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Zeneca’s Growth Prescription

The search for shareholder value is pushing some drug makers to consolidate to create mega-ceutical giants, But others believe value will come from a focus on core capabilities. Either way, relying on blockbuster drugs is no longer enough. Zeneca CEO Sir David Barnes diagnoses the challenges ahead.

Giants such as AT&T and GM do it; consumer product and services firms like Pepsico and Marriott do it. Even conglomerates such as ITT and Hanson Industries do it-albeit under shareholder pressure. Divestitures and demergers have become almost commonplace as a device to unlock shareholder value. In their book, Breakup! How Companies Use Spin-offs to Gain Focus and Grow Strong, Ashridge Strategic Management authors Andrew Campbell and David Sadtler estimate that up to $1 trillion worth of shareholder value is locked up, waiting to be released by the breakup of multi-business organizations in the U.S. and the U.K.

Notwithstanding the Novartis merger and the aborted SmithKline-Glaxo deal, even the pharmaceutical industry is not immune. The experience of Zeneca plc, once the pharmaceutical and bioscience arm of Britain‘s Imperial Chemical Industries (ICI), underscores why the spin-off bug is catching. Since its demerger from ICI in June 1993, Zeneca’s market value of 117 billion (about $27 billion) is almost four times that of ICI. Zeneca CEO Sir David Barnes, 61, argues that the spin-off had been in the planning stages for more than a year before Hanson bought a 2.8 percent stake in the company in ’91, threatening a takeover. On the other hand, Ashridge’s Campbell argues that “ICI had for years insisted there were major technology synergies that justified its keeping its chemical and pharmaceutical operations under common ownership. Hanson had forced the issue. The combined value of ICI and Zeneca was considerably greater than before; ICI went from underperforming the stock market to outperforming. And Zeneca has consistently beaten the market since being freed to go its own way.”

A leading maker of cardiovascular and anti-cancer treatments such as Casodex and Zoladex for prostate cancer and Nolvadex for breast cancer, the $8.7 billion drug and agrochemicals firm has enjoyed better than 15 percent average annual operating profit growth since its “de-merger.” Nonetheless, the recent fall-off in its share price has led observers wonder whether Zeneca’s rise has come to a halt. Speculation that it would be wooed by Switzerland‘s Roche and Sweden‘s Astra prompted brief bid speculation, but Barnes insists that talk of its cupboard of new drugs running bare is misplaced. Dr. Richard Auty, its R&D director of pharmaceuticals, told analysts there are 87 development projects currently underway, including 26 new compounds. The company is working across five broad therapeutic areas including cancer, cardiovascular, central nervous system, respiratory, and metabolism, with a pipe-line of compounds in each. With the U.K. yielding only 45 percent of the company’s pre-tax profit, and North America just more than a third, Barnes says there is sufficient head room for growth in its selected markets without a merger at this time.

Barnes joined ICI’s sales department after serving with the Royal Artillery in the Malayan emergency and, in 1971, became the company’s youngest director at 34. He was made chairman of the paints division in 1983, where he initiated a series of international expansions culminating in the purchase of Glidden Paint. Three years later, he joined the ICI board and was responsible for pharmaceuticals, agrochemicals and seeds, and explosives. Recently, he talked with CE about the challenges facing Zeneca, including the integration of the single market and the impact of the euro.

A DELICATE PROCEDURE

Since the “de-mergering,” your market cap is greater than ICI’s and the merger share price is much higher-not what analysts had anticipated. What happened?

They are different businesses. The Zeneca businesses are R&D intensive; the ICI businesses are capital intensive. The Zeneca businesses are selling to very large numbers of small customers and in small packets; the ICI businesses are, in the main, selling to a small number of industrial customers and in huge quantities. Zeneca businesses are horizontally integrated; that is to say, the output of one is not the input of another. But they are horizontally integrated in terms of sharing technology platforms. The ICI businesses are more vertically integrated. Zeneca products are unique, dioxide is titanium dioxide, chlorine is chlorine, PVC is PVC. So when we looked across the spectrum of ICI, there was a natural fracture plane.

And that had been there for awhile, true?

