discussion paper

P 02 - 902 Shareholder Value, Management Culture and Production Regimes in the Transformation of the German Chemical-Pharmaceutical Industry Sigurt Vitols*

August 2002

*Sigurt Vitols Wissenschaftszentrum Berlin für Sozialforschung e-mail: [email protected]

ZITIERWEISE/CITATION Sigurt Vitols

Shareholder Value, Management Culture and Production Regimes in the Transformation of the German Chemical-Pharmaceutical Industry Discussion Paper P 02 - 902 Wissenschaftszentrum Berlin für Sozialforschung 2002 Working Group on Institutions, States, and Markets

Wissenschaftszentrum Berlin für Sozialforschung Reichpietschufer 50 D-10785 Berlin e-mail: [email protected] Internet: http://www.wz-berlin.de

Abstract One of the greatest points of controversy in the recent literature in political economy is the extent to which "shareholder value" oriented institutional investors are drivers of change in national systems of corporate governance. This article argues that the key question is how management cultures shape managerial responses to pressures for change from capital markets. Empirical evidence for this argument is provided through an examination of changes since the mid-1990s at the "Big Three" German integrated chemical/pharmaceutical companies: Hoechst, Bayer and BASF. Despite facing similar demands from shareholder-value oriented investors, management at the three companies have pursued quite different strategies. The end result, however, may be the same from a production regime perspective, that is, the long-run withdrawal of "Big Pharma" from Germany as a location for R&D due to a more favorable institutional framework in the US.

Zusammenfassung Eine der größten Kontroversen in der Literatur der politischen Ökonomie ist an der Frage entbrannt, in welchem Ausmaß dem „Shareholder value“ orienterte institutionelle Investoren für die Veränderung von nationalen Systemen der Corporate Governance verantwortlich sind. Dieser Artikel entwickelt das Argument, dass die diesbezügliche Kernfrage ist, auf welche Weise Managementkulturen die Reaktionen des Managements auf kapitalmarktseitigen Anpassungsdruck beeinflußen. Diese Argument erfährt empirische Untermauerung durch eine Untersuchung der „drei Großen“ der integrierten chemisch-pharmazeutischen Industrie Deutschlands: Hoechst, Bayer und BASF. Obwohl die Anforderungen Shareholer value – orientierter Investoren an die drei Unternehmen die gleichen waren, hat das Management jeder einzelnen Firma eine individuelle Strategie verfolgt. Aus der Perspektive der Produktionsregime mag das Endergebnis trotzdem dasselbe sein, nämlich der Rückzug von „Big Pharma“ aus Deutschland als Standort der Forschung und Entwicklung, der besseren institutionellen Rahmenbedingen in den USA wegen.

Table of Contents

PAGE 1.

Introduction

1

2.

The Big Three Chemical Companies in the Postwar Years

3

Changes Since the Mid-1990s

6

From Hoechst to Aventis: Management-Driven Shareholder Value

9

3.

4.

Bayer: Staying the Course with the Rhineland Model

12

BASF: Fine Tuning the Verbund Strategy

14

A Corporate Governance Perspective on the Big 3

15

Production Regimes and the Future of the German Pharmaceutical Industry

16

References

19

1.

Introduction

One of the greatest points of controversy in the recent literature in political economy is the extent to which "shareholder value" oriented institutional investors are drivers of change in national systems of corporate governance (Froud et al. 2000).1 One school of thought sees pressures on management from internationally-active, primarily US and UK-based, investors to prioritize share price at the expense of other strategic goals as a force sufficiently strong to drive cross-national convergence on the Anglo-American model (Dore 2000; Rubach and Sebora 1998). Another school of thought, focusing on the notion of production regimes embedded within national economies, sees more continuity by conceptualizing these developments as incremental changes in different national models of capitalism. In the latter approach, capital markets are only one of the ensemble of institutions that companies interact with, in addition to labor relations systems, education and training systems, innovation and research systems, and standard setting systems (Hall and Soskice 2001). This article addresses this controversy by arguing that, although shareholder value is a significant force which publicly-listed companies have to confront, it is not by itself a sufficient explanation of change in national corporate governance systems. Instead, the key question is how managers respond to pressures for change from capital markets. In doing so they are guided and influenced by management culture, i.e. the set of values and beliefs that define for them the identity and purpose of the firm, the members of the firm's community and the firm's responsibility to these members, as well as good general business practice.2 One reason for this is that management may simultaneously be faced with conflicting demands from other parts of the company's environment, including labor and product markets, and will be guided by their culture in developing an overall response (Kädtler and Sperling 2001 and 2002). For example, whereas shareholder value advocates typically demand the break-up of diversified firms into more focused companies, labor generally resists such break-ups due to the corrosive effects of reorganization on worker solidarity. A second reason is that there may be a high degree of uncertainty regarding the best response to new pressures. Management may view the solutions being demanded 1

2

Special thanks to Heiko Günther for research assistance for this paper and to Ilona Köhler for organizational assistance. Martin Höpner made several important suggestions for improvement on an earlier version of this paper. Thanks also to Gregory Jackson, Rainer Zugehör, Wolfgang Streeck, Anke Hassel, Britta Rehder and Ariane Berthoin Antal for useful comments or discussions on specific aspects of corporate governance in Germany. This definition draws on the diverse literatures on organizational, corporate and managerial cultures (Davis 1984; Frost 1985; Hofstede 1980 and 1991; Kotter and Heskett 1992). In particular the work of Hofstede demonstrates that, though national and sector-specific variables explain a significant proportion of variation in culture across firms, a large degree of organization-specific residual remains which is influenced by the company's history and collective experiences.

