The Health Care M&A Monthly: Size Does Matter: Pharmaceutical Industry Consolidation Continues

Frankly, since the beginning of the year we had been fretting about the absence of billion-dollar deals from the health care M&A market. Until this month, that is. Two such deals were announced in the Pharmaceutical sector (and a third in Specialty Pharmacy, see below). While neither deal is a record-breaker, each illustrates how the globalization of the pharmaceutical industry is driving continued consolidation.
Generics Gain Ground
In the first deal, the larger of the two, Novartis AG (NYSE: NVS) is acquiring two related generic drug companies, privately held Hexel AG and publicly traded Eon Labs (NASDAQ: ELAB). Their connection lies in that fact that both are controlled by the Struengmann brothers, Andreas and Thomas, who founded Hexel and own a 66.7% stake in ELAB.
Based in Switzerland, Novartis is the world’s sixth largest pharmaceutical company, generating annualized revenue of about $28.25 billion. It has two primary divisions: pharmaceuticals and consumer health. Its pharmaceuticals division has both branded and generic units, with branded products outselling generics by five to one. However, NVS would like to change that: it bought the generics business of BASF AG in 2000, Solvenia’s Lek, DD for $877.8 million in 2002 and Canada’s Sabex Holdings for $565 million in 2004. These now form part of the company’s generic Sandoz unit.
Hexel is the second-largest generic drug manufacturer in Germany, which is the largest market for generics in Europe and second only to the U.S. in its appetite for generic products. It has over 120 products, including analgesics and cholesterol drugs. In 2004 it generated revenue of $1.7 billion. Eon Labs, based in New York, develops, licenses, manufactures and distributes generic drugs in the United States. Its products include 67 molecules in 147 dosage strengths; in 2004 it generated revenue of $431 million. ELAB obtains new drugs either through internal development or through strategic licensing or co-development with other companies, primarily Hexel. The two of them generate combined annual revenue of $2.13 billion.
Under terms of this all-cash deal, Novartis will offer $7.4 billion for all of Hexel and two-thirds of ELAB. It will then offer $31 per share for the one-third of ELAB that is not held by the Struengmann family, which represents an 11% premium to ELAB’s prior-day price and a 25% premium to its price before media speculation earlier in the month started ramping up the price. The total purchase price works out to $8.4 billion.
The market seemed to like the deal, with shares of NVS rising 3% on news of the deal. News of the transaction also sparked talk of further consolidation in the German generics market, with shares of Stada Arzneimittel (DE: STAGn), for example, rising by nearly 10%.
Is this optimism justified? The operations of these two targets will be combined with NVS’ Sandoz unit, creating a generic pharmaceutical company with annual revenue of $5.1 billion and a portfolio of 600 drugs. In doing so, it would supplant Israel’s Teva Pharmaceuticals (NASDAQ: TEVA), with annual revenue of $4.8 billion, as the world’s largest manufacturer of generic drugs, but not by much.
Though Teva didn’t appear overly fazed by the Novartis’ deal, it has been rumored in the bazaar that Teva is stalking a very large generic drug company in India, where production costs are low. It if were able to score a company such as Dr Reddy Laboratories (NYSE: RDY), it might quickly regain its position as top dog.
The price to revenue (P/R) multiple in the Hexel/Eon deal is 3.9x, which struck some analysts as a tad expensive for a pair of generic drug companies. But the potential rewards may outweigh the risk. First, this deal gives Sandoz access to high-margin versions of hard-to-make branded drugs. This should help to improve profitability at the division, which last year had an operating margin of 7.7%, as compared with the 28.4% in its branded pharmaceuticals division.
Second, as an all-cash deal, this transaction may generate better cash returns than if it were paid for in stock. Third, with increased size comes the ability to generate scales of economy, reduce costs and engage competitively in the generic drug market. The company hopes to capture 10% of the $100 billion generics market by 2010. It might be countered, however, that NVS is buying in markets where it has already suffered price pressure. The presence of ELAB in this deal is key to Sandoz’s plans to grow in the large U.S. market. Under a change approved by Congress in late 2003, millions more people will qualify for Medicare prescription drug benefits starting in 2006. Sandoz is positioning itself to benefit from the drive to contain costs by migrating patients from more expensive branded drugs to their generic counterparts.
