UK: FORTRESS ZENECA. - The fortunes of Zeneca since its demerger from ICI have been attracting interest not only as a test of fashionable theories about focus on core businesses but also from industry rivals on the prowl for vulnerable prey. Matthew Lynn

by Matthew Lynn.
Last Updated: 31 Aug 2010

The fortunes of Zeneca since its demerger from ICI have been attracting interest not only as a test of fashionable theories about focus on core businesses but also from industry rivals on the prowl for vulnerable prey. Matthew Lynn the rapidly consolidating drugs industry.

David Barnes, the chief executive of Zeneca, could have been forgiven for expecting an easy, even pleasurable, day. A Thursday morning in early March and the company was set to announce its annual results. The numbers themselves looked good: pre-tax the company had made £878 million in the past 12 months, double the figure of three years ago. Earnings were well ahead, and the pipeline of new products due for launch in the next few years meant that the prospect of continuing strong growth was easy to demonstrate; easier, anyway, than for most of its rivals in either the UK or the rest of the world. For Barnes the day should have been a breeze.

Events intervened, however. That same morning two of Zeneca's giant Swiss rivals, Sandoz and Ciba-Geigy, announced plans to combine. With a total market value of more than £40 billion, the new company, Novartis, was the result of the largest merger ever in corporate history. Its arrival on the scene marked a new and dramatic twist to the rapid consolidation of the drugs industry that has been gathering pace for the past two years. On the stock market, Zeneca's shares leapt, not so much in response to the results the company released that morning, but in reaction to the more immediately exciting prospect of it being the next player in the consolidation, most probably as prey not predator. Then as analysts gathered to question the Zeneca management about the results, the ceiling promptly fell in on top of Barnes and his team. Though they tried to make a joke of it - 'The results were so good, they bought the roof down,' quipped John Mayo, the amiable finance director - the analysts could not help but see it as a portent. 'It was very funny,' said one later, 'as though the gods had spoken.'

Takeover rumours are something that Barnes and his team have had to learn to live with. For more than a year, Zeneca has been a staple feature of the market report pages. Sometimes the gossip is that Roche of Switzerland is about to pounce, often tomorrow if you listen to some of the more enthusiastic pundits; on other occasions it is Glaxo or Merck or SmithKline Beecham which is rumoured to be getting ready to strike; sometimes it is just a whisper about massive sterling borrowings in Basle. Whatever the rumour of the day, Zeneca is punted around as though it had put itself in play. 'It is very irritating,' reflects Barnes. 'It is obviously unsettling for the staff, particularly when you get totally silly comments in some of the papers.

But life is life, and it is a challenge for us to manage that situation.'

Speculation about a bid, though a racy story, in many ways masks a more interesting tale. For Zeneca in the past three years has been one of the great experiments in industrial engineering, a laboratory in which the fashionable management theories about focus and concentration on core businesses are being tested.

Zeneca's divorce from ICI was, after all, one of the first really significant demergers, and one of the first to test whether splitting companies in half creates two stronger businesses or simply two smaller companies.

Zeneca was demerged from ICI in the summer of 1993, three years ago.

It was not an entirely voluntary move. More than a year earlier, ICI, always regarded as one of the bastions of British industry, had been stalked by Hanson. Their lordships, Hanson and White, had taken a 4% stake in the corporation and made little secret of their desire to take over and split apart a company which then spanned everything from heavy chemicals to high-technology pharmaceuticals. Hanson was seen off, partly by some nimble public relations from which Hanson has never fully recovered. But its move forced a strategic rethink, and Mayo, then a corporate financier at SG Warburg, sold the board the idea of a demerger as the best long-term defence of the independence of both the chemicals and the drugs businesses, a strategy of getting your retaliation in first. ICI, under the then chairman Sir Denys Henderson, bought into the idea, and hired Mayo to help implement it, which is how he ended up as finance director at Zeneca.

Barnes, an ICI loyalist who joined the company in 1959 and has spent his whole career climbing its carefully sculpted hierarchies, strongly believes that the demerger was a powerfully liberating force. Everything in the old ICI that was loosely related to biosciences (primarily pharmaceuticals, agrochemicals, seeds, and some speciality chemicals) was put into Zeneca, and hived off, a logistical nightmare since it involved splitting up 520 companies in more than 180 different territories. 'The most important aspect of the demerger was that it prompted a change of culture,' says Barnes. 'My theory is that it is very helpful if there is an event which would measure an eight on the Richter scale. It is very hard to change culture when you are just moseying along.'

Implicit in the need to change culture is a criticism of the old ways at ICI, and it is a criticism from which few of Zeneca's leading executives, most of them old ICI hands, shirk. Peter Doyle, the research director at Zeneca, who did the same job at ICI before the demerger, believes that the old structure lacked the ability to concentrate on businesses simply because it was involved in so many areas. 'It was a source of frustration at ICI that sometimes we did not really focus on issues because we had so many different things to grapple with,' he says. 'We did not spend enough of our time wrestling with strategy.'

