Jenks Healthcare Business Report December 2002

In the December 2002 issue:

2002: The Year Of The Abandoned Investor

Health care has unfortunately mirrored the larger market this year; only managed care has done substantially better, while pharmaceuticals did worse. But health care M&A and venture capital have both been healthy. We discuss the portents for profit in the public markets in 2003. See page 1

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Public Equity Market

IPOs everywhere are negligible, but health care managed another one this month, two secondaries priced, and another IPO is in the wings. See page 3

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Venture Capital Market

Health care grabbed a lot of venture capital as the year drew to a close, with 47 deals worth over $530 million announced. Biotech is back in the limelight, too, and investors are again showing interest in genomics.
See page 8

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Feature Stories

Pharma: Slowdowns and Showdowns. A look at what’s really happening in the drug pipeline. See page 4

Who Wins The Claritin War? A better question might be, who loses the least. See page 5

Profile: Songbird Hearing. One in a series of closer looks at firms successfully attracting VC. See page 11

Jenks Healthcare Business Report

2002: The Year Of The Abandoned Investor

For the second year in a row, there will be a sigh of relief when a year is finally behind us. In 2001, the reason was obvious; this year, embattled investors are looking for signs that the bear market is finally over. With just two weeks left in the year, however, the Nasdaq Composite and the S&P 500 are down 30% and 22%, respectively, while the Dow Jones Industrial Average is down just 15%.

While this is better than the mid-summer bottom, it has been a long time since investors have had something really to cheer about, especially something that has lasted more than just a few weeks. As one head of convertible sales at a large securities firm likes to remind us, the last time the market declined three years in a row (which will officially be the case in two weeks’ time), World War II followed. A sobering thought, but one that, notwithstanding the threat of war with Iraq, is not likely to come to pass this time around.

Other than the managed care sector, which has outperformed the market this year, and the hospital sector before Tenet Healthcare’s (NYSE: THC) disclosures several weeks ago, the performance of most health care stocks has mirrored the overall market. One other exception is the pharmaceutical sector, which has suffered disproportionately ever since the meltdown began with the Bristol-Myers Squibb (NYSE: BMY)/ImClone Systems (NAS-DAQ: IMCL) fiasco. All of the major pharmaceutical companies should end the year with negative returns except Forest Laboratories (NYSE: FRX), which is up about 20% for the year and recently announced a 2-for-1 stock split. Six companies in the sector could end the year with a 30% or greater drop in market cap.

Quite obviously, the tenor of the overall market has impacted the ability of smaller companies to tap the IPO market. So far in 2002, there have been fewer than 20 health care IPOs, with one more expected to be priced before year-end. Although the performance of these IPOs has been mixed, with a range of -56% to +50% from their offering prices, all but two did eventually trade above their initial pricing levels. The problem is that over time, most of these IPOs trended downward and seven are now in single digits. Investors remain skeptical, and that is why nearly a dozen health care IPOs have been withdrawn from the market since last summer.

One IPO that could have given the market a boost, Merck’s (NYSE: MRK) spin-off of Medco Health Solutions in a $1.0 billion offering, was pulled in July as its pricing levels started to erode. The pricing level began to deteriorate even before it was revealed that 20% of Medco’s revenues were actually the $10 and $20 co-payments to pharmacies that the company never actually received. Even though Medco’s bottom line is not impacted by this accounting treatment, and at least one other company does the same thing, the news spooked investors enough to cause the underwriters to withdraw the offering. Now, the IPO is expected to be brought to market in mid-2003, but whether the expected pricing has dropped even further is unknown.

Despite the lack of an IPO market, or perhaps because of it, venture firms continue to pump funds into growing health care companies. For most of the year, at least 20 new deals were announced each month, with total funds invested averaging between $250 million and $400 million. In the past two months, the volume has been the heaviest of the year, and while health care technology and development companies dominate the investment activity, health services is beginning to attract some renewed interest. The higher volume can be attributed to lower values placed on the companies as well as to the dearth of other funding alternatives for existing investors.

The problem, of course, is that at some point the venture capital well will run dry for these companies, and they will have to raise additional capital by going public, or else they will be sold to larger competitors. Either way, public company investors should benefit because unless there is a sharp rise in the market, IPOs in 2003 will be reasonably priced and significantly discounted from values that would have been obtainable a few years ago. Alternatively, if the companies end up being sold off because of a lack of demand in the IPO market, acquisition prices will be discounted, and that should be accretive to the earnings of the ultimate buyer.

And speaking of the merger and acquisition market, relative to other sectors, the health care M&A market has been alive and well in 2002, with an increase in both deal volume and total transaction value. The latter was helped, obviously, by the $60 billion price tag for the acquisition of Pharmacia Corp. (NYSE: PHA) by Pfizer (NYSE: PFE), since the largest deal in 2001 was just $16 billion. This year should end with just over 900 announced health care transactions for $100 billion (for deals with disclosed prices), compared with 820 and $75.3 billion last year.

Other than the Pharmacia deal, transactions are getting smaller in general. Barring a surprise announcement in the last two weeks of the year, there were only eight M&A transactions in 2002 with price tags of $1.0 billion or more, compared with 13 last year and 14 in 2000. Excluding the largest deal in both 2002 and 2001, the average deal size dropped to $44 million this year compared with $72 million in 2001.

If financing had been more plentiful, the volume of health care mergers and acquisitions this year would have been higher, primarily because valuations have become more reasonable. There also would have been more competition for target companies than occurred in 2002. In other words, with values driven so low, one would have expected to see more bargain-hunters enter the market, and more bidding wars, such as the battle for NCS Healthcare (OTCBB: NCSS) that is about to come to an end.

When Genesis Health Ventures (NASDAQ: GHVI), with the full backing of NCSS management (who also controlled more than 65% of NCSS stock), agreed to buy the company last July for approximately $1.60 per share, it looked like that might be the end of the story. But when OmniCare (NYSE: OCR), which had already been rebuffed by management, offered $3.00 per share, and then $3.50 per share, which was ultimately matched by Genesis, we had the makings of a true battle, the likes of which had not been seen in a few years.

Just two weeks ago it appeared as if Genesis would finally win in court, where the skirmish had moved. But then OCR got a court injunction, and raised its cash offer by an unheard of 57% to $5.50 per share, a price that Genesis was unwilling to match. This bidding war took place because investors had undervalued NCSS while the value of the business to the two competitors was, ultimately, worth more than three times the original public market value last summer. In fact, a year ago NCSS traded for less than $0.10 per share, but has over $600 million of revenues. More of this should occur next year if potential buyers try to understand the inherent value of some of the targets in the market and if public equity values remained depressed.

Values may remain relatively low, at least for the first half of next year, because investors are tired of the series of "surprises" with which they were bombarded throughout 2002, causing many of them to abandon the health care sector entirely. But if Bristol-Myers has one more embarrassing disclosure, or HealthSouth (NYSE: HRC), Tenet Healthcare or some other provider has another Medicare "interpretation issue," it won’t take much for more investors to walk away from the sector and others to remain on the sidelines even longer. Because health care technology is becoming increasingly complicated, and the entire reimbursement system is worse than the tax code, it is no wonder that investors are confused. But where there is chaos and puzzlement, opportunity will eventually appear for those that are patient.

Read the past headlines.