Yes, it had. The argument that they were better as part of the larger family was probably true up until 1980. If you go back, the pharmaceutical and agrochemical businesses were probably not large enough to be capable of being spun off much before the beginning of the ’80s. They had grown from infancy into adolescence, but they had not reached mature adult status. In September 1990, we waited for the buyers to come back after the summer holidays, and they didn’t. None of us knew at that time how deep and how long that cycle would be in the trough, but we knew the cycle had turned. And [Sir] Denys [Henderson] had a number of working parties looking at the structure of the company.

The first things that became immediately clear was that we were too widely spread and we didn’t have the cash flow to support all those businesses. The normal temptation would be to take 10 percent off every business and have 14 malnourished children. We were looking for a way to say, “No, we don’t want 14 malnourished children. There are four or five orphans here that might be sold, but that will leave us with 10 well-nourished children.” But as the thinking developed and we became more aware of the fracture plane, we moved-not in a sudden, blinding flash of light, but in an iterative and a reiterative process-towards separation.

What was preying on your mind in those early days when you felt you really had to make this work?

The biggest concern was to establish a different culture in Zeneca. I did not want Zeneca to be ICI by another name. I wanted to keep the good things from the ICI heritage, but I also wanted to inject new things. The biggest and the most important task I had-although I didn’t fully realize it at the time-was to state what sort of company I wanted Zeneca to be and what sort of values we would adopt. I hate the word “mission statement”-I did a “What is our group purpose?”-but a mission statement’s crude purpose is to provide a sense of direction; the values provide the corporate blue and the motivating actions that follow. And that was the single largest challenge: to give the company a character.

How did you do that?

I sat down in a hotel room somewhere in Europe and wrote it out. The question coming to me was, “How would you like Zeneca to be seen five years down the track?” It’s easy enough to describe what we do, but I wanted to flesh that out.

So I answered the question from the point of view of five separate constituencies. I wanted to be seen by customers as the company they turn to first because of our knowledge of their needs and the quality of our service and products. I wanted to be seen by competitors as an alert, alive company they respected-admired would be too strong a word-because we were innovative, had high quality people, and so on. I wanted us to be well-benchmarked, an upper-quartile performer. I wanted us to be positively welcomed into the communities in which we operated because of the safe and responsible way we operated our plants and the quality of the employment we brought.

By employees, I wanted to be seen as a company in which they felt empowered, stretched, and supported. People perform best when they’re stretched, but they also need to be supported. It’s important that they go together, because if you don’t provide the support, either by way of coaching, training, or facilities, they will become stressed. I also wanted to be viewed as a company in which they felt well rewarded, and where, if in a pub someone asked them, “Who do you work for?” and they said “Zeneca,” they were likely to elicit a response such as, “Hmm, that must be a pretty exciting, good place to work.”

And finally, shareholders. That shocked some of the Puritans. Why finally shareholders? Not because we ignore shareholder value; indeed we’re very conscious of it. But if we could do the other things, then we would have a quality company in which shareholders would be pleased to invest, and in which they would wish to remain invested, because they were going to get an excellent return. I get a bit fed up at times about these philosophical debates-which stakeholder comes first, the customer or the supplier, the community or the employee? I’d rather look at it this way, and they all intermesh.

What did you do to ensure that these things happened the way you had written them down in the hotel room?

Try to get that ethos-my interpretation of it-right down the line. Huge task. I did write to every employee with those sort of corporate purpose, values, description of the company-type status. Those were fleshed out in more detail in each country and each business. And I’m still singing that song, because it takes one hell of a lot of effort to get it all the way.

PROGNOSIS: POSITIVE

Your market cap is at an all-time high, so some are saying the rise and rise of Zeneca has perhaps reached its peak.

We’ve just written the prologue actually. Inevitably, there will come a bump somewhere, and I agree that the true test of an organization is how it faces up to adversity. But neither has it been all plain sailing. We’ve had to work damned hard to make corrections along the way so that we’ve had success.

