between what the investor received minus what the
investor expected to receive. A positive abnormal retum is beneficial to investors. The
investor wants the merger to increase retums to him. Therefore, the investor would
compare the retums after the merger with what was expected by each firm individually
without the merger. Most studies use a time frame of one month to six months prior and
64
after a merger to judge its success. This study wiU examine extended time periods prior to
and after the merger. This is beneficial because the act of combming two large firms is
difficuh, and the retums may be delayed untU logistics are completed. Also,
pharmaceutical firms that merge to increase R&D expenditures may not experience the
benefits for several years.
A second measure to judge a merger is to examine the retum on assets, which
indicates firm performance. The change in the stock price before the merger indicates
what the market believes will occur. The change in retum on assets show what did occur.
If the merger is successful, then the stock price will continue upward at a quicker pace.
However, if the merger is not successfiil, the stock price will faU. The performance
measure will not improve after an unsuccessful merger. It indicates the success the
integration process. The retum on assets demonstrates how weU the firm utilizes its assets
to produce sales and earnings.
Stock price retums and company performance are the two key ways to analyze a
merger. Both measures indirectly include the opinions of other stakeholders though their
effects on sales, cash flows, bond convenants, and regulations. Direct effects on
consumers and bondholders is an additional way to judge the success of a merger. The
variety of prices and the unavailability of the prices limits one's ability to analyze the price
effects. Instead, retums to consumers and bondholders are discussed on quantity and
quality issues.
65
CHAPTER V
METHODS AND PROCEDURES
5.1 Introduction
The focus of the empirical section of this study is on retums to economic agents.
The first empirical section focuses on retums to the various stockholders of firms that
have merged. Using an event study, the stock price retums are investigated with two
parametric models and one nonparametric model. The three models aUow for an
assessment of the retums to bidder and target stockholders. The mean adjusted retum
model is the historical method but the market model includes a measure for risk. The
nonparametric sign test is then used to test the consistency of the parametric resuhs. In a
second empirical section, regression analysis is employed to investigate the annual retums
of the mergers on firm performance.
5.2 Retums to Stockholders
An event study measures the impact of a specific event on the value of a firm. As
long as the market is rational, the effect of an event wiU be reflected in the price of the
firm's stock. The first step in constmcting an event study is to determine the time frame
for the study. As has been discussed, prior studies use a narrow wmdow around the
event, in this case, the merger announcement. This measures the expectations about the
merger but not necessarily the actual merger result. By widening the time frame, the
impact of the actual integration process is examined. While the possibUity of the inclusion
66
of effects other than the merger increases as the time frame widens, a wider time frame is
needed in order to assess whether the initial expectations about the merger are actually
fiilfiUed. Passive management, better known as the buy-and-hold method, advocates long
term possession of stocks instead of repetitive and frequent buying and seUing of stocks.
This is because ownership of a stock is optimally based upon the fiindamentals of the firm
and not temporary movements in the stock price. Also, taxes and commissions diminish
the gains from frequent buying and selling. Therefore, while the investor is interested in
the immediate stock price effect of a merger announcement, the long term effect of the
merger is more relevant for portfoUo theory. This study uses a time frame of two years
around the merger announcement.
The event study utilizes a concept caUed the abnormal retum in its measurement.
The abnormal retum is the difference between the actual retum and the normal retum.
The normal retum is the predicted retum that would be expected if no event occurred.
For firm i and event date / the abnormal retum is ARu = Rit - E{Rit \ Xt), which is the
actual return for the firm minus the predicted retum. The abnormal retum, also called the
residual, is an estimate of the change m the firm value attributed to the event, in this case
the merger. The abnormal retums are then summed to produce a cumulative abnormal
retum, which is used in the test statistic.
There are two main methods for determining the normal retum: the mean adjusted
return model and the market model. Both methods use a clean period. During the clean
period, no information about the merger is released. In this study, the clean period wiU be
the third and fourth years prior to the event.
67
In the mean adjusted retum method, the average retum for the firm is calculated
A
during the clean period, ji = Y,"=i^'' 1^^ where wis the number of observations. The
average retum is used as the predicted normal retum in the calculation of the abnormal
retum.
The market model is Rit = ai+ /3Jlmt+ e.^. Rmt is the retum on the market index
for time period t, )9,. is a measure of risk of the firm and a t measures the variability not
explained by the market. The market model is estimated by mnning a regression on the
clean period. The regression yields estimates of a. and P i. The normal retum for the
event period is found by substituting the estimates into the equation with the actual retum
for the market for the time period. Weston, Chung, and Siu (1998) and MacKinlay (1997)
consider this to be the most widely used method because it includes a measure for risk
even though the results are comparable to the results from the mean adjusted method.
After obtaining estimates of the normal retum, the abnormal retum is calculated.
Residual analysis tests whether the actual retum to the stock is greater or less than what
would be normally expected from the basic risk versus retum relationship. The abnormal
retums for the firm are aggregated across time to arrive at a cumulative abnormal retum.
The cumulative abnormal retum (CAR) is assumed to be normally distributed.
t2 CARi{ti, ti) = J^ARit and CAR(ti,t2) ~ N{0,(j. ( i, 2))(MacKinlay, 1997). The
t=ti
CAR is then divided by its standard deviation to arrive at a t-statistic, which can then be
tested for significance across the event time period.
68
MacKinlay (1997) recommends the use of both parametric and nonparametric
tests. The nonparametric test can check the robustness of parametric resuhs and may
provide more reUable inferences depending upon the data set. The nonparametric test
used to analyze abnormal retums is the sign test. A benefit of this test is that it does not
assume a specific distribution of the abnormal retums. The sign test is based on the sign
of the abnormal retum. It requires that the residuals are independent and have an
expected proportion of positive values equal to 0.5. The null hypothesis is that it is
equally probable that the ARs wiU be positive or negative. If the nuU hypothesis is
rejected, a positive or negative trend exists in the abnormal retums. The total number of
cases (N) and the total number of positive cases (N^) are needed to calculate the test
statistic (Conover, 1980 and MacKinlay, 1997). The test statistic (9) is,
N^ r-e = [-— - 0.5] VN / 0.5 ~ N{0,1).
The methods discussed above will allow for inferences about the retums to
stockholders, both bidder and target. The event studies examine whether the stockholders
gain significant positive or negative retums from the merger event.
5.3 Operating Performance of the Firms
The firms are also affected by the mergers. The second empirical section employs
regression analysis to investigate the annual retums to the firms between 1984 and 1997.
Retums to the firm are measured by the return on assets. The retum on assets is
computed by dividing net income by total assets. It is also the product of the total asset
69
turnover and the net profit margin. The retum on assets examines how efficiently a firm is
using its assets to generate sales and earnings. The resuhs of the regression analysis allow
for some inferences about the effects of the mergers on operating performance.
The estimation method used in this study is regression analysis. The principles of
least squares in regression analysis and the mimmization of the error sum of squares are
weU known. To make any mferences about the population regression curve, some
assumptions must be satisfied regardmg the population. In the simple Unear regression the
foUowmg assumptions are usuaUy made for each observation in the population:
1. Lmearity of the function form: Y= a + EX + u;
2. Zero mean of the disturbance: E{u) = 0;
3. The variance of the population residuals is constant with nonautocorrelation:
Var{uu') = 0-' / ;
4. The residuals are independent of each other: X nonstochastic;
5. The distribution of the residuals is normal: u ~ N.
Factors that may impact the retums to economic agents are the retum on the S&P
500 index, market return, long-term debt, cash flows, the type of merger, the year of
observations, sales, firm classification, and a merger tune variable. The S&P 500 mdex is
used to account for overaU movements in the retums to stocks due to market conditions.
The type of merger is defined as a horizontal or vertical merger. Which year the
observations are from is used to capture a potential trend. Annual sales are included in
order to account for the size of each firm and to assess if the motivations for the mergers
were realized. Firms are classified as either a bidder or target firm. The merger time
70
variable refers to whether the yearly observations are for a firm before or after it merges.
Firms for this analysis include the following: American Home Products, American
Cyanamid, Bristol-Myers, Squibb, Merck, Medco, and Eli Lilly. Consistent with empirical
work in finance, first difference and annual growth data transformations will be employed
to correct for potential time-series autocorrelation problems.
5.4 Data and Sources
The data requirements for the events studies include stock prices and dividends for
each firm and the S&P 500 index. Standard and Foofs Daily Stock Price Record records
this daily information about each firm traded in the United States and the index.
Firm level data needed for the discussion of retums to the firm include assets, net
income, sales, cash flows, long-term debt, and equity. The data was obtained from the
annual 10-K reports submitted to the Securities and Exchange Commission (SEC)
avaUable on the Internet from the EDGAR database (www.sec.gov/edgar) and from
Lexus-Nexus Company Financial Reports (www.lexus-nexus). All publicly traded firms
must submit a 10-K report to the SEC each year which summarizes the financial activity of
the firm. Specific accounting guideUnes must be followed in the 10-K report. The
consumers price index (CPI) used to deflate dollar denominated variables like long-term
debt, cash flow, and sales was obtained from the Bureau of Labor Statistics. The dmg
CPI base year is 1982.
In the discussion of retums to consumers, information about the number of dmgs
and types of dmgs is needed. This information is avaUable from the Food and Dmg
71
Administration (FDA). The FDA also ranks each dmg for its therapeutic value. Bond
quality ratings are avaUable from Moody's and Standard and Poor's.
72
CHAPTER VI
RESULTS
6.1 Introduction
Between 1989 and 1994 the pharmaceutical industry reacted to its changing
environment with a series of mergers. The literature is dearth of any significant empirical
research on the pharmaceutical merger events. The purpose of this chapter is to discuss
the impact of pharmaceutical mergers on economic agents. Utilizing a case study
approach, this chapter empirically examines three specific merger events. The first merger
is the 1989 horizontal merger of Bristol-Myers Squibb. The second merger is the 1993
vertical merger between Merck and Medco. The third main merger is the 1994 horizontal
merger between American Home Products and American Cyanamid. These mergers are
representative of the three types of merger activity that occurred in the industry.
Traditional methods of merger performance evaluation, event studies, nonparametric
methods, and regression analysis are employed.
Section two presents the background of the various mergers. The third through
fifth sections demonstrate the empirical results. Event study results are discussed in
section three. The consistency of the event study results is verified using a nonparametric
method in section four. The fifth section presents industry regression results. In the sixth
section, anecdotal evidence concerning the impact of pharmaceutical mergers on other
agents is examined. Conclusions and implications are discussed in section seven.
73
6.2 Merger Descriptions
6.2.1 Bristol-Mvers Squibb Horizontal Merger
In 1989, Bristol-Myers was the twelfth largest pharmaceutical firm in the world
and known for its diversified approach to the industry. In the preceding decades, Bristol-
Myers found the feast or famine cycle of research and development (R&D) unnerving and
the starting up new divisions difficuh. Richard Gelb, CEO of Bristol-Myers, diversified
the firm by acquiring firms in new markets. By 1988, Bristol-Myers was composed of
over twenty different divisions. Each part, in particular the Consumer Products division,
was intended to provide cash flow for the pharmaceutical R&D. A strength of Bristol-
Myers was its ability to manage the diverse divisions and market their many products. The
firm had the first or second highest market share in over fifty markets. In consumer
products, Bristol-Myers' brand names included Miss Clairol, Bufferin, Excedrin, Comtrex,
and Windex. Pharmaceutical strengths included products for oncology, breast implants,
and central nervous system diseases (Annual Reports).
The 1980s was a good decade for Squibb. It consistently ranked as a good
investment and Financial World (1988) listed it as one of the best twenty-five companies
of the decade. Over the prior ten years, it had a price gain of 310%) and earnings per share
grew at an average rate of 15%). Squibb's strength lay in its ability to recognize changes in
the marketplace and shift resources and products to meet them. An example is Capoten.
