1. Upjohn – Pharmacia Merger Darryl Kraemer and Derek Webb

2. Agenda Industry Strategic Issues Industry Response Background Assessment of Merger –Class Exercise Prospective Analysis Post Script

3. Industry Strategic Issues

4. Cost concerns putting pressure on drug companies to lower prices Industry consolidation to lower costs from economies of scale Highly fragmented with many competitors In the 1980’s, drug companies had high power

5. Industry Strategic Issues In the 1980’s, buyers consolidating into larger entities b/c of cost pressure Drug purchase decisions made by HMO’s and plan admins Bulk purchases = lower prices Formularies are docs short list of approved drugs Buyers want limited number of suppliers with variety of products

6. Industry Strategic Issues Few new blockbuster drugs are in the pipeline Generic drugs used when possible for reduced costs Docs have financial incentive to prescribe generics Generics price ½ of brand equivalents Generic comprised 23% of market in 1980, 40% in 1990 and 66% by end 1990

7. Industry Response

8. Operations changed to become more efficient Operations downsized, restructured, loss of jobs Non-core businesses divested JV’s with medical device companies and care providers for total package Industry wide consolidation

9. Industry Response Vertical consolidation to move closer to patients, acquire PBM, HMO Horizontal consolidation because: –Buyer strength increasing –Cost to develop new drugs increasing –Markets expanding worldwide –Looking for larger markets to spread costs –Seeking efficiency gains to reduce R&D costs More horizontal than vertical integration, though vertical seen as way of the future

10. Industry Response Industry future looks strong because: –Aging population, with increased prescription coverage in insurance plans –Pharmaceutical products more cost effective than hospitalization –Number of countries attempting to improve health care systems –Industry is relatively recession proof

11. Background

12. Upjohn –19 th largest pharmaceutical company – midsized –7 product categories: Central nervous system Steroids Anti-inflammatory and analgesic Reproductive and women’s health Critical care, transplant and cancer Infectious disease Metabolic

13. Background Upjohn cont’d –10 products comprise 56% of sales –International sales small portion of revenue –Numerous patents have expired causing: Lower prices Lots of competition from generic brands Reduced margins –Few blockbuster drugs in the pipe –Weak in foreign sales

14. Background Pharmacia –18 th largest pharmaceutical company – midsized –7 product categories: Cancer treatment Growth hormones Cataract surgery products Intravenous nutrition Allergy diagnostics Smoking cessation Chemicals for Biotech R&D

15. Background Pharmacia cont’d: –10 product comprise 44% of company sales –59% of revenue in Europe, 16% in NA and Japan –Few blockbuster drugs in the pipeline –Larger number of products with small potential sales –Focused on niche segment of hospitals and specialists –Several acquisitions in the past

16. Assessment of Merger

17. Proposed Merger Details Tax free exchange of shares (pooling of interests) 1 Upjohn share = 1.45 shares in new company 1 Pharmacia share = 1 share in new company Upjohn’s Zabriskie would be President/CEO Pharmacia Ekberg would be non-executive chairman Corporate headquarters in London Operational headquarters in Stockholm, Kalamazoo and Milan

18. Class Exercise Class will be split into 4 groups: 1.Upjohn shareholders 2.Pharmacia shareholders 3.Management of Upjohn 4.Management of Pharmacia See handouts for questions 15mins to prepare overhead 5mins for presentation of answers

19. Prospective Analysis

20. Assumptions: –Key drivers of operation is sales –Management believes combined companies will grow faster than separate, and faster than industry 7% growth rate for next 4 years for combined firm 2.7% for Upjohn separate 5.1% for Pharmacia separate –Operating costs synergies of $500M, with 85% in place by 1996 –Results in operating margin > 25% by 1998

21. Prospective Analysis Assumptions cont’d: –Capital structure: 50/50 debt/equity for combined firm 52/48 for Upjohn separate 42/58 for Pharmacia separate –Interest costs based on all debt = 2% –WACC assumed to be 8%

22. Prospective Analysis Assumptions cont’d: –Net operating working capital as % of sales: 69% for combined firm 62% for Upjohn separate 76% for Pharmacia –Long term assets as % of sales: 88% for combined firm 90% for Upjohn 86% for Pharmacia

23. Prospective Analysis Upjohn operating separately In millions19961997199819992000 Sales35273622371938193922 Net Income 598614630647664 Total Assets 52435361550656535805 Abnormal Earnings 245251257264271 Value of equity based on discounted abnormal earnings: $4,371,000,0000 Value of equity based on share price: $39.63 X 171,000,000 = $6,776,000,000

24. Prospective Analysis Pharmacia operating separately In millions19961997199819992000 Sales38444040424644624690 Net Income 402422443466490 Total Assets 59636227654468797228 Abnormal Earnings (76)(77)(82)(85)(89) Value of equity based on discounted abnormal earnings: $2,844,000,0000 Value of equity based on share price: $25.38 X 255,000,000 = $6,471,000,000

25. Prospective Analysis Combined firm In millions1996E1997E1998E1999E2000E Sales75188044860792099854 Net Income 10921328153316411756 Total Assets 1113711803126291351314458 Abnormal Earnings 308502649696744 Value of equity based on discounted abnormal earnings: $10,256,000,0000 Value of equity based on share price: $6,776,000,000+$6,471,000,000 = $13,247,000,000

26. Prospective Analysis DuPont Analysis ProfitabilityAsset Turnover LeverageROE Upjohn (1995) 0.1520.6552.09521% Pharmacia (1995) 0.1060.6141.72311% Combined (2000E) 0.1780.6821.41017.1%

27. Post Script

28. Merger was approved as proposed in Nov 1995 In Oct 1996, management expected to report lower than expected 3 rd quarter earnings due to integration problems Stock price dropped by 10% in response (~$2.8billion, reversing merger gain) Continued to report earnings below expectations

29. Post Script Zabriskie resigned in 1997 Appointed Hassan as new CEO (American Home Products, Harvard MBA) Solution: –Moved head office back to USA –Centralized management team, all recruited from the outside

30. Post Script Solution cont’d: –Cost cutting: Shutting two research sites in Sweden Dismantled operations centers in Stockholm, Milan and Kalamazoo Overhauled purchasing practices –Accelerated launch of new product – Detrol –Licensed external products Analysts warming to stock in June 1999

31. Post Script Bear Sterns upgraded stock from Neutral to Attractive Stock traded at P/B = 5 in June 1999, well below industry multiple of 21, and S&P multiple of 8.5