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2. Much of our discussion is based on analysis of the acquisition presented by Thomas Lys and
Linda Vincent in “An Analysis of the Value Destruction in AT&T™s Acquisition of NCR,” Journal
of Financial Economics 39, No. 2“3 (Oct./Nov. 1995): 353“379.
3. Of course, another possibility is for the profitable firm to acquire the unprofitable one. How-
ever, in the U.S., the IRS will disallow the use of tax loss carryforwards by an acquirer if it appears
that an acquisition was tax-motivated.
4. See Steven Kaplan, “Management Buyouts: Evidence on Taxes as a Source of Value,” Jour-
nal of Finance 44 (1989): 611“632.
5. Krishna Palepu, “Predicting takeover targets: A methodological and empirical analysis,”
Journal of Accounting and Economics 8, No. 1 (March 1986): 3“36.
Mergers and Acquisitions

15-21 Part 3 Business Analysis and Valuation Applications

6. Chapter 2 discusses the pros and cons of corporate diversification, and evidence on its im-
plications for firm performance.
7. See Paul Healy, Krishna Palepu, and Richard Ruback, “Which Mergers Are Profitable”
Strategic or Financial?,” Sloan Management Review 38, No. 4 (Summer 1997): 45“58.
8. See Stewart Myers and Nicholas Majluf, “Corporate Financing and Investment Decisions
When Firms Have Information That Investors Do Not,” Journal of Financial Economics (June
1984): 187“221.
9. For evidence see Nicholas Travlos, “Corporate takeover bids, methods of payments, and
bidding firms™ stock returns,” Journal of Finance 42 (1987): 943“963.
10. In 1999 the Financial Accounting Standards Board voted to eliminate the use of the pooling
of interests method.
11. However, pooling-of-interests may make it more difficult to assess whether an acquisition
is generating positive value for the acquiring firm™s stockholders, since the acquired assets are not
reflected at market values. Managers that make acquisitions that are likely to be unprofitable may
therefore prefer to use the pooling method.
The Upjohn Company: The Upjohn - Pharmacia Merger

macia & Upjohn will be a powerful new competitor in the
global pharmaceutical industry. For both Pharmacia and Upjohn, this merger is
a bold strategic move to build a highly competitive company as the worldwide
pharmaceutical industry continues to consolidate. The new company will be posi-
tioned to attain its goals of revenue growth above the industry average and oper-
ating margins exceeding 25% by 1998.
Business Analysis and Valuation
Jan Ekberg, President and CEO of Pharmacia
Proposed Chairman of Pharmacia & Upjohn
This is a merger that truly constitutes far more than the sum of the parts. The
new company will be able to take full advantage of uniquely complementary geo-
graphic reach, product portfolio, pipeline and R&D strengths. As a result of the
merger, Pharmacia & Upjohn will have extensive financial and operating re-
15 sources, market scope and earnings potential. Consequently, we fully expect the
new company to achieve additional growth in expected 1996 EPS as well as ac-
Mergers and Acquisitions

The Up- celeration of future earnings growth. Above all, Pharmacia & Upjohn is expected
hohn Com- to generate significantly enhanced value for shareholders.
pany John L. Zabriskie, Ph.D., Chairman and CEO of Upjohn
Proposed President and CEO of Pharmacia & Upjohn
On August 20, 1995, The Upjohn Company and Pharmacia AB, two pharmaceutical
companies incorporated in the U.S. and Sweden, respectively, announced that they were
forming a “merger of equals.” With combined sales of nearly $7 billion, the new com-
pany would be the ninth largest pharmaceutical company in the world. Management and
major shareholders alike seemed excited by the deal. William U. Parfet, great-grandson
of founder W. E. Upjohn and a company director, stated, “We recognize we™re being dis-
tanced from our heritage, and that tugs at you, but this is absolutely the right thing for
Upjohn to do in today™s environment, and John Zabriskie is really the key.”1

The Upjohn Company, founded in 1886, developed, manufactured, and sold prescription
and nonprescription pharmaceuticals (68 percent of sales), animal health products (10

Research Associate James Weber prepared this case under the supervision of Professors Amy Patricia Hutton and
Krishna Palepu as the basis for class discussion rather than to illustrate either effective or ineffective handling of an
administrative situation. Copyright © 1996 by the President and Fellows of Harvard College. Harvard Business
School case 9-197-034.
1. Keith Naughton and Heidi Dawley, “Upjohn Finally Makes It to The Big Leagues,” Business Week, September 4, 1995.