In the 1970s, Squibb's management realized that a significant portion of the aging U.S.
population would suffer from chronic heart disease. They moved into the therapeutic
market of cardiovasculars and innovated Capoten in 1979 for hypertension. The dmg was
74
a blockbuster and accounted for 40% of Squibb's total sales in the early 1980s. Other than
cardiovasculars, Squibb was strong in the cholesterol market. In both the cardiovascular
and the cholesterol markets, Squibb's main competitor was Merck. Merck was 2.5 times
the size of Squibb in 1986 and was able to outspend Squibb in advertising and R&D.
While Bristol-Myers used many divisions to provide cash flow for R&D, Squibb foUowed
the philosophy of selling off divisions to provide cash flow for R&D. Squibb also used
very littie debt. By the end of the 1980s, Squibb was feeling the pressure for cash to
continue competing with Merck. The company had been stripped down to the bare
minimum through the sell-offs. This coupled with hs limited debt and strong R&D staff
made it a takeover target. While Glaxo was interested in Squibb, the management decided
to look for a white knight and found Bristol-Myers (Perham, 1986; Teitelman, 1987;
Benway, 1988).
In July 1989, Bristol-Myers and Squibb announced their merger. It was the first in
a series of mergers in the industry. Together, Bristol-Myers and Squibb moved from
twelfth and fourteenth respectively to second in size behind Merck. The merger was
valued at $12.5 bilUon and was the fourth largest merger in doUar terms in U.S. history at
that time. The merger was important not just because of the size of the merger but
because both firms were financially healthy and did not appear to outsiders to need a
partner (Benoit, 1989). Synergies were expected to come from the combination of
Squibb's strong R&D skills with Bristol-Myers' marketing and management skills.
Bristol-Myers was to provide the cash flow and marketing expertise to fiand Squibb's
projects, to formulate over-the-counter versions of Squibb's dmgs, and then to market the
75
dmgs through the combined sales force and intemational presence. Squibb's R&D skiUs
were to be applied to Bristol-Myers product pipeline in order to increase the number and
speed of innovations along with a movement into new therapeutic areas (Weber and
Benway, 1989;Hager, 1990; Teitelman, 1989).
6.2.2 Merck and Medco Vertical Merger
Merck's 1993 acquisition of Medco Containment Services was the first merger
between a pharmaceutical manufacturer and a pharmacy benefit manager. It was valued at
$6,226 bilUon. Merck was the largest pharmaceutical firm in the world with 1992 sales
over $9.5 billion. Medco was the largest marketer of discount prescription services with
sales over $2 biUion in 1992. The acquisition made Merck the only integrated producer
and distributor of pharmaceuticals.
Medco managed prescription dmg benefit plans for many customers, including the
State of California and Keystone Health Plan East, through a discount mail order business
and retail pharmacy insurance program. Medco covered over 33 million people. It was
successful at forcing pharmaceutical firms to give sharp discounts and then passing the
discounts on to customers, which encouraged more customers to join. Leading up to the
merger, Medco's CEO, Martin Wygod, had been seeking a pharmaceutical partner or
partners. At that time, Medco received 80%) of its sales from 25 different suppUers.
Medco management wanted to decrease the number of suppliers down to fewer than five
in order to cut logistical costs. Of Medco's sales, Merck represented less than 10%),
76
which Medco felt was underrepresentive considering Merck's size (Tanouye and Anders,
1993).
Prior to the merger, Merck had resisted doing business with managed care
companies preferring instead to relying on its strong product line and to forcing managed
care to accept hs terms. Merck President Richard Markham advocated Merck's change
from ignoring managed care to ehher acquiring a pharmacy benefit manager (PBM) or to
developing a PBM themselves. Markham's position motivated the firm to seek out
Medco before it was acquired by someone else, leaving Merck to choose from among the
other smaller PBMs. Markham left Merck two weeks before the merger announcement
over disagreements with Merck management on the speed and conditions of the merger
discussions (Waldholz and Anders, 1993).
The merger would allow Merck to decrease its sales force and use Medco's
marketing ability to increase sales. Medco would be able to offer an expanded formulary
with the inclusion of Merck's dmg line at a reasonable cost. Merck would also gain
access to Medco's database of consumer information, which would provide information
on Merck's customers along with its competitor's customers. The information would be
used to better target products and marketing techniques. While concems were expressed
about Federal Trade Commission involvement in the merger, none occurred. The two
firms maintained separate management in order to avoid anti-tmst problems. Industry
analysts expressed concern at whether Medco, which had been successflil by forcing
pharmaceutical firms to its terms, would lose credibility and be seen as just a distribution
77
arm of Merck (Waldholz and Anders, 1993). Merck and Medco beUeved that savings
from decreased marketing and sales costs would be passed on to Medco's customers.
6.2.3 American Home Products and American Cvanamid OTC/BIO Horizontal Merger
During August 1993, American Cyanamid was in merger discussions with
SmithKline Beecham when American Home Products made a hostUe bid of $95 a share for
American Cyanamid, a 50% premium over American Cyanamid's price. American
Cyanamid, which had been a takeover target for several years, was not interested in a
hostUe takeover. American Home Products sweetened the deal to $101 a share and
American Cyanamid agreed after holding out for two weeks (Steinmetz, Tanouye, and
McCarthy, 1994; Steinmetz and Tanouye, 1994). The deal worth $9.7 billion created the
fourth largest firm in terms of sales behind Merck, Glaxo, and Bristol-Myers Squibb. In
terms of total revenue, the new firm moved ahead of Bristol-Myers Squibb into the third
position. Before the merger, American Home Products ranked twelfth and American
Cyanamid ranked thirty-first in terms of sales.
American Home Products was an established firm known for its stringent financial
methods. For instance, expenditures as low as $1500 had to be approved by the top
management and employees had to pay to attend their own office Christmas party. The
attitude towards cost did keep the firm financially strong even when its product pipeline
was sparse. American Home Products had products Uke Premarin for treating menopause
symptoms and Ativan for treating anxiety along with many over-the-counter products like
78
Anacin, Advil, Robitussin and Preparation H, but they did not have anything new in the
pipeline (Tanouye and Steinmetz, 1994).
American Cyanamid offered American Home Products two things, greater size and
biotechnology. John Stafford, CEO of American Home Products, wanted to increase the
critical mass of the firm in order to improve its bargaming power with managed care
organizations. The addition of American Cyanamid moved the firm mto fourth place in
size. American Cyanamid also had a strong presence in biotechnology, through its
subsidiary, Immunex. American Home Products wanted Immunex's expertise in
biotechnology and especially in cancer dmgs to boost its flagging R&D. American Home
Products had acquired A.H. Robms m 1989 in order to gain its OTC Une, which included
Robitussin. American Home Products would use its OTC brands to fund the
biotechnology m hopes of innovating a blockbuster. Other than oncology dmgs, the firm
wanted to use American Cyanamid's Centmm brand-name to market herbal supplements it
was developing to meet the current demand for natural remedies (Stemmetz and Tanouye,
1994). The horizontal approach to growth was traditional in vision but had been replaced
by the msh to acquire pharmacy benefit managers (PBMs). American Home Products'
management believed that the managed care revolution would dissipate, and the industry
would return to emphasizing R&D. They envisioned their firm a leader in biotechnology
research, which had gained superiority while the other firms toiled with PBMs.
79
6.2.4 Other Mergers
The vertical merger strategy was followed by Eli LUly and SmithKline Beecham.
In 1994, EU Lilly acquired PCS Health Systems for $4.1 bilUon from McKesson, which
had become the largest PBM during 1993-1994 serving 51 miUion Americans. SmithKline
Beecham acquired Diversified Pharmaceutical Services, which served 14 million patients,
eariier in the year. The Federal Trade Commission (FTC) intervened in the Eli Lilly
takeover but not the Merck or SmithKline Beecham takeovers. The FTC required Lilly
and PCS to maintain an open formulary and to protect any dmg price information PCS
gained about other firms. Both Merck and SmithKline Beecham separated the
management of the firms in order to avoid FTC regulations after it intervened in the Lilly
merger. Like Merck, Lilly and SmithKline Beecham anticipated increased marketing
opportunities for its dmgs. SmithKline Beecham is a British firm and the merger would
increase its presence in the United States. The Lilly merger will be included in the
regression in section 6.5. It was not included in the event study, because no separate
financial data existed for PCS. SmithKline Beecham is not included because accurate
financial data in dollars was not available.
Firms taking the horizontal merger path included Glaxo's acquisition of fellow
British firm WeUcome, Swedish Pharmacia's merger with U.S. firm Upjohn, and Swiss
competitors Ciba-Geigy's and Sandoz's merger into Novartis. The Glaxo-WeUcome
merger created either the largest or second largest firm in the world, depending upon the
measurement method. It gave Glaxo the ability to better compete with Merck and an even
stronger intemational presence especially in Europe. The merger with Upjohn was to give
80
Pharmacia a better foothold in the U.S. market, both for dmg marketing and for access to
financial markets. Ciba-Geigy's and Sandoz's merger was a surprise simply because the
two firms had been staunch competitors. The combination was meant to allow the
combined firm to receive the fiiU support of the Swiss government as it maneuvered within
the changing European market and to increase its critical mass to be used for marketing
expenditures in the U.S. None of these firms are included in this study because reUable
financial data in dollars was not available.
6.3 Event Study Empirical Results
Retums to target and bidder stockholders are examined using the event study
approach. An event study measures the impact of a specific event on the value of a firm.
The first step in constmcting an event study is to determine the time frame for the study.
A typical event study uses daily data with a forty-day window around the announcement
date. In this study, monthly data is used with a two-year window. As discussed in
Chapter V, the wider time frame is employed in order to examine the effects of the actual
merger and not just the merger announcement. A problem with a broad time frame is that
the potential for the inclusion of other effects increases. The two-year time frame is used
in this study because it is broad enough to capture the merger but narrow enough to
minimize the impact of nonmerger events. The clean period selected for the mean
adjusted and market model methods is also two years to maintain consistency. Chapter V
outlines the methods and procedures of the event study.
81
Residual analysis basically tests whether the retum to the common stock of
individual firms is greater or less than that predicted by general market relationships
between retum and risk. Most merger studies in recent years have made use of residual
analysis. These studies have sought to test whether merger events provide positive or
negative abnormal retums to the participants. The study of abnormal retums provides a
basis for examining the issue of whether or not value is enhanced by mergers. Cumulative
abnormal retums (CAR) are obtained by summing the monthly abnormal retums for each
firm. In this study, two cumulative abnormal retum event windows are utilized. The
event window [-24, 24] is a broad measure combining pre- and post-merger
announcement stock price performance. The relatively wide time frame captures
information about bidder and target performance, which may provide insights into the
motivation for the merger. The event window [0, 24] is a narrow measure focusing solely
on post-announcement stock price performance. Statistical significance of an event
vdndow can be estimated with a t-statistic by dividing the CAR by the standard deviation
(Weston, Chung, and Siu, 1998).
6.3.1 Mean Adjusted Retum Model Results
In the mean adjusted retum method, the normal retum used in the calculation of
the abnormal retum is the predicted retum from the clean period. Table 6.1 shows the
abnormal retums and cumulative abnormal retums based on the mean adjusted retum
method for the Bristol-Myers Squibb merger. Stockholders of Squibb, the target firm, do
not appear to benefit from the horizontal merger with Bristol-Myers. Twenty-nine of the
82
forty-nine monthly abnormal retums are negative. The cumulative abnormal retum for the
event window [-24, 24] is negative and statistically significant at the five percent level.
For the event window [0, 24], the cumulative abnormal retum is positive but not
statistically significant. Stockholders of Bristol-Myers, the bidder firm, also do not appear
to benefit from the merger. Thirty of the forty-nine abnormal retums are negative. The
cumulative abnormal retum for the event window [-24, 24] is negative and statistically
significant at the five percent level. For the event window [0, 24], the cumulative
abnormal retum is also negative but not statistically significant.
