Pharma deal-making: In the pink of health

Deal-making in the global pharmaceuticals sector is booming, with no signs of slowing down, as this report from Aranca indicates.

2015 promised to be a prosperous year, with deals likely to be at their highest since 2005 — as evident from Shire's hostile takeover bid for Baxalta. The total size of M&A deals was USD200 bn in 1H15, the highest reported for the first-half period in the last 10 years. Deal values in 2014 and 1H15 have exceeded the average deal value of USD105 bn for the period 2000–13.

With M&A continuing in the pharmaceuticals sector, we expect the total deal value in 2015 to surpass the USD275 bn mark recorded in 2014, reaching the highest level in the decade.

Since 2014, M&As worth USD475 bn have been announced. It's likely that this surge is driven by sluggish growth in revenues, lower capital cost due to low interest rates, patent cliffs, high cost of manufacturing new drugs, and tax inversion.

M&A activity is expected to continue as major pharmaceutical companies focus on aligning product portfolios with their long term growth plan and cutting product lines.

Rise in M&A Activity Primarily Due to Declining Revenue and Lower Capital Cost

M&A activity in the pharmaceutical sector has been stoked by a decline in revenues and low interest rate environments. Companies have taken advantage of low interest rates by issuing bonds to finance acquisitions.

Many pharmaceutical companies are grappling with slow revenue growth; they're also likely to face higher competition from generics manufacturers as their patents for blockbuster drugs expire.  The emergence of new players is putting pressure on larger generics players to either move up the value chain or expand their revenues inorganically.

Slow Sales and Earnings Growth

The global pharmaceutical sector has been coping with slow growth, and companies operating in the sector are looking for new growth avenues amid pricing pressures and higher competition.

Our study of the top 10 pharmaceutical companies based on sales over 2005–14 indicate that their average revenue and net income growth slowed significantly during the period. It revealed that revenue growth in 2014 was among the lowest during that decade.

Revenue declined 3.0% yoy on average in 2014 vis-à-vis an average rise of 4.8% over 2005–14. A few companies (Bayer, Johnson & Johnson, Roche, and Sanofi) reported mid to low single-digit growth. In 2014, revenues at Eli Lilly and GlaxoSmithKline (GSK) declined 15.1% yoy and 15.2% yoy, respectively. Likewise, average earnings of these top 10 pharmaceutical companies declined 0.2% in 2014 vis-à-vis the average earnings growth of 10.6% during 2005–14.

It's notable that the average return on equity (ROE) of these companies declined to 11.6% in 2014 from 12.6% in 2013 and the average return on assets (ROA) decreased to 7.9% in 2014 from 9.1% in 2013.

Reduction in Capital Cost Owing to Low Interest Rates

Many pharmaceutical companies have raised debt through loans and bond issuances, taking advantage of low interest rates. Major bonds issued to finance acquisitions by pharmaceutical companies totaled about USD51 bn till July 2015.

In March 2015, Actavis PLC sold bonds totaling USD21 bn to finance its USD70.5 bn acquisition of Allergan Inc., a Botox manufacturer. Amid a low interest environment, investors have shown a strong appetite for corporate bonds that involve greater risks but have higher yields. Among other companies, Merck & Co. raised a USD8 bn jumbo bond for the acquisition of Cubist Pharmaceuticals for USD9.5 bn and Valeant Pharmaceuticals raised USD10.1 bn in debt for the USD14.5 bn acquisition of Salix Pharmaceuticals.

Patent Cliffs and the High Cost of Innovating New Drugs

Pharmaceutical companies continue to face patent cliffs, scenarios where exclusive rights to top-selling drugs expire. While some companies are investing in product innovation, others are buying growth off-the-shelf. Many blockbuster drug patents expired over the last few years, with few more expected to expire in the years to come. New drugs are costly to innovate; they require significant investment and are subject to higher regulatory processes. The costs of developing a new drug increased from USD1.1 bn in the late 1990s to USD5bn in 2013.

Some companies have made acquisitions in order to add existing patents to their own portfolios. In May 2015, Teva Pharmaceutical acquired Auspex Pharmaceuticals for USD3.2 bn. Auspex is close to launching a new drug to treat Huntington’s disease. In May 2015, Dublin-based Horizon Pharma acquired US-based Hyperion Therapeutics for USD1.1 bn, adding two orphan drugs used in the treatment of generic disorders.

Companies Realigning Product Portfolio to Meet Cash-Flow Needs

Companies are divesting their nonstrategic assets, using the proceeds to invest in a pipeline of new medicines that are core to their business.

In March 2015, GSK and Novartis completed a series of asset swaps totaling over USD20 bn. GSK bought Novartis’ vaccine business in exchange for its cancer drug portfolio, resulting in net proceeds of USD7.8 bn with the former. The deal is likely to fortify Novartis’ substantial presence in oncology and boost its core margins, while GSK plans to distribute the proceeds to its shareholders.

Among other transactions, AstraZeneca recently divested Capreisa, used to treat of a rare type of cancer, to Sanofi for USD300 mn, after it sold off Entocort (gastrointestinal drug) to Tillotts Pharma for USD 215 mn.

Tax Inversion Seen as an Added Advantage in Deal-Making

In 2014, tax inversion emerged as one of the major catalysts that led to a spurt in global M&A activity. US companies carried out M&As primarily focused on availing lower global tax rate benefits.

One such deal in the pharmaceutical space was Actavis Plc. acquiring Allergan, Inc. for USD70.5 bn in 2014. Mylan’s USD5.3bn deal to acquire Abbott’s generic business is another case in point. However, the imposition of a stringent rule on tax inversion by the U.S. in September 2014 put a brake on such deals.

Future Outlook

M&A deals in the global pharmaceutical sector are expected to continue to gain momentum in 2H15.  Major companies aim to expand their strategic assets, bouncing back from slow growth rates and divesting nonstrategic assets. Small biotechnology firms with late-stage drug candidates and healthy pipelines are likely to be prime targets for acquisition. We may also see more acquisitions among generics players, as the market still remains largely fragmented.