Mergers and Acquisitions

15-23 Part 3 Business Analysis and Valuation Applications

percent), and bulk pharmaceutical chemicals and other products (22 percent). Upjohn
maintained headquarters in Kalamazoo, Michigan, and owned research, manufacturing,
and distribution facilities throughout the world. In 1994 Upjohn had sales of $3.3 billion
of which 59 percent were U.S. sales, 20 percent European, 13 percent Japanese and Pa-
ci¬c Rim, and 8 percent in other countries. Sales were down 2 percent from the previous
year while net income, at $491 million, was up 25 percent. Upjohn employed 16,900
The proposed merger with Pharmacia was an attempt by Upjohn to address a number
The Uphohn Company

of the strategic problems it faced. While some of these problems affected the industry as
a whole, others were speci¬c to Upjohn. For the industry, the increasing strength of cost-
conscious buyers such as hospital networks, Health Maintenance Organizations
(HMOs), and insurers, was putting downward pressure on pharmaceutical companies™
margins. In an effort to maintain margins, drug companies were consolidating in order
to reduce costs and obtain economies of scale. For Upjohn, a number of its patents had
expired on key products resulting in stiff competition from lower priced generic drugs.
Upjohn had fewer products than it would have liked in its product development pipeline
with which to replace these older drugs. Further, Upjohn was weak in foreign sales, a
market segment that made up approximately two-thirds of the world market for pharma-
ceutical products. Finally, Upjohn™s stock price had been stagnant over the six months
preceding the merger announcement and the company was rumored to be a potential
takeover target.

The worldwide prescription drug market was estimated at $252 billion in 1994 and was
expected to grow by 6 percent in 1995. North America was the largest segment ($79 bil-
lion), followed by Europe ($77 billion) and Japan ($49 billion). Even with the ongoing
consolidation among pharmaceutical ¬rms, the industry was still highly fragmented
with many competitors. Glaxo Wellcome, the largest ¬rm in the industry in mid-1995,
had pharmaceutical sales of just under $12 billion, while the top ten ¬rms in pharmaceu-
tical sales had a 28 percent market share and the top 50 ¬rms had just over 60 percent.3
Further, in an industry where companies needed large markets to cover high develop-
ment costs, the sales of many companies were concentrated in one or two markets.
Prior to the late 1980s, drug companies had greater power in relation to drug buyers.
Drug company salespeople contacted doctors directly and sold them on the superior ben-
e¬ts of their company™s products. Doctors were largely free to prescribe medications of
their choosing and they frequently chose the branded products that were developed by
the major pharmaceutical companies and with which they were most familiar. Payers”

2. The Upjohn Company 1994 Annual Report.
3. Medical & Healthcare Marketplace Guide, 11th Edition, p. 55.
620 Mergers and Acquisitions

Mergers and Acquisitions

mostly insurance companies, employers, and governments”had little choice other than
to pay for what doctors prescribed. In this market, drug companies continuously raised
prices on their products and most companies were able to increase earnings over 10 per-
cent yearly. Some observers felt that this high historical pro¬tability in the industry had
led to signi¬cant excess capacity in production and bloated administration staf¬ng.
Since the late 1980s, signi¬cant change had been occurring in the pharmaceutical in-
dustry. Most of this change was a direct result of pressures from buyers to reduce the
costs of health care. The high prices charged by the pharmaceutical companies for pre-

The Uphohn Company
scription drugs made them an obvious target. Buyers of pharmaceutical products were
consolidating into increasingly larger entities and gaining power relative to suppliers.
Drug purchasing decisions were increasingly being made by plan administrators and
pharmaceutical bene¬t management (PBM) ¬rms, with a strong eye on cost, rather than
by individual doctors.
PBM companies served as intermediaries between pharmaceutical companies and
large drug purchasers such as HMOs, hospital networks, and insurance companies. Both
PBMs and individual plan administrators were able to negotiate lower prices through
bulk purchases. These bulk purchases were made possible by the large numbers of pa-
tients they were buying for, and by the ability to limit the number of different drugs pur-
chased by requiring doctors to prescribe only drugs that appeared on approved lists
called formularies. The large drug buyers also sought to limit the number of suppliers
they purchased from by purchasing from large suppliers that could provide many differ-
ent drug products.

