The portfolio challenge – to focus or diversify?

June 2017 | EXPERT BRIEFING | SECTOR ANALYSIS

financierworldwide.com

The question of portfolio focus is one that any executive team in the pharmaceutical industry faces on a regular basis. Is the focus appropriate to ensure critical mass of skills and capabilities? Or are the risks too correlated and would spreading bets more broadly be beneficial? During challenging times when sales or profits decline, ‘increasing focus and competitive position’ becomes a popular phrase for cost cutting.

Which strategy is preferred depends on the time horizon and utility function of owners or investors. Public pharma or biotech investors, for whom any time horizon longer than six months is long-term, believe that diversification is not the job of management but of shareholders and thus prefer focused companies with clearly defined risk-return profiles. On the other end of the spectrum are those families that still own or control a good proportion of European pharma companies and who take the long-term view. For them, corporate portfolio diversity is a way to spread risk so they can hand over the company to the next generation.

Nevertheless, as so often in the field of management practices, the preferred approach is also subject to significant pendulum effects and the currently accepted wisdom seems to change every few decades. On the stock market, the uniquely focused pharmaceutical company has been the success model of the last 20 to 30 years. Most companies have spun off or divested ‘non-core’ businesses, such as generics, consumer health, animal health, medical devices and diagnostics. A prime example for this strategy is German chemicals-pharma conglomerate Hoechst, one of the top global players in the 1980s before deciding to reinvent itself, move out of the cyclical and lower margin chemicals business, and transform itself into a life science company with a clear focus on pharma. It may just be a simple twist of fate that it lost its identity over the course of several mergers and has now been fully absorbed into Sanofi. The other leading German chemicals-pharma conglomerate, Bayer, had similar ambitions when it sold or spun off its chemicals activities, acquired Schering AG and most recently Monsanto. After almost two decades of portfolio transformation, it has now re-emerged as a pure life science company (thereby reviving a theme that fell out of grace with most investors around 2000). For most US-based big pharma firms, such as Pfizer, Merck & Co or BMS, the stories were similar, only these companies are typically very focused on the most profitable segment of all: patent-protected prescription drugs.

A short history of corporate portfolio strategies

Where does the belief of most investors that focused firms deliver better performance stem from? Though, interestingly, in academic circles there is still large controversy on the topic, to really answer this question, let us take a quick look at the last 50 years of corporate portfolio strategies. Across industries, the big strategic topic of the era, from the 1950s to the 1970s, was how to best diversify, given that capital and opportunities were abundant. The first business guru in history, Peter Drucker, taught that general managers possessed leadership skills that were generically applicable across industries. In parallel, the fast rising management consulting industry provided the tools that allowed corporations to compare the prospects of their different businesses in comparably simple and intuitive ways. Portfolio matrices always compared an internal perspective (market share or competitive position) to an external perspective (growth or market attractiveness). Harry Markowitz and his modern portfolio theory further strengthened the idea of a balanced portfolio in which risk and return were balanced across a number of businesses (with ideally uncorrelated risks). During that period, pharma companies were part of diversified parents that often had their roots in chemicals.

During the 1980s, corporate raiders exploited weaknesses in the capital structures and performances of conglomerates, by taking them over, restructuring and selling off individual businesses often for a huge profit. Novel forms of financing such as junk bonds further accelerated that development. The result was that management teams realised that just looking at growth and market share was not sufficient to steer performance, and value management became a popular concept. The basic idea behind this was that management should act like owners or shareholders and maximise not only revenues or profit but value of the corporation. Alfred Rappaport coined the term shareholder value in 1986. Over the next decade, management within the pharmaceutical industry started building discounted free cash flow models of their businesses to see whether they created a growing excess return over the cost of capital employed. An additional consequence of this development was the rising use of stock or options as a form of compensation, especially in the US.

However, even the best value management concepts can be problematic if they do not capture the significant risk of a pharmaceutical business. For example, many smaller (biotech) companies will have positive projections of their risk adjusted discounted cash flows, but as they have only one or two projects, the outcomes are rather more binary than a probability-weighted average of all outcomes in a decision tree.