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by investors as inadequate for dealing with these complex challenges. Management culture is therefore a filter through which the external environment is perceived and responded to. Empirical evidence for this argument is provided through an examination of changes since the mid-1990s at the "Big Three" German integrated chemical/pharmaceutical companies: Hoechst, Bayer and BASF. Since the end of World War II, these three companies exemplified many aspects of the "German model" of stakeholder-oriented corporate governance and high quality production. Though there was some variation between companies,3 overall the similarities in strategy and structure for most of the postwar period were quite striking. Corporate strategy prioritized investment and sales growth over profitability. Growth was achieved in part through diversification into a wide variety of chemicals-related activities. Pharmaceuticals, which at the time enjoyed strong R&D synergies with other branches of the chemicals industry, played a special role through helping smooth earnings from more cyclically-sensitive chemicals divisions. Since the mid-1990s, however, the strategies pursued by these three companies have greatly diverged. This is significant since the demands of the Anglo-American investment community to increase share price have been the same for each of the companies: first, reduce complexity by splitting up pharmaceutical and chemical activities, and second, focus on developing a critical mass of "blockbuster" products achieving annual sales of at least $1 billion within pharmaceuticals. Hoechst, which is invariably one of the cases cited by supporters of the convergence thesis, has adopted a pure "life sciences" strategy involving the divestment of its chemicals activities. Furthermore, through merger with the French company Rhône-Poulenc, Hoechst gave up its name and its "German identity" through the formation of a new company, Aventis, with headquarters in Strasbourg. Bayer, in contrast, has reaffirmed its commitment to an integrated chemical/pharma strategy, and has resisted the initiatives of US investors and advice of analysts to split up the company. BASF's primary commitment is to a "Verbund" strategy emphasizing scale and transaction economies through vertical integration at a small number of production sites. Whereas in the mid-1990s pharma was still a key component of this Verbund strategy, a recent shift in the drug research paradigm away from synthetic chemistry and towards biotechnology has reduced the synergies between chemicals and pharma. As a result, in early 2001 pharma operations were sold off to the US-based Abbot Labs. A key variable in explaining this divergence in strategy is differences in management cultures at the three companies. At Hoechst, an internal coup resulted in a top management team which shared a commitment to a radical version of shareholder value. Not surprisingly, this management team had a great degree of experience in other countries, particularly in the US. These managers believed that a pure life sciences strategy was the best way to achieve a higher level of profitability and growth in the future. At Bayer, in contrast, top managers subscribed to a "Rhineland" version of capitalism emphasizing commitment to employees and 3

2

For example, BASF's entry into pharmaceuticals occurred much later than at Bayer or Hoechst.

community, and to incremental change within a diversified conglomerate strategy. Finally, top management at BASF believed that sticking to the traditional Verbund strategy and its various economies was the best way to ensure their company's survival into the future. The fact that managers were able to implement their strategies despite the reservations of or even against the resistance of important constituencies, including investors and employee representatives, provides strong evidence that management cultures are a crucial variable in short-term models of change. Furthermore, rather than creating clear pressures for change in one direction, the globalization of capital markets appears to have increased the room for maneuver available to management in implementing changes in corporate strategy and organization. In the long run, however, the experience with the Big 3 companies suggests that the production regimes approach may be more useful in explaining the production location decisions of companies, and that an increasing specialization of national economies in different types of activities can be observed. Even though the roads chosen by the Big 3 companies vary considerably, in fact the outcomes are strikingly similar from a production regime point of view -- specifically, the exit of large companies from Germany as a location for the pharmaceutical industry. In other words, an increasing international division of labor between sectors may in fact reinforce national differences in corporate governance by allowing different productive activities to migrate to locations where the most hospitable governance regimes are dominant.

2.

The Big Three Chemical Companies in the Postwar Years

The comparative literature on corporate governance distinguishes between two models of governance. In the shareholder value model, the primary goal of companies is to satisfy dispersed shareholders' interest in maximizing share price. In the stakeholder model, management seeks to balance the interests of different groups with a role in the company, including "inside" (typically large) investors, employees, suppliers and customers, and the communities in which the company's main plants are located. In the German variant of the stakeholder model, special attention has been paid to the role of the large universal banks as inside investors, and to the representation of employees through codetermination at the plant level (works councils) and the company level (board representation) (Kelly, Kelly and Gamble 1997; Prowse 1994; Vitols 2001). In the literature on production regimes, a link is made between this German model of governance and a long-term orientation or "commitment" to markets, employees and investors. This link helps explain the prominence of companies oriented towards high quality niche markets in "medium-tech" industries such as machine tools, automobiles and speciality chemicals (Casper and Vitols 1997; Jackson 1998; Jürgens, Naumann and Rupp 2000; Porter 1992). 3

The Big Three German chemical companies have been exemplary of both the corporate governance and the production regime views of large German companies. In terms of corporate governance, the major banks and insurance companies have significant minority equity stakes in all three of the companies and also have representatives on the supervisory boards. Though the degree of dispersed ownership by small investors (i.e. "free float") appears to be quite high compared to other German companies, in fact the banks are quite able maintain effective control at shareholders meetings through mechanisms such as proxy voting, typically accounting for more than 80% of the votes exercised (Pfeiffer 1986; 1993). The one partial exception to this pattern is a large minority shareholding in Hoechst of about 25% acquired by the Kuwait Petroleum Corporation in the 1970s. 4 Labor as a stakeholder also became strongly represented in the Big 3 companies after World War II. A highly cooperative relationship with works councils and the union (which was effectively dominated by the works councils of the Big Three companies) developed and has become known as one of the leading examples of partnership in German industrial relations (Markovits 1986). Innovative industry-level collective bargaining agreements on remuneration, working time and the hiring of long-time unemployed have been negotiated in recent years in the chemicals industry. The Big 3 companies paid significantly more than the minimum wage levels bargained for the industry and also effectively offered "lifetime employment" to most of their employees. The Big 3 companies also showed a strong degree of commitment to the communities in which their main production sites were located. BASF's headquarters and primary site at Ludwigshafen has long been the world's largest integrated chemicals site, and this site has tended to be favored when there have been conflicts about new investment or reducing redundant capacity. In the sports world Bayer is well known for its sponsorship of the soccer club FC Leverkusen. Though Hoechst's relative importance as a regional employer is not as great as the other companies, being one of a number of large companies in the Frankfurt area, it nevertheless is considered central to the district Frankfurt-Höchst (Krohn and Lang 1989). In terms of the production regime view, the Big 3 companies were able to grow through a long history of innovation-based high product quality. The original driver of discovery was the steady demand for new dyestuffs from the rapidly expanding textile industry. Though its industrial takeoff was much later than England's, Germany quickly overtook the UK in the late 1800s and gained the leading position in this lucrative sector. This comparative advantage was based on the establishment of the first specialized industrial R&D facilities, which collaborated closely with the newly founded technical universities. These laboratories were able to discover thousands 4

