Big Pharma Diversification: A Winning Model or Recipe for Disaster?

Pharmaceutical companies have traditionally relied on multiple streams of revenue to help offset the risk inherent in drug development. Merck, for instance, boasts billion-dollar consumer-care and animal-health divisions. Eli Lilly also complements its drug business with an animal health unit that brings in more than $2 billion annually.

While revenues from these segments hardly compare with overall drug sales, Merck and Lilly are two examples of pharmaceutical companies that have decided to stick with the industry's traditional business model. Abbott Laboratories and Pfizer (PFE 2.98%), on the other hand, have taken drastically different approaches. Abbott decided to spin off its branded drug business into AbbVie (ABBV 1.56%) last year, and AbbVie's focus on drug development makes it more similar to a big biotech than a classic pharma company. Pfizer, a stalwart of the industry, is also starting to resemble a big biotech; after spinning off its animal-health unit into Zoetis and selling its nutrition division, a consumer-health unit is the last remaining adjunct to its pharmaceutical business.

As investors watch the major players in this space take divergent paths, the question on everyone's mind is whether big pharma diversification is strategically sound, or if diversification in this industry is actually diworsification. Furthermore, are companies like Merck and Eli Lilly -- which have relatively small animal-health units -- diversified enough? In the following video, Bernard Munos, the founder of the InnoThink Center for Research in Biomedical Innovation, takes an in-depth look at this topic with Motley Fool analyst Max Macaluso. A transcript follows the video.

Max Macaluso: Let's talk a little bit about companies that have already shrunk, and whether or not it's a good idea. Look at Abbott, for instance -- at the beginning of 2013, spun off its pharmaceutical unit into AbbVie, which has been performing well, but they have Humira, which will go off patent in the next few years. We have to see whether or not there will be a biosimilar competitor for that. That's one example.

You have Pfizer, spun off its animal-health unit into Zoetis, sold its nutrition unit, and recently reorganized its business into three distinct parts. Some speculation over it perhaps breaking up further; we'll see if that actually happens or not, but is it good for big pharma companies to become pure-play drugmakers, and "un-diversify?"

Bernard Munos: The research tells clearly that it is not a good idea. It is not a good idea because, at the moment, we do not have good tools to mitigate risk in drug R&D, which is a problem at the macroeconomic level, because capital does not flow to this industry as it should. Too many investors have been burned too badly and are now investing elsewhere or sitting on the fence, so we need to somehow get better at that.

Until we really understood the dynamics of the blockbuster model, or the black-swan model, that we have in the industry, it was really very difficult to imagine better tools to mitigate risk. Now it is becoming possible, and there are some research projects under way that hopefully will offer some interesting ideas in the near future.

But until that time happens, we've got to live with the situation where risk in the pharmaceutical industry cannot really be mitigated adequately. You can do portfolio management. Every company has done portfolio management. It has failed miserably across the board. That was supposed to protect everybody against patent cliffs, and everybody has fallen down patent cliffs, so clearly portfolio management has not worked.

We understand why, now. It's because it assumes things that are grossly violated in the pharmaceutical industry. I don't want to get into a statistical discussion here -- that will be in the paper -- but there are some very good reasons why it hasn't worked. Now, why the industry continues to stick with portfolio management is a bit of a puzzle to me. It clearly doesn't work. In some companies you have this kind of surreal situation, where the scientists are being let go, but the portfolio managers keep doing their thing when it clearly is creating no value at all. It's clear we've got a management problem there.

But you look at [Johnson & Johnson]. You look at Roche. You look at companies that have been diversified -- look at Bayer, for that matter -- and they've been able to hold their ground much better when divisions experience some difficulty, because the other divisions could tide them over.

You have the old business school argument, which really does not apply in this particular case, which is that you should not diversify your company because investors can do it in the marketplace cheaper, more effectively, than you can do it by buying and selling assets. This is a specious argument because, in the pharmaceutical industry, the probability of ruin is not trivial -- which is not the case if you're running a food company, or a clothes company ... although we could talk about that.

But in a pharmaceutical business, because it is driven by blockbusters, if you hit a dry spell, you'll go bust. Typically, that's the way it happens. As long as the model works -- as long as you come up with innovation, as long as you somehow create that culture where the scientists bring you the goods -- you'll do very well. But historically, if you hit a dry spot, you die. You disappear.

The list of companies that were significant in the 1950s, and that made major contributions to innovation over the last six decades, that have disappeared because they hit a dry spot, is a very long one. So, the business school argument that you can diversify in the marketplace is true for investors, but it's irrelevant for the people who work in the company, because if you hit a dry spell you're gone -- unless you're diversified. Unless you're J&J. Unless you're Bayer. Unless you're one of those companies.

Now, what amount of diversification can you achieve if you've got a $60 billion pharma business, or $50 billion pharma business and a $5 billion animal-health business? Yeah, that is debatable. Clearly, not much. In the case of Bayer, it's much more balanced. In the case of J&J it's also more balanced. But clearly, the short of that is that we don't really understand risk, or the nature of risk, in the pharmaceutical industry.

Let's face it. Unless you can describe your risk statistically, you don't really understand what risk you face. Look for a paper that describes risk in drug R&D in statistical terms; that paper has not been written yet.

Macaluso: I have a funny suspicion you're currently writing it.

Munos: We're working on it, and it's fascinating because the managerial implications are very counterintuitive. For example, the fact that risk is directly correlated to the size of your portfolio. Typically, if you do portfolio management, the underlying assumption is that by diversifying, by extending the size of your portfolio, you will diversify away a significant proportion of your risk.

Well, that assumption, in a blockbuster industry, is erroneous. If you increase the size of your portfolio, you will increase the size of the risk that you carry. Far from mitigating the risk, you're taking on more of it, so what do you do? Under the current situation, the best thing you can do is diversify in non-pharmaceutical areas.

Certainly by the end of the decade, we should have an understanding of risk in drug R&D that, I hope, will permit the creation of effective instruments to mitigate risks to a far greater degree than it has been possible to do in the past.