Clean Bill of Health
The Deal
by Thomas Zadvydas
Updated 02:07 PM, Dec-10-2010 ET
M&A activity has recovered from a two-year decline, and the healthcare industry is a driving force of the revival.
There have been 1,037 healthcare mergers announced year to date, according to a November M&A report from William Blair & Co. LLC, topped only by the computer and electronics (1,993) and business services (1,287) sectors.
The industry's prominent return to the auction tables is a result of several conspiring factors. For starters, drastic healthcare reform in the U.S., coupled with uncertainty for much of the year about potential changes in the country's tax code, have cast a pall over the biotechnology and pharmaceutical industries, pushing many companies to seek deals in order to adapt to an amorphous landscape. At the same time, looming patent expirations for compounds are driving many companies to go hunting for targets to fill holes in their pipeline. All of this is happening in a market still recovering from the worst economic downturn since the 1930s, leaving valuations restrained and obscured.
"We continue to see a lot of consolidation; you're seeing big companies like Amgen Inc., Pfizer Inc., Johnson & Johnson to be actively looking in the market," says Jones Day life sciences partner Jonn Beeson.
One driving factor is the pending loss of patent exclusivity on key drugs for many pharmaceutical companies. IMS Health Inc., which collects marketing data for the pharmaceutical and healthcare industries, says that more than three dozen drugs that produce about $137 billion in annual revenue are expected by 2013 to fall off the patent cliff, an apocalyptic term the industry uses to describe the coming end to the brand-name exclusivity that laws across the world grant their medications.
Pfizer is one big pharmaceutical company grappling with this issue.
"Everybody knows Lipitor is one of Pfizer's biggest products. It's a blockbuster [drug] and they're losing patent protection soon," says Gregg Blake, a managing partner at healthcare investment bank Brocair Partners LLC. "They're buying King Pharmaceuticals Inc. in order to bring in a bunch of new products and also diversify a little. King has a drug delivery business with injectibles and also an animal health business."
Lipitor, which generated $13 billion in sales in 2009, falls off the patent cliff at the end of November 2011. Blake explains that sales of a drug can crater by as much as 90% in a year after a patent is lost and generic alternatives enter the market.
Pfizer announced an agreement on Oct. 12 to buy Bristol, Tenn.-based King Pharmaceuticals for $3.6 billion cash. About one week later, on Oct. 20, the New York pharma bought a 40% stake in Brazil's Laboratório Teuto Brasileiro SA for $240 million in an effort to expand its presence in both an emerging economy and the generic drugs market. Meanwhile, Pfizer has also placed its Capsugel hard capsules unit on the auction block, a move that could portend other noncore divestitures by the conglomerate, analysts say.
"They've made a big strategic move into generics over the last 20 years," says Blake of Pfizer. "A lot of other big pharmaceutical companies are diversifying that way too."
Adding drugs new to the market, or even drugs in the late stages of development, through acquisitions also allows pharmaceutical companies to sidestep the long and arduous process of developing drugs from scratch, a costly undertaking that can take years, with no guarantee that the drug will ever reach the market, let alone become a financial success.
"At the end of the day, pharmaceutical companies are finding that it is cheaper to buy than to just research," says Alden Philbrick, chief executive of Oxford Finance Corp.
Gregory B. Brown, a managing director at Cowen Healthcare Royalty Partners, a healthcare private equity firm affiliated with Cowen Group Inc., agrees, adding that many pharmaceutical companies face increasing shareholder pressure to find cheaper, safer, alternatives.
"It's an industry that has been acculturated or accustomed to taking capital that's generated from product revenue and plowing it back into research, but shareholders today are saying, 'Wait a minute, there may be a better way,' " Brown says, referring to the increase in M&A.
Expanding drug offerings via M&A to appease shareholders is no sure bet, of course. Consider the plight of San Diego-based Cypress Bioscience Inc., which in September put itself up for sale after rejecting a sweetened $4.25 per share bid from shareholder Ramius Value & Opportunity Acquisition LLC. The affiliate of New York hedge fund Ramius LLC, a 9.9% shareholder, on July 19 offered $4 per share, then a 60% premium over Cypress' share price, complaining that management had destroyed the drugmaker's shareholder value. Specifically, Ramius deemed Cypress' purchase of Proprius Pharmaceuticals Inc. "a complete failure," one that cost the company $40 million while generating less than $600,000 in revenue. Lagging drug production at Cypress was also a concern of Ramius. Two days before rejecting the hedge fund's first bid, Cypress said it would discontinue its co-promotion of the Savella drug with partner Forest Laboratories Inc. (Ramius raised its bid for Cypress to $5.50 per share on Friday.)
On the regulatory front, the Food and Drug Administration's sluggish approval process for new drugs and devices has led pharmaceutical companies to buy targets that have drugs already approved, or close to winning regulatory approval, rather than develop them through their own research. "[The approval] process has been slower, I think, in the U.S. than it has been in Europe, and it's gotten slower over the last few years, which is a real concern to emerging companies in particular, and [their] investors," says Steve Jannetta, a life sciences lawyer at Morgan, Lewis & Bockius LLP.