4

Note that Grant et al (1988) question whether the Big 3 companies in fact typified Germany due to their low dependence on bank loans and the relatively low level of bank ownership. This is likely due to the fact that the chemicals industry was in stronger financial shape throughout the 20th century than the much more cyclical steel, coal and machine tools industries, where dependence on bank finance is much greater. However, through dependency of the Big 3 on banks may be weaker than is the case for other industrial companies, banks are still represented on the company boards and exercise proxy voting rights.

of new chemical compounds in coal tar, a byproduct of the iron and steel industry and the main feedstock of the nascent organic chemicals industry. The Big 3 companies also proved to be adept at integrating chemists with professionals from other new fields such as pharmacology and industrial engineers, which led to the discovery of innovative medicines and the development of new and efficient equipment and production processes. Top management tended to be dominated by people with a technical background, particularly from chemistry. Although it is perhaps difficult to imagine now given that pharmaceuticals has developed into an independent high-profile industry, up until recent decades pharma was mainly thought of as a specialized sub-sector within the broad chemicals sector. The emergence of pharmaceuticals as a knowledge-based industrial activity in the second half of the nineteenth century was based on the pioneering application of rational experimentation and discovery techniques in the new fields of pharmacology and synthetic chemistry (Bäumler 1963; Landau, Achilladelis and Scriabine 1999). Although the ability of dyestuffs and related chemical compounds to treat certain diseases was known decades earlier, it took the major economic downturn of the 1870s (Gründerkrise) to spur two of these companies, Hoechst and Bayer, to systematically diversify their research into the new area of pharmacology. On the basis of important discoveries they quickly achieved a status of world leadership in pharmaceutical products through new products such as the pain reliever asprin and medications for treating tuberculosis, malaria and syphillus. Interestingly enough, today's world leader in pharma, the US, was quite underdeveloped and dominated by "quacks" until well into the 20th century. Not until World War I, when trade between Germany and the US was interrupted, was the US spurred to develop its own comprehensive pharma industries.5 The "glue" that produced complementarities and held together produtivistoriented management and the stakeholder corporate governance system was a corporate strategy which prioritized sales growth over profitability. A revealing comparison of the world's largest chemical/pharmaceutical companies shows that the Big Three companies held the lowest three positions in terms of profitability, but also held three of the four top positions in terms of sales growth (Richards 1998). Whereas the average sales growth rate of this group for the period 1960-96 was 8.9%, BASF, Hoechst and Bayer had growth rates of 12.6%, 11.4% and 11%, respectively. At the same time, the Big Three were the only companies to have profitability rates of less than 5% in the period 1991-96, while other firms ranged from profit rates of slightly above 5% to 25%.6 5

6

An alternative path of development from diversification out of textile dyestuffs was the application of industrial techniques at enterprising pharmacies (the "industrial apothecaries"). Although this second path of development was more common in the US and England, important examples can also be found in Germany, such as the "Green Apothecary" in Wedding, Berlin (Schering) and the "Angel Apothecary" in Darmstadt (E.M. Merck). Though the highest profitability rates were achieved by companies that were predominantly pharma, e.g. Lilly Industries, even companies with little or no pharmaceutical sales, such as Union Carbide, 3M, and ARCO, were able to achieve much higher levels of profitability than the German companies.

5

As a result of this strategy the Big 3 were able to attract able scientists and engineers through their emphasis on high-quality products and leading technology in a steadily growing industry. Banks profited from moderate but steadily increasing dividends and a decreasing but still substantial demand for bank loans and other financial products. Employees could be satisfied with a high degree of job security (underwritten by long-term growth) and a remuneration and social policy aimed at rewarding long-term service rather than short-term performance. Thus the integration of chemicals and pharma within a single company made sense in terms of both the stakeholder system of corporate governance and productivist management orientation. Though the percentage of sales from pharmaceuticals was small relative to the chemicals divisions, sales growth was higher than chemicals and thus helped contribute to a high growth rate overall. More consistent earnings from pharma could be used to smooth out cyclical peaks and valleys from chemicals and thus help ensure the continuity of long-term investment programs. Finally, significant synergies could be realized through the direct application of advances in chemistry methodology and new chemical compounds in pharmaceuticals.

3.

