Jenks Healthcare Business Report July 2002

In the July 2002 issue:

The M&A Market: A Premature Eulogy?

While many were off on their summer vacations, bankers and lawyers put the finishing touches on the first blockbuster deal of the year with the surprise announcement that Pfizer will buy Pharmacia Corp. in an all stock deal. See page 1

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Other M&A Activity

The Pfizer/Pharmacia deal may result in renewed consolidation in the pharmaceutical and biotech sectors, but the health care services segment dominated M&A activity in the second quarter. See page 6

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Public Equity Market

Despite a deteriorating public equity market, four IPOs managed to get priced in the past month. The last two, however, suffered in their pricing, and the IPOs waiting to get done may have a long wait. Medco Health Solutions has dropped its expected price, but may have to go even lower to attract the necessary interest level in this market. See page 8

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Venture Capital Market

For the third month in a row, more than 20 health care companies tapped the venture capital market, raising approximately $350 million. See page 10

Jenks Healthcare Business Report

The M&A Market: A Premature Eulogy?

While the market’s focus was on who would take
on an acquisition of Bristol-Myers Squibb (NYSE: BMY) as its stock price continued its downward spiral, people seemed to forget that there are other targets in the market, as well as buyers with aspirations that do not include assimilating a troubled company.

For weeks, if not months, all we have been hearing is that the merger and acquisition market is dead, bankers’ fees have dried up to an extent not seen in a few decades and that the too numerous to mention accounting scandals have left corporate board rooms (let alone management) nervous about any potential missteps. And then, in the heat of the summer, everything has changed. Or has it?

Pfizer’s (NYSE: PFE) recent agreement to buy Pharmacia Corp. (NYSE: PHA) for approximately $60 billion was most surprising because of its timing. The concept of "value" has been battered, especially amid a jumpy stock market that produces 5% swings in a matter of hours, and where most pharmaceutical company stocks have tumbled by 20% to 50% in price this year.

In this environment, one may even question the need to pay much of a premium at all to take over a company, if the merger makes sense for both sets of stockholders.

The deal, which valued PHA’s shares at just over $45 per share, represented, at the time of the announcement, an astounding premium of 44% and a price that has been criticized by some analysts as too rich for the current environment. With PFE’s subsequent price drop, the premium has been cut in half. It must be remembered, however, that PHA’s share price was above $45 three different times in the past year: mid-2001, late 2001 and just three months ago.

Up until the past month, PHA’s trading range for the past year had been between $37 and $46 per share. Consequently, in this historical context, $45 per share does not appear outrageous, but questions will linger whether that full of a premium was really necessary, especially given the recent trend in values and the suspicion that pharmaceutical companies in general have an uphill perception battle with investors, Congress and consumers.

The other question is, why Pharmacia and why now? Since PHA’s stock traded as high as $64 per share a little over 18 months ago, one could argue that the timing was right in terms of snaring the pharmaceutical company at the bottom of the market, or so they hope. In addition, the two companies know each other well, having jointly marketed PHA’s top-selling drug, Celebrex, for the past three years as well as Bextra, a new arthritis drug.

The combination also brings Pfizer into a few markets in which it has little presence, most notably the cancer market. Mostly because their respective drug portfolios complement each other, few antitrust issues are expected to be raised, even though the combined company will be 50% larger than its nearest competitor (GlaxoSmithKline, NYSE: GSK) but will have just 11% of the worldwide drug market. International positioning is another reason for the deal as well. Pfizer will become the largest drug company in Europe and Japan, where before the merger, its rank was fourth and third, respectively.

Financially, the two companies are very different, however. Pfizer’s revenues last year of $32.3 billion were nearly 2.5 times Pharmacia’s, but more importantly, PFE’s profit margin of 24.1% last year was more than double the 10.9% margin produced by PHA in 2001. Both companies spend about 15% to 16% of revenues on R&D, but PHA’s R&D budget is 50% greater than the company’s net income, while PFE’s expenditures were just 62% of 2001 net income. It is interesting to note that if R&D expenditures of the combined companies are not reduced, they will be more than the total revenues of all but the top ten pharmaceutical companies worldwide. However, if that does not put them in a leadership role in terms of new blockbuster drugs, investors will quickly vote with their feet.