Table 6.2 shows the abnormal retums and cumulative abnormal returns based on
the mean adjusted retum method for the Merck and Medco merger. Stockholders of
Medco, the target firm, do not appear to benefit from the vertical merger with Merck.
Thirty-three of the forty-nine monthly abnormal retums are negative. The cumulative
abnormal retum for the event window [-24, 24] is negative and statistically significant at
the five percent level. For the event window [0, 24], the cumulative abnormal retum is
negative and statistically significant. Stockholders of Merck, the bidder firm, also do not
appear to benefit from the merger. Twenty-five of the forty-nine abnormal retums are
negative. The cumulative abnormal retum for the event window [-24, 24] is negative and
statistically significant at the ten percent level. For the event window [0, 24], the
cumulative abnormal retum is also negative and statistically significant at the five percent
level.
Table 6.3 shows the abnormal retums and cumulative abnormal retums based on
the mean adjusted retum method for the American Home Products and American
83
Cyanamid merger. Stockholders of American Cyanamid, the target firm, appear to benefit
from the horizontal merger with American Home Products. Thirty of the forty-nine
monthly abnormal retums are positive. The cumulative abnormal retum for the event
window [-24, 24] is positive and statistically significant at the five percent level. For the
event window [0, 24], the cumulative abnormal retum is positive and statistically
significant. Resuhs for the stockholders of American Home Products, the bidder firm, are
mixed. Twenty-six of the forty-nine abnormal retums are negative. The cumulative
abnormal retum for the event window [-24, 24] is negative and statistically significant at
the ten percent level. For the event window [0, 24], the cumulative abnormal retum is
positive and statistically significant at the five percent level.
84
Table 6.1: Mean Adjusted Retums-Bristol-Myers Squibb Merger
Event Date
-24 -23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10 - 9 - 8 - 7 - 6 - 5 - 4 - 3 - 2 - 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 t-value
AR
-0.02255 -0.009729 -0.004828 -0.0126 0.004544 -0.188018 -0.140366 0.104486 -0.00529 -0.005505 -0.125902 -0.016319 0.054849 -0.10301 0.0587 -0.063012 0.037691 -0.011186 -0.02255 -0.025359 0.008436 -0.04714 0.030671 0.017344 -0.007205 -0.047739 -0.025134 0.01631 0.024832 0.006021 0.028376 -0.018145 -0.081761 -0.02255 -0.02255 0.026401 0.068561 0.012073 0.001072 -0.076396 -0.034745 -0.047241 0.087155 -0.085288 0.093069 0.079268 -0.009349 -0.003006 -0.006576
Bristol-Myers CAR f-24,241 -0.02255 -0.03228 -0.03711 -0.04971 -0.04516 -0.23318 -0.37355 -0.26906 -0.27427 -0.27978 -0.40568 -0.422 -0.36715 -0.47016 -0.41146 -0.47447 -0.43678 -0.44797 -0.47052 -0.49587 -0.48744 -0.53458 -0.50391 -0.48656 -0.49377 -0.54151 -0.5664 -0.55033 -0.5255 -0.51948 -.04911 -0.50925 -0.59101 -0.61356 -0.63611 -0.60971 -0.54115 -0.52907 -0.528 -0.6044 -0.63914 -0.68638 -0.59923 -0.68452 -0.59145 -0.51218 -0.52153 -0.52453 -0.53111 -3.071
CAR [0,24]
-0.0072 -0.0549 -0.0801 -0.0638 -0.0389 -0.0329 -0.0045 -0.0227 -0.1044 -0.127 -0.1495 -0.1231 -0.0546 -0.0425 -0.0414 -0.1178 -0.1526 -0.1998 -0.1127 -0.198 -0.1049 -0.0256 -0.035 -0.038 -0.0445
-0.787
AR
0.10771 -0.05478 -0.0361 0.056083 0.018467 -0.26343 -0.27719 0.018391 -0.0321 -0.02054 -0.09703 0.01645 -0.09703 -0.1083 0.057238 -0.04778 0.019244 -0.14599 0.02449 0.012575 -0.04744 -0.07158 0.007813 -0.07287 -0.00619 0.126884 -0.0978 0.402179 0.030993 0.058737 0.009026 -0.03749 -0.10111 -0.0419 -0.0419 0.007051 0.049211 -0.00728 -0.01828 -0.09575 -0.0541 -0.06659 0.067805 -0.10464 0.073719 0.059918 -0.0287 -0.02236 -0.02593
Squibb CAR 1-24,241 0.10771 0.052996 0.016893 0.072975 0.091443 -0.171992 -0.449186 -0.430795 -0.462891 -0.483432 -0.580465 -0.564015 -0.661048 -0.769346 -0.712108 -0.759891 -0.740647 -0.886636 -0.862146 -0.849571 -0.897006 -0.968591 -0.960778 -1.033643 -1.039829 -0.912945 -1.010745 -0.608566 -0.577573 -0.518836 -0.509811 -0.547305 -0.648416 -0.690316 -0.732216 -0.725165 -0.675954 -0.68323 -0.701508 -0.797255 -0.85135 -0.917941 -0.850136 -0.954774 -03881055 -0.821137 -0.849836 -0.872192 -0.898117
-2.938
CAR 10,241
-0.0062 0.1207 0.0229 0.42508 0.45607 0.51481 0.52383 0.48634 0.38523 0.34333 0.30143 0.30848 0.35769 0.35041 0.33213 0.23639 0.18229 0.1157 0.18351 0.07887 0.15259 0.21251 0.18381 0.16145 0.13553
0.888
85
Table 6.2: Mean Adjusted Returns-Merck and Medco Merger
Event Date
-24 -23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10 - 9 - 8 - 7 - 6 - 5 - 4 - 3 - 2 - 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 t-value
AR
0.00141 0.04997 -0.07683 0.05224 0.01358 0.06166 0.09771 -0.09763 -0.00968 -0.07136 -0.06432 0.04618 -0.05983 0.039 -0.11187 -0.11099 -0.01417 -0.00029 -0.06788 -0.13817 -0.00942 -0.15525 0.08723 -0.02877 -0.10747 -0.14693 0.01109 -0.05295 0.00676 0.037 0.01126 0.00287 -0.14274 -0.11534 0.04317 -0.0496 -0.04196 -0.03433 0.13538 0.03632 -0.04605 0.01296 0.0048 0.01372 0.03739 0.00409 -0.03412 0.07015 0.02476
Merck
CAR f-24, 241 0.00414 0.05138 -0.02545 0.02679 0.04037 0.10203 0.19974 0.10211 0.09243 0.02107 -0.04325 0.00293 -0.05691 -0.01791 -0.12977 -0.24077 -0.25493 -0.25522 -0.3231 -0.46127 -0.47069 -0.62594 -0.53871 -0.56748 -0.67495 -0.82188 -0.81079 -0.86374 -0.85699 -0.81999 -0.80872 -0.80585 -0.94859 -1.06394 -1.02077 -1.07036 -1.11233 -1.14666 -1.01128 -0.97496 -1.02101 -1.00804 -1.00324 -0.98953 -0.95213 -0.94805 -0.98217 -0.91202 -0.88725 -1.994
CAR 10,241
-0.107 -0.254 -0.243 -0.296 -0.29 -0.253 -0.241 -0.238 -0.381 -0.496 -0.453 -0.503 -0.545 -0.579 -0.444 -0.407 -0.454 -0.441 -0.436 -0.422 -0.385 -0.381 -0.415 -0.345 -0.32
-2.83
AR
-0.0797 0.13095 0.02017 -0.0209 -0.0074 0.00071 0.01407 -0.0255 -0.0867 -0.1416 -0.0854 0.05304 -0.1225 0.09833 -0.2471 0.20549 -0.0357 -0.0428 -0.1472 -0.1629 -0.1459 0.05191 0.065616 -0.0887 -0.001 -0.0182 0.19891 -0.0874 -0.0278 0.00248 -0.0232 -0.0316 -0.1772 -0.1499 0.0087 -0.0841 -0.0765 -0.0688 0.1009 0.00183 -0.0806 -0.0215 -0.0297 -0.0208 0.00288 -0.0304 -0.0686 0.03565 -0.0097
Medco CAR 1-24, 241 -0.0797 0.05125 0.07142 0.05048 0.04311 0.04383 0.0579 0.03238 -0.0543 -0.1959 -0.2813 -0.2282 -0.3507 -0.2524 -0.4994 -0.294 -0.3296 -0.3724 -0.5197 -0.6826 -0.8285 -0.7766 -0.7114 -0.8001 -0.8011 -0.8193 -0.6204 -0.7078 -0.7355 -0.733 -0.7563 -0.7879 -0.9651 -1.115 -1.1063 -1.1904 -1.2669 -1.3357 -1.2348 -1.233 -1.3136 -1.3351 -1.3648 -1.3856 -1.3827 -1.4131 -1.4817 -1.4461 -1.4558
-2.84
CAR 10, 241
-0.001 -0.0192 0.17975 0.09233 0.06458 0.06707 0.04384 0.0122 -0.165 -0.3149 -0.3062 -0.3903 -0.4668 -0.5356 -0.4347 -0.4329 -0.5134 -0.535 -0.5647 -0.5854 -0.5826 -0.613 -0.6816 -0.6459 -0.6557
-2.275
86
Table 6.3: Mean Adjusted Returns-American Home Products and American Cyanamid Merger
Event Date
-24 -23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10 - 9 - 8 - 7 - 6 - 5 - 4 - 3 - 2 - 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 t-value
AR
-0.06148 0.02381 -0.053474 -0.116266 0.0168 0.03216 -0.07488 -0.08581 -0.047111 0.0421362 0.0330 -0.026498 -0.065617 -0.046587 0.0149032 -0.067972 0.0032439 0.0068549 -0.003538 -0.04636 -0.061202 -0.061131 0.02856 -0.042342 -0.04941 0.00041 0.0240143 -0.008939 0.03447 0.006332 -0.034598 0.07273 0.0114353 -0.005074 0.0430548 -0.056314 0.0267032 -0.002703 -0.033264 0.068749 -0.015795 0.0782324 0.0344811 0.0474768 -0.044054 0.07771 -0.036696 -0.002156 0.08133
American Home Products CAR 1-24,241 -0.0615 -0.0377 -0.0911 -0.2074 -0.1906 -0.1585 -0.2333 -0.3191 -0.3663 -0.3241 -0.2911 -0.3176 -0.3832 -0.4298 -0.4149 -0.4829 -0.4796 -0.4728 -0.4763 -0.5227 -0.5839 -0.645 -0.6165 -0.6588 -0.7082 -0.7078 -0.6838 -0.6927 -0.6583 -0.6519 -0.6865 -0.6138 -0.6024 -0.6074 -0.5644 -0.6207 -0.594 -0.5967 -0.63 -0.5612 -0.577 -0.4988 -0.4643 -0.4168 -0.4609 -0.3832 -0.4199 -0.422 -0.3407 -1.90
CAR 10,241
-0.0494 -0.049 -0.025 -0.0339 0.0005 0.0069 -0.0277 0.045 0.0564 0.0514 0.0944 0.0381 0.0648 0.0621 0.0288 0.0976 0.0818 0.16 0.1945 0.242 0.1979 0.2756 0.2389 0.2368 0.3181 2.89
American Cyanamid AR
-0.04538 0.087408 -0.04561 -0.06864 0.035362 0.007793 -0.0031 -0.08931 -0.06914 0.027203 0.04592 -0.03581 0.008977 -0.00787 0.032871 0.008474 0.003765 -0.04855 -0.05548 -0.00561 -0.09126 -0.00034 0.07679 0.091288 0.036527 0.126945 0.528646 0.060527 0.048634 0.020522 -0.01758 0.083815 0.025625 0.009096 0.057265 -0.04212 0.040892 0.011467 -0.01907 0.082958 -0.00162 0.092422 0.048671 0.061667 -0.02986 0.0919 -0.02249 0.01202 0.095524
CAR 1-24,241 -0.04538 0.042024 -0.00359 -0.07222 -0.03686 -0.02907 -0.03217 -0.12148 -0.19061 -0.16341 -0.11749 -0.1533 -0.14433 -0.1522 -0.11933 -0.11085 -0.10709 -0.15564 -0.2112 -0.21674 -0.308 -0.30833 -0.23155 -0.14026 -0.10373 0.023215 0.551861 0.612388 0.661022 0.681544 0.663964 0.747779 0.773404 0.782499 0.839764 0.797641 0.838533 0.85 0.830926 0.913884 0.912261 1.004684 1.053355 1.115021 1.085157 1.177057 1.154565 1.166584 1.262108 2.367
CAR [0,241
0.0365 0.1635 0.6921 0.7526 0.8013 0.8218 0.8042 0.888 0.9137 0.9228 0.98 0.9379 0.9788 0.9903 0.9712 1.0541 1.0525 1.1449 1.1936 1.2553 1.2254 1.3173 1.2948 1.3068 1.4024 4.344
87
6.3.2 Market Model Rftsiihs
The market model includes a measure of risk in its prediction of the normal retum
used in the calculation of the abnormal retum. Table 6.4 shows the abnormal retums and
cumulative abnormal retums based on the market model method for the Bristol-Myers
Squibb merger. Resuhs are mixed for Squibb stockholders. Twenty-nine of the forty-nine
monthly abnormal retums are negative. The cumulative abnormal retum for the event
window [-24, 24] is negative and statistically significant at the five percent level. For the
event window [0, 24], the cumulative abnormal retum is positive and statistically
significant at the ten percent level. Bristol-Myers stockholders do not appear to be
affected by the merger. Twenty-four of the forty-nine abnormal retums are negative. The
cumulative abnormal retum for the event window [-24, 24] is positive but not statistically
significant. For the event window [0, 24], the cumulative abnormal retum is also positive
but not statistically significant at the ten percent level.