Changes Since the Mid-1990s

The striking similarities between the Big 3 companies in terms of corporate governance structures and business strategy came to an abrupt end in the mid1990s. In addition to changes in international capital markets, major factors influencing this shift included significant changes in both the innovation and product market environment of these companies, particularly in the pharmaceuticals segments, and the post-unification recession and profitability crisis. The global market environment of pharmaceuticals had been transformed in the past decades by a handful of large US and UK-based companies that successfully developed the so-called "blockbuster" strategy (Schweitzer 1997; The Boston Consulting Group 1999). This strategy focuses on the development of prescription drugs with annual sales potential of at least $500 million. Due to high costs of R&D for blockbusters, which arise particularly in the drug approval process, these companies looked beyond their traditional national markets to try to make profits through comprehensive plans for global marketing. German pharmaceutical companies faced the double disadvantage of not having rebuilt their market shares after WWII in the US, the world's largest and most dynamic pharmaceutical market, at the same time that the Anglo-American competition was systematically taking away market share in continental Europe. Along with this shift in the market environment, the nature of drug discovery had fundamentally changed with the development of new technologies such as bioinformatics and genomics (Landau, Achilladelis and Scriabine 1999; Schweitzer 6

1997). Though the results from biotechnology to date have been modest, it is difficult to underestimate the impact this shift in research paradigms has had in the pharmaceutical industry on the internal organization of R&D, the skills and technologies utilized, and the extent of cooperation with external parties such as universities and pure research firms. Big 3 companies, whose traditional scientific strength was in chemistry-based science, were poorly situated to respond to this fundamental shift toward biology- and IT-based approaches. Paralleling these developments in markets and innovation were major changes in international capital markets. The Big 3 companies had long had among the highest level of foreign ownership of German companies listed on the stock exchange. The Big 3 companies offered a particularly attractive investment for large institutional investors due to their large size and thus high degree of liquidity. It is therefore not surprising that the philosophy of "shareholder value", which is a business approach stressing the primacy of appreciation in share price among competing corporate goals, became a particularly important issue for these companies in the mid-1990s. Shareholder value was particularly propagated by institutional investors from the US and UK, who tended to diversify risk by taking a large number of small equity stakes in companies (Jürgens, Naumann and Rupp 2000; Vitols et al. 1997). These institutional investors were particularly dominant in the US and UK, the countries where the "privatization" and the "capitalization" of retirement systems (and thus the accumulation of large pools of private capital) had gone the furthest (Jackson and Vitols 2001). Given sharp incentives for short-term performance, these investors increasingly sought opportunities for higher returns abroad, including in Germany as the largest European economy. Not surprisingly, these investors brought demands regarding transparency and strategic priorities with them. Though shareholder value is still controversial in continental Europe, a number of German investors, particularly the Deutsche Bank and its investment fund group DWS, have adopted some pro-shareholder rhetoric and adopted some of the practices that Anglo-American institutional investors follow.7 These institutional investors were particularly unhappy with two aspects of the Big 3 companies' strategies. The first issue was the focus of these companies' management on sales growth rather than on profitability.8 As a result of this emphasis, the companies were involved in a wide variety of product markets, many of which offered fairly low profit margins. Furthermore, sales growth had in part been achieved through the acquisition of companies which often had a relatively small market share in their particular segment or were not among the top handful of 7

8

The extent to which the large financial institutions have actually adopted an "arms length" approach is currently a matter of debate. Both the Deutsche Bank and Allianz have stated that they want to manage their shareholdings in a more strategic, return-oriented manner and to reduce their representation on company boards. Though interlocking board representation in Germany has in fact decreased substantially since the early 1990s, the degree of concentration of shareholdings appears to have decreased only slightly between 1997 and 2001 (Beyer 2002; Wojcik 2001). The profit situation of the companies was not aided by the fact that, at the macroeconomic level, European growth during the 1990s slowed considerably due to both the way in which German unification was financed and fiscal austerity was pursued prior to introducing the single currency (Carlin and Soskice 1997).

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companies regarding technology. Since little company financial information was provided on a division or product segment basis, it was very difficult to ascertain which activities were "cash cows" and which were "cash pigs" (i.e. which activities achieved reasonable levels of profitability and which were loosing money, respectively). Shareholder value advocates demanded that these companies introduce detailed segmental reporting and mechanisms for determining cost-ofcapital. Furthermore, minimum profitability targets (typically benchmarked against industry leaders) should be set for the individual business units and under-performing units should be sold off or closed down. The pharmaceuticals divisions of the Big 3 companies would be among those divisions faring poorly in this exercise since they appeared to be significantly less profitable than the US/UK competition, and thus would run the risk of being divested under a shareholder value approach. Above and beyond this emphasis on profitability, shareholder value advocates demanded that companies should have a strategic focus on core markets where they have strong competencies and could expect to be among the two or three leading companies. Companies that have two or more core markets are often able to achieve synergies between these markets. In this respect, the pharmaceutical divisions of the Big 3 companies came under critical scrutiny from shareholder value advocates for two reasons. First, the shift in the scientific basis for innovations in pharmaceuticals meant that fewer synergy effects could be realized between chemicals and pharmaceuticals (Drews 1999; Landau, Achilladelis and Scriabine 1999). Second, due to the much more rapid growth of the Anglo-American blockbuster companies, none of the Big 3 German companies could be found among the ranks of the top 10 pharmaceutical firms, as ranked by sales. Analysts increasingly believed that it was necessary for pharma companies to reach a certain "critical mass" or minimum size in order to finance the escalating costs of R&D across a number of therapeutic areas and have enough potential blockbuster products in the development "pipeline." A powerful illustration of the need for a strong pipeline was provided by the extreme dependency of one company, Glaxo Wellcome, which derived about 30% of its sales from one product, Zantac, which went off patent in the late 1990s. In the long run, only the handful of pharmaceutical companies able to achieve this critical mass would be able to survive. In part due to the low share prices of the Big 3 companies, it was considered nearly impossible for the Big 3 companies to achieve this critical mass through acquiring other companies. Thus the only viable alternative for the Big 3 companies would be to sell off their pharmaceutical divisions. Though the types of pressures facing the Big 3 companies in the mid-1990s were broadly similar, the response in terms of reformulating overall business strategy and in reforming corporate governance structures was very different, suggesting that the new environment allowed a level of diversity among large German companies difficult to imagine during the heyday of the postwar German model.

