Merger and acquisition (M&A) activity is heating up among specialty pharmaceutical companies and potentially creating a once-in-a-generation investment opportunity in an industry that is quickly consolidating. We believe a convergence of factors will drive further M&A activity and value creation for investors in 2014.
While M&A activity has long been a tool driving growth among pharmaceutical companies, the uptick in 2013 was considerable, with more acquisition activity (in terms of deal value) than the two previous years combined. The average deal size and total value of deals also reached highs in 2013.
In several cases, both the acquirer and acquired company have seen a jump in stock price after announcing deals. Yet as a group, the market multiple for specialty pharmaceutical companies is in line with the rest of the index, suggesting room for further stock appreciation as more companies announce deals. And there are plenty of reasons more deals will follow.
A few important secular trends are encouraging consolidation in the industry. The pharmaceutical industry has been incredibly fragmented globally, with the largest five companies owning less than 10% of market share. But the supply chain of companies buying drugs has consolidated and now has only four major buyers. Those four large buyers have considerable clout and are pushing down prices throughout the industry. By consolidating, the pharmaceutical companies have a chance to gain some scale of their own and push back on prices.
The potential of drugs in many specialty pharmaceutical companies’ pipelines is another factor driving acquisition activity. In an environment focused on lowering health care costs, innovative therapies that significantly improve patient outcomes are the only treatments that can command pricing power. Innovative therapies also have a much easier time getting FDA approval than “me-too” drugs that offer only an incremental benefit over existing treatments. Many of these innovative therapies lie with specialty pharmaceutical companies, and large-cap pharmaceutical companies are finding it is often more profitable to acquire those companies than research and develop their own drugs.
Savvy management teams are also driving M&A activity. In the late 2000s, many specialty pharmaceutical stocks underperformed, driving management changes at many companies. Now, the quality of management teams within the industry has never been higher, in our view. This new generation of managers is more aggressive, more global in scope and more willing to access accommodative debt markets to make deals.
The interests of new management teams are often well-aligned with shareholders. At Forest Laboratories, for example, the new CEO put $5 million of his own money into the company’s stock. Similarly, Endo Health Solutions’ new CEO invested $7 million into the company’s stock. New CEOs also have incentive structures that are generally more aligned with stock performance, which has resulted in management teams looking for deals that drive value.
While secular trends and aggressive management teams are the main drivers of consolidation, there is also a tax benefit to many acquisitions. By acquiring a company overseas, U.S.-based pharmaceutical companies have an opportunity to re-domicile and convert to a lower overseas tax rate. Conversely, the tax-advantaged status of a non-U.S. pharmaceutical company allows that company to come into the U.S. market and pay a premium for an acquisition target in a deal that is still accretive to the acquiring company because they are moving the U.S. company into a lower tax structure.
The inherent tax advantage is a quick boost to the earnings power of companies, and the market has responded favorably when such acquisitions are announced. For example, Endo Health Solutions is up 78% since its November announcement it would acquire Paladin Labs and re-domicile in Ireland. Likewise, Actavis and Forest Laboratories were up 17% and 39%, respectively, after Actavis announced in mid-February it would acquire Forest Laboratories.
The secular trends favoring industry consolidation, aggressive management teams, accommodative debt markets and the tax advantages of many acquisitions, should keep M&A activity heated among specialty pharmaceutical companies. Given the inherent benefits of many of these acquisitions, and with valuations at a reasonable starting point, we would also expect the market to continue to respond favorably as more deals are made.
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Investing involves market risk. Investment return and value will fluctuate, and it is possible to lose money by investing.
The health care industries are subject to government regulation and reimbursement rates, as well as government approval of products and services, which could have a significant effect on price and availability, and can be significantly affected by rapid obsolescence and patent expirations.
The views expressed are those of Janus research analysts as of March 2014. They do not necessarily reflect the views of Janus portfolio managers or other persons in Janus’ organization. These views are subject to change at any time based on market and other conditions, and Janus disclaims any responsibility to update such views. No forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of trading intent on behalf of any Janus fund.
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