March 6, 2015

The market for healthcare and pharmaceutical M&A remains in positively rude health. Some acquirers retain a disciplined and focused approach rooted in a coherent strategic vision whilst others seize headlines with a more opportunistic style. An example of the latter is AbbVie (NASDAQ:ABBV), which dramatically swooped in to trump Johnson & Johnson (NYSE:JNJ) and win the auction for Pharmacylics (NASDAQ:PCYC). PCYC shares had already almost doubled over the course of 2015, and ABBV’s bid of $21 billion represented a handsome premium the rumoured $17.5 billion being offered by Pharmacylics’ marketing partner Johnson & Johnson.

The competitors in the auction for PCYC are not small firms: ABBV has a $97 billion enterprise value (and trades at a 14.5x EV/EBITDA multiple) and seems tiny only by way of comparison with JNJ, which boasts a $270 billion enterprise value (less than its $285 billion market capitalisation due to its cash hoard). These firms look to substantial transactions to fund growth for both familiar reasons – an acquisition can “move the needle” more swiftly than internally developed initiatives – as well as for the more industry specific model of finding emerging blockbuster drugs and rolling them into the corporate distribution channels. This has led to fevered bidding for desirable assets. An example of the success of this model is Gilead Life Sciences, a firm that, in 2011 spent $11 billion to acquire a firm that had a highly promising hepatitis drug but – at the time –  no sales. In 2014 that product – Sovaldi – generated slightly over $10 billion in revenues for Gilead. Stories such as underpin the rationale for paying rich prices for promising drugs (and their makers).

It is also why pharmaceutical deals now account for ~10.5% of total global M&A deal volume – about three times the historic norm.

Global Pharmaceutical M&A: 2000-2015 $US Billion

(Note: Were 2015 year-to-date pharmaceutical M&A annualised, then the total would exceed $350 billion)

Blog 6 March 2015 chart

Source: Thomson Reuters

Pharmacyclics  (NASDAQ:PCYC) has been, by any measure, an enormously successful turnaround. CEO Mr. Riley Duggan, an experienced businessman but no pharmaceuticals expert, first invested in Pharmacylics a little over a decade ago, subsequently naming many allies to the board and becoming CEO. Originally focused on drugs to treat brain tumours, Mr Duggan pivoted the company’s focus to a drug used to control certain types of leukemia. Very much in tune with the feast-or-famine model alluded to in the Gilead example above, the compound at the core of these drugs had been purchased by Pharmacylics for slightly less than $7 million (not billion) from DNA sequencing firm Celera Genomics

This compound became a drug and the drug was approved for sale towards the end of 2013. In 2014 sales of the product comfortably exceeded half a billion, with company guidance that sales were set to double in 2015. The company has other products in development, but a great many industry observers very much view Pharmacylics as a one-trick pony.

The wrinkle is that, in order to fund development of the leukemia drug,  Pharmacyclics sold a 50% interest to Johnson & Johnson for $1 billion. This 2011 deal also gave JNJ marketing rights in both US and international markets. Now AbbVie values Pharmacylics’ cancer drug at $42 billion ($21 billion for a 50% interest). It is worth noting that the patent on this blockbuster drug expires in 2026 – a little over a decade hence.

The current three best-selling cancer drugs (all made by Roche / SWX:ROG, which boasts a CHF233 billion enterprise value) each generate ~$7 billion in annual sales. During its analyst call AbbVie forecast that the Pharmacylics drug could exceed $11 billion in sales. Even so, at $21 billion for a 50% stake this represents almost 4x peak revenues (as opposed, to return to a previous example, 1x run-rate sales for the hepatitis drug maker).

AbbVie’s proposed deal structure combines 58% cash and 42% shares. This is a fixed price structure: the cash component is fixed as is the dollar value of the share component. If AbbVie’s share price falls – and the stock dropped almost 6% on announcement of the deal – then ABBV ‘s existing shareholders will experience increased dilution

Last year AbbVie attempted to buy Shire Pharmaceuticals, an undertaking that would have both added drugs to the product roster and – more importantly for AbbVie – given it the ability to undertake a redomiciling of its corporate headquarters to Ireland This so-called “inversion” transaction would have accorded AbbVie an Irish tax rate (which compares favourably with what is on offer in the US). When the U.S  Treasury Department moved to block such transactions AbbVie was left paying a $1.6 billion break fee.

Some have consequently suggested that AbbVie has deal hunger; indeed some analysts quoted in the press labelled AbbVie as looking “desperate”. It could conversely be pointed out that the firm faces a very serious strategic challenge. Roughly 60% of ABBV’s turnover is generated by a treatment for rheumatoid arthritis: the patent on this drug (Humira) expires in 2016 and the expectation among industry watchers is that generic drug makers will produce near-copies (“biosimilars” in industry parlance) reasonably shortly thereafter. This may have explained why a company already known for its aggressive stance in auctions elected to so decisively trump two other bidders.

AbbVie’s value-creating case is that, even allowing for the issuance of shares, the deal will be accretive to EPS in 2017. Moreover AbbVie argues that the compound underpinning the leukemia drug can potentially be applied to treat other cancers. There is undoubtedly execution and dilution risk embodied in this strategy: a problem not confined to the sector as any large company making a substantial transaction faces issues around price and the impact on capital structure.

We do not expect the industry dynamics underpinning the robust and active deal dynamics in biotechnology, pharmaceuticals and healthcare to change as long as equity and debt markets remain healthy and the upside of outsized bets remains significant.

Blog 6 March 2015 share price chart

Source: S&P CapitalIQ