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From Hoechst to Aventis: Management-Driven Shareholder Value Hoechst since the mid-1990s represents the most radical departure from the postwar model among the Big 3, and arguably among the largest German companies as well.9 Hoechst provides an illustration of the "relative autonomy" of top management from shareholders and stakeholders. In this case, an increased emphasis on profits and the adoption of a pure life sciences strategy, which involved drastic organizational changes provoking the resistance of employees and conservative managers, was legitimated through the need to satisfy the interests of shareholder value oriented investors. On the one hand it was clear that a number of stakeholders, at least those represented on the supervisory board, wanted to see substantial changes at Hoechst in the mid-1990s. Hoechst had long seen itself as one of the world leaders in innovation, not only in traditional segments of the chemicals industry but also in more research-intensive areas such as pharmaceuticals. Despite the massive loss of market share during the world wars and interwar period, Hoechst expanded rapidly after World War II and by the 1980s had regained its position as one of the world's largest diversified chemicals companies. In the pharmaceuticals segment it was even ranked number two in terms of global sales (Neukirchen and Wilhelm 2000). In addition to organic growth, this expansion was also in large part achieved through acquisitions. By the early 1990s Hoechst had accumulated fifteen different divisions offering 25,000 different products on the market. In the late 1980s and early 1990s, however, Hoechst seemed to loose its competitive advantage, particularly in pharmaceuticals where it was overtaken by a number of blockbuster-oriented AngloAmerican companies. Furthermore, a deterioration in profit margins in chemicals worried not only shareholders but also managers concerned about the company's ability to self-finance the large investments needed to stay competitive. As a demonstration of the increased importance of profitability, the supervisory board broke with the tradition of choosing management board chairmen with technical backgrounds. Instead, it appointed the Chief Financial Officer, Jürgen Dormann, to this position in 1994. In accordance with the matrix form of organization used in Hoechst at the time, Dormann's functional responsibilities for finance and controlling were complemented by operational responsibility for the North American region. In addition to successfully integrating a large US company, Celanese, into the conglomerate, he also had been in charge of the introduction of business units at Hoechst, which had established his reputation as a firm, but moderate, advocate of change. Prior to his appointment Dormann appeared to support change under the motto of greater focus within an integrated chemical/pharmaceutical strategy. In a widely cited lecture, for example, he emphasized that

9

For detailed accounts of changes at Hoechst see Berthoin Antal (2001 a and b), Menz et al (1999), and Eckert (2000).

9

"Organizational changes occur most sensibly in small steps; in practice, cultural revolutions cannot be implemented – perhaps with the exception of turnaround situations in crisis cases" (Dormann 1993: 1077) author's translation. Once in control as CEO, however, Dormann's approach to change took on more and more the flavor of revolution rather than evolution. Shareholder value became the ultimate measurement of performance, rather than traditional goals such as sales or product quality. For example, the 1997 Annual Report boldly stated that "The value of Hoechst shares and the assessment thereof by the international capital market are the yardsticks we use to measure our success" (Hoechst Annual Report 1997: 29). One implication of this commitment to shareholder value was the abandonment of the integrated chemicals/pharmaceuticals strategy and the embracement of Hoechst's future as a pure "life sciences" company. Life sciences (pharmaceuticals and agro products) were held to have a much higher growth potential than chemicals and was thus valued more highly by the stock market. The consequence of this decision was that chemicals and related activities would have to be sold off. Money raised from the divestments would be used to finance new investments in life sciences. In the words of one of Dormann's top managers, this radical decision to sell off chemicals activities was motivated by the following stock market logic: "[In the mid-1990s], the [best companies in] the commodity chemical business…had a [share price to earnings] multiple of 12. A mediocre pharmaceutical company would have a multiple of 20 or 25, a good one would be up at 30-35. So, if you are creating shareholder value and you have this choice of businesses, where do you put your resources? You put it into pharmaceuticals. It is that simple…" (Interview with Ernest Drew from Berthoin Antal 2001b: 9). A second implication of the shareholder value/life sciences strategy was that Hoechst would have to make major acquisitions or even contemplate a merger in order to reach the size needed to be one of the big global players in life sciences. Although a number of significant acquisitions were made (the French-based Roussel Uclaf and the US-based Marion Merrell Dow) and merged together to form a new identity called Hoechst Marion Roussel (HMR), this was still not enough to bring Hoechst into the league of the pharmaceutical world top 10 league. Bayer, the logical partner within Germany, was reportedly not interested in merging. However, another interested party was found in the French-based chemical/pharmaceutical company Rhône-Poulenc. In order to emphasize that this was a "merger of equals", a new name (Aventis) invented and a new headquarters was established in Strasbourg, which was symbolically "halfway between" Frankfurt and Paris. Nevertheless the new company was subject to French company law rather than German law with its strong codetermination provisions. The sale or flotation of divisions accounting for three quarters of sales at Hoechst meant the abandonment of a century of paternalistic identification of employees with 10

the corporation. Dormann however showed little attachment to these sentimental beliefs: "Naturally the employees won't be able to orient themselves anymore toward a unitary corporate image. The traditional feelings of security and comfort provided by a large concern belong to the past… The big mother Hoechst won't come anymore and help when the going gets difficult. From now on, employee's identification with the direct business area will be much more important than with the mother superior Hoechst" (N.N. 1997: 43) author’s translation. These steps required that Dormann violate a number of important norms in the strong management culture that had evolved at Hoechst. In order to do this, he had to bring in a team of people sharing his beliefs into top management positions. This involved the abandonment of the principle of filling empty management positions through hiring from the next-lower level, which effectively had led to a long-term career of gradual promotions within the firm for competent managers. One example of this was Dormann's appointment of a Task Force on corporate strategy, which bypassed the top layer of management and included many persons who were seen as "outsiders" by central headquarters. Significantly, the chairperson was an American who was brought into the company through the acquisition of Celanese in 1987. The Task Force developed processes for benchmarking operations which went far beyond anything Hoechst had tried before and highlighted the weak international position of many of its divisions. Some of these persons were later appointed to replace retiring members of the management board, leapfrogging managers in higher positions. Other key appointments were also made with "outsiders". For example Richard Markham, an American who spent twenty years at Merck before switching to Marion Merrill Dow, another Hoechst acquisition, was appointed head of the global pharmaceuticals business. By 1996 all of the division heads had retired or been replaced with new people (Berthoin Antal 2001b). These radical changes ran into strong opposition from a number of stakeholders, who did not believe that they were part of Dormann's original remit. The works council participated in organizing regular "Monday demonstrations" at Hoechst's main site to show their concerns about job losses and their feeling of betrayal by the new top management. These protests received a great deal of attention in the press. Middle management was also shaken up by the plans and new demands, and also resisted the implementation of change. In addition, there also were concerns with the new system of pay above the minimum levels defined in the industry-level collective bargaining agreement, which tied part of this remuneration to the financial performance of both the company as a whole and to the individual business unit the employee belongs to (Becker 1999; Mainzer 1994). The city of Frankfurt also was concerned with the economic and social consequences of the weakening commitment of a major employer to this production location. The Kuwait Petroleum Corporation (owned by the Emirat of Kuwait), Hoechst's largest shareholder, also reportedly had major concerns with the new strategy. Dormann, however, proved adept at dealing with opposition from these sources and eventually received approval for his plans. The traditional stronghold of the 11

