Last month’s gossip has become this month’s headline news. Two rumors in the pharma industry, which were noted in last month’s issue, have now materialized as full-fledged deals. Both reflect the ongoing attractiveness of consumer products and generic drugs to many within the industry.
J&J Gains A Dominant Role In Consumer Health Care
Pfizer (NYSE: PFE), we reported in June, had hired Lazard to shop its consumer health care group. Health care pundits thought this unit would fetch somewhere between $14.0 billion and $15.0 billion in the current market, citing GlaxoSmithKline (NYSE: GSK) as the most likely buyer from a small, yet distinguished field of bidders.
Last month’s speculations have now been replaced with a concrete deal. In late June, Johnson & Johnson (NYSE: JNJ) laid out a proposal to acquire Pfizer’s consumer health care unit for $16.6 billion in cash. In doing so, it gains a stable of well-known brand names and a dominant position in the consumer health care market. But the price is steep, so does the deal make sense for all concerned?
Pfizer, it appears, has an addiction to the revenue highs from sales of blockbuster drugs and wants to focus on its prescription pharma business, even more than Rush Limbaugh. Understandably, the revenue from the prescription side of the business generates better margins than the OTC and consumer side. On a trailing 12-month basis, PFE generated revenue of $51 billion, EBITDA of $21 billion and net income of $11.9 billion. The consumer health unit accounted for 8% of PFE’s revenue and 4% of its operating profit; in 2005 it generated revenue of $3.9 billion and operating profit of $670 million. When the numbers are crunched, holding on to the unit doesn’t seem a matter of great strategic value, making it vulnerable to sale.
What is PFE divesting in this deal? Benadryl, Bengay, Listerine, Lubriderm, Neosporin, Nicorette, Rogaine, Rolaids, Sudafed, Visine and Zantac. As part of this deal, JNJ is also acquiring the U.S. OTC switch rights to the prescription antihistamine Zyrtec upon patent expiration. It is believed that nine of the brands being divested generate over $100 million in annual revenue, each. While these are not exactly nonperforming assets, they lack the financial impact of a Lipitor or Viagra on PFE’s income statement.
Johnson & Johnson has three main business lines: devices, drugs and consumer health care. JNJ has doggedly pursued a growth-by-acquisition strategy: since 2003 it has made approximately 20 major acquisitions, with the majority in devices and drugs, followed by consumer health with a scant three deals. This transaction reorients that focus. Consumer health currently generates about 18% of total sales; after adding Pfizer’s products to its own brand-name stalwarts, such as Band-Aid, Neutrogena and Tylenol, it will account for 24% of total sales. On a trailing 12-month basis, JNJ generated revenue of $51 billion, EBITDA of $15.4 billion and net income of $10.9 billion.
The price to revenue multiple in this deal is 4.3x, which is higher than what others have recently paid to buy consumer health businesses. Reckitt Benckhiser (LSE: RB), another unsuccessful bidder for PFE’s consumer unit, paid 3.6x revenue for Boots Healthcare International ($3.4 billion, 2005); Bayer AG (NYSE: BAY) paid 2.4x for Roche Holding’s (SWZ: ROCZ.S) consumer unit ($2.95 billion, 2004); and GSK paid 1.4x for Block Drug ($1.2 billion, 2000). The only other deal that comes to mind where analysts approved such a lordly multiple is Proctor & Gamble’s (NYSE: PG) 2005 $54 billion acquisition of Gillette at about 4.9x revenue; even there, the PFE consumer unit still lacks the worldwide brand recognition that Gillette has. So clearly, relative to its cohort, JNJ is paying a hefty acquisition premium for market clout.
And clout it will have. This transaction effectively crowns JNJ king of the consumer health care hill. The 2005 pro forma revenue of the combined consumer businesses is estimated at nearly $14 billion, well ahead of the $5.5 billion GSK’s consumer unit generated in 2005 and the $3.0 billion BAY’s corresponding business generated the same year. Accounting for nearly a quarter of JNJ’s revenue, consumer health now steps out of the background as a major business line for the company.
How did JNJ finance this acquisition? Well, it had about $16 billion in cash on hand as of last year, and then it received a $700 million breakup fee when Guidant terminated the $25 billion deal to be acquired by JNJ in favor of being bought out by Boston Scientific (NYSE: BSX).
But how does Pfizer fare in the deal? First and as noted above, PFE got a very good price in this market. Here, though, the motivation seems more opportunistic than strategic; despite low margins relative to the rest of the business, the consumer unit could be counted on for a steady profit stream. Second, while several competitors are trying to balance their operations by buying consumer health businesses, among them BAY, GSK and now JNJ, PFE is moving toward a pure-play prescription pharma company. Michaela Drapes, industry editor at Hoovers, suggests that Pfizer has a sufficient level of confidence in its development pipeline to concentrate all its eggs in this one basket.
But beyond what investor relations might make of these two bullet points in their next presentation, what use will Pfizer make of the proceeds? It will apply the $13.5 billion in after-tax proceeds to a two-year, $17.0 billion stock buyback program, which could, management points out, make this divestiture nondilutive to earnings in 2007 and accretive in 2008. It appears to us that PFE is also trying to stabilize its share price so that it can effectively use its stock as an acquisition currency in future deals instead of drawing down from cash flow.
Even so, this seems to us to be a timid, defensive use of the proceeds rather than of proactively applying them to buying some juicy biotechs with plump and promising pipelines. True, PFE recently acquired worldwide rights to Bayer’s DGAT-1 inhibitors, a class of compounds that modify lipid metabolism, but this appears to be small potatoes. An analyst at Deutsche Bank suggests Sepracor (NASDAQ: SEPR) could be an acquisition target, but that remains just speculation at this point.
