Jenks Healthcare Business Report January 2002

In the January 2002 issue:

The level of M&A activity should increase in 2002, as several sectors recover from the financial distress of the past few years while many companies will turn to tactical acquisitions.
P. 1

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Public Equity Market

Last year’s fourth quarter IPOs are still the stars of the market; four companies have recently filed and hope to do as well.
P. 7

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Venture Capital Market

A record $320.5 million was raised in less than four weeks by just 15 companies.
P. 10

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e-Health In The Black

Once written off, the e-health sector may be making a comeback as several companies are doing better than expected. Will cash burn rates finally be a thing of the past?
P. 12

Jenks Healthcare Business Report

Mergers and Acquisitions: A Rebound In Store For 2002

By most accounts, 2001 was a relatively flat year in the health care merger and acquisition market. The number of announced transactions each quarter ranged between 180 and 220, with a total of just under 800 for the year, and was evenly split between the services and technology segments. The dollar volume, however, was heavily weighted toward the technology side, driven by several high priced pharmaceutical and biotech transactions. Of the $80.5 billion spent on acquisitions last year, 82% was in the technology segment. The decrease in blockbuster deals (over $1 billion) was a result of declining stock market valuations and uncertainty with the economy. Despite the fallout subsequent to September 11, however, during the fourth quarter there were four transactions announced valued at $1 billion or more each.

During 2001 there were some discernible trends in the acquisition market, a few of which may carry over into this year. The most obvious was the increased interest in biotech companies. The number of announced biotech transactions in the second half of 2001 (53) was 66% above the number in the first half of the year (32). Biotech companies are being sought by both larger pharmaceutical companies looking to fill a lagging drug pipeline as well as other biotechs trying to reduce costs and combine duplicative research efforts in a competitive market. The risk, however, is that most of the biotech targets do not yet make money, so the acquirors are gambling that products under development will first work and then get approved. As we will see, that is a bet that is not always won. The pharmaceutical sector witnessed a similar jump in deals from the first half of the year to the second half (53%), and included two transactions valued above $7 billion each announced in the first quarter.

The beleaguered long-term care sector, which had been drifting along with an unusually low average of 10 transactions per quarter for the first three quarters last year, almost doubled that volume with 19 announced deals in the fourth quarter, which was also a 171% increase over the fourth quarter 2000. Much of the activity has revolved around the repositioning of assets, both from financially troubled companies as well as strategic divestitures, such as companies exiting particular regions or states. The buyers have been predominantly regional companies looking to selectively grow with one or two facility acquisitions. In the first time in a decade, no deal topped $200 million in value, partly because there were few companies financially capable of such a large transaction, with perhaps even fewer lenders willing to finance it.

The hospital sector, which historically has been one of the most active areas of health care services acquisitions, was dominated by small tactical acquisitions throughout the year. Up until the last week of the year, two of the three largest transactions in 2001, based on purchase price, involved the sale of individual hospitals. It was not until late December, when Daughters of Charity, Western Province announced it was buying back seven hospitals from Catholic Health Care West for a purported $403 million, that the sector had a deal valued above $200 million in 2001.

As we look into 2002 and beyond, some of the year-end trends of 2001 can be expected to continue. As an example, the volume of long-term care transactions will remain close to the fourth quarter’s level, if not even higher. During the past 18 months, most of the largest nursing home chains have been in bankruptcy, but two emerged in 2001 and two more are expected to have their reorganization plans approved during the first half of 2002. With stronger balance sheets and an appetite to grow (again), these companies will be looking to make tactical as well as strategic acquisitions. The regional nursing home companies will find renewed competition in the market, but they should not be counted out. In the assisted living sector, there are still over 100 facilities that need to be sold by some struggling national chains, and this will dominate the market throughout the year. By the end of 2002, however, financial stability will begin to return, occupancy levels will increase and, with practically no new development occurring, the sector will see new interest from investors.

Although few large transactions are expected in the hospital sector, a merger between two of the publicly traded chains, something we have not seen since the fourth quarter of 2000, is likely. The real activity will continue to be centered on tactical acquisitions in geographic areas where companies want to increase their penetration. The for-profit chains have been turning in near-record financial results during the past 12 months while the performance of many nonprofits has been lagging. This may force the latter institutions to seek alliances with the former. With the current recession, combined with back-to-back double-digit increases in health care costs, however, hospitals may begin to feel a reimbursement squeeze in the very near future, something that has been avoided for several years.

In the managed care sector, the industry seems to be dividing between those insurers that are healthy and those that are being confined to the sickbay. As the valuations of the struggling managed care companies decline, the question is, will they be tempting acquisition targets for the healthier ones? Although anything is possible, and one has to consider the ego factor, there would be too many risks involved to warrant any significant deal, and Wall Street would surely give it a thumbs down. There will, however, be continued interest in the various Blue Cross Blue Shield plans that are still independent, as evidenced by the two deals announced by WellPoint Health Network (NYSE: WLP) late last year. With Anthem (NYSE: ATH) now public, it will also have its eye on a few targets. One may be Horizon Blue Cross Blue Shield of New Jersey, the state’s largest health insurer with 2.5 million covered lives and $4.9 billion in revenues. Horizon’s board authorized management to explore the process of converting the company to for-profit status, a step that often leads to being acquired.