works council was effectively divested with the sale of specialty chemicals operations to the Swiss-based Clariant. A statement regarding employment guarantees in Frankfurt reduced worker unrest somewhat, and a major allocation of funds for regional development helped appease the Frankfurt government. A number of trips to Kuwait also helped convince this shareholder that the new plans were not against their interests. By the beginning of 2002 the new Aventis had largely carried out the original merger plan. Non life sciences activities have been largely divested and the new corporate structure for the most part implemented. Although Aventis claims that profitability has been significantly improved and that it has developed a promising pipeline, the stock market has adopted a "wait and see" attitude. As of this date Aventis has only 2 blockbusters and a third product with near-blockbuster status, US companies have much stronger portfolios. Pfizer, for example, with roughly twice the level of pharmaceuticals sales, has eight blockbusters and a ninth near-blockbuster. GlaxoSmithKline, also roughly the size of Pfizer, has six blockbusters and four nearblockbusters. In 2001 Aventis only achieved a profitability margin of 9 per cent (net income as a percentage of sales), somewhat less than half the level of profitability of about 25 percent attained by the Anglo-American blockbuster companies. Dormann has not achieved the goals set by his risky strategy. Bayer: Staying the Course with the Rhineland Model An interesting contrast to Hoechst is provided by the case of Bayer, which until the mid 1990s followed a strikingly similar path of development. Bayer also was founded in the second half of the 1800s and quickly became one of the leading diversified chemical companies in Germany. Though the initial product portfolio was concentrated around dyestuffs, Bayer was also able to develop innovative and major pharmaceutical products, most famously the pain reliever aspirin, which remains a household staple more than 100 years after its discovery. In the last decade Bayer has been faced with many of the same environmental challenges and criticisms that Hoechst had to confront. Bayer has acknowledged that substantial changes have to be made. Nevertheless, in strong contrast to Dormann's team, the general attitude of Bayer's top management has been that moderate change within the framework of the company's traditional culture and diversified product portfolio is the best way forward. The process of change in the sense of adopting a more financially-oriented strategy actually began a few years earlier than at Hoechst, dating back to the appointment of Manfred Schneider as CEO in 1992. As with Dormann, Schneider also comes from a financial rather than a technical background. However, in stark contrast to his counterpart, Schneider has maintained a public commitment to the "Rhineland capitalism" model of corporate management, including major decisions made in consensus with stakeholders and an incremental approach to change. Though many analysts and some investors have been publicly pushing for a breakup

12

of the company, Schneider's succinct response has consistently been "we stick to our strategy and don't let ourselves be swayed by every fad" (Ruess 2001: 68). At a strategic level this has meant that Bayer has adopted a "four pillar" model involving gradual refocusing on core areas within the broad context of an integrated chemical/pharmaceutical strategy. As stated in the current corporate principles, "…we want to be the leading integrated pharmaceutical-chemical company in the world" (Company Web Site, 2002). The four pillars, or main product areas, in Bayer's core business areas are: polymers (with € 11.4 billion sales in 2000), chemicals (€4.3 billion), health care (€10 billion – with pharmaceuticals accounting for €6.1 billion) and agro (€3.5 billion). Although the relative proportion of sales from health care in general and pharmaceuticals in particular should increase slowly over time, the four pillar strategy emphasizes no weakening of the commitment to an integrated strategy. Smaller product lines that do not fit into the four core areas, or that are make chronic losses, should be divested over time, but new acquisitions strengthening core areas should also be made. In terms of industrial relations the "Rhineland" approach has meant a consensusbased approach and the public acknowledgement of a close and cooperative relationship with the works council. According to the chairman of the of the concern works council, "For us the strategy of consensus-building is of crucial importance. The works council is involved in all strategic decision-making processes. Our primary goal is to secure jobs. We support Schneider's attitude, which is 'I will only make acquisitions, when there are no negative synergy effects on employment.' This consensus strategy is also practiced when painful decisions have to be made" (Interview on 14 October 1999) – author's translation. In contrast with the Hoechst Standortvereinbarung (Production Site Agreement), which has not been made public and is believed to contain only fairly vague commitments to minimizing involuntary redundancies, the Bayer agreement is publicly available and contains specific commitments to investment and training levels.10 While the system of "übertarifliche Bezahlung" (i.e. pay above collective bargaining contract minimums) has also been restructured, unlike at Hoechst business unit performance has not been included as one of the factors used in determining this additional pay. As a further illustration of Bayer's commitment to corporate traditions, top management pay has risen only modestly in previous years, in line with historical norms. Höpner (2001: Table 5) reports that the average compensation of board members increased only 7.3% at Bayer between 1996-1999. A major increase in remuneration to help bring top management pay in Germany more in line with US practice is of course one of the major changes generally associated with the shift to a shareholder value orientation. For example, top management at Daimler-Benz (now DaimlerChrysler), which (like Hoechst) has adopted a more radical form of 10

I gratefully acknowledge Britta Rehder's help in pointing out this fact to me.