During the 1990s another movement became popular which led to an even greater focus of many companies. The concept of ‘core competencies’, popularised by management gurus such as C.K.Prahalad and Gary Hamel, was viewed as a key source of competitive advantage and corporate health.

The pendulum of business focus v. diversity swung back a little bit after the financial crisis of 2008, when some companies started viewing diversification (again) as the best way to protect again sudden external shocks (for example, Glaxo Smith Kline announced at the time that diversification was a key pillar of the strategy to reduce volatility within the pharmaceuticals area). However, as with many other consequences of the first financial crisis, they have largely disappeared by now.

Focus leads to greater R&D productivity

Within the core pharmaceuticals business, executives ask similar questions around focus v. diversity at the level of therapy areas and technologies.

In our annual survey of corporate and R&D performance of the largest 30 public pharma companies, the best performers are focused on a few therapy areas. Gilead started out with an exclusive focus on virology (HIV and HepC) and has since then diversified into oncology. Biogen has recently increased its focus on neurology by spinning off its haemophilia business Bioverativ. Novo Nordisk is uniquely focused on diabetes, as is Celgene on oncology (recently inflammation was added as a second pillar). Although top performer Regeneron covers many different therapy areas, the company is clearly focused around its industry-leading monoclonal antibody and genetics platforms.

R&D is the key value driver of the pharmaceutical industry, and R&D organisations in particular benefit greatly from a high degree of focus as it enables companies to build deep capabilities in disease biology, which is essential when selecting the right drug targets to work on. It also allows for the building of a great network of external collaborators as part of an open innovation model.

The two problems of highly focused pharma companies

Two main problems exist for highly focused (bio)pharma companies – firstly, they can be forced to diversify due to performance issues in core markets. After all, pharma is a risky area with very high failure rates in clinical development, and patent expirations force companies to renew their portfolios every 10 to 15 years. We typically only hear of those that have survived and thrived through extended periods, and those that have failed or were acquired along the way go unnoticed. The second problem is when highly focused companies become a victim of their own success and go through periods of hyper-growth – in these cases there are sometimes not enough high quality growth opportunities in existing focus markets, or those markets may simply become less attractive. As a result, M&A, often in the form of biotech acquisitions or even mega deals with other pharma companies, leads to diversification into uncharted territory. Acquiring risky biotech companies requires excellent skills and capabilities to select the best opportunities and conduct high quality due diligence. The consequence is often a disappointing performance post-acquisition that leads to an even greater need for further inorganic growth, essentially a ‘vicious circle’. Fortunately, some of the current crop of biopharma outperformers have learned their lesson and have carefully diversified into adjacent areas, often following a long build-up of relevant capabilities (for example, Gilead moving from HIV to HepC, or Celgene moving from haematological malignancies to solid tumours; both companies have done this through acquisitions). There are exceptions, such as Johnson & Johnson (JNJ), a company that seems to have found the magic formula for successful diversification.

JNJ – ‘parenting advantage’ at its best

JNJ is clearly a success model for companies that wish to diversify, as the company has annually grown its top- and bottom-line for more than 100 years. JNJ has found the right balance between decentralised and centralised decision-making and operating model. For example, JNJ has historically used acquisitions very strategically and has been careful to keep those elements intact that made the acquired companies attractive takeover targets in the first place.

Closely linked is the concept of ‘parenting advantage’ or being the best owner for a particular business. This implies that the corporate structure must provide clear benefits to all its constituents so that the sum of the whole becomes much larger than the sum of the parts. These benefits include synergies, high quality management oversight, economies of scale and scope and access to capital and people. However, another element may be even more crucial, as the key success driver for JNJ: its strong culture as the ‘glue’ that holds all the decentralised elements in together, exemplified by its credo and leadership principles.

Markus Thunecke is a senior partner at Catenion. He can be contacted on +49 163 850 9154 or by email: markus.thunecke@catenion.com.

Markus Thunecke

Catenion