Table 6.5 shows the abnormal retums and cumulative abnormal retums based on
the market model method for the Merck and Medco merger. Medco stockholders do not
appear to benefit from the merger. Thirty-two of the forty-nine monthly abnormal retums
are negative. The cumulative abnormal retum for the event window [-24, 24] is negative
and statistically significant at the five percent level. For the event window [0, 24], the
cumulative abnormal retum is negative and statistically significant at the five percent level.
Merck's stockholders do not appear to benefit from the merger. Thirty of the forty-nine
abnormal retums are negative. The cumulative abnormal retum for the event window
[-24, 24] is negative and statistically significant at the ten percent level. For the event
88
wmdow [0, 24], the cumulative abnormal retum is negative and statistically significant at
the five percent level.
Table 6.6 shows the abnormal retums and cumulative abnormal retums based on
the market model method for the American Home Products and American Cyanamid
merger. Stockholders of American Cyanamid appear to gain from the merger. Twenty-
five of the forty-nine monthly abnormal returns are positive. The cumulative abnormal
retum for the event window [-24, 24] is positive and statistically significant at the five
percent level. For the event window [0, 24], the cumulative abnormal retum is positive
and statistically significant at the five percent level. Resuhs for American Home Product's
stockholders are mixed. Twenty-nine of the forty-nine abnormal retums are negative.
The cumulative abnormal retum for the event window [-24, 24] is negative and
statistically significant at the five percent level. For the event window [0, 24], the
cumulative abnormal retum is positive and statistically significant at the five percent level.
The results from the mean adjusted and market models are consistent. Merck and
Medco stockholders received negative retums in both windows, whereas American Home
Products and American Cyanamid stockholders received positive gains in the narrow
window. In the Bristol-Myers Squibb merger, Squibb stockholders received a negative
CAR in the broad window but a positive CAR in the narrow window. Results for Bristol-
Myers are mostly insignificant, indicating no predominant effect on stockholders.
89
Table 6.4: Market Model Retums-Bristol-Myers Squibb Merger
Event Date
-24 -23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10 - 9 - 8 - 7 - 6 - 5 - 4 - 3
2 - 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 t-value
AR
-0.009609 -0.042563 -0.027092 -0.011756 0.011587 0.049649 -0.028401 0.020574 0.017489 -0.034034 -0.106418 0.023735 0.054439 -0.102893 0.076304 0.025395 -0.014226 -0.020276 0.020157 -0.016514 -0.051419 0.005607 0.017563 -0.006383 -0.029552 -0.020051 -0.08269 0.006489 0.052095 0.052742 0.019948 -0.024776 0.023254 -0.015368 -0.021261 0.064612 -0.005203 0.041217 0.031428 0.033925 0.009642 -0.002931 0.050758 -0.073347 0.061449 0.018595 0.007598 -0.008011 -0.007804
Bristol-Myers CAR 1-24,241 -0.009609 -0.0522 -0.0793 -0.091 -0.0794 -0.0298 -0.0582 -0.0376 -0.0201 -0.0542 -0.1606 -0.1368 -0.0824 -0.1853 -0.109 -0.0836 -0.0978 -0.1181 -0.0979 -0.1145 -0.1659 -0.1603 -0.1427 -0.1491 -0.1786 -0.1987 -0.2814 -0.2749 -0.2228 -0.1701 -0.1501 -0.1749 -0.1516 -0.167 -0.1883 -0.1236 -0.1288 -0.0876 -0.0562 -0.0223 -0.0126 -0.0156 0.0352 -0.0382 0.0233 0.04189 0.04949 0.04148 0.03368 0.412
CAR [0,241
-0.0296 -0.0496 -0.1323 -0.1258 -0.0737 -0.021 -0.001 -0.0258 -0.0025 -0.0179 -0.0392 0.02544 0.02024 0.06146 0.09288 0.12681 0.13645 0.13352 0.18428 0.11093 0.17238 0.19098 0.19857 0.19056 0.18276
1.742
Squibb AR
0.115241 -0.07391 -0.0491 0.05652 0.022509 -0.12533 -0.21216 -0.03044 -0.01895 -0.03718 -0.08576 0.039682 -0.09732 -0.10828 0.067419 0.003558 -0.01099 -0.15133 0.049264 0.017664 -0.08228 -0.04097 0.000141 -0.08671 -0.01923 0.142927 -0.13131 0.396417 0.046789 0.085844 0.004074 -0.0414 -0.04012 -0.03778 -0.0412 0.029211 0.006278 0.009613 -0.00068 -0.03167 -0.02834 -0.04089 0.046594 -0.09775 0.055285 0.024595 -0.0189 -0.02532 -0.02669
CAR [-24, 241 0.11524 0.04133 -0.0078 0.04875 0.07126 -0.0541 -0.2662 -0.2967 -0.3156 -0.3528 -0.4386 -0.3989 -0.4962 -0.6045 -0.5371 -0.5335 -0.5445 -0.6958 -0.6466 -0.6289 -0.7112 -0.7522 -0.752 -0.8387 -0.585 -0.715 -0.8463 -0.4499 -0.4031 -0.3173 -0.3132 -0.3546 -0.3947 -0.4325 -0.4737 -0.4445 -0.4382 -0.4286 -0.4293 -0.461 -0.4893 -0.5302 -0.4836 -0.5813 -0.5261 -0.5015 -0.5204 -0.5457 -0.5724
-2.45
CAR [0,241
-0.0192 0.1237 -0.0076 0.3888 0.4356 0.5214 0.5255 0.4841 0.444 0.4062 0.365 0.3942 0.4005 0.4101 0.4094 0.3778 0.3494 0.3085 0.3551 0.2574 0.3127 0.3373 0.3184 0.293 0.2663 1.95
90
Table 6.5: Market Model Returns-Merck and Medco Merger
Event Date
-24 -23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10 - 9 - 8 - 7 - 6 - 5 - 4 - 3 - 2 - 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 t-value
AR
0.04201 0.03305 -0.08082 0.07163 0.0182 0.10137 0.00137 -0.06569 -0.00699 -0.03783 -0.0769 0.04382 -0.03694 0.01612 -0.07686 -0.10077 -0.02103 -0.01112 -0.06923 -0.14604 0.00271 -0.1658 0.11789 -0.04724 -0.08457 -0.13898 -0.01101 -0.03755 -0.00172 0.06534 0.04047 -0.04946 -0.09589 -0.0419 0.01738 -0.05037 -0.00268 -0.06134 0.11614 0.07467 -0.05172 0.07123 -0.01025 -0.00349 0.01126 -0.02311 -0.05148 0.03835 0.00653
Merck CAR [-24,241 0.042 0.0751 -0.006 0.0659 0.0841 0.1854 0.1868 0.1211 0.1141 0.0763 -.0006 0.0432 0.0063 0.0224 -0.054 -0.155 -0.176 -0.187 -0.257 -0.403 -0.4 -0.566 -0.448 -0.495 -0.58 -0.719 -0.73 -0.767 -0.769 -0.704 -0.663 -0.713 -0.808 -0.85 -0.833 -0.883 -0.886 -0.947 -0.831 -0.757 -0.808 -0.737 -0.747 -0.751 -0.74 -0.763 -0.814 -0.776 -0.769 -2.004
CAR [0,241
-0.085 -0.224 -0.235 -0.272 -0.274 -0.208 -0.168 -0.217 -0.313 -0.355 -0.338 -0.388 -0.391 -0.452 -0.336 -0.261 -0.313 -0.242 -0.252 -0.256 -0.244 -0.268 -0.319 -0.281 -0.274
-3.605
AR
-0.0234 0.10222 0.01056 0.004 -0.0043 0.05568 -0.132 0.01795 -0.0864 -0.0957 -0.1077 0.04584 -0.0924 0.0608 -0.199 0.21687 -0.0495 -0.0625 -0.153 -0.1783 -0.1317 0.03259 0.10675 -0.1197 0.02915 -0.0102 0.16254 -0.0684 -0.044 0.04064 0.01621 -0.1127 -0.1117 -0.0451 -0.0331 -0.089 -0.0221 -0.1125 0.06875 0.05479 -0.0927 0.06084 -0.0557 -0.0499 -0.0395 -0.0743 -0.098 -0.0151 -0.0404
Medco CAR [-24,241 -0.0234 0.0788 0.08935 0.09336 0.08908 0.14476 0.01275 0.03071 -0.0557 -0.1514 -0.2592 -0.2133 -0.3057 -0.2449 -0.444 -0.2271 -0.2766 -0.3391 -0.4921 -0.6704 -0.8021 -0.7695 -0.6627 -0.7824 -0.7533 -0.7634 -0.6009 -0.6693 -0.7133 -0.6726 -0.6564 -0.7691 -0.8808 -0.9258 -0.959 -1.0479 -1.0701 -1.1825 -1.1138 -1.059 -1.1517 -1.0908 -1.1465 -1.1964 -1.2358 -1.3102 -1.4082 -1.4232 -1.4636 -3.094
CAR [0,241
0.0292 0.019 0.1815 0.1132 0.0692 0.1098 0.126 0.0133 -0.098 -0.143 -0.177 -0.266 -0.288 -0.4 -0.331 -0.277 -0.369 -0.308 -0.364 -0.414 -0.453 -0.528 -0.626 -0.641 -0.681 -2.616
91
Table 6.6: Market Model Returns-American Home Products and American Cyanamid
Event Date
-24
-23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10 - 9 - 8 - 7 - 6 - 5 - 4 - 3
2 - 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 t-value
American Home Products AR
-0.04771 0.00656 -0.031497 -0.111084 0.0104063 0.023081 -0.077538 -0.092884 -0.040631 0.0332416 0.0520364 -0.040754 -0.051842 -0.04294 -0.00181 -0.059281 -0.004242 0.024315 -0.003883 -0.064299 -0.031169 -0.013105 0.0093419 -0.044611 -0.02431 -0.019635 0.0092335 0.0153066 0.028887 0.0440724 -0.046538 0.0593279 -0.008012 -0.025245 0.029547 -0.079603 0.0126054 -0.01483 -0.033484 0.0498626 -0.020826 0.0613365 0.022459 0.0310075 -0.045613 0.0720817 -0.032111 -0.012022 0.0982594
CAR [-24,241 -0.04771 -0.04115 -0.07265 -0.183734 -0.173328 -0.150247 -0.227785 -0.320669 -0.3613 -0.328059 -0.276022 -0.316776 -0.368618 -0.411558 -0.413369 -0.47265 -0.476891 -0.452576 -0.45646 -0.520758 -0.551927 -0.565032 -0.55569 -0.600301 -0.62531 -0.644466 -0.635233 -0.619926 -0.591039 -0.546967 -0.593505 -0.534177 -0.542189 -0.567435 -0.537888 -0.617491 -0.604886 -0.619715 -0.6532 -0.603337 -0.624163 -0.562827 -0.540368 -0.50936 -0.554973 -0.482891 -0.515002 -0.527024 -0.428764
-2.554
CAR [0,241
-0.024531 -0.044165 -0.034932 -0.019625 0.009262 0.053334 0.006796 0.066124 0.058112 0.032867 0.062414 -0.01719 -0.004585 -0.019414 -0.052898 -0.003036 -0.023862 0.059934 0.059934 0.090941 0.045328 0.11741 0.085299 0.073277 0.171537
3.089
American AR
-0.01973 0.05522 -0.00465 -0.059 0.023414 -0.00916 -0.00808 -0.10252 -0.05708 0.010594 0.081393 -0.06242 0.03464 -0.0011 0.001682 0.024657 -0.01022 -0.01602 -0.05615 -0.3909 -0.03528 0.089193 0.040928 0.087033 0.082896 0.089546 0.501061 0.105714 0.0382 0.090872 -0.03987 0.058801 -0.01066 -0.02854 0.032054 -0.08557 0.014581 -0.01117 -0.01951 0.047717 -0.01103 0.060893 0.02623 0.030933 -0.03279 0.081381 -0.01397 -0.0064 0.127061
Cyanamid CAR 1-24,241 -0.01973 0.03549 0.030838 -0.02816 -0.00475 -0.01391 -0.02199 -0.12451 -0.18159 -0.171 -0.0896 -0.15202 -0.11738 -0.11848 -0.1168 -0.09214 -0.10235 -0.11837 -0.17452 -0.21361 -0.24889 -0.1597 -0.11877 -0.03174 0.051157 0.140703 0.641763 0.747478 0.785678 0.87655 0.836682 0.895483 0.884821 0.856278 0.888332 0.802758 0.817339 0.806171 0.786663 0.83438 0.823352 0.884246 0.910476 0.941409 0.908614 0.989995 0.97603 0.96963 1.096691 2.246
CAR 10,241
0.0829 0.17244 0.6735 0.77922 0.81742 0.90829 0.86842 0.92722 0.91656 0.88802 0.92007 0.8345 0.84908 0.83791 0.8184 0.86612 0.85509 0.91598 0.94221 0.97315 0.94035 1.02173 1.00777 1.00137 1.12843 4.86
92
6.4 Nonparametric Empirical Resuhs
The resuhs discussed in section 6.3 are parametric in nature, in that assumptions
have been made about the distribution of abnormal retums. An aUemative approach is
avaUable which is nonparametric in nature. This approach is free of specific assumptions