The logic, so far as it went, of combining a chemicals company and a pharmaceuticals company under the same roof had been that the two businesses would cross-fertilise; both, after all, were involved in the same fundamental business of manipulating and manufacturing chemical compounds. 'But the synergies just did not exist,' says Mayo. 'So it was just a waste of time.' In truth the old chemicals/pharmaceuticals combine was largely a historical accident. Chemicals companies such as ICI, Ciba in Switzerland or Bayer or Hoechst in Germany hit upon medicinal compounds as part of their chemical research, and immediately started selling them. Their drugs companies were in fact nothing other than wildly successful accidents.

The logic of the combination was always a post-hoc rationalisation of an accident.

Looking back, Barnes believes that one of the key decisions of the demerger was opting for an entirely new name, calling the new business Zeneca rather than ICI Biosciences or something similar (as Courtaulds did when it divorced Courtauld Textiles). 'It was a hell of a shock to throw away such a well-known brand name,' he says. It was also a shock essentially to give up being a part of what was still one of the best known industrial organisations in the world. Yet it was a shock worth creating. It was a way of drilling into staff that this was a new company, with a new set of values, a new organisational structure, and a desire to prove itself. It is unquantifiable but Barnes is convinced the change unleashed a sense of renewal into the company that could not have been created if managers had stuck with the ICI name. 'The impact on staff was only dimly perceived at the time,' he says. 'But it has been tremendously helpful. It has certainly helped to give us a much sharper performance edge.'

At the same time as changing the name, managers took the opportunity to revamp the structure of the company, throwing out the layers of bureaucracy that had built up at ICI. The old organisation had operated on a matrix structure, with chains of command for territories, for products and for functions, but 'it was all swept out with the demerger', says Mayo. 'The organisation was hollowed out.' What remains, he claims, is leaner and much quicker to respond to the market. The management structure is now organised around countries, and whoever manages the leading business in each territory, usually the pharmaceuticals division, also takes responsibility for running the company there, reporting back regularly to head office on its performance.

The logic of demerging drugs and chemicals companies is now widely accepted throughout the industry. Since Zeneca spun away from ICI, Ciba has sold off its chemicals arms, Sandoz will do the same after the Novartis merger is completed, and Dow Chemical has sold its Marion Merrell arm to Hoechst, which in turn has announced plans to demerge its drugs unit from its main chemicals business. The trend for demergers has sent ripples throughout industry. 'Even Hanson is demerging,' says Mayo with something of a smirk, referring to the high priest of conglomeration whose unwelcome attentions provided the catalyst for the ICI demerger.

But it has not been a process entirely without sadness or loss. 'It is like resigning from a club,' says Barnes. The two companies now have very little contact with one another, and so inevitably do their people. Whether the relationships that had been built up between employees over professional lifetimes had any hard commercial value is debatable - the leading executives at Zeneca say they suspect not - but their loss is still a source of regret.

There may be other more serious consequences, however. One result of the demerger is that the two companies are now much smaller than they would otherwise have been; Zeneca currently has a market capitalisation of £12.8 billion and ICI of £6.8 billion, implying that the combined business might now be valued at more than £19 billion. (This compares with a value of a mere £9.9 billion for the old ICI just before the demerger. Zeneca accounts for the bulk of that increase in value. Its share price has risen from just over 600p at the time of the demerger to above 1300p now, although ICI's has also gone up from around 600p to above 900p.)

In itself, the fact that Zeneca is smaller than it might have been is of little importance. But when it comes to doing deals, size may prove to be a crucial factor. It is no secret, for example, that after Glaxo launched its hostile bid for Wellcome in early 1995, Barnes and his team tried to launch a counter-bid to rescue Wellcome. The attempt failed, largely because Glaxo had struck such a tight deal with the Wellcome Trust (which owned close on 40% of Wellcome's shares) that Zeneca could not move without prompting a higher (than £9.4 billion), and unmatchable, bid from its larger rival. At the time, there was widespread scepticism as to whether Zeneca could afford to pay the £10 billion-plus it would have needed for Wellcome, and certainty that it did not have the financial muscle to get involved in a bidding war with the heavy artillery of Glaxo (which was valued at just under £25 billion at the time of the bid). If it had still been a part of a much larger ICI, Zeneca might have found itself better able to finance a deal on that scale.

Moreover if ICI had not been chivvied by the predatory attentions of Hanson, it might have chosen to complete an acquisition before it demerged. That was the route taken by Hoechst, and it may well be the logic behind the recent acquisitions by BASF and Rhone-Poulenc. Just as significantly, a combined ICI/ Zeneca would have been much less vulnerable to a takeover itself.

Barnes and his team refuse to indulge in such regrets. The company did, he admits, spend a long time studying whether it should make a pharmaceuticals acquisition before the demerger from ICI. It did not do so for two reasons. The first was that it would have had to issue shares to finance a deal - shares with the low rating that is usually attached to cyclical chemicals companies rather than the high multiples that recession-proof drugs companies are awarded. The second was that it never found the right deal. 'Acquisitions have to be industrially driven,' says Barnes.

