WHEN BIG PHARMA CHASES MEGA PHARMA.

Glaxo Wellcome and SmithKline Beecham, Pfizer and Warner Lambert--the pharmaceuticals have clearly caught the mega-merger fever. When the dust settles, newly formed AstraZeneca will place third among the powerhouses. Will big be big enough in an industry ruled by giants? AstraZeneca CEO Tom McKillop says size isn't everthing.

IN THE PHARMACEUTICAL INDUSTRY today, size matters. It matters a lot. Even by the standards of a sector that has gone through several cycles of consolidation, recent mergers have come at an unprecedented rate. The ever increasing cost of research and development and of launching new drugs, is so onerous, runs the argument, that you have to be huge to stay competitive--and how better and faster to grow than by marriage?

Atop the biggest pharma company of all--just about--sits Tom McKillop, 57-year-old chief executive of AstraZeneca, formed last year from the merger of Sweden's Astra and Britain's Zeneca. The size/scale argument is preoccupying McKillop, a burly Scotsman with a science PhD and a love of sport and carpentry, more than most in the industry A former academic, McKillop will hold his No. 1 slot for just a brief few months before the merger of GlaxoWellcome and SmithKline Beecham is completed and the takeover of Warner Lambert by Pfizer goes through, creating two further contenders for the crown of biggest mega pharma of them all.

What's more, say industry experts, further consolidation is inevitable. "It's still highly fragmented compared to other sectors," says Dr. Andrew Baum, pharmaceutical analyst with Morgan Stanley Dean Witter. "The largest players are not that big. GlaxoSmithKline will still be very short of 10 percent market share."

Yet despite the industry's unseemly haste to merge, the size argument is not entirely straightforward. For a start, just about all the mergers of recent decades have resulted in companies with lower market shares than the combined total of their constituent firms. As for innovation, there's no evidence that just throwing money at R&D results in more or better discoveries--in fact, a good deal of cutting edge research is being conducted by small bio-tech start-ups, with whom the industry giants, AstraZeneca included, are falling over themselves to collaborate.

So will this round of mergers be any more successful than the last? AstraZeneca's marriage already is, according to McKillop. Not only was the merger itself achieved in record time last year, but, he observes, the company's first post-merger results, announced in February showed an increase in market share. Pre-tax profits, meanwhile, (excluding discontinued operations and the exceptional costs of the merger) rose from $3.13 billion in 1998 to $3.56 billion. The markets were less impressed, however. AstraZeneca shares fell 10 percent in London, principally, says Morgan Stanley's Baum, because of lower than expected cost savings from the merger. While McKillop had predicted 70 percent cost savings going through to the bottom line, only 50 percent were achieved, said Baum.

Shares were already trading low, he added, due to market pessimism about the imminent expiry of key patents for the anti-ulcer drug Losec. The

Losec issue continues to hang heavily over AstraZeneca's short-term future. Marketed as Prilosec in the U.S., the drug accounts for $6 billion in sales, nearly 40 percent of the group's total. AstraZeneca has a two-pronged strategy to soften the blow--defending secondary patents for the formulation of Losec, while simultaneously bringing replacement products onto the market. Its biggest hope in that respect is the gastrointestinal drug Nexium, due to be launched later this year, which it claims is more effective than Losec. If things go Astra's way with Losec and Nexium, the company should be able to hold the fort until its next round of drugs comes on stream in three or four years' time. Otherwise, concedes McKillop, "we would face a transition, which we would have to manage.

In the meantime, McKillop has a number of strategic priorities. Structurally AstraZeneca has almost completed the transition from a total "life science" company to one focused entirely on pharmaceuticals. It has sold off its specialty chemicals business and is preparing to merge its agri-chemical business with that of Novartis and then spin off the new entity as Syngenta, a freestanding company that would have almost 25 percent market share in the sector. Key aims for McKillop include keeping AstraZeneca in the top league in the U.S. market, and securing the flow of new products, which is "the true driver of a pharmaceutical company," he says, adding that the nature of R&D and the types of drugs it will soon be possible to produce really do favor larger companies more than ever before. Much of research now, for example, uses enormous databases and computing power--technology that only the largest companies can afford.

