Pharmaceutical Industry mergers look more attractive in the current financial climate

The Financial times ran a story on April 10th takign a new look at M&A activity in the Clinical and Pharmaceutical sector.

They observed that merger and acquisition (M&A) activity has slowed as the financial crisis restricts the ability of companies to put together debt-financed deals. But analysts say the depressed valuations of companies in defensive sectors – such as pharmaceuticals and healthcare – are starting to look attractive to rivals with cash in hand.

News of a $41bn tie-up between Merck and Schering- Plough – the second-largest deal of the year after the $68bn sale of Wyeth to Pfizer in January – has encouraged some investors to scour the market for future takeover targets.

In the first quarter of the year, the volume of M&A deals around the world fell sharply, dropping 36 per cent on the same period in the previous year, to $524.9bn, according to Dealogic.

Takeover numbers fell by the same percentage over the period, to 6,866. In the UK, the fallout from the downturn has been similarly harsh, with deal volumes, excluding government acquisitions, falling to $14.6bn – the lowest level since 1995.

Pharmaceuticals companies have bucked the trend, though – leading analysts to suggest that it is the most promising sector for investors looking to buy into a takeover target and profit from a price uplift.

This year’s two big pharmaceutical tie-ups have been cited as proof that cash-rich companies can find opportunities in the market turmoil.

Pfizer – facing the expiry of its lucrative patent on Lipitor, the cholesterol drug – made the move to acquire Wyeth to diversify its drug portfolio and keep a lid on costs. This acquisition – which will be paid for with a mixture of cash, equity and debt – creates a group with $71bn in sales from a broad range of products, with the potential to save $4bn in yearly operating costs by cutting 15 per cent of the combined workforce.

“The case for mergers in the pharmaceutical industry can be convincingly and unequivocally made at the current time,” say Deutsche Bank analysts Barbara Ryan and George Drivas in a recent report. “At present, rampant overcapacity, redundancy of effort and rising costs and risks associated with research and development are leading to diminishing returns.”

Three groups named as future targets are Bristol-Myers Squib, which markets a number of successful cancer drugs and is now trading at an attractive level of just 9.7 times forward earnings, and the biotech groups Biogen and Amgen.

But for those buying into pharma companies in the hope of a takeover bid – or for existing investors – it is important to study the terms of any deal before deciding to sell up or hold on to shares.

For example, Merck’s tie- up with Schering-Plough is funded by cash, debt and shares, giving Schering-Plough shareholders 0.5767 Merck shares and $10.50 in cash for each share in Schering-Plough.

At the time of the offer, these terms represented a slight premium as Schering-Plough’s shares hovered around $23.50 and Merck’s stood at $26.75. But in the wake of the deal’s announcement, Schering-Plough’s shares rose more than 20 per cent, while Merck’s shares fell more than 10 per cent because of concerns about the risks of including a particular cholesterol drug in the line-up.

Another sector that looks poised to enter a period of M&A-driven consolidation is technology, says Ian McCallum, manager of Bedlam Asset Management’s global fund. He suggests that some Asian chipmakers – such as ProMOS Technologies and Powerchip – look poised for mergers. Shrinkage in the gold supply and other precious metals may also prompt more mergers between resource companies, he says.

But Leigh Harrison, head of UK Equities at Threadneedle, claims the task of cherry-picking stocks ahead of a merger is more difficult than it appears. “M&A is unpredictable in that, unless a company has announced to shareholders that it intends to merge or acquire other businesses or is trying to sell itself, then information about activity would be regarded as price sensitive and, hence, confidential,” he points out.

Falling share prices also bring the threat of hostile takeovers, which can lead to further volatility. However, investors on both sides of an M&A deal can often reap benefits. Fund managers tend to look to buy in to companies with strong cash flows that will see a spurt in their share prices if they acquire a smaller rival, or those with collapsed valuations that suggest they stand to gain from being taken over.

“The question to ask is why does our analysis suggest a valuation materially different to the current share price?” says Harrison. “We have to ask ourselves ‘what might this business be worth to someone else?’

“Does it own any unique assets or does it have big market shares or resilient cash flows – qualities that might command a premium valuation were control of them to change hands.”

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