Consolidation Blurs Drug Categories

Investor's Business Daily

Last month, during an otherwise ho-hum conference call on 2014 financial guidance, Valeant Pharmaceuticals (VRX) CEO Michael Pearson electrified the stock market by making an audacious promise.

"Today we're introducing our sixth strategic initiative, which is to become one of the top five most valuable pharmaceutical companies as measured by market cap by the end of 2016," he said. "This equates to roughly $150 billion in market cap.

Essentially, Pearson was promising that the 37-year-old Canadian upstart will take a place in the Big Pharma lineup, alongside century-old titans like Merck (MRK), Bristol-Myers Squibb (BMY), Roche (RHHBY) and Eli Lilly (LLY).

Usually, the only thing that changes that roster is one of them buying another. But Valeant's bid for a place in the drug trade's Ivy League shows a large piece has reshaped itself in a relatively short period and how, even as Big Pharmas have been paring down, Specialty Pharmas have gotten bigger, badder and richer than ever.

For the past five years, Valeant has binged on acquisitions, large and small. And while it's the only Specialty Pharma that's outwardly expressed Big Pharma ambitions, a lot of its peers have also been making large, transformative buyouts.

Just last week, Forest Laboratories (FRX) closed its $2.9 billion acquisition of Aptalis, which it says will add $700 million in revenue and 78 cents a share to profit next year. Akorn (AKRX) is in the process of buying equal-sized Hi-Tech Pharmacal (HITK), which it plans to turn into dominance of the niche field of generic ophthalmics.

Salix Pharmaceuticals (SLXP) recently acquired the nearly-as-big Santarus for $2.1 billion.

They all follow in the footsteps of Actavis (ACT), which after being reborn in a merger of equals in late 2012, acquired Warner Chilcott for $8.5 billion last year.

Pharma Phraseology

What is a Specialty Pharma? It's not an industry group, but is a popular term on Wall Street to distinguish smaller pharmaceutical players from Big Pharmas and biotechs. While not all the research houses IBD asked wanted to be quoted, the typical definition is that they are companies focused on marketing to specialists in the medical industry rather than general practitioners.

In this respect they're like biotechs. Unlike biotechs, they aren't focused on scientific novelty — developing new drugs from scratch. Many specialty players do have labs, but their development efforts are usually focused on refining existing drugs, or finding better delivery methods for them.

Many specialty drugmakers' products are older, on the verge of going generic, or already past patent protection. In fact, researchers on Wall Street typically group Specialty Pharmas and generic-drug makers together, since nearly all U.S. generics firms have Specialty Pharma divisions.

According to Morningstar, over the past year the total return on the specialty/generics stocks has been more than 46% — still not quite as high as the scorching biotechs with their 55% return, but better than double the return on Big Pharmas.

Research by Ernst & Young has also found spec pharmas outpacing Big Pharma on revenue growth and, in the past year, acquisitiveness. The latter was a particular surprise, since Big Pharma has long been the industry's top buyer.

Blockbuster Woes

The drug industry's biggest players have suffered well-documented problems in the past five years. Many of their biggest blockbusters have seen patent protections expire. They've faced pricing pressures in Europe and soft macroeconomic conditions squeezing their consumer divisions.

Many have responded to shareholder pressure by selling or spinning off their slower-growing businesses, making themselves smaller and focusing on development pipelines, even as the specialists grow.

Spec pharmas have benefited from this in more than one way, say analysts. Those who sell generics have been on the right side of the patent cliff, able to sell knock-offs of some of the best-selling drugs in history. The fact that Big Pharmas are buying less also leaves more choice targets for spec pharmas.

David Schechner, managing director of health care at Robert W. Baird, says specialty drugmakers have been particularly well positioned to capitalize on the broader bull market in drug stocks.

"We're seeing generalist funds come into these stocks — and growth investors," he said. "So now as valuations go up, (spec pharmas are) able to raise money; they can use their stock for acquisitions, (and) debt is cheap.

The combination provides more firepower to buy acquisitions, which fulfill multiple purposes. Some companies acquire in order to avoid the hazard of being overdependent on one or two drugs.

For instance, Jazz Pharmaceuticals (JAZZ) hit it big with narcolepsy drug Xyrem. Then it sank its capital into buying EUSA Pharma and Azur Pharma in 2012, broadening its portfolio. It's currently acquiring Gentium (GENT) in a $1 billion deal. Gentium is actually a biotech, which shows how the categories can overlap when an especially attractive prospect comes along.

The Italian company has an orphan-disease drug in its newly approved Defitelio, for a condition called hepatic veno-occlusive disease. Orphan drugs are granted special FDA protection to encourage treatment of rare diseases that would otherwise be ignored. They have become especially hot since companies like Alexion Pharmaceuticals (ALXN) proved you can make a fortune with them.

Taking From Biotech

The lines between specialty and biotech categories are also blurring as spec pharma players pursue attractive disease categories previously considered to be biotech turf.

That is, "companies who make orphan drugs or antibiotics, or companies who are developing a broad portfolio of drugs that may also include a few products for cancer or multiple sclerosis," Cantor Fitzgerald analyst Irina Rivkind wrote in an email to IBD.

Nonetheless, even when they acquire biotech drugs, spec pharmas stick to their market-focused business model. They aren't about to invest in early-stage companies whose products are years from the market.

Rivkind says this feeds into another popular reason for acquisitions: tax breaks. Some of spec pharma's recent targets have been based in Ireland, and getting an Irish HQ address can mean a significant tax cut for an American business.

This was considered to be a factor in Actavis' purchase of Warner Chilcott, as well as Perrigo's (PRGO) buyout of Elan.

But these "tax inversion acquisitions" make sense only if you're making money — which is why they're so much more popular in spec pharma than in biotech, according to Rivkind.

Outlook

How much longer can this go on? Schechner says he sees several more years in the consolidation trend, as spec pharma margins continue to be high and Big Pharma continues to restructure, potentially shedding attractive assets.

Rivkind is a bit more cautious. She notes that many companies find M&A attractive right now, but she's "not sure how sustainable that will be over time, since some of the deals are only accretive in the short term. Total reliance on M&A for growth without additional competitive advantages could be risky in my view."

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