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shareholder value, experienced an average increase of 467% in their compensation during this same period of time. Many analysts and some US investors have been pushing for a breakup of Bayer into chemicals, pharma and agricultural products. However, the proposal by a US investor to do this at the 2001 annual meeting received only 1.19% of the votes present, showing how weak the power of American investors is given management resistance and the lack of support from German investors.11 BASF: Fine Tuning the Verbund Strategy As is the case with Bayer and Hoechst, BASF was founded in the late 1800s with an initial focus on textile dyestuffs. BASF was also able to show a high degree of innovativeness and move into new product areas and processes throughout its history, and is currently the largest diversified chemicals company in the world. Perhaps the most important distinguishing feature of BASF is the extent to which it has emphasized its so-called Verbund (combine) strategy of deep vertical integration. This competitive strategy aims at combining innovation and high product quality with cost leadership in core markets. Since many branches of chemical production involve high fixed costs and substantial scale economies, cost leadership can be realized through concentrating production at one location. BASF is unique among large chemical companies in its degree of concentration of production at one location, Ludwigshafen. Upstream BASF could produce intermediate chemicals from carbon-based feedstocks (coal and coke and, after World War II, crude oil) on a large scale. Downstream the development of new production processes could often be used for a number of new products. BASF's historical commitment to pharma was much weaker than that of Hoechst and Bayer. Nevertheless, a series of acquisitions starting in the 1960s led to a significant presence in health care products, and up until the mid 1990s BASF continued making acquisitions to strengthen its presence in this area. Along with the energy division, health care was one of the core areas which would help smooth out highly cyclical earnings in the main chemicals activities. BASF's response to the pressures of the 1990s follows the Bayer experience to a much greater extent than the Hoechst/Aventis experience. The current CEO, Jürgen Strube, has a legal background and first rose in the BASF hierarchy within the finance department. However, the increased emphasis on financial performance and planning is to take place within traditional strategy and commitment to specific markets. As Strube has stated, 11

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Martin Höpner, who was present at the shareholders' meeting in question, points out that a number of German investors present also spoke out in favour of splitting up Bayer. The fact that these investors did not support the American proposal, however, shows that German investors may still think in national terms and prefer a slower pace of change implemented in a more negotiated manner.

"…the changes we make must be shaped in accordance with company tradition…BASF stands for solidness, reliability and consistency" (Schlote 1997: 88-95). The Verbund business strategy of concentration on a main production location was not only strengthened in Germany but also duplicated in BASF's attempt to increase market presence in the US (Port Arthur, Texas) and Asia (Kuantan, Malaysia and Nanjing, China). Although product lines not fitting into defined core areas as well as under-performing units were to be sold off, no major changes in core areas was to be made. As of the late 1990s BASF still declared health care as one of its core business areas. Industrial relations at BASF are much more like at Bayer than at Hoechst/Aventis. A Production Site Agreement (Standortvereinbarung) was signed within weeks of the Bayer agreement and, unlike the confidential Hoechst/Aventis agreement, contains specific promises regarding investment and training (N.N. 1999). In contrast with the Hoechst shareholder value approach, BASF developed an explicit stakeholder approach in its corporate principles "Vision 2010" developed in the mid-1990s. These principles have been reflected in linking the introduction of a stock option plan for managers with an employee stock ownership plan with similar incentives (Brinkkötter 1999). Furthermore, management remuneration has risen roughly in line with employee pay. The increase in top management pay has also remained moderate, at 14.8% only moderately above Bayer's increase of 7.3% between 1996-1999 (Höpner 2001: Table 5). However, top management decided that the recent shift in the drug research paradigm away from synthetic chemistry and towards biotechnology has reduced the synergies between chemicals and pharma. The smaller proportion of pharma within the health care area compared with Bayer also made it more difficult to pursue a blockbuster strategy. As a result, in early 2001 pharma operations sold off to the USbased Abbot Labs. A Corporate Governance Perspective on the Big 3 The interesting point about the Big 3 is the dramatic increase in variance in strategy since the mid-1990s, despite very similar governance structures and production strategies. This argues that there is considerable managerial discretion, and that therefore management attitudes about how to deal with environmental changes and future uncertainties become a key explanatory variable. The Hoechst case seems to clearly disprove at least the simple version of convergence variants of corporate governance theory. Though some have argued that the threat of a hostile takeover essentially forced Hoechst to follow a shareholder value life-sciences oriented strategy (Eckert 2000), in fact the 25% equity stake held by the state-owned Kuwait Petroleum Corporation meant that a hostile takeover was 15

even less likely at Hoechst than at the other two companies.12 Nevertheless, the new top management was convinced that shareholder value was needed to legitimate the changes needed for Hoechst to survive and therefore pushed through radical changes despite considerable opposition from stakeholders. The changes made at Bayer and BASF also at least in part can be explained by management beliefs and commitment to specific strategies. Bayer is deeply committed to the Rhineland model and moderate changes within a diversified strategy, including keeping pharmaceuticals and chemicals together. BASF also believes in the benefits of focus within diversity, but the greater commitment to the Verbund strategy and the apparent weakening of the rationale for keeping pharma within the logic of this strategy led to the decision to sell off pharma operations.

4.