U.S. healthcare reform, embodied in the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010, which were signed into law by President Obama on March 23 and March 30, respectively, is also a driving force of M&A in the industry, for a number of reasons. For starters, the laws subject medical device makers to a 2.3% excise tax, a tariff intended to generate $20 billion over the next 10 years to help pay for the $940 billion healthcare package. As a result, smaller medtech companies have less incentive to invest money into their businesses because the associated compliance and regulatory taxes affect their bottom line more than that of a larger company. At the same time, larger players in the medtech space have begun to scale up in order to offset another 230 basis points to their operating margins.
The immediate result has been a round of larger companies moving to build up their businesses by jockeying for smaller players that are seeking tax shelter, as seen in Boston Scientific Corp.'s $443.5 million acquisition of asthma treatment products maker Asthmatx Inc. in September. Medtronic Inc. has also pursued this strategy. The Minneapolis medical therapy device maker purchased cardiovascular device manufacturer ATS Medical Inc. for $370 million in April and later acquired bone-grafting materials manufacturer Osteotech Inc. for $123 million in August.
Some industry professionals say that healthcare reform could implement price controls over new products or changes in reimbursement and payment structures, all of which could cut into drugmakers' revenue, once again providing incentive for smaller companies to seek partnerships. Bottom line, companies in the industry are confused about what the regulatory landscape will look like once the dust settles — and that was before the balance of power dramatically shifted in Washington with the midterm elections. Republicans have gained control of the House of Representatives, and while Democrats still hold the Senate by a narrow margin, the GOP has made it clear that it wants to repeal certain aspects of healthcare reform.
"There are going to be more people in the [healthcare] system; therefore, theoretically there's going to be more demand for product," Jannetta says. "But the payment mechanism and reimbursement structure, it is still looking to be a challenge. That's going to impact coverage decisions, we think."
Adam Berger of Leerink Swann LLC adds that it is difficult for most in the industry to understand what the new regulations actually mean. "There are so many regulatory decisions that are subject to interpretation," he says.
Likewise, uncertainty about potential changes in the U.S. tax code has driven deals in the healthcare sector, just as it has in many other industries. With many of the tax cuts established during the Bush administration set to expire at year's end, many companies rushed to complete deals before the capital gains tax increased from 15% to 20%, one of the many anticipated changes to the tax code had Congress let the tax cuts lapse. Obama's recent deal with Republicans on an extension of the tax cuts, if approved by the Senate, will keep the capital gains tax unchanged. However, lacking a crystal ball to predict the future, many companies, such as Celgene Corp. , which in June acquired Abraxis Biosciences Inc. for about $2.9 billion in cash and stock, spent the year trying to lock in deals to avoid paying a higher capital gains tax.
"Abraxis, although publicly traded, is 80-plus percent owned by Patrick Soon-Shiong, who was going to take a capital gain on that sale. We got it closed, but there was a big push to get it closed by year-end," says Beeson, who represented Celgene on the transaction.
Despite the increased volume of M&A in the healthcare sector, valuations of these targets are generally not as high as they are in other sectors. According to the November William Blair M&A report, healthcare deals in 2010 were valued at an average of 12.2 times Ebitda. The multiple lags slightly behind the other industries driving M&A this year, computers and electronics (13.3 times) and business services (12.3 times).
Even these numbers can be misleading, however. A more accurate way to value a biotech company is by a multiple of revenue rather than Ebitda, professionals in the industry say. "It's for those companies that maybe have two products on the market [that are] generating $50 million in revenue, but they've got five more in the clinic being tested and waiting for approval, and they're investing a lot of money in those clinical trials, then really only the revenue is going to be meaningful," Blake says.
In addition, biotech auctions are not usually crowed affairs. "[Auctions are] dominated by strategics," Brown says, "and strategics' needs are highly specific. They need drugs that are going to [help them] grow but grow in a specific area. [As a result], some of the auctions don't actually turn into sales."
The banker cites the auction of Biogen Idec Inc., which makes multiple sclerosis drugs Avonex and Tysabri. The company hit the block in October 2007 after investor Carl Icahn made an approximate $23 billion offer for the company. "Icahn forced the company to undergo a strategic process and [it] sought bidders and nobody pulled the trigger, and Biogen Idec remains independent," Brown explains.
A more recent bellwether for the auction climate is the $4 billion acquisition of Melville, N.Y.-based OSI Pharmaceuticals Inc. by Astellas Pharmaceuticals Inc. of Tokyo, which closed in June. OSI rejected a hostile $3.5 billion bid from the buyer on March 15 and tried to seek other offers — Swiss pharmaceutical heavyweight Roche Holding AG had been tipped as a potential white knight — but it came up short and ended up being bought by Astellas. Through the acquisition, Astellas gained rights to Tarceva, a non-small-cell lung and pancreatic cancer treatment that had 2009 sales of $1.2 billion.
"In biotech, it's not uncommon for a very high quality, very high profile to go on the block, and there's not a buyer because of the specificity of what's in the company's pipeline," Brown says.
Brown attributes the valuation slide to a lower number of new, captivating drugs on the market. "There are times when the biotech industry is in favor and those tend to be times when there are some high-profile pipeline products that are on the verge of approval or recently launched and they capture the imagination of the investment community," he says. "There are other times when it is out of favor, when a couple of high-profile products may have crashed and burned so that the real risk of product development seems larger than it is."
Others agree, but no one expects deal activity in the sector to wane anytime soon, despite the foggy regulatory climate. "No matter what the outcomes of some of the political debates, good companies that solve problems are going to be very successful," Philbrick says.