Although the market focused on the "surge" in fourth quarter 2001 biotech acquisitions, the reality is that the number of transactions was actually less than in the fourth quarter of 2000. The difference was the size of the deals and who was doing the buying. This level of activity may not be sustainable, however, because the speculative increase in stock valuations in the fourth quarter last year may have priced some of the most likely targets out of the market. Still, an argument can be made that there are too many biotech companies, often chasing the same products or cures, which could benefit from economies of scale. The large pharmaceutical companies have been happy to let them conduct their research independently or in partnership with them, but with a record number of blockbuster drugs coming off patent in the near future and with earnings expected to be flat in 2002 for some companies, big pharma is looking for deals to provide a jump start for future growth.

Finally, two sectors that have been in a coma for the past year - home health care and e-health - will both see increased activity in 2002, even though any activity in the home health sector would give it life. The concept of e-health remains valid, it was just the absurd valuations in 1999 and 2000 and many of the business plans that were flawed (hindsight is always 20/20) that caused such a rapid deterioration. The M&A activity in 2002 will continue to center around the repositioning of assets of troubled or bankrupt companies, much like 2001, but most of the survivors are expected to turn cash flow positive this year.

The key word is "expected," because those that experience an unintended hiccup will suffer a harsh drop in valuation and become a target themselves. Home health care, which is seeing many technological advances with the Internet, does not have a solid pool of logical buyers with the capital to fuel growth by acquisition. If the senior care providers would ever wake up and accept the logical relationship of home health with their primary business (Sunrise Assisted Living, NYSE: SRZ, has seen the light, so to speak), there would be a resurgence in deal flow. Most likely, we will have to wait until 2003 or beyond.

This brings up the age-old question. Do acquisitions really make financial sense? The easy answer is that properly executed tactical acquisitions usually do while strategic acquisitions, which are either large or in a different product or service type (or both) often do not. Overpaying for either tactical or strategic acquisitions, however, will almost always make little sense. The targeted deals, whether a hospital company increasing its market share in a metropolitan area or a pharmaceutical company buying the rights to an important new product, usually involve little risk, small amounts of capital and not too much senior management time.

The large strategic acquisitions, however, are often the exact opposite, compounded by the fact that they usually come with excess baggage that must be sold off at a later date, with the cash proceeds uncertain. This is especially true in such facility-based businesses as hospitals and long-term care.

The drop in large, strategic acquisitions in 2001 reflected both the economic (and capital market) realities of the year as well as, we hope, a heightened realization of the risks involved in such deals, with the former obviously influencing the latter. In any acquisition, however, there is always a certain amount of risk that due diligence can not analyze away. A case in point is Bristol-Myers Squibb’s (NYSE: BMY) acquisition of a 19.9% interest in ImClone Systems (NASDAQ: IMCL) late last year for just over $1.0 billion. BMY’s primary reason for investing in the company was to get access to IMCL’s experimental colorectal cancer drug, Erbitux, and it has agreed to pay an additional $1.0 billion for the right to keep 40% of the profits from the drug. After BMY’s blockbuster cancer drug Taxol went off patent, the company’s share of the cancer market dropped from a high of 37% in 1996 to 21% today. This investment appeared to be a way to get back on top.

Unfortunately, either the due diligence was not thorough enough or the problems to be encountered with the FDA could not have been uncovered. In late December, ImClone announced that the FDA rejected its application for Erbitux, mostly because of a lack of key clinical data needed to show that the drug is effective in treating patients with colorectal cancer. Regarding the failure to adequately document some of the patients in a clinical trial, at the J.P. Morgan H&Q Healthcare Conference in early January, ImClone’s CEO, Sam Waksal, apparently stated that it’s "not an insignificant problem; the data does not exist." To add insult to injury, Mr. Waksal sold 700,000 shares of his company’s stock in early December for approximately $71 per share (just above what BMY paid for its interest), only to see it drop by 50% in just over a month.

Timing is everything, and the delay in bringing Erbitux to market means that a competing drug may get to market before IMCL can produce more detailed paperwork to the FDA for approval. Depending on its ultimate effectiveness, Erbitux could still be a blockbuster drug, but it does show the inherent risk in trying to secure a drug pipeline by acquisition, and agreeing to pay a few billion for it. This setback will not stop the interest in biotech companies, but buyers may be a bit more conservative, at least until this fiasco becomes a distant memory (by next month).

Meanwhile, the acquisition market started the year with a flurry of deals, most of which have been relatively small. Chiron Corp. (NASDAQ: CHIR) agreed to buy cancer drug maker Matrix Pharmaceutical (NASDAQ: MATX) for $61 million, or $2.21 per share. MediChem Life Sciences (NASDAQ: MCLS) agreed to be sold to Iceland-based deCODE genetics (NASDAQ: DCGN) in an $83.6 million stock swap. Capital Senior Living (NYSE: CSU) announced the formation of a joint venture with Blackstone Real Estate Advisors to acquire in excess of $200 million of senior housing properties. On December 31, the venture acquired a 394-resident community in New York.

In the rumor mill, shares of generic drug maker IVAX Corp. (AMEX: IVX) have been rising based on speculation that it may be bought by another drug company. Rumors abound that Abbott Laboratories (NYSE: ABT) may try to buy its U.K. partner, Biocompatibles International PLC (ISEL: BII), which recently received U.S. approval for a stent to prevent small blood vessels from re-clogging after heart surgery. And an analyst at SG Cowen Securities named one Swiss and three U.K. biotech firms that are "potential brides that would or could come with near-term dowries." Presumably, they will all have their paperwork in good order before anyone says, "I do."

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