Resulting scientific breakthroughs will allow for a wider variety of treatments, tailored to more stratified groups of patients. "You're going to see asthma not as one disease. You're going to see 10 different regimes of treatment that will be tailored to individual groups," explains McKillop. "So there's a tremendous goal to see more products coming through that will be very defined, much more effective and deliver an economic benefit. That's the head room that the industry has to create to get the reward for the invest-

BIGGER EQUALS BEITER?

Glaxo Wellcome and SmithKline Beecham, Pfizer and Warner Lambert--the pharmaceutical industry is in a consolidation frenzy. How big is big enough?

Fascinating question and one that's occupying an awful lot of brain power at the moment. But we mustn't lose sight of the fundamentals--a flow of new products that bring value in the treatment of disease. We need to reinvent our companies every 10 years and, if you want to grow at the same time, you've got to be reinventing faster. You have to ask the question of size in relation to that.

It comes down to two really important components. One is, if you were much bigger would you be much more creative? Would you be faster in getting to the marketplace with product? History says no. But the character of science is changing. It's much more automated. The critical mass you need to support an R&D-driven pharmaceutical company has gone up significantly. So you get this trade-off Can you run a much bigger R&D operation and retain the creativity and speed? And if you can't, is the arithmetical benefit of skill going to be more than offset by the loss in operating efficiency? That's the debate on the R&D side.

We spend 17 percent of sales revenue on R&D. We're the second largest R&D spender in the industry, behind only Aventis at the moment. Ultimately the only measure of the productivity of that research is the value it creates in sales at the end. There are some simple rules--like what percent of your sales are from products that have been introduced within the last eight years--that we monitor very deftly. But I think the mind-set is more important. What are you seeking to do? I have set for the R&D organization the target of doubling the value of [intellectual property] every five years. That's a very challenging task.

When you get to the marketing side, though, it's evident that the big products, the big companies, are winning in the marketplace. The level of resources you've got to put in with a new product is now enormous. I estimate $1 billion to put a primary care product on the market. That's a very strong argument for size.

Will ever bigger mergers continue?

I'm not sure that the simple arguments about benefits of scale will merit it. There's a real danger that you get so focused on delivering synergy, cost cutting, that you'll lose sight of the fundamentals of a healthy company, which is organic growth, replacement, regeneration. We have to be careful we don't get into the merger and acquisition mania.

Aren't we there already? Or do the larger mergers trigger within you a reevaluation of where the arithmetic truly lies?

I'm always analyzing and I've said to my people, if we were twice the size we are today as AstraZeneca, how would we behave in the marketplace? What would we do differently that would give us a real enduring competitive advantage?

That's the positive way to generate the rationale for any further strategic moves. I don't think it's good enough just to be doing it for fear. "Others have done it, so we'd better do it." Our No. 1 priority has got to be to drive the organic growth.

What sort of organic growth are you hoping to achieve?

Well, I'm not going to give you an EPS forecast. As far as we are concerned, we face doubts about the intellectual property battle, but we think we have a very good case to defend our No. 1 product. We also have a new product to introduce in the GI area that we think is outstandingly better. So we believe we're going to face less of a problem in growing our gastrointestinal business than the external market. If that's the case, then we're going to have a lot of growth in the years ahead because we have all these new products to introduce. If, however, we lose the intellectual property battles, then we'll face a transition of two or three years, which we would have to manage.

So there's a range, a spectrum of forecasts out there by analysts. My job is to make sure we're right up at the top or better, of that spectrum. What are we setting ourselves? We will measure ourselves against the top dozen companies in the industry--the Pfizers, the Mercks, the Schering Ploughs, the J&J's, Glaxo, SmithKline.

AstraZeneca once championed--certainly as Zeneca--the concept of pharmaceutical, agricultural, and nutritional conglomerate, the total life science company. What changed?