concerning the distribution of retums. The common nonparametric test for event studies
is the sign test. The basis of the test is that, under the hypothesis, it is equally probable
that the abnormal retums will be positive or negative. For example, if the null hypothesis
is that there is a positive abnormal retum associated with a given event, the nuU hypothesis
is Ho:p<0.5 and the aUemative is Ha:p>0.5 where/? =pr[ARi > 0.0]. The sign test and
the test statistic (6) derived from the sign test are discussed in Chapter V.
The nonparametric test statistics from the sign test are presented in Table 6.7.
Test statistics for the sign test are derived from abnormal retums from the mean adjusted
and market models for the periods [-24, 24] and [0, 24]. Unlike the results from the
previous section, the sign test does not consider the magnitude of the abnormal retums.
The sign test results indicate that there is not a significant trend in the abnormal retums for
Bristol-Myers, Squibb, Merck and American Home Products. Hence, on a month-to-
month basis across the event windows, abnormal retums are not significantly higher or
lower than anticipated when magnitude is eliminated. Significant trends in abnormal
retums exist for Medco and American Cyanamid. Medco's results indicate that a negative
abnormal retum was more likely than a positive abnormal retum under each model in both
event windows. American Cyanamid's positive and significant result from the mean
93
adjusted model for the narrow event window indicates that stockholders were more likely
to receive a positive abnormal retum after the merger.
The cumulative abnormal return (CAR) allows for several large abnormal retums
to dominate the resuhs. This is beneficial for the examination of the overaU merger effects
and retums to stockholders following the buy and hold method. The sign test examines
whether the occurrence of a positive or negative abnormal retum in any time period is
more Ukely.
While the parametric resuhs find that Merck stockholders had a cumulative
negative abnormal return, the sign test indicates that there was no trend in the abnormal
retums. The negative CAR suggests that several abnormal retums were large in
magnitude and not compensated for by the positive abnormal retums. Following the
merger, Merck's largest negative abnormal retums were -0.14 twice from the mean
adjusted model and -0.13 and -0.09 from the market model. The largest positive abnormal
retums were 0.13 and 0.07 from the mean adjusted model and 0.11 and 0.07 from the
market model. Medco stockholders received negative CARs over both windows in each
parametric model. Prior to the merger, Medco had large negative abnormal retums in
months, -4, -5, and -6. After the merger, the abnormal retum in month 2 was the largest
positive abnormal retum. However, following the merger, negative abnormal retums
occurred twice as often as positive abnormal retums, maintaining the negative cumulative
abnormal retum.
American Home Products' largest negative abnormal retums occurred before the
merger. The insignificance of the sign test indicates that the positive result from the
94
cumulative abnormal retums after the merger came from larger positive abnormal retums,
while the likelihood of a positive or negative abnormal retum was about equal.
American Cyanamid's positive retums in all four parametric cases indicate a culmination
of positive abnormal retums. Prior to the merger, the cumulative abnormal retum for
American Cyanamid was negative but large, positive abnormal retums in the months
following the merger aimouncement compensated for the negative CAR and made the
results positive. Under the mean adjusted model, stockholders were more likely to receive
a positive abnormal retum after the merger.
The parametric results for Bristol-Myers were mostly insignificant. Therefore, the
insignificance of the sign test is not surprising. The cumulative abnormal retum for Squibb
stockholders is negative over the longer event window but positive over the narrow
window. While positive or negative abnormal returns were both likely, the large positive
abnormal retums in months 1 and 3 boosted the cumulative abnormal retum for the after
merger event window but was not enough to compensate for the negative CAR before the
merger.
Table 6.7: Nonparametric Results (test statistic -0)
Firm Mean Adjusted Mean Adjusted Market Model Market Model [-24, 241 10, 24] 1-24, 24] [0, 24]
Bristol-Myers Squibb Merck Medco American Home Products American Cyanamid
-1.57 -1.29 -0.143 -2.43* -0.43
1.57
-0.60 -1.00 1.00
-2.20* 0.60
2.60*
0.10 -1.29 -1.57 -2.14* -1.29
0.14
0.60 -0.60 -1.40 -2.20* 0.20
1.00
* denotes significance at the five percent level. 95
6.5 Regression Empirical Resuhs
This section uses regression analysis to investigate pharmaceutical merger
performance in the tune period 1984 through 1997. In contrast to the event study analysis
in the prior sections, which examined retums to stockholders, this analysis investigates
retums to the firms. The time period extends around the period of merger activity in order
to examine fundamental conditions of the firms, such as long term debt and cash flow,
which are potential motivations for the mergers.
6.5.1 Model
The seven firms in this section include the six firms in the event studies, Bristol-
Myers, Squibb, Merck, Medco, American Home Products, American Cyanamid, plus EU
Lilly. Initially, A.H. Robins was included as an eighth firm but was deleted because of
numerous outliers that existed in the data.
The regression model is specified as foUows:
ROA,= a,+ a, LTD, + a^ CASH, -H a, SALES, + a.MKRET, -H a,SP,
+ a.TYPE, + a.CLASS, + a.PERLOD, + a.NME, + a.JJME, + u,, ^^~^^
where subscript i represents the individual observations.
The descriptions of the explanatory variables and their expected signs, expressed in
brackets, are presented as the foUowing:
ROA = the ratio of annual net income divided by total assets;
96
LTD = natural log of long-term debt in thousands of 1982 doUars [-];
CASH = natural log of cash flow in thousands of 1982 doUars [+];
SALES = natural log of annual sales m thousands of 1982 doUars [+];
MKRET = holdmg period retum to the stockholders [+];
SP = yearly retum on the S&P 500 index [+];
TYPE = 1 if the firm engaged in a vertical merger; 0 otherwise [+];
CLASS = 1 if the firm was the bidder firm; 0 otherwise [+];
PERIOD = 1 if the tune period is after the merger; 0 otherwise [+];
NME = the number of new molecular entities patented that year [+];
TIME = an ordered variable mdicatmg the year of the financial data [-];
u = a stochastic error term.
Most explanatory variables are expected to have a positive effect on the retum on
assets. One of the variables expected to have a negative sign is LTD. Long-term debt is
debt held by the firm that does not mature in the next year. WhUe some leverage is
acceptable for a firm, excessive debt and the corresponding interest payments wiU retard
the performance of the firm by reducing net income. Both CASH and SALES are
expected to have a positive impact on the retum on assets. Higher sales and cash flow
should increase net income and return on assets. MKRET is expected to have a positive
relationship with operating performance. Stockholders should bid up the price of a firm
whose performance is improving and bid down the price of a firm with a declining
performance. SP is a proxy for the performance of the stock market and is expected to
have a positive relationship v^th ROA. Firm performance should be positively correlated
97
with overaU market performance. TYPE, CLASS, and PERIOD are aU expected to have
a positive impact on performance. The two types of mergers in this analysis are vertical or
horizontal. Vertical mergers should have a greater increase in the retum on assets because
of the monopolistic power gained through the new avenue for marketing the
manufacturers' products. Bidder firms should also receive a positive retum from the
merger as the firms receive the synergies that motivated the mergers. The retum on assets
should increase after the mergers as the gains from the merger are realized. New
molecular entities (NME) are the totally new dmgs developed by the firms. This should
have a positive impact on the retum on assets as the firms receive gains from their
research and development processes. TIME is ordered from one to fourteen for the years
1984 through 1997, with one representing the former year and fourteen representing the
latter year. TIME is expected to have a negative sign because of the impact of managed
care and governmental pressure for cost and price controls on dmgs that began in the late
1980s and continued into the 1990s. This should put downward pressure on net income,
reducing ROA.
6.5.2 Results
Regression results from a fuU model and a reduced model are presented in Table
6.8. The reduced model is derived by using a stepwise elimination process (a = . 10) to
eliminate insignificant variables and to reduce multicolUnearity. Both regression models
are statistically significant at the one percent level and explain approximately 53% of the
98
variation in retum on assets. Six out of the ten variables specified in equation 6-1 are
statistically significant at the ten percent level.
Long-term debt (LTD) has a negative and significant impact on retum on assets.
EU Lilly undertook significant debt in order to buy PCS as did American Home Products
in its merger with American Cyanamid. The newly merged firms must dramatically
increase revenues or decrease costs in order to maintain enough income to make the
interest payments. The resuhs imply that a firm that augments its debt stmcture in order
to undertake a merger can experience a loss if it is unable to adequately service the debt.