But it’s just the beginning. First, the field of biological science, along with everybody else, has been turned upside down as a result of modern biotechnology, genomics, etc. Just as people talked about the wave of marvelous drugs in the early ’50s following the end of World War II and the rise of synthetic chemistry, I think we’re about to see a similar avalanche of new technologies and products.

Second, we’ve set ourselves a number of aspirational targets. The key one I want to focus on at the moment is 15 percent per annum on average earnings per share growth, and we’ve done that since we were de-merged. As we get bigger it gets harder to keep that up, but I am confident that as far as one can reasonably see into the near future, that is a credible target.

In order to become the best, people need to have credible milestones along the way. We’re not going to stand up and say, “I am going to be the No. 1 pharmaceutical company in the world inside 12 years.”

People would roll about in laughter. But let’s set a target that leverages us up the lead table, which keeps us an upper-quartile performer, and try and go for this 15 percent per annum on average.

Does your being in the top quartile necessitate combining with something else in order to achieve all this?

Not so far. I don’t think you can leverage size in the pharmaceutical sector the way you can in certain other sectors-say, telecoms or airframe manufacture-because it’s not a common market. We’re selling to urologists, oncologists, anesthetists, psychologists, cardiologists, general practitioners, etc. It is no good going to a cardiologist and saying, “You have to buy my ho-hum cardiology product because I’m No. 1 in over-the-counter laxatives.”

Do you think those who are pursuing combinations are chasing the wrong fox?

No. They’re doing it for different reasons. If you’ve run out of top-line sales growth and you merge or acquire somebody, you can take out cost. If you take out cost, you can get earnings per share growing again for two or three years, and it may be a way of life until the next bunch of new products comes through and you get top-line sales growth. I talk about alpha, beta, and gamma growth. Alpha growth in my language is 15 percent per annum earnings per share growth that comes from launching new products. Those products have, say, an effective patent life of 10 years, and therefore that growth is likely to endure for a decade. Gamma growth comes from banging two companies together and stripping out the cost. You’ll get 15 percent earnings per share growth for two years, maybe three, but then you’ve mined it dry. Unless you fix the problem that faced you in the first instance-why you didn’t have top-line sales growth-you’re back facing the same problem.

Do you think the euro can work?

If you’re going to have a single currency, then you actually need a single fiscal authority. There can be regional variations in the way individual U.S. states have some taxing powers, but basically it’s a single federal tax system that applies across countries. Whether I like it or not in that sense, I think fiscal sovereignty has passed in Europe once you go to a single currency, because I don’t think you can be running the economies at different levels with different fiscal measures with one currency.

Up until now, exchange rate movement has been something of a shock absorber, allowing economies to adjust to different potholes. But you’re not going to have a shock absorber in the future currency, so how are you going to adjust? That mechanism’s gone. The whole basis of the euro is that you are ineluctably tied to a rate of X-the entry rate-and that’s it.

How will European union affect Zeneca?

In a number of ways. Because we have operating units of substantial size in all the major European union countries, Zeneca will be participating in EMU. The U.K., it’s clear, will be outside.

We’re still very far from a common market, and particularly in some of the sectors Zeneca’s in, such as pharmaceuticals. It isn’t even a free market-horror, horror for Americans. In every country there’s a different form of price control. It isn’t a common market yet, although there is movement towards it, in terms of regulatory clearances. So I would rather see an emphasis on getting towards a more common market than on monetary union.

Furthermore, if you are approximating national legislation, it is very difficult to level down to an average; some countries come up in terms of regulatory rigor while others come down. The only mechanism I see is that everybody moves up to the most picky level. If I don’t translate that into environmental concerns-and there are some very extreme aspects of environmental legislation in Europe-then that will be bad for Europe. If you move to the most adverse end of the spectrum, that’s going to be terrible for Europe as a whole.

But I would much rather have a gradually unifying market of $350 million than 15 or 20 disparate markets. So I would have to be positive, and the U.K. is part of Europe. I don’t think the U.K. can set itself up as some sort of special isolationist unit which has a special transatlantic relationship and is semi-European. I don’t think that will work. I want to preserve the transatlantic relationship whilst being, as far as possible, a full European.

About JP Donlon

JP Donlon is the Editor-in-Chief of Chief Executive magazine.