We have to understand the history. [When] ICI split itself in two, we looked for the natural cleavage. And it fell clearly between the large continuous manufacturer of petrochemical, plastics, industrial chemicals, and the batch synthetic, biological area, which was hydrochemicals, specialty chemicals, pharmaceuticals.

But we very deliberately set up the businesses with a lot of autonomy, saying, if there are synergies, we'll get them by networking. As the last few years have gone past, it came down, really, to the biggest synergy being in the lab. We did not think that justified keeping the businesses together. We felt the right thing to do was to get these businesses into a configuration that would give them the scale to really be top tier competitors in their respective industries. For that reason we had no qualms about reconfiguring the old Zeneca into AstraZeneca and then to this structure [Syngenra] that we are aiming to create with Novartis.

So what can Syngenta do that couldn't have been done with the antecedent companies?

Well, if you look at the rate of spending on R&D in the agri-chemical world, it's been going up very significantly, into the double digit level. This is an industry that typically grows in line with GDP and it cannot really afford double digit R&D expenditure. By combining and making bigger units you can now afford in absolute terms to have all the technologies you need and still keep your R&D level of spending at an acceptable percentage of sales.

[Syngenta] will be the first true agri-chemical company. And it will be, unless something else happens, the leader.

On the subject of agri-chemicals, what is this reaction against genetically modified scientific foods all about? How should we in North America view what has happened, particularly to Monsanto? Who got what wrong?

A series of factors. One, through the BSE issue and one or two other food-related scares, the population in Europe was much more sensitized than in the U.S. Furthermore, Europe did not have a well-established food regulating agency, whereas you do in the U.S. with the FDA.

Now let me just stand back a little. Zeneca introduced the first genetically modified product in Europe. It was tomato paste--very clearly labeled, generically modified, sitting side-by-side on the shelf with the non-genetically modified products.

That was launched in pilot marketing studies very successfully. No problem. None.

I think what happened was, with the lack of any food regulating agency, product was then pushed into the chain, not labeled. People were very sensitive in Europe and reacted negatively. The press picked it up and had a wonderful time with this story-- Frankenstein foods, and all this emotive language.

The population said, well, there's not a lot wrong with our food at the moment, why do we need to rake any risk? Prove to us that it has zero risk. And, of course, scientifically you can never prove zero. So retailers said, why take the risk? People began to back off wanting this product. A product coming from the U.S., incidentally, into Europe was now no longer acceptable.

Some suspect that certain elements in the industry found this a convenient way to foster protectionism.

I don't believe that for a moment. I know that occupied the U.S. Government for a period, and trade negotiations and so on--the feeling that this was denying access for U.S. product and it was anti-U.S., but I don't think that was true at all.

So if Monsanto had been a European firm nothing would've been different?

If Monsanto had been a European firm, Monsanto would've been much more sensitive. And, frankly, there were people in the industry telling Monsanto not to do what it was doing. Bob Shapiro has stood up and publicly said that they badly misjudged this.

Don't you think that some companies saw an opportunity to take a public outrage and turn it to their advantage?

No. I don't know anybody who wanted that to happen. The opposite, in fact. In the discussions that have been going on between industry and governments in Europe in the last year or two, one of the most expressed concerns--and it's one I feel very deeply about--is that Europe is losing its competitiveness. The U.S. is much more responsive to innovation. It rewards innovation. You go to Asia and people just love new things. You go around Europe and there is this kind of abiding conservativism. "Convince me that it's all right." Over a period of time this resistance to innovation is going to be Europe's undoing.

Several British CEOs have said privately that they recognize that Britain's future is with Europe, but perhaps it might've been better to have joined NAFTA instead of the EU.

It's true that in some European countries the mind-set is not about rewarding entrepreneurship. There's a drift increasingly to the U.S. We are seeing Glaxo SmithKline move its operating headquarters to the U.S. for those kinds of reasons. You can pay competitively more easily without it becoming politicized. If you pay people large salaries and large bonuses it's a national newspaper issue in most European countries, whereas its standard day-to-day practice in America. There was some NAFTA vs. Europe debate, but it wasn't very active because the cold reality is we're sitting as part of Europe geographically.

