Examples of this restructuring abound. The most dramatic was the December 1999 creation of Aventis from the merger of Hoechst’s and Rhône-Poulenc’s pharmaceutical businesses and the divestment of both firms’ chemical operations. The former Hoechst chemical businesses now operate independently as Celanese AG. This was “the most direct, fastest, and most favorable way to achieve our goal of transforming Hoechst into a leading life sciences company,” said Hoechst’s last CEO, Juergen Dormann. (In 1998, Rhône-Poulenc similarly divested its chemical operation, which is now known as Rhodia.)

Another example, BASF’s recent sale of its Knoll drug division to Abbott Laboratories for $6.9 billion, illustrates key points common to these sales. BASF, Europe’s largest chemical firm, has long been urged by investors to focus on its core chemicals, oil, and gas businesses and to sell its relatively small pharmaceutical operations. Although Knoll was a valuable asset, its 1999 sales were less than 10% of BASF’s total sales of 29.5 billion euros. With a global market share of just 0.7%, industry analysts believed that Knoll lacked the critical mass needed for long-term success. In the opinion of Volker Koester, fund manager at Merck Finck Invest in Munich, BASF’s pharmaceutical business provided no synergies with BASF’s other business divisions, and Knoll was too small to garner the type of investment needed to launch a major pharmaceutical product.

In the same week as BASF’s sale of Knoll, DuPont approved a plan calling for a similar spin-off or sale of its drug business, originally a joint venture with Merck. With less than a 6% share of the U.S. drug market, DuPont believed that it had not achieved a critical mass in pharmaceuticals. Last year, DuPont’s failure to establish a European R&D and marketing alliance with Aventis marked the beginning of the end. Richard De Shutter, former chairman and CEO of G. D. Searle, joined DuPont shortly thereafter and recommended that DuPont exit the pharmaceutical industry (see box, "Separation of chemical and pharmaceutical operations").

Decisions to exit the highly profitable prescription drug business are not made lightly. Several factors have contributed to the failure of the “chemical + pharma” business model.

Skill sets and cultures
Many of the skills required for success in the pharmaceutical and chemical businesses are different. The regulatory processes for performing clinical trials and obtaining approval to market a new drug are far more detailed and costly than those for commercializing a new chemical product.

The different business environments and regulations faced by prescription drug firms and chemical companies result in different corporate cultures and employee skill set requirements. R&D investment levels often exceed 15% in the pharmaceutical industry, whereas they are usually only 2–4% in the chemical industry. Pharmaceutical companies are far more dependent on successful new product development efforts than are chemical companies.

Chemical production plant costs are often much greater than pharmaceutical plant costs and are frequently a major barrier to chemical production by new entrants. In addition, once chemical product and process patents expire, the capital requirements necessary for chemical production remain.

The lower barrier to entry for pharmaceutical production is evidenced by the rapid introduction of generic equivalents of prescription drugs once all relevant patents expire. However, for chemical companies wishing to develop and produce pharmaceutical products, drug patents serve as the primary barriers to competition.

According to Gary Pisano and Steven Wheelwright of the Harvard University Graduate School of Business Administration, pharmaceutical manufacturing costs are small relative to sales. The opposite is true in many chemical businesses. The chemical industry employs a relatively small number of sales people who call on a comparatively small number of corporate customers. In contrast, prescription drug companies employ thousands of sales people, each of whom calls on numerous physicians.

R&D focus
The cost of developing a new pharmaceutical product (known as a new chemical entity, or NCE) has increased much faster than inflation. According to the Pharmaceutical Research and Manufacturers of America, this cost has increased from $54 million in 1976, to $231 million in 1986, to approximately $500 million today. In addition, successfully developing and commercializing new drugs requires an extra ordinary amount of skill and focus.

To maintain the necessary focus, drug companies are increasingly divesting other operations. For example, since the late 1980s, Pfizer has divested 24% of its company, selling 15 businesses, including water-soluble polymers, Coty cosmetics, a food-science business, and talc mines. Hank McKinnell, now Pfizer CEO, noted that although Coty was a profitable and growing business, “it was just a distraction to this management,” and that divestment allowed Pfizer to better focus on its pharmaceutical operations.

The question for chemical companies with drug operations, then, is how to adequately fund and focus on their pharmaceutical operations while successfully operating a profitable chemical business. These companies also must confront questions of how to achieve the critical mass with their pharmaceutical operations that is crucial for success in the increasingly competitive environment in which new areas of development are constantly emerging. (For example, a greater emphasis on patients’ quality of life is producing a growing demand for medicines that treat conditions such as obesity, acne, and hair loss; in tandem with this is the fact that the side effects associated with such “luxury” therapies may decrease consumer acceptance and thus increase the commercial risks associated with their development.)

One way to cope with these uncertainties is to have a large drug R&D program in which commercialization risks are spread over many new drugs in various stages of development. However, the pharmaceutical divisions of chemical companies often lack the scale necessary to develop large numbers of products concurrently and thus to spread their risks. And at a chemical company, the pharmaceutical division has to compete for research funding with chemical businesses for which the potential risks are usually less.

Joseph A. Dimasi, Henry G. Grabowski, and John Vernon of Duke University’s department of economics have studied, in 12 pharmaceutical-based U.S. firms, the relationships between size, R&D costs, and industry output. They found that R&D costs per new drug approved in the United States decrease with increasing firm size, whereas sales per newly approved drug rise. The economies of scale in pharmaceutical R&D were greatest in drug discovery and preclinical development.

The need to generate more lead compounds is increasing R&D spending requirements. Increased rates of compound generation through combinatorial chemistry have created a need to perform assays at high rates. Increasing productivity of assay methods has created a need to rapidly analyze, store, and communicate information. And improving candidate assay productivity has created a feedback loop in which still higher rates of compound generation are needed.

Combinatorial chemical synthesis and high-throughput screening can reduce drug development costs, but they require a large investment in equipment and operators. Once the equipment and researchers are acquired, they must be kept busy to justify the investment. Broad research programs aimed at developing treatments for many diseases can accomplish this. However, doing so tends to increase economies of scale associated with large drug R&D programs. Chemical firms, with their relatively small drug divisions, are seldom in a position to benefit from such economies of scale.

Survival of the model
Not all of the joint pharmaceutical–chemical ventures are refocusing their efforts on just one division. Germany’s Bayer, for example, has been urged to separate its health care and agriculture divisions from its chemical and polymer units. However, Bayer executives insist that they have no plans to do so and believe that there are synergies between pharmaceuticals and their other businesses. Industry analysts think that Bayer is vulnerable to acquisition by a drug company as corporate size becomes increasingly important to developing and marketing prescription drugs.

Another firm currently retaining its pharmaceutical business is the Dutch chemical group Akzo Nobel. Pharmaceuticals account for about 25% of Akzo’s sales, contribute more than 40% of its operating income, and have been Akzo’s main profit driver in recent years.

Overall, it is now seen as an intelligent business decision for a company to conclude that it does not have the resources necessary to compete effectively in both the drug and chemical industries. However, one business model does not fit all, and some chemical firms may continue to succeed in the pharmaceutical business—usually, though, as small niche players.

Further reading