In theory, cash flows are one of the primary determinants of merger activity. Cash
flows in a bidder firm can be used to purchase a new firm, whereas cash flows in a target
firm make it an attractive acquisition choice. The resuhs from Table 6.8 indicate that
cash flows (CASH) have a positive impact on ROA. The cash flow variable is significant
at the ten percent level in the fiiU and reduced models. Cash flows were extremely
important in Merck's decision to acquire Medco. In the five years prior to the merger,
Medco had increased its cash flow from $28,832,000 to $192,471,000.
Sales is used in the model as a proxy for firm size. The results indicate that sales
have a positive impact on ROA. The positive impact is statistically significant at the ten
percent level in the reduced model. Sales should increase after the merger as synergies are
recognized. The Bristol-Myers acquisition of Squibb increased sales by over fifty percent.
Two capital market performance variables are expressed in the model. Overall
movements in the capital market are captured by the S&P 500 (SP), whereas firm-specific
retums are characterized by a firm's market retum (MKRET). The empirical resuhs
99
indicate that market retum has a positive influence on ROA. The market retum variable is
statistically significant at the ten percent level in the fuU and reduced models. The resuhs
imply that operating performance is recognized by investors in the capital market during
stock price valuation. Surprisingly, the S&P 500 (SP) is not significant in the model. It
appears that pharmaceutical ROAs did not move with the market during the specified time
period. The defensive nature (CAPM betas less than one) of the pharmaceutical industry
may insulate it from the random movements in the market.
Firm classification (CLASS) has a positive and highly significant impact on ROA.
Firms classified as bidders have higher ROAs than target firms. This supports the theory
that a merger will combine firms in a way that more effectively uses assets for net income.
All four of the bidder firms (Bristol-Myers, Merck, American Home Products, and Eli
Lilly) are well established, capable of successfully managing the combined assets.
The results indicate that retum on assets tend to fall after a merger. The
coefficient on the variable PERIOD is negative and significant at the five percent level in
the reduced model. The anticipated sign on the coefficient was positive since synergies
from the merger should increase operating performance. The negative sign implies that
synergies are overestimated at the time of the merger decision and are not completely
realized. ROA for both Merck and American Home Products fell after their respective
mergers.
The variables TYPE and NME both have negative coefficients but are insignificant
at the ten percent level. Merck and Eli LUly anticipated increased marketing power after
their vertical mergers with pharmacy benefit managers (Medco and PCS, respectively). A
100
potential explanation for the negative sign on the TYPE coefficient is that growth
opportunities for the pharmacy benefit managers was limited because the market became
saturated once most consumers were covered by a pharmacy insurance plan in the mid-
1990s. New molecular entities (NME) are the new and unique dmgs mnovated by a firm.
The fact that the NME variable is insignificant can be explained by the tune needed to
innovate and to market a new dmg. In addition, as noted in previous chapters, few new
dmgs are financiaUy successful.
The last variable m the model is TIME. The resuhs mdicate that there is not a tune
trend associated with retum on assets. TIME was expected to have a negative sign due to
the downward pressure on costs and prices from managed care organizations and the
government. WhUe the variable TIME is negative, it is not significant at an acceptable
level.
101
Table 6.8: Regression ResuUs-Retum on Assets
Variable Intercept
LTD
CASH
SALES
MKRET
SP
TYPE
CLASS
PERIOD
NME
TIME
Full Model Coefficient Reduced Model Coefficient -0.38877 (-1.75)**
-0.00379 (-1.83)**
0.02042 (1.69)**
0.01818 (1.50)
0.04919 (1.88)**
-0.03318 (-0.71)
-0.00285 (-0.17)
0.05899 (2.30)*
-0.02332 (-1.13)
-0.00405 (-0.60)
-0.00151 (-0.59)
-0.37187 (-2.36)*
-0.00444 (-2.31)*
0.01981 (1.89)**
0.01716 (1.73)**
0.03902 (1.67)**
0.05671 (2.93)*
-0.03202 (-2.08)*
N F Value R-square Adjusted R-square Durbin-Watson statistic
80 8.04 0.5381 0.4711 2.0381
80 13.68 0.5292 0.4905 2.0403
t-ratios are given in parentheses. * denotes significance at the five percent level. ** denotes significance at the ten percent level.
102
6.6 Anecdotal Evidence
The mergers in the pharmaceutical industry have also affected bondholders,
consumers, and pharmacies. While complete information about effects on these
stakeholders is difficuh to obtam, evidence exists that aUows for discussion.
6.6.1 Bondholders
Buyers of corporate bonds charge and receive an interest rate that compensates
them for delaying consumption, inflation risk, maturity risk, default risk, and liquidity risk
along with risk premiums for firm-specific considerations. The bondholders evaluate the
risk-return tradeoff in the decision to buy a bond. The retum they eam from the bond
should compensate them for the risk they assume. One way that investors judge the fijture
risk potential of a bond is by its bond rating. The lower the rating on the bond, the higher
the retum demanded on the bonds by investors. If a bond is downgraded, the bondholders
lose value because the interest eamed is not enough to compensate them for the increase
in risk or if they seU the bond, they wiU receive less for it. If a bond is upgraded, the
bondholders gain value because the interest eamed exceeds the amount necessary to
compensate them for risk and the sale of the bond wiU gamer a higher price then before.
After a merger, if a bond is downgraded, it represents a loss to bondholders and a shift of
value from them to other stakeholders or a loss from negative synergies. A bond
upgrading represents a shift of value to the bondholders from other stakeholders or a gain
in value from synergies from the merger.
103
Bonds from Bristol-Myers carried a triple A rating from both Moody's and
Standard & Poor's, the highest rating possible. Moody's and Standard & Poor's (S&P)
are the two main bond rating services. Squibb's bonds carried a double A rating from
S&P and an Aa2 rating from Moody's. Moody's adds numerical modifiers to its ratings to
indicate relative standing within the tier the bond is ranked. An Aa2 rating means that
Squibb's bonds were high quality bonds, and it ranked in the middle of the second tier.
After the merger, Bristol-Myers' bonds maintained their triple A rating, and Squibb's
bonds were upgraded to the triple A rating. Since the merger, all new Bristol-Myers
Squibb bonds have been rated triple A. Squibb bondholders received a ratings upgrade
and Bristol-Myers' bonds maintained their highest rating.
Since 1984, Merck's bonds have carried a triple A rating from both rating services.
Medco's bonds were ranked Bal before 1990 and upgraded to Baal in 1991 by Moody's,
which indicates a move from a bond considered to have speculative qualities to one
considered medium quality. Medco's bonds were unranked by Standard & Poor's. After
the merger was announced in July 1993, Moody's upgraded Medco's bonds in October
1993 to Aa3, indicating a move from medium quality to high quality bonds. The modifier
3 indicates the bonds were in the bottom of the second tier. After the merger was
completed in November 1993, Medco's bonds were upgraded again to the triple A rating
held by Merck. Since the merger, Merck bonds have carried a triple A rating. Merck's
bondholders did not appear to be hurt by the merger, and Medco's bondholders received a
gain from the ratings upgrade.
104
HistoricaUy, American Home Products has not carried much debt. In 1992, they
issued bonds that were rated triple A by both Moody's and S&P. American Cyanamid did
carry debt. Prior to 1990, Moody's ranked its bonds as Aa3 and S&P ranked them as A+.
The plus is a modifier much lUce the numerical modifiers used by Moody's. In 1990,
Moody's dovmgraded American Cyanamid to an A1 rating, whUe S&P kept theh A+
ratmg. After the merger between American Home Products and American Cyanamid,
both sets of bonds were downgraded. Moody's ratmg on American Home Products'
bonds feU from an Aaa to an A2 ratmg. S&P downgraded the bonds from AAA to A-.
Ratings changes are usuaUy within a tier or between tiers. The decrease from the top tier
to the third tier is sharp and mdicates a severe loss m quaUty. American Cyanamid's bonds
were downgraded to A- by S&P and A3 by Moody's. Since the merger, the bonds have
stayed in the single A tier by both ratmgs services. Clearly, a move from the highest tier
to the third tier indicates a loss m wealth for the American Home Products' bondholders.
American Cyanamid's dovmgradmg also indicates a loss.
EU LiUy's bonds carried a triple A rating from both services before its merger with
PCS. After the merger, S&P downgraded the bonds to an AA ratmg where it remains
today. Moody's downgraded LUly twice m 1994. First, m the begmmng of the year from
the Aaa ratmg to an Aal rating. After the merger was completed, the rating was
downgraded again to an Aa3 rating where it remains today. LiUy bondholders appear to
have lost from the merger.
105
6.6.2 New Molecular Entities for Consumers
Advances in dmg therapies provide gains to consumers. The number and type of
new dmgs innovated by the firms is the concern of consumers. Because of the length of
the R&D process, the complete current effect of the mergers on dmg development is
limited. The examination of the new dmgs innovated does provide insights into what the
firms have innovated, for whom, and in some cases, the level of therapeutic gain from the
innovation. The Food and Dmg Administration (FDA) classifies all dmgs that it reviews.
New molecular entities receive a classification of one. A new molecular entity is a totally
new dmg in that the active ingredient has never before been marketed in the United States.
These are the significant advances in dmg therapies. Starting in 1986, the FDA began
ranking some of the new molecular entities on therapeutic benefit. An A ranking was
given to dmgs offering significant therapeutic gains. A B ranking was for new entities
offering moderate therapeutic gains, whereas a C ranking was for dmgs offering slight or
small therapeutic gains. In 1992, the FDA altered the ranking to either a P ranking for
those dmgs under priority review because they offer a therapeutic advance or an S ranking
for those dmgs under standard review because they offer little therapeutic advance. Dmgs
also receive designations for those treating life threatening ailments and for those treating
ailments that afflict fewer than 200,000 people called orphan dmgs.
After the 1989 merger, Bristol-Myers Squibb patented fifteen new molecular
entities, which are presented in Table 6.9. Of the fifteen, eight received a ranking of C or
S and the remaining six received a ranking indicating therapeutic gains. Two dmgs were
for life threatening ailments and two received orphan status. Over half of the innovations
106
were patented in 1991 and 1992, which were probably already in the dmg pipeUne before
the merger. Bristol-Myers Squibb have been producing new dmgs since the merger, but
with only one new dmg developed between 1995 and 1997, coupled with its S rating,
clear gains are not shown.
Merck's merger with Medco was not intended to enhance R&D production,
especially since Medco did not conduct R&D. Between 1984 and 1992, Merck innovated
fifteen new molecular entities, with something patented almost every year (Table 6.10).
Since the merger, Merck has patented five new dmgs of which four received priority
status. While the time lag of R&D implies that these dmgs were already in the pipeline,
the ratings on dmgs do indicate that Merck has produced significant new dmgs.
As indicated in Table 6.11, from 1984 through 1993, American Home Products
innovated nine new molecular entities, and American Cyanamid innovated eight new
molecular entities. However, since the merger, only two dmg have been innovated and
both have been removed from the market because of safety concems. Consumers have
not realized potential gains from the combination of American Home Products' marketing
skills with American Cyanamid's biotechnology research.
In the ten years before Eli Lilly's acquisition of PCS, it innovated nine new
molecular entities as shown in Table 6.12. Of the entities ranked, none received the
highest priority. In the years after the merger, Lilly has produced four new dmgs with two
receiving a priority ranking. After only one innovation in the first half of this decade,
Lilly's pipeline does appear to be innovating dmgs.