'You cannot just rush out and do a deal because that is what you happen to want to do at that moment. It is putting the cart before the horse.'

All of which may be true, but does nothing to diminish Zeneca's vulnerability.

'The big companies are trying to solve their own problems,' says Robin Gilbert, pharmaceuticals analyst at stockbrokers Panmure Gordon. 'Zeneca is a very good company, and many of them might see it as their solution.

If they are to survive they are going to have to keep performing.'

Barnes believes that the best defence lies in the company's research and development. 'Historically, if you look at the companies that have reached the top of the pile they have done so through very good R&D. Size does not allow you to escape that reality,' he says. There is plenty of evidence to back up his view. The most successful companies in the world drugs industry right now are businesses such as Astra of Sweden or the American biotechnology outfit Amgen which have grown from very little as a result of inventing novel new medicines.

Driven by such logic, Zeneca's pharmaceuticals business has a clutch of new products scheduled to be launched over the next few years - as many, if not more, than companies twice its size. Doyle argues that the research effort, which consumes more than £500 million a year, has benefited from the increased focus since the demerger. R&D is directed towards original research in the key therapeutic areas where Zeneca is strong, and is based primarily on the idea that it is breakthroughs which drive the big profits.

Unlike many of its rivals Zeneca has traditionally been slower to forge alliances and deals with the emerging biotechnology companies, preferring to keep the bulk of its research in-house.

It is not just Zeneca's drugs arm which is research-driven. Agrochemicals also require heavy scientific support. This division's largest product is the herbicide Gramoxone (also known by its generic name Paraquat), with annual sales of over £200 million, and the portfolio also includes insecticides such as Karate and fungicides such as Impact. Over £100 million a year is spent on researching new agrochemicals, and the company is working to improve the lead time - sometimes as long as a decade - in bringing a new agrochemical to the market. Research is also key to the speciality chemicals division, which includes products such as the meat substitute Quorn, and the biodegradable plastic substitute Biopol. Neither of those products has yet produced the profits that were once hoped for, although Quorn may improve its performance once it is licensed for sale in the US.

Determined to maintain Zeneca's independence, Barnes does not rule out making an acquisition himself. With no debts and a market value of over £12 billion, Zeneca may not make it into the top 10 in the pharmaceuticals industry, but it is still a sizeable company, and one that could certainly finance a deal. So far, despite the flirtation with Wellcome, it has kept its powder dry. If the right deal came along, there is little doubt that it would strike. But the target would have to be a company with good growth prospects - there would be little point, Barnes believes, in buying a company just to wind it down, since any increase in Zeneca profits would be a one-off.

Its successful investment in R&D means the company does not have to worry about its own growth rate too much. It is judged to have one of the better pipelines of new products in the world industry, and probably the best among the major UK drugs companies. In its most important therapeutic area, cancer treatment, it is planning to launch Casodex, a new drug for prostate cancer.

In asthma, one of the fastest growing pharmaceutical markets because of the growing prevalence of the condition in the western world, it has the upcoming launch of Accolate, a new type of treatment for which there are high hopes. And in the treatment of schizophrenia, Zeneca has a new drug called Seroquel set to be filed for regulatory approval later this year. It also has a new migraine drug, developed by Wellcome, acquired when anti-trust regulations forced a sale after the Glaxo takeover.

Since none of the patents on its existing drugs are set to expire before the end of the decade, most analysts believe that Zeneca's portfolio should be strong enough to keep its profits growing strongly until the end of the century. Forecasts suggest profits of £1.1 billion by 1999, an impressive rate of increase for a large company. If the new line of agrochemical products coming through lives up to expectations, and if the seeds business, which has recently been put into a joint venture, manages to make the sort of return from bio-engineering crops that managers hope for, then those profits forecasts may well be beaten.

In a recent development the company has also started dabbling in the general healthcare market, hoping, as Barnes puts it, to tap into the 90% of healthcare expenditure that does not go on drugs. In a move towards vertical integration, Zeneca last year paid around £130 million for a 50% share of Salick Health Care, an American chain of cancer clinics and hospitals. It is so far only a toe in the water, but Mayo confidently predicts that within a few years clinics and hospitals could be as big a business for Zeneca as its pharmaceutical arm. It is certainly a move which the rest of the industry is watching with keen interest: a number of drugs companies have acquired distributors but Zeneca was the first of the majors to move into providing healthcare directly.

It remains to be seen, however, whether the company will have the chance to see the experiment through. The market remains convinced that a bid for Zeneca is just a question of when, not if, and it is certainly true that one slip will trigger a bid. If a bid does come, though, it is unlikely Barnes and his team will give up without a fight. And such a bid will be a fascinating test of the stance of British shareholders: will they support a growing company with good technology and good management or simply sell out in the face of instant cash? More than just the fate of Zeneca may depend on the answer to that question.

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