Production Regimes and the Future of the German Pharmaceutical Industry

Although diversity among the Big 3 in company structures and strategy is increasing from a corporate governance point of view, it is interesting to note that the effects of these different strategies on the national economy are very similar from a production regime point of view, namely a tendency of Big Pharma to exit Germany as a research and production location. The production regime perspective asserts that there are fundamentally different models of capitalist economies, or "varieties of capitalism" (Hall and Soskice 2001). These national systems are characterized by ensembles of institutions centered in different areas, such as finance, labor markets, education and training, and research. Specific patterns of company innovation are more compatible with some ensembles of institutions than with others. German institutions, which emphasize long-term, low risk finance, long-term employment relationships and the acquisition of companyspecific skills, and specialized research, are particularly compatible with incremental innovation in established areas of production and science. On the other hand, German institutions are less hospitable to radical innovation, which is much higherrisk and involves more rapid shifts in organizations and individual competencies. Thus the US is seen as a more hospitable institutional environment for the pharmaceutical industry than Germany due to the radical innovations involved in the integration of biotechnology (Casper 1999; Casper, Lehrer and Soskice 1999).

12

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It is argued that the Kuaiti holding, which was originally acquired in 1982 for strategic reasons (oil is one of the main feedstocks for the chemical industry and a strategic holding would presumably help create a reliable customer), at some point turned into a financial holding and thus could be available for sale on the market to a hostile bidder. However, the threat of a hostile bid was probably not taken seriously by the German corporate community until Vodafone's attempt to take over Mannesmann in 1999/2000, i.e. well after the beginning of Dormann's efforts.

This tendency is clearest in the case of BASF with the sale of its pharma operations (Knoll AG) to the US-based Abbott Labs. Historically, US pharmaceutical firms have made acquisitions in Germany in order to gain market access through buying name recognition and relationships with an existing customer base. Acquiring licensing rights to drug portfolios have played only a secondary role in acquisitions. Typically the marketing division in acquired companies is upgraded, and R&D and production divisions greatly scaled down or completely terminated. With the unfolding of this scenario Knoll AG would be reduced to a marketing operation in Germany. The second clearest case of exit is Hoechst/Aventis. Although this was formally structured as a "merger of equals", the status of the German operations clearly have been downgraded, particularly R&D. There has been a symbolic shift in the national identity of the company based on the location of company headquarters and the removal of Hoechst/Aventis from the DAX, the index of the 30 most important listed German companies. More concretely, the merger has meant a loss of jobs for Germany since the company headquarters has been moved to France and R&D in only 3 of 10 major diagnostic areas has remained is now centered in Frankfurt.13 Bayer top management has proclaimed that it remains committed to the "Rhineland" approach and an integrated chemical/pharmaceutical strategy, and has easily blocked the efforts of some US investors to force a breakup. However, a relative increase in the importance of the US as a location for R&D can also be observed. Of the 12,000 employees involved in R&D, 25% are located in the US and the tendency is increasing (Bayer AG 2000). Perhaps more significantly, in the summer of 2001 the dangers of pursuing a "blockbuster" strategy in pharmaceuticals for the entire concern became clear due to the controversy surrounding the cholesterol-treatment medication Lipobay. This was one of Bayer's most important new drugs in terms of sales and (up to then) an apparent indication of the success of Bayer in restructuring its R&D efforts. As evidence linking more than 50 deaths and thousands of cases of muscle weakness attacks became public, Bayer decided to withdraw Lipobay from the market, resulting in a large decrease in expected profits and a major fall in stock price. Since a larger company with a greater number of high-sales drugs would have not been as severely affected, this has reopened a discussion of whether Bayer's pharmaceutical operations are large enough to handle the risk of loss of a major product. Bayer's CEO has recently stated that he is now taking a closer look at "all options" regarding the future of pharma, including a joint venture or full divestiture of part or all of the health care operations. One of the large US pharma companies would be a logical partner or purchaser given their high market capitalization (thus ability to finance deals through share exchange) and their interest in expanding European operations. If this scenario were realized and R&D and production operations in Germany reduced, then there would be an almost total withdrawal of Big Pharma from Germany. 13

R&D in three diagnostic areas is centered in Vitry, France and four areas in Bridgewater, New Jersey.

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Ironically these developments are taking place at the same time that major doubts are emerging about the long-term viability of the blockbuster approach. First, although concentration has reduced the number of large players in the pharmaceutical industry, these companies are increasingly focusing their research on the same types of problems, particularly the major causes of death. This has resulted in increased competition and lower profit margins through the more rapid emergence of "me too" drugs, i.e. substances which can be easily substituted for drugs that have been the first-to-market. Second, cures for the relatively "simple" mass medical problems have for the most been developed, leaving the much more complex and costly problems for research to solve (The Boston Consulting Group 1999). The exit of large pharma companies from research on substances without blockbuster potential has, however, created new opportunities for companies with less ambitious sales goals. Interestingly, many German mid-size, often family-owned pharma companies have stepped up their research efforts based on incremental innovation strategies focused on niche markets within a single therapeutic area.14 Companies such as Schering, Schwarz Pharma, and Grünental are successfully integrating new biotech "platform technologies" with highly specialized know-how in a core therapeutic area. Profit margins in specialized niche markets are typically higher, since the markets are too small for large companies to be interested in and the number of competitors are lower. Costs and risks of R&D are also typically much lower because incremental innovations can build on previous sunk costs. The costs of clinical testing, which can make up 80% of the total R&D costs of a new medication, are generally lower for niche markets since fewer patients have to be involved in the tests. This type of "Mittelstand" oriented focus on high quality niche products is of course a defining characteristic of a wide variety of "medium-tech" industries in Germany, such as machine tools, electrical equipment, and segments of the automobile industry (Streeck, 1992; Vitols 1995). The increasing division of labor in the world pharma market, with US/UK companies gaining a dominant share of blockbuster products while mid-size German companies increasing their global presence in specialized niche markets, shows that traditional patterns of industrial production also hold in knowledge-based industries, and thus represent a powerful confirmation of the strength of the production regimes approach to explaining longrun industrial change.

14

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This analysis is based on interviews conducted jointly with Heiko Günther, Humboldt University Berlin, with management at a number of mid-sized German pharmaceutical companies and with representatives of pharmaceutical associations.

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