107
Table 6.9: New Molecular Entities-Bristol-Myers and Squibb
Year
1984 1984 1984 1985 1985 1986 1986 1986 1987 1988 1989 1989 1990
1991 1991
1991
1991 1992 1992 1992 1992 1993 1994
1994 1996
Firm Bristol-Bristol-Squibb Bristol-Squibb Bristol-Bristol-Squibb Squibb Bristol-BMY BMY BMY
BMY BMY
BMY
BMY BMY BMY BMY BMY BMY BMY
BMY BMY
Myers Myers
Myers
Myers Myers
Myers
Dmg Precef Cephalothin Sodium Capozide Mexate AQ Cychlophosphamide Buspar Enkaid Azactam Choletec Ifex Paraplatm Cardiogen-82 Ultravate 0
MonoprU Videx
Pravochol
CefzU Vumon Betapace Proltance Taxol Dovonex Zerit
Serzone Maxipine
Therapeutic Use Anti-infective Anti-infective Anti-hypertensive Anti-hypertensive Cancer Anti-anxiety Anti-asthmatic Antibiotic Imagmg Agent Testicular Cancer Ovarian Cancer Imaging Agent Inflammatory Dermatoloy Anti-hypertensive HIV treatment
Cholesterol lowering Anti-infective Childhood leukemia Anti-arrhythmic Imaging Agent Ovarian Cancer Psoriasis Advanced HIV
Anti-depressant Cephalosporin
Rating na na na na na na na na na A - orphan B C C
c A-life threatening C
B P - orphan P - orphan S P S P - life threatening S S
Source: Food and Dmg Administration
108
Table 6.10: New Molecular Entities-Merck and Medco
Year 1984 1985 1985 1985 1986 1986 1986 1986 1987
1987 1989
1989 1991 1991
1992 1994 1995 1995 1996 1996
Firm Merck Merck Merck Merck Merck Merck Merck Merck Merck
Merck Merck
Merck Merck Merck
Merck Merck Merck Merck Merck Merck
Dmg Tonocard Syprine Vasotec Primaxin Pepcid Technescan Noroxin Recombivax HB Mevacor
Privivil Losec
Congulate Vaccine Plendil Zocor
Proscar Tmsopt Cozaar Fosamax Stromectol Crixivan
Therapeutic Use Anti-arrhythmic WUson's Disease Anti-hypertensive Anti-infective Anti-Ulcer Imaging Agent Anitbiotic Hepatitis B Cholesterol Lowering Anti-hypertensive Inflammation of Esophagus HaemophUus B Anti-Hypertensive Cholesterol Lowering Prostate Glaucoma Hypertension Osteoporosis Strongyloidiasis m v treatment
Rating na na na na na na na na A
na B
na C C
P P s p p P - life threatening
Source: Food and Dmg Administration
109
Table 6.11: New Molecular Entities-American Home Products and American Cyanamid
Year 1984 1984 1984 1985 1985 1986 1987 1989 1989 1989 1991 1991 1991
1992 1993 1993 1993 1996 1997
Firm AHP AHP ACY AHP ACY AHP ACY AHP AHP ACY AHP AHP ACY
ACY AHP ACY ACY AHP AHP
Dmg Sectral TriphasU Indomethacin Cordarone Propranolol HCL Omdis Novantrone Cefjjirandie Dalgan Suprax Lodine Ismo Sargramostim
Zebeta Effexor Zosyn Tetramune Pondimin Duract
Therapeutic Use Anti-hypertensive Birth Control Anti-inflammatory Anti-arrhythmic Anti-hypertensive Anti-inflammatory Leukemia Antibiotic Pain Reliever Antibiotic Antiarthritic Agina Pectoris Bone Marrow Transplant Hypertension Anti-depressent Antibiotic Vaccine Obesity Anti-inflammatory
Ratmg na na na na na na na C C c c c na
S S
c/a
na S-Removed S-Removed
Source: Food and Dmg Administration
110
Table 6.12: New Molecular Entities-EU Lilly and PCS
Year 1984 1985 1987 1987 1988
1988 1989 1989 1991 1995 1996 1996
1997
Firm EU LUly EU Lilly Eli Lilly Eli Lilly Eli Lilly
EU LUly Eli Lilly EU Lilly Eli Lilly Eli Lilly EU Lilly Eli Lilly
EU Lilly
Dmg Oncovin Tazidime Levatol Prozac Permax
Axid Pindac Decabid Lorabid Dynabac Gemzar Zyprexa
Evista
Therapeutic Use Cancer Anti-infective Anti-hypertensive Anti-depressant Parkinson's Disease Anti-ulcer Anti-hypertensive Anti-arrhythmic Anti-infective Antibiotic Pancreatic Cancer Psychotic Disorders Osteoporosis
Ratmg na na na na B
C C C C
c/a
P s
p
Source: Food and Dmg Administration
111
6.6.3 Pharmacies
Pharmacies have also been affected by the mergers and changing environment in
the pharmaceutical industry. One reason for the pharmaceutical mergers was to increase
marketing ability. The pharmacy benefit managers set the reimbursement price, which is
based on the current market price and includes sales prices and volume discounts. For
instance, the PCS reunbursement price for Axid, which is manufactured by LiUy, includes
the volume discounts Wal-mart and K-mart receive. The independent pharmacies, unable
to buy large quantities to receive volume discounts from the manufacturers and having
their profit margins determined by pharmacy benefit managers, have found another way to
control costs: short-dated dmgs. Because a dmg can not legaUy be sold after it expires,
manufacturers try to dump their stock when it nears expiration. They offer these dmgs at
significantly lower prices. One company was offering Generic Zantac at 8 cents a pill.
Before Zantac went off patent, it was $1.59 a piU. While there is nothing iUegal about
selUng short-dated dmgs, ethical questions do arise. Currently, there is no way to stop or
control a pharmacy that transfers the short-dated dmgs to a bottle with a later expiration
date. Inspections of the purchase invoices and sales records of the pharmacy may be the
only way to determine if this is occurring. Most dmgs have a three year expiation date
because stabiUty and efficacy studies completed on the dmg during the evaluation period
last for three years. A dmg suddenly does not lose efficacy the day after it expires, but
efficacy has not been proven for the dmg beyond expiration. The use of short-dated dmgs
causes pharmacies to consider the trade-off among cost control, patient safety, and the
112
pharmacy's reputation. Patients may also be at risk if they receive dmgs with reduced
efficacy.
113
CHAPTER VII
SUMMARY AND CONCLUSIONS
7.1 Contributions
The purpose of this study is to examme the effects of pharmaceutical mergers on
various economic enthies. This study contributes to the work on mergers in several ways.
Fu-st, the case study approach aUows for a more complete assessment of the effects on
mdividual stockholders and bondholders than traditional merger studies. Most merger
analyses use large numbers of firms m many industries. By only using pharmaceutical
firms, mdustry effects are eUminated. Sbc firms are used m the event studies analysis and
seven firms in the analyses of retum to the firms, bondholders, and consumers.
Second, the longer time frame captures not just the immediate effects of a merger
announcement but also the actual integration process. Events studies usuaUy consider
only the time around the merger announcement but not around the merger process. The
extended time frame permits the examination of whether the reasons for the merger are
fulfiUed. The two year tune frame in the event studies is used to limit the inclusion of
other effects.
A third contribution is the examination of retums to various stakeholders. If
synergies occur from the merger, then new gams are available. If the potential synergies
are overestimated, then gains by one shareholder group may be offset by losses to other
shareholders. For mstance, a transfer of wealth appears to occur between American
114
Home Products' stockholders and bondholders after the merger. Prior analyses do not
consider other stakeholders.
Fourth, this study contributes to the existing knowledge on the variables significant
to merger decisions and resuhs. The variables identified from the regression are
summarized in section 7.1.6.
7.1.1 Firms Included in Study
Mergers are the combination of two firms to form a new entity. Mergers are
extemal grov^h and occur when intemal growth is inefficient or undesirable. The
pharmaceutical industry's environment underwent changes in the late 1980s and early
1990s. Managed care organizations and the federal government appUed pressure to the
industry to control costs and prices of dmgs. The basis of the industry has always been
research and development (R&D). The cost and length of the R&D process was
increasing. As a response, firms began to merge.
The Bristol-Myers Squibb 1989 horizontal merger was one of the first mergers.
The merger represents the classic combination of two firms, where the weaknesses of one
firm are offset by the strengths of the other firm. By increasing size and critical mass,
synergistic gains should be realized as the firm is better able to market and to innovate
new dmgs. The merger moved the firm into the top five in terms of size where it has
remained.
The Merck and Medco 1993 merger is the opposite of the Bristol-Myers Squibb
merger. Instead of merging with a firm to increase R&D capabilities, this merger was
115
motivated by the pricing pressure applied by managed care organizations on the
pharmaceutical firms. Through the acquisition of a pharmacy benefit manager (PBM),
Merck should gain not just from the sale of its products but also by the sale of competitor
products through Medco's insurance and provider programs. Merck should also gain
access to the consumer database Medco maintamed of all of its customers. Using the
database mformation, Merck should improve its marketing techniques.
The third merger was between American Home Products and American Cyanamid
in 1994. This merger is included for several reasons. First, this horizontal merger
occurred when other pharmaceutical manufacturers where acquiring pharmacy benefit
managers. American Home Products beUeved that the managed care revolution would
fade. It focused on obtaining a research and development partner. American Home
Products had purchased A.H. Robins in 1989 for its over-the-counter (OTC) products.
American Home Products wanted to use the cash flow from the OTC products to fiand
research and development. It beUeved that the growth in R&D would come from
biotechnology. American Cyanamid owned a subsidiary, Immunex, which was developing
dmgs based on biotechnology research. This OTC/Biotech merger represents an
altemative choice to the straight horizontal mergers or the vertical mergers occurring in
the industry.
Eli LiUy is mcluded in the regression and the discussion on bondholders and
consumers. EU LiUy acquired PCS, a pharmacy benefits manager, from McKesson in
1994. The merger is not included in the event studies and PCS is not included in the
regression because no separate financial or stock price data existed for PCS. The Lilly
116
merger represents one of the last mergers in the wave. Other mergers had reduced the
relative size of Lilly in the industry. PCS was the last main PBM to be acquired. While
the motivation of the other mergers is fairly clear, gains to Lilly from the acquisition were
not so evident. The Federal Trade Commission's requirements limited Lilly's abUity to use
PCS's database. Also, Lilly already had a large market share in its key therapeutic area,
diabetes, making any gains limited. Finally, PCS did not conduct R&D and would not
assist in LUly's pursuit of new innovations.
7.1.2 Event Studv Resuhs
An event study approach is employed to examine the impact of a merger on the
value of a firm's stock. The abnormal retums are the difference between what is realized
and what is predicted by the normal risk versus retum market relationship. The abnormal
retums are then summed into cumulative abnormal retums (CAR). In the prediction of the
abnormal retum, two methods are used. The mean adjusted method uses the normal
retum from the clean period as the predicted retum. The market model uses risk in the
calculation of the normal retum. Results from both models are consistent with each other.
Two different time frames are also used in the residual analysis. A time frame of
two years before through two years after the merger announcement [-24,24] is a broad
measure of stock price performance. The event window [0,24] covers only the stock price
performance after the announcement. A negative CAR indicates that the stockholder did
not receive retums as great as predicted from the normal retum. If the CAR is negative in
the broad time frame, it indicates that the merger either bought down the stock price or
117
that the positive attributes of the merger were not able to compensate for inadequate
performance before the merger. A positive CAR in the broad time frame indicates a gain
to stockholders who received greater price appreciation than was anticipated. A negative
CAR in the narrow time frame indicates that the stockholders lost after the merger. A
positive CAR in the narrow time frame indicates a gain by the stockholders after the
merger.
Squibb stockholders receive a gain in the time period after the merger. However,
the stock price performance over the broad time frame is negative and significant in all the
cases. This impUes that while Squibb's stock price performance over the four years was
less than would normally be expected, after the merger, stockholders began receiving a
gain albeit not enough to dissipate the poorer pre-merger performance. Results for
Bristol-Myers' stockholders mostly indicate that they were unaffected by the merger.
Only the statistic from the mean adjusted model for [-24,24] is significant. It indicates that
Bristol-Myers stockholders received a negative retum over the broad time frame.
The results from the Merck and Medco merger are all negative and significant.
Both sets of shareholders received losses as the stock prices' performances feU below
what was normally expected. While target shareholders usually gain after a merger, as did
Squibb's and American Cyanamid's shareholders, Medco's shareholders suffered a loss.
