Bigger Size, Lower Returns

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In a world where you can buy a 30-pound jar of mayonnaise, it seems that bigger is almost always better. But when it comes to acquisitions in the health-care space, history says otherwise.

Sure, companies say they'll experience huge synergy savings to justify their large acquisitions, but the numbers say otherwise. Just look at the dramatic cuts in return on equity (ROE) that these companies have experienced after making major acquisitions.

Company	Target	Three Years Before Acquisition	Two Years Before Acquisition	Year Before Acquisition	Year After Acquisition	Second Year After Acquisition	Third Year After Acquisition
Pfizer (NYSE: PFE)	Pharmacia	41.9%	42.3%	41.9%	3.2%	13.6%	16.5%
Boston Scientific (NYSE: BSX)	Guidant	20.0%	32.2%	13.3%	(37.5%)	(1.9%)	(16.5%)
Mylan (Nasdaq: MYL)	Merck KGaA's generic-drug business	11.6%	29.0%	20.7%	(5.90%)	N/A	N/A

Source: Capital IQ, a division of Standard & Poor's. N/A = not applicable.

Now, you'd expect ROE to drop the first year after an acquisition as a bunch of one-time charges work their way through the income statement. What's disconcerting, though, is that two and three years after the acquisitions, it hadn't come back up for Pfizer and Boston Scientific.

One big problem, as I see it, is that research and development isn't very scalable. A company that increases its revenue by 50% reasonably needs to push out roughly 50% more drugs, either in sales of existing drugs or in introducing new ones, to increase earnings by the same amount. Unfortunately, researchers at the larger, post-merger company have less incentive to develop new drugs because their discoveries have less impact on the company's success.

For a generic-drug company like Mylan, this R&D issue is not as big, and it shows. As Mylan approaches its second year after swallowing an acquisition twice its size, the company's return on equity is approaching its pre-acquisition levels at 13.6% over the past four quarters.

Another problem is asset turnover, or how efficiently the company's assets are being used to generate sales. For instance, in the year before Pfizer bought Pharmacia, asset turnover was 0.7. So for every dollar in assets, it was able to generate roughly $0.70 in sales. Nearly two years after acquiring Pharmacia, it was only 0.4. That's a big drag on ROE.

This time it's different. Right?
Both Pfizer and Merck (NYSE: MRK) think their stories will be different when they acquire Wyeth and Schering-Plough (NYSE: SGP), respectively. Both have put their management teams in place well ahead of the closing of the deals, to try to hit the ground running.

And they might. Pfizer certainly has a lot of experience in what not to do with large acquisitions. In addition to Pharmacia, it also struggled with the integration of Warner-Lambert. Merck, meanwhile, has familiarity with Schering-Plough through its joint venture to sell the cholesterol drugs Vytorin and Zetia -- a move that itself should help smooth the transition a little.

Still, even under the best circumstances, these aren't going to be easy tuck-in acquisitions.

A better way
It's a little late for Pfizer and Merck, but I think a series of smaller acquisitions could have given the companies more bang for their buck. Both Abbott Labs (NYSE: ABT) and Johnson & Johnson (NYSE: JNJ) have specialized in smaller tuck-in and bolt-on acquisitions, and that's reflected in their stellar ROE consistency.

Company	2004	2005	2006	2007	2008
Johnson & Johnson	27.9%	28.5%	28.3%	25.6%	30.2%
Abbott	23.2%	23.5%	12.1%	22.7%	26.9%

Source: Capital IQ, a division of Standard & Poor's.

The only two blemishes -- J&J in 2007 and Abbott in 2006 -- were due to the companies' decisions to slip out of their usual M.O. and instead make larger acquisitions: Pfizer's consumer health-care division and the vascular division of Guidant, respectively.

Big picture
As when you push your cart back down the aisle to get something you forgot at Costco, the pertinent advice here is to proceed with caution.

Yes, Pfizer and Merck are trading well off their lifetime highs, and if everything goes smoothly, they're probably undervalued at these levels. But history is definitely not on investors' side, and I'm hesitant to put on my bull horns quite yet.

If you do own shares, or if you'll inherit them shortly once the acquisitions close, the good news is that you're getting paid a decent dividend to wait it out. Just don't expect that the dividend yield will provide much downward resistance. Remember that Pfizer had a yield of 7.3% before it announced the acquisition and halved its dividend.