The naysayers, and there are a few of them, may question some of the motives for this transaction. At a time when patents in general are expiring and few blockbuster drugs are on the horizon, combined with decreasing margins and slower revenue and income growth amidst a threat, not of price controls, but pricing pressure, it could be said that this merger will hide a few things during the next two years when turmoil is certainly going to reign in the pharmaceutical industry.

Assuming the deal goes through at the end of the year, it will be difficult to analyze what is really going on behind the reported numbers for a few years, especially given the projected cost savings of $1.4 billion in 2003 and $2.5 billion the following year. Even with these savings, the deal may not be accretive to Pfizer’s earnings in 2003, and will only be accretive by six cents a share in 2004.

Speaking of the cost savings, in a time of slower earnings growth, an argument could be made that one motivation for the deal was to goose earnings beginning in 2004, with more accretion in succeeding years. The problem, however, is that the projected accretion is relatively slim, at least in 2004, and little mention has been made regarding any boost to earnings from potential blockbuster drugs, which are the real earnings drivers for pharmaceutical companies.

Perhaps the real motivation for the acquisition is the marketing clout that will accrue to the combined company. Already the largest pharmaceutical company prior to the merger, Pfizer will be the true 800-pound gorilla in the market that cannot be ignored by biotechnology firms looking for a partner, pharmacy benefit management companies or HMOs trying to contain drug spending. Its sales force will be far larger than the closest competitor, and, as we have mentioned, Pfizer will spend more on research than most companies make in selling their drugs.

And herein lies the crucial issue. Will having the capacity to spend more than $7 billion on R&D translate into a leadership position in drug development? Unfortunately, money alone does not guarantee success, and an even more bloated bureaucracy could hinder the kind of innovation that is needed, especially at this critical period for the pharmaceutical industry.

In addition, it is questionable whether Pfizer will maintain all of PHA’s research laboratories, and how the ones that do remain will assimilate into one overall drug discovery program. The marketing strength and diverse portfolio of existing drugs is a given; it remains to be seen, however, whether management can deliver on a proportionate share of future blockbuster drugs. Only that will drive the long-term value of Pfizer’s shares, not squeezing what it can from cost savings and perhaps a few other tricks.

As a result of the Pfizer/Pharmacia deal, pharmaceutical companies, and their bankers (of course), are scurrying around to see what other opportunities may exist in the market. The M&A market in general has been extremely quiet for the past year, and the value of the Pharmacia transaction is more than double the total amount spent so far this year for all health care mergers and acquisitions, just to put the size in perspective. Market participants assume that this deal will trigger more consolidation among the major pharmaceutical companies, but investors will be more demanding than ever in terms of a financial rationale for any major deal other than size matters.

There have been only two pharmaceutical company deals larger than the Pfizer/Pharmacia merger: Pfizer’s purchase of Warner-Lambert in late 1999 and Glaxo Wellcome’s merger with SmithKline Beecham in 2000. The next largest deal was about one-fifth the size of the Pharmacia transaction. Because Pfizer’s management did such a good job assimilating the Warner-Lambert acquisition, analysts are assuming that Pharmacia will present few problems.

What this mega-merger has done is put everyone in play, either as a buyer or seller. Speculation about a possible Roche Holding AG merger with Novartis (NYSE: NVS), however, was mooted by the CEO of Roche, and potential suitors for Bristol-Myers Squibb have to remain cautious about what else may be wrong at the beleaguered drug giant. As the stock market continues its downward spiral, an increasing number of companies will look more attractive, but this will include the large stable of biotechnology firms. The M&A market certainly received a jolt, and it is far from being dead, but it is questionable whether a flurry of deals will soon follow.

Read the past headlines.