Swiss pharmaceutical firm Novartis’s pending bid to acquire majority ownership of Alcon, an eye care products maker, in a deal valued at about $40 billion, stood out against a backdrop of only 3% mergers-and-acquisitions growth across industry sectors globally for the first half of 2010. While we aren’t likely to see many more large-scale mergers, there are several factors driving M&A growth in the industry, and I believe we will likely see many smaller deals.

What are the factors driving M&A activity?

In the pharmaceutical industry, many large companies are looking for bigger pipelines for drug development, and one of the few ways to do that is by acquiring biotechnology firms. In addition, many of these companies are realizing that they need a more balanced business model to help them be less susceptible to the swings of boom and bust brought on by drug approvals and patent expirations. Today, pharmaceutical companies are looking for things like vaccines, over-the-counter (OTC) products, and emerging-market sales to complement their current businesses.

Another impetus is the so-called patent cliff of 2011. Many major drug patents are set to expire in 2011, and the generic drug industry is positioned to step in and grow because of it. Pharmaceutical companies are looking for ways to diversify their product lines and generate more organic growth, and are looking to make acquisitions.

What types of companies are pharmaceutical firms looking to acquire?
Pharma is looking at a range of companies, including biotechnology, emerging-market drug makers, OTC consumer health care, animal health, vaccines, specialty pharma, and, in some cases, generics and medical devices.
Another area of interest is molecular diagnostics. The trend toward personalized medicine reinforces diagnostics as a way to reduce drug development costs and improve the chances of success by targeting those specific patients most likely to benefit from that drug. If a company doesn’t have the diagnostics expertise, they may look to acquire it.

How does health-care reform factor in?
Health-care reform in the United States and Europe is making companies realize that the profit outlook is only going to get tougher in major markets. The FDA’s standards for drug testing and approval are also getting more stringent. Expanding into other parts of the world not only allows firms to leverage their product development costs across more markets, but it allows them to participate in the higher growth rates in markets like Russia, Brazil, India, and China. In many developing nations, the profitability is almost as high as that of developed markets because the incremental research and development resources needed to launch drugs in those markets is low.

Is the pharmaceutical industry moving more toward research of “niche diseases”?
Yes. In the past, large drug companies seemed to prefer to go after blockbuster drugs that could generate more than $1 billion in annual sales. Today, companies are learning that the cost to develop drugs for niche or orphan diseases — those that affect smaller portions of the population — is relatively low. The approval risk is lower, and some drugs can be sold with smaller, more focused sales forces. Recently, Pfizer and GSK have announced collaborations with companies in the orphan drug space.

Is Putnam Global Health Care Fund positioned for these trends?

In the past, M&A activity has contributed positively to returns in the fund. Today, we own stocks that we think are attractive in their own right, but that we believe also might be attractive to an acquirer.

As of June 30, 2010, Novartis represented 1.91% of the fund’s portfolio and Alcon was not a fund holding. Allocations will vary.