Will the genomic revolution [using genes and proteins as the basis for drug research and creation] ultimately change the economics of the pharmaceutical industry, just as the Internet is changing distribution and economics in other industries?

There's a whole string of new science being translated into a new technology base for the industry. We're seeing new chemistry, new biology You've got the whole genomics, genetics area--massively important. You've got bio-infomatics and knowledge management systems. You've got all of those things, then you've got all the clinical science evolution that's taking place. And that's very important. Because the biggest part of our R&D expenditure is still in development. So when somebody picks out one thing and says it's all about that one thing, I think they're exaggerating. It's about the whole mix.

Where does your company stand with genetic research?

Oh, we have a huge program. We've got hundreds of collaborations. We're very active in the genomics, genetics area. We're active in all of those areas that I've been describing. But we haven't gone out and trumpeted it. You know, SmithKline took a leading position in the genomics area, but they didn't necessarily have a nicely balanced spectrum of all the other technologies. And I'm not sure their productivity is any higher than any other firm's. In fact, some people would argue other than that.

How do you compare your science and your lab vs. genetic start-ups, like Celera and Human Genome Sciences?

Across the board, we're up there with the best of them. Can you take a particular bit of genomics or genetics and say you are the best in the world, or has one of these start-ups got a technology you don't have? Sure. You will always find somebody who's got something you want. That's why you go into collaborations. It would be totally arrogant to believe you've got it all in house.

What about your Internet strategy? How will it change the way you do business?

It's going to have an enormous impact, huge impact. This is a very fast-moving area. And you're trading off having a coherent strategy, against encouraging an entrepreneurial [approach]--trying things and trying things.

Some parts of it will be impacted significantly by regulating attitudes. At the moment you cannot provide information on the Internet on your products to patients directly in Europe. You're seeing European governments now scrambling to set up some policy framework that they will use to regulate the Internet. You're seeing the FDA asking for--is it $6 million or $10 million more?--to set up a team to monitor activities on the Internet?

Do you see the Internet as a vehicle for revolutionizing the distribution system, or is it going to change something else that you haven't quite anticipated?

Look at it this way. What do we sell? We sell a tablet or lotion. But that's not really what we sell. What we sell is information on how to use certain products in the treatment of a particular disease.

Now, we have a complicated customer structure. Who is our customer? Is it the patient? But the patient can't buy directly--though it's happening on the Internet. Is it the doctor? But he or she didn't take the product, doesn't even pay for the product. Is it the pharmacist the patient goes to, or mail order, or whatever? Will the Internet impact that? For sure.

There's a very complex pattern of understanding your customer. And they need different information. They're asking different questions. And historically the industry has been based around individual representatives talking to individual groups. Then along comes DTC that has allowed us to talk to the consumer.

Increasingly, what we see is the Internet impacting every one of those communications. You've got wholesalers in the distribution chain. If you want to change the law of distribution such that somebody is given a prescription for the product, and can go on the Internet and get it from AstraZeneca directly--that could take a huge cost out. You would completely transform the pharmacy infrastructure in countries. Governments are only going to embark on that with huge care. They're not going to just suddenly throw out the whole pharmacy profession. So every single element of this is going to be impacted by the Internet. I have no doubt about that.

How important is the U.S. market?

Massively important. I have five priorities, and one of them is winning in the USA. It's by miles the No. 1 market in so many ways. So we have got to be a top tier company by any measure in the U.S. We've got to be able to offer people in America who are joining our company the opportunity of being part of a truly global or transnational company.

How will you spend your time going forward differently, personally as the chief executive?

Going forward, it's got to be insuring we've got our marketing presence. It will be creating our global company. The key drivers are the achievement of optimal performance through this tricky 2002-2003 period, when it could go any number of ways.