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Darwin's Medicine blog

Professor Brian D Smith is an authority on the pharmaceutical industry and works at SDA Bocconi University and Hertfordshire Business School.

J&J's portent of purity

The future of corporate structures is emerging before our eyes

Activist investors are currently agitating for a restructure or even a break-up of Johnson and Johnson, the world's largest healthcare products company. This adds to a pattern of shareholder pressure that we see across the sector. Both Amgen and GSK have faced the same challenges. And we see similar patterns in diverse, non-healthcare companies too. Look at Xerox's recent announcement of a split, for example. To an evolutionary scientist like me, such patterns indicate an emerging property of the business environment that will inexorably reshape the industry. As usual in this column, allow me to talk about the science a little before returning to the practical implications.

On the surface, activist investors press for a break-up when they perceive negative synergy. That is, the whole creating less value than the sum of its parts. In the media, investors are critical of senior management and often claim that the group is too large or too diverse to manage effectively. But drill down and interview the investors, as I have, and a more fundamental reason appears. The attentions of activist investors are not well correlated with company size. Their focus is better, but still imperfectly, correlated to the diversity of firm. This tells us that something other than the size or spread of business activity is concerning them. Ask directly and investment bankers and analysts talk about the heterogeneity of the business model and the transparency, or lack of it, of the risk-adjusted rate of return.

We face a future of purer, more differentiated pharma firms

What investors mean by this is that it is not necessarily the product or market diversity that bothers them; it is that a large business like J&J contains multiple business models that span a large range of different risk levels and offer correspondingly different returns. They are, in effect, old fashioned conglomerates even if they are focused around healthcare. Investors don't like firms that bundle together different levels of risk-adjusted rates of return. They like to be able to clearly see the risk and return of each business and make their portfolio management decisions accordingly. In the eyes of activists, conglomerate CEOs are doing the investors' job for them. And less well than the investors could for themselves. So the calls of investment managers to split J&J into devices, consumer and pharma is a demand to make the key investment factors more visible. Other companies, such as Abbott and Baxter, have of course already yielded to such pressure.

But follow that logic beyond J&J's break-up. Even within those three divisions, J&J's famously autonomous business units include models that are relatively high risk/high return and relatively low risk/low return. The same is true of most other large life science companies, whose portfolios range from relatively low tech, low risk to more innovative, riskier businesses. Splitting into innovative and mature, as Abbott did, will make each unit more homogenous but still leaves a lot of intra-business risk heterogeneity. In evolutionary terms, investor pressure for transparency is a selection pressure favouring business models that are homogeneously high or low risk and disfavouring those that are portfolios of very different risk/return levels.

Back to the practical implications. This selection pressure for investor transparency points towards business models that are small and address only a single product and market. But that pressure is balanced by a selection pressure for economies of scale and scope. Together, these selection pressures favour business models that combine a number of product/market strategies that, although they may vary in technology or disease area, share very similar levels of risk and return. In other words, J&J's travails portend the evolution of business models that are, in investors' eyes, pure play. Shire/Baxalta may be an early example of this because most rare disease models have similar risk/return profiles. But pure play business models needn't mean all rare disease or all one therapy area. It simply means a business model in which every part of the business has a similar level of risk and return. This makes the investors' view easier and reduces their uncertainties. By contrast, a conglomerate model will always give a blurred view, which investors will punish with a reduced valuation - the so-called conglomerate discount.

So evolution points to a future of life science companies that may or not be smaller - that's not what break-ups are telling us. Rather, life science companies are likely to be ever more homogenous within their organisation and, as a corollary, ever more different from other organisations. We face a future of purer, more differentiated firms. Whether J&J and other heterogeneous firms will move in that direction voluntarily or will be dragged, kicking and screaming, by activist investors, is another question entirely.

4th March 2016

From: Sales



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