Generic Drugs and Patents
The new pharmaceutical environment opened the door for producers of generic drugs.
Under the old system, doctors and patients tended to select well-known branded drugs
even when generic drugs were available. By the mid-1990s, drug buyers were requiring
the use of lower cost drugs wherever possible and doctors were required to justify their
use of higher cost drugs whenever lower cost alternatives were available. Further, doc-
tors working for HMOs and other medical plans often had ¬nancial incentives to pre-
scribe generic products.
The development and use of generic drugs became possible once patent protection
had expired on the branded product that had opened the market. While some branded
products seemed to have unreasonably high prices, the pharmaceutical companies that
developed the branded products argued that the high cost of R&D and the long regulatory
approval process justi¬ed such prices. Bringing a new drug to the market could take ¬f-
teen years and cost between $350 million and $600 million.4 Generic producers did not
have these costs, nor did they have the advertising expenditures associated with branded

4. Eric Reguly, Drug Firms Take the Merger Treatment to Stay Healthy, Times Newspapers Limited, August 22, 1995.
Mergers and Acquisitions

15-25 Part 3 Business Analysis and Valuation Applications

drugs; thus, generic drugs typically were priced at one-half the price of their branded
equivalents. In 1995 generic drug makers had a 40 percent U.S. market share, up from
23 percent in 1980. By the late 1990s, it was estimated that generics would control two-
thirds of the market.5 In an effort to limit lost sales, some branded drug producers, in-
cluding Upjohn, had begun selling generic drugs that copied their own branded products.
Drugs coming off patent were a signi¬cant issue in the pharmaceutical industry. Be-
tween 1996 and 2000, drugs generating $15 billion in sales would lose patent protection
and become open for generic competition.6 The concern for the branded producers was
The Uphohn Company

that there were few blockbuster drugs, those with expected sales of over $500 million,
in the development pipeline to replace the lost sales due to generics. A key reason for
this was that the chronic diseases that had yet to be solved, and that affected large num-
bers of people, were only poorly understood. Thus, breakthrough drugs for chronic dis-
eases were not expected until perhaps early in the next century. There were few diseases
such as diabetes where an individual could be successfully treated by pharmaceuticals
for a lifetime. The dif¬culty in developing new drugs had led to industry R&D expendi-
tures of nearly 19 percent of sales in 1994, up from less than 16 percent in 1990.7

The Industry™s Response to the New Environment
In the face of the economic changes occurring in the industry, pharmaceutical companies
began making signi¬cant changes in their operations, strategies, and organizations. The
¬rst step that many companies took was to rationalize their operations in search of ef¬-
ciency gains. Downsizing, restructuring, and the closing of plants had been the order of
the day. Further, companies were selling off their nonpharmaceutical businesses to focus
on their core activities. The use of a “disease management” approach to health care was
growing. Disease management involved focusing on all facets of an illness from preven-
tion to diagnostics and treatment in an effort to offer a complete care package that was
of higher quality and lower cost than a piecemeal approach. For drug companies, this
often meant joint ventures with medical device companies and even medical care
The most dramatic change in the industry, however, was the ongoing consolidation.
Nearly $70 billion in mergers and acquisitions occurred in the two years prior to the Up-
john-Pharmacia announcement. Further, while the top ten companies had less than a 30
percent market share in 1995, they were expected to have a near 50 percent market share
by the turn of the century. Between 1993 and 1994, the consolidation trend, along with
company downsizing efforts, had led to the elimination of over 60,000 jobs in the indus-
try worldwide.8

5. Health Care Products & Services, Standard & Poor™s Industry Surveys, 1995, p. 26.
6. Ibid.
7. Marketplace Guide , 11th Edition, p. 66.

8. Health Care Products 1995 , p. 4.
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