For the time being, it seems that Pfizer will try to soothe investors’ concerns with the stock buyback program and an aggressive move into the generics space itself. As of June 30, its blockbuster antidepressant Zoloft went off patent. Instead of abandoning the drug to the predations of generic pharma firms, Pfizer has decided to produce and market its own generic version of the drug through its own generic arm, Greenstone Ltd.
Typically, a big pharma firm ends up licensing a generic version of its drug to a generic company. If the generic firm happens to have challenged the brand-name pharma’s patent exclusivity and won, it can then have a six-month period of exclusive sales. During that period, the generic version, which is priced, say, 35% to 40% lower than the brand-name model, can capture up to 90% of the market from the brand name it copies. If, however, the brand-name manufacturer makes a generic version of its proprietary drug, a so-called “authorized generic,” prices drop by about 50% during the exclusive period and the competing generic pharma company winds up with about half the market share it would otherwise have gained. In undercutting the pricing and market share of the generic competitor, the brand-name pharma company also undercuts the profitability of the generic competitor’s operations and, therefore, that competitor’s economic motivation to mount a legal challenge to brand-name drug patents. So Pfizer is effectively sticking it to Teva Pharmaceuticals (NASDAQ: TEVA), which acquired an exclusivity period for a generic version of Zoloft when it bought Ivax Corp. a year ago for nearly $8.0 billion.
All of which is surely a diverting entertainment in the short run. Sooner or later, however, Pfizer will have to accede to investors’ demands for a more robust pipeline and fill it with acquisitions. Why? PFE’s Greenstone generic division generated just $775 million in revenue in 2005.
Barr Expands Into Eastern Europe
In what is the company’s first deal outside North America, Barr Pharmaceuticals (NYSE: BRL) is poised to double its size, and move into Eastern European with a proposed $2.3 billion acquisition of Croatia’s Pliva Pharmaceuticals, d.d. (LSE: PLVD), the largest generic pharma company in the region. In doing so, it has outflanked Iceland’s Actavis Group, h.f. (ISE: ACT), which had also hoped to grow its global generic business by snagging Pliva. This transaction gives BRL geographic diversification, access to increased manufacturing capacity and a good opportunity to reduce its overall cost structure.
Barr manufactures generic and branded drugs, perhaps 80 in all. On a trailing 12-month basis, BRL generated revenue of $1.24 billion, EBITDA of $507.2 million and net income of $296 million. This medium-sized generic pharma company needed more heft to compete in the generics space, and went to the M&A market to buy it.
Pliva, which has been in business since 1921, is Eastern Europe’s largest generic pharma company, operating in 30 countries including Germany, Italy, Russia, Spain and the U.K. It is involved with as many as 120 drugs, and its assets include 21 generic drug applications pending at the FDA (but see below). Pliva reorganized its operations to concentrate on its generic operations. It restructured by selling Pliva Research Institute to GlaxoSmithKline for up to $50 million. For 2005, PLVD generated revenue of $1,197,100,000, EBIT (before restructuring) of $147.4 million and a loss of $75 million.
Barr first offered $2.2 billion (at HRK 705 per share) for PLVD. Our readers will recall that Actavis had approached PLVD some months back with an offer valuing the company at $1.6 billion, which PLVD rebuffed. ACT returned in March 2006 with a $1.85 billion offer, which came to BRL’s attention and sparked a bidding war. (BRL and PLVD had been collaborating since 2005 on a generic version of Amgen’s [NASDAQ: AMGN] Neupogen, a drug used to treat cancer patients.)
Once Barr made its move, offering $2.2 billion, or HRK 705 per share, ACT jumped in with a counteroffer of HRK 723, to which BRL responded with its current offer of HRK 743. A larger bid by Actavis would likely leverage the company beyond what it is comfortable with but, depending on who blinks first, BRL may have to sweeten its offer the same way that Bayer bought off Merck KGaA (DE: MRCG) in its pursuit of Schering (NYSE: SHR). See “Pharmaceuticals” below.
Based on a transaction value of $2.3 billion, the deal is valued at 1.9x revenue and about 17x EBIT. The transaction is to be financed with cash and new debt of about $2 billion. Banc of America Securities, LLC served as financial advisor to Barr.
Barr management believes that the combined company will generate pro forma revenue of $2.5 billion and net income of over $550 million. The deal also combines BRL’s solid oral dosage capabilities with PLVD’s cream/ointment delivery technologies, permitting a good amount of cross-selling opportunities. Given the increased manufacturing capacity the Croatian facilities offer BRL, as well as the potential cost savings to be reaped from eastern European operations with their low wages, BRL will readily assent to these conditions. This combination is likely to result in the world’s third-largest generic pharma company.
Some stumbling blocks remain. The Croatian government owns 17% of Pliva, locally regarded as something of a national treasure (it is profitable, after all). The government has, however, signalled its willingness to vote its shares in favor of the deal if jobs are retained in Croatia, and the company’s headquarters and production units are kept in Zagreb. In the course of bidding and counterbidding, Actavis now controls about 20.4% of PLVD, with which BRL will have to contend. Also, the FDA indicated earlier in the year that it will not approve any new drug applications from PLVD until it irons out some problems at its Zagreb plant. Although a corrective plan was submitted in May, the FDA’s ban has yet to be lifted.
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