With the markets headed south, no one really expected the announcement of the largest deal of 2002. Yet that is precisely what took place on Monday, June 15, 2002, when Pfizer, Inc. (NYSE: PFE) announced that it would acquire Pharmacia Corp. (NYSE: PHA) for an exchange of stock valued at $60 million (based on the price of PFE’s stock the day before the announcement).
In perspective, that price tag makes this transaction the third largest pharmaceutical deal in history. On a smaller scale, it makes it nearly three times larger than the total amount expended during the first two quarters of 2002 to finance 445 deals in the entire health care industry.
Pfizer is a global pharmaceutical company, with the numbers to match. Among its stable of blockbuster drugs are Lipitor, the world’s best selling prescription drug, and Viagra, the world’s most uplifting. On a trailing 12-month basis, PFE generates revenue of $33.4 billion, EBITDA of $12 billion and net income of $8.4 billion. No stranger to the acquisition market, PFE achieved its 800-pound gorilla status, most recently through its $114 billion merger with Warner-Lambert, which closed in mid-2000.
In terms of revenue, Pfizer is already the largest pharmaceutical company in the world followed by GlaxoSmithKline (NYSE: GSK), Merck (NYSE: MRK) and AstraZeneca (NYSE: AZN); now, as they say in the movie trailers, it is about to get a whole lot bigger, catapulting itself squarely 50% ahead of its closest rival.
Another 2000 merger, that between Swedish Upjohn-Pharmacia and Monsanto, produced the company now known as Pharmacia, which is engaged in the research, development, manufacture and sale of pharmaceuticals and other related health care products and agricultural products. Among its best known drugs are the Cox-2 inhibitor, Celebrex, used for the treatment of arthritis. On a trailing 12-month basis, PHA generates revenue of $13.8 billion, EBITDA of $2.2 billion and net income of $1.5 billion. At the end Q1:02, PHA had long-term debt (including the guarantee of its ESOP plan) worth $2.64 billion.
The Deal
Under terms of the deal, PHA will first spin off to shareholders its 84% interest in Monsanto (NYSE: MON) (with, we assume, a proportional amount of debt). PHA is now set to distribute its stake in MON on August 13, somewhat earlier than first proposed. Subsequently, each share of PHA common will be exchanged for 1.4 shares of PFE common stock. PHA has 1.29 billion shares outstanding, so PFE will issue 1.806 billion shares. Based on PFE’s stock price of $32.20 the day before the announcement, that yields $58.2 billion. When PHA’s share of long-term debt is added on, this effectively rounds the purchase price up to $60 billion. The deal values PHA stock at $45.08 per share, or a 38% premium over the prior-day price.
As might be expected, on the day of the announcement, PFE’s stock price dropped: it declined 11% to $28.78, resulting in a decrease of the total purchase price to about $53.7 billion and a reduction in the valuation of PHA’s stock to $40.29. That same day PHA’s stock rose 20% to $39.25, which in effect reduced the exchange premium to a puny 3%.
Based on the $60 billion valuation, the price to revenue multiple in this deal is 4.35x, somewhat lower than the corresponding multiples in the first and second largest pharmaceutical deals (see the chart opposite). The price to EBITDA multiple is 27.65x.
Interestingly, the agreement contains no collar so the ultimate purchase price consequently rises and falls with PFE’s share price. To offset such variation, PHA management negotiated an exchange ratio high enough for them (and their shareholders) to live with. During the year and a half of courtship, PFE wanted an exchange ratio of 1.2x or 1.3x, while PHA management held out for (and ultimately won) 1.4x. After the deal PFE shareholders will own 77% of the combined company and former PHA shareholders will own 23%. The agreement does, however, contain a break-up fee of $1.6 billion.
Antitrust issues appear to be minimal and will, in any case, be decided on a drug-by-drug basis. Three product areas which might attract some antitrust scrutiny are treatments for migraine, COPD and overactive bladder.
In this deal, Pfizer was advised by Lazard and Bear Stearns & Co. while Pharmacia was advised by Goldman Sachs & Co. Cadwalader, Wickersham and Taft provided legal counsel to PFE while Sullivan & Cromwell provided legal counsel to PHA.
The Consequences
The combination of these two companies should spawn a pharmaceutical giant with $47.9 billion in annual sales. Of that amount, the combined company would have 12 drugs that generate $1 billion each in annual revenue. Importantly, with the graying of America, their drugs will be prominently featured in the medicine chests of the over 50 crowd.
Management expects this deal to generate cost savings of $1.4 billion in 2003, $2.2 billion in 2004 and $2.5 billion by 2005, savings which should drop to the bottom line and please investors. This comes, some analysts believe, at a time when PFE has wrung most of the benefits it can out of the synergies it derived through its merger with Warner-Lambert.
This merger brings PHA’s specialties in oncology, ophthalmology and the endocrine system to PFE’s more general palette of drugs. And PFE hopes to leverage those specialties through its larger, broader marketing base. PFE also hopes to reduce its risk through diversification by acquiring PHA’s drugs and, importantly, its pipeline. The deal will also allow PFE to better manage financial difficulties associated with patent expiration: PHA has no such expirations during 2007-08, when some PFE drugs are due to go off patent.
The combination will have a huge R&D budget: this year, PFE is dedicating $5.2 billion to its R&D efforts, PHA $2.3 billion. The combined company’s pipeline should have 120 new chemical entities and over 80 in-line product enhancement (read, patent extension) programs. And, as argued below, it will need those large figures to survive and prosper.
All of these potential benefits noted thus far really skirt the central issue: Will the combination of these two giant pharmaceutical companies be able to continue producing enough new blockbuster drugs to generate the kinds of returns to which investors have become accustomed? Some analysts believe that the combined company would have to produce two new blockbuster drugs a year to sustain the customary margins. Management at PFE and PHA predict that over the next five years, the enlarged Pfizer will introduce 20 major new drug applications, or NDAs, on average four per year.
Management’s projections on the financial benefits of this merger naturally involve counting a certain number of chickens before they’re hatched. Even if internal R&D efforts do not produce the predicted 20 NDAs over the next five years, PFE will attempt to offset this shortfall by licensing other companies’ drugs, a strategy it has pursued in the past. Nor will it neglect its massive marketing machine. What this new company really has going for it is its 11% share of the global market, and the marketing clout that confers. Each company’s sales force will work to leverage the other’s products to its customers. Of course, in the end, and management recognizes this, customers will only listen if you have new, improved drugs to sell.
It appears that over the next six or seven years this deal will probably confer a number of the benefits it is touted to do; the question for the long-term investor is whether the new PFE can maintain the pace of discovery and introduction of new drugs over the long haul to warrant continued investment.
Finally (for now), if this merger can be shown to create sustainable product and revenue growth which satisfies customers and shareholders alike, it will likely spawn another round of M&A activity in the Pharmaceutical sector as other large pharma companies scramble to catch up.