And with about 150 manufacturers of generic drugs worldwide, scope remains for further consolidation in this industry niche.
Novartis was advised by Goldman Sachs. Merrill Lynch & Co. acted as financial advisor to ELAB in this deal. Hexel did not use an investment bank.
Preparing for Globalization
The second major deal is taking place in the world’s second-largest pharmaceuticals market and involves the combination of two Tokyo-based pharmaceutical companies. Sankyo Co. (T: 4501) announced plans to buy Daiichi Pharmaceutical Co. Ltd. in an all-stock deal that is worth $7.84 billion.
Sankyo is currently Japan’s second-largest pharma company by sales, specializing in circulatory drugs. It is projected to generate revenue of $5.6 billion for the year ending March 31, 2005. However, its number-two position is being threatened by the $7.76 billion merger of Fujisawa Pharmaceutical (T: 4511) with Yamanouchi Pharmaceutical (T: 4503), announced last year, which would demote Sankyo to number three—if it did nothing. What it proposes doing is bulking up through an acquisition.
Daiichi is Japan’s sixth-largest pharma company and specializes in drugs for infectious diseases. For the year ending March 31, 2005, it is projected to generate revenue of $3.1 billion.
According to the mechanics of the deal, the two companies will first establish a holding company by October 2005. In a share swap with the holding company, each Sankyo share will equal one share of the holding company while each Daiichi share will equal 1.159 holding company shares. As a result of the stock swap, current Sankyo shareholders will own 58% of the holding company, which is to be known as Daiichi Sankyo Co. and to be traded on an exchange yet to be determined.
In the first phase of this merger, the two companies will become subsidiaries of Daiichi Sankyo Co., which will take its position as Japan’s second-largest pharma company. In a second phase, their ethical pharmaceuticals business will be combined while the status of their OTC drug and other business lines will be reviewed.
The deal offers Daiichi shareholders a 14% premium, and is valued at 2.5x revenue. The premium struck some observers as a bit rich in the context of the Japanese market, but others noted that it may be justified by Daiichi’s relatively higher profit margin.
This combination will help the two companies pool resources for the R&D budget they need to accelerate drug development and remain competitive. And in the short term, it may also cushion some of the damage to Sankyo’s profits from declining revenue from its cholesterol drug, which went off patent in 2002. Merrill Lynch Japan advised Daiichi in this deal; Nomura Securities advised Sankyo.
After the dust settles, Takeda (T: 4052) will remain the number one pharmaceutical company, with $9.5 billion in revenue, followed by Daiichi Sankyo with $8.7 billion and Astellas Pharma, formed from the combination of Yamanouchi and Fujisawsa, with $8.1 billion. Also among Japan’s top 10 is Dainippon Pharmaceutical (T: 4506), which last November announced a $2.2 billion merger with Sumitomo Pharmaceuticals Co., a unit of Sumitomo Chemical (T: 4005).
What is driving all this consolidation in the Japanese pharma industry? A new law slated to come into effect in 2006 would permit greater foreign investment in Japanese companies. Viewed in one light, the merger of Daiichi and Sankyo, each of which is more than 30% foreign-owned, might be viewed as a kind of poison pill to ward off potential foreign takeovers. But while first and second, respectively, in the domestic market, on a global scale, Takeda is the 14th largest pharma company in terms of revenue and Daiichi Sankyo, the 15th. So if one of the big pharma companies wanted to make significant inroads into the Japanese market through acquisition, the targets might well lack the resources to withstand an attractive offer.
And it’s not just the size of Japan’s domestic pharmaceutical market that big pharma covets. Given the low price-to-book ratio, relatively low market cap and attractive pipelines of many Japanese pharmaceutical companies, they may be all but irresistible to buyers.