Unlike the Bristol-Myers stockholders who were fairly unaffected by the merger, Merck's
stockholders definitely lost. The losses from this merger indicate that the capital market
did not believe in the gains Merck expected from the merger. Performance after the
merger by the new entity was not enough to reverse investors' opinions.
118
The four year performance of American Home Product's stock price was negative
and statistically significant. However, after the merger, American Home Product's
stockholders received positive and significant abnormal retums. Clearly, the merger
benefited them as it did American Cyanamid's stockholders. American Cyanamid's
stockholders received significant abnormal retums. After the merger, American
Cyanamid's resuhs are positive and significant. The resuhs mdicate definite merger gams
to American Cyanamid's stockholders.
Target stockholders are expected to benefit from the merger. This is tme for
Squibb and American Cyanamid. The loss by Medco's stockholders is unusual. Bidder
stockholders should gain, but because firms may overpay for a firm or overestimate
synergies, bidders may receive zero to negative abnormal retums. American Home
Products stockholders gamed while Merck's stockholders lost and Bristol-Myers's
stockholders maintained performance.
7.1.3 Summary of Effects on Bondholders
When investors price a bond, they infer quality of a bond from its ratmg. If a bond
is downgraded while the investor is holding the bond, the investors receive a loss because
the bond can only be resold at a discount. A bond rating upgrade represents a gain by the
bondholders who now are holding bonds that wiU seU at a premium to the prior market
price.
Bristol-Myers' bonds were ranked as AAA before and after the merger, indicating
no loss in quality to the bondholders. Squibb's bonds were upgraded to match Bristol-
119
Myers' high rating after the merger. The bondholders received a gain in quality. Like
Bristol-Myers' bonds, Merck's bonds maintained their high rating of triple A after the
merger. Medco's bondholders gained in quality as their bonds were upgraded to Merck's
rating.
Bondholders of American Home Products and American Cyanamid received a loss
in quality after the merger. American Home Products' bonds were downgraded from a
triple A rating to a single A rating. American Cyanamid's bonds were dovmgraded within
the single A tier. The ratings feU because of the large amount of additional debt American
Home Products undertook to complete the merger. Eli Lilly also added a substantial
amount of debt for its acquisition of PCS. Its bonds were downgraded twice by Moody's;
first from a triple A rating to a double A rating and then to the lowest tier of the double A
rating. S&P lowered Lilly from a triple A to a double A rating. Clearly, the bondholders
of these three firms suffered a loss in quality from the ratings declines.
7.1.4 Potential Wealth Distributions
In the Merck and Medco merger, stockholders received a loss. However,
bondholders involved in this merger were either unaffected or received a gain in quality.
The opposite was tme in the American Home Products and American Cyanamid merger
where the bondholders loss quality on both firms but the stockholders gained. These
results suggest that wealth may have been transferred from Merck and Medco
stockholders to Medco bondholders and from American Home Products and American
Cyanamid bondholders to stockholders of both firms. In the Bristol-Myers Squibb
120
merger, target stockholders and bondholders gained whUe Bristol-Myers shareholders and
bondholders were fairly unaffected mdicating an increase in weahh from the merger.
7.1.5 Consumer Considerations
Consumers are another stakeholder m the performance of the pharmaceutical
firms. They are concemed with the number and quaUty of new dmgs innovated along with
the accessibiUty of the dmgs. Pharmacy benefit managers developed in order to control
the accessibUity of dmgs by bargaining the price with manufacturers who want to ensure
mclusion of theh dmgs m the formulary. The two horizontal mergers (Bristol-Myers
Squibb and American Home Produas-American Cyanamid) discussed m this study were
partiaUy motivated to mcrease the abUity to conduct research and development. Merck
and LUly decided to merge to increase theu* marketmg abUity through the pharmacy benefit
managers. It was hoped that the increased marketing abiUty might free resources that
could be used for research and development (R&D).
The Food and Dmg Administration (FDA) considers the new molecular entities to
be the tme mnovations m the mdustry. Within the category of a new entity, the FDA
ranks the dmgs based on their potential therapeutic benefit. Because new dmgs take
about twelve years to reach the market, this study can only examine those products that
were in the pipeline of the firms before the mergers. However, the number and ranking of
new dmgs can provide insights into the R&D process of the firms.
Before the merger, both Bristol-Myers and Squibb were innovating new dmgs. In
the three years foUowmg the merger, nine new molecular entities were patented. This
121
indicates that the combmed resources of the uvo firms were able to finish the R&D
process for several dmgs. In the last few years, few dmgs ha\e been innovated and those
that have been patented represent Uttle therapeutic gain.
In the first half of the 1990s, Merck did not have as many new entities as in years
past. However, m 1995 and 1996, Merck patented four new dmgs of which three were of
priority ranking. Merck's R&D process does not appear to have been distracted by the
merger.
Since the American Home Products and American Cyanamid merger, only two
new molecular entities have been patented by the firm. Both were touted as potential
blockbusters but were removed from the market because of safety concems. Prior to the
merger, American Cyanamid had been receiving a patent in almost every year, which is
one reason it was an attractive acquisition for .American Home Products. However, the
dmgs innovated by both these firms have never received a ranking indicating significant or
moderate therapeutic value. The combination of cash flow from the OTC lines with
biotechnology research have yet to provide gains for consumers.
Before EU LUly's merger, it produced dmgs of Uttle therapeutic value. After only
one patent m the first five years of the decade, LUly produced four new molecular enthies
in the last three years of which half received a priority ranking. LUly apparently stUl had
resources avaUable after its merger to market these new products.
Consumers gained new dmgs from aU the merged firms. Merck's new dmgs are of
therapeutic significance and in contrast to American Home Products' new iimovations,
which were removed from the market. In the years just foUowing the Bristol-Myers
122
Squibb merger, the new innovations were of great therapeutic value but ui the later years,
the quantity and quality of dmgs decUned. While LUly assumed a large amount of debt for
its merger with PCS, cash was stiU avaUable to finish the R&D process and market its new
dmgs. These findings along with the insignificant coefficient on the new molecular entity
variable in the regression unply that while new dmgs are unportant, they may only have a
temperate affect on operating performance. On the Ust of the top 200 dmgs dispensed in
1997, Merck had eight dmgs mnovated as new molecular entities during the tune covered
in this study mcluded on the Ust. American Home Products, Bristol-Myers Squibb and EU
LiUy each had three dmgs mcluded. However, the dmg ranking highest for each company
was not a new molecular entity innovated in the 1980s or 1990s. American Home
Products' best seUer was Premarin, innovated in 1964. LiUy's top dmg was a generic.
Both Bristol-Myers Squibb's and Merck's top dmg were not considered new molecular
entities by the FDA. Of the eleven new molecular entities on the Ust that received
rankings by the FDA, three received a ranking indicating a therapeutic gam.
7.1.6 Operating Performance Results
Regression analysis is used on aggregated firm data from the tune period 1984
through 1997 to measure operating performance m the pharmaceutical industry. Retum
on assets (ROA) is the measure of performance analyzed. It represents how effectively
the firm is usuig its assets to produce net uicome. Because mergers represent the
combination of two firms and thek assets, changes in the return on assets mdicate the
123
success of the integration. Factors influencing ROA also provide insights into the reasons
for a merger.
The results indicate that long-term debt has a negative impact on ROA. This
implies that the additional debt undertaken by American Home Products and EU Lilly in
their mergers decreased the return on assets. This result is consistent with the
downgrading of the bonds issued by these fkms. Cash flows have a positive impact on
ROA. The cash flow allows a bidder firm to acquire another firm. If the cash is held by
the target firm, it makes h an attractive choice as was the case in the Merck and Medco
merger.
Sales have a positive impact on ROA. Sales increased dramatically after the
Bristol-Myers Squibb merger as the combined assets were used for marketing their
products. The increase in sales is consistent with the reasons to merge. The market retum
on the stock is positively related to ROA. This indicates that investors recognize good
operating performance and bid up the price of the stock.
The variable indicating whether the firm was a bidder or target was positive and
significant. Bidder firms have higher retum on assets, indicating that they are better able
to efficiently combine assets for net income than the target firms are. This provides a
rationale for undertaking the mergers. The results also indicate that ROA fell after the
merger. This indicates that the synergies gained were less than expected or that the
integration process does hamper performance initially after the merger.
Whether the firm partook in a horizontal or vertical merger was not a significant
factor affecting ROA. Also insignificant was the number of new molecular entities which
124
suggests that the new molecular entities, while valuable as therapeutic advances, do not
affect net income substantiaUy.
7.1.7 OveraU Assessment
An evaluation of the success of the mergers is dependent upon the viewpoint of the
concemed parties. Each merger provided gams to some stakeholder. American Home
Products and American Cyanamid stockholders gamed, but the bondholders lost in quaUty.
Consumers had potential gains from new innovations before the dmgs' removal from the
market. The retum on assets (ROA) for the American Home Products and American
Cyanamid merged firm was higher than any of American Cyanamid's prior ROAs but less
than half of American Home Products' pre-merger ROA. This indicates that while
American Home Products was able to more efficiently utilize the assets than American
Cyanamid, the integration process did drag down the ROA.
Bristol-Myers' stockholders and bondholders were fairly unaffected by the merger,
whereas Squibb stockholders and bondholders gained. New dmgs were innovated for
consumers. The ROA of the combmed firm m the year after the merger was lower than
pre-merger ROAs for both firms. However, by the second year, the ROA exceed pre
merger figures and has remamed high. This merger appears to be the best aU-around of
the four mergers for none of the stakeholders exammed received a definite loss.
Merck's and Medco's stockholders lost whUe Medco's bondholders gamed.
Consumers gained new innovations after the Merck-Medco merger. The ROA of the
combined firm exceeded Medco's ROAs. The ROA for Merck feU after the merger and
125
stayed below pre-merger level for five years, indicating a decrease in operating efficiency
and integration problems.
LUly's bondholders lost, but consumers gamed new mnovations. The ROA for
LiUy had fallen by more than 50% m the two years prior to the merger. After the merger,
the ROA increased but it hasn't been steady indicating difficulty in successfiiUy completing
the integration process.
7.2 Future Extensions of this Study
Some of the stockholders and bondholders gamed while others lost. A potential
fiiture extension of this study would be to attempt to quantify weahh transfers between
bondholders and stockholders. This would require accurate price data on bonds which is
unavaUable at this time.
A second future extension of this study would be to revisit the quantity and quality
of new dmg innovations topic at a later date when new dmgs would have had time to
complete the R&D process and examine if new dmgs were innovated as a result of the
mergers. In the case of American Home Products, one could examine if they innovated
new dmgs based on biotechnology research started at American Cyanamid.
A third potential extension of this study would be to expand it to include the
foreign firms who merged together or with American firms. Before this could be
accompUshed, accountmg differences must be addressed along v^th the correct exchange
rate to be used to convert the data into doUars.
126
ENDNOTES
A notable exception is Premarin, an estrogen replacement dmg, for which the Food and Dmg Administration has aUowed no generic equivalent to enter the U.S. market.
For example, annual dmg therapy for an outpatient with schizophrenia costs $4,500, whereas treatment within a hospital costs $73,000 a year. Over 150,000 patients a year are treated outside of mental institutions (PhRMA, 1997).
For example. South Dakota government programs reimburse based on the equation: AWP - 10% + dispensing fee ($4.75).
"^Consider Biaxin whose price is sixty tablets for $195.59 or $3.26 a piece. The usual prescription is for 20 tablets to be taken twice a day. The average wholesale price is $65.20, which is then reduced by 10%) and a dispensing fee of $4.75 is added. The pharmacy wiU be reimbursed $63.43 for the prescription. The State of Texas reimbursement equation is [(quantity * unit price + $5.27)/ 0.98]. The State Department of Health determines the unit price as an average acquisition price from wholesalers.
127
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