Some of our colleagues, particularly our venture capital friends, have begun to believe that the “smart” money is returning to the healthcare sector via the merger & acquisitions route. They define the smart money as larger industry participants buying smaller, technology rich companies as a way of replacing slowing sales of existing, maturing products and as an alternative to internal product development. The ample supply of companies, enhanced by very attractive valuations, lead some to conclude that public investment is not far behind and that stocks in the healthcare sector may be bottoming.
Certainly there are several caveats that must be put forward before the group returns to clear sailing. First, the bottom can be a long trough. While healthcare stocks may outperform other groups on a relative basis, their ultimate performance will still be dictated by the market’s overall recovery. Secondly, attractive valuations can become even more attractive. If the market reacts negatively to any number of still unknown factors, healthcare stocks will surely decline as well. And finally, since corporate buyers are strategic buyers, they have longer time horizons than do institutional or even individual investors. Just as corporate buyers need to be selective, so do institutional and individual investors.
So what evidence do we have that acquisition activity is heating up, valuations are reasonable and perhaps we are bottoming out? The following table demonstrates recent acquisitions by major companies and the multiple of revenues paid.
As the table suggests, there is wide variability in the multiples being paid on acquisitions with the larger, friendly transactions being priced at about 3.0X incremental revenues. As a point of reference, orthopedic companies are selling at 2.2X forward 12 month revenues, as is the cardiovascular group and medical device companies at 2.4X, a slight premium. So the acquisition premium appears to be 20% to 25%, fairly reasonable based on historic trends which can average 5.0X or 6.0X revenues.
Another way of looking at M&A premiums is the premium paid to the prior day’s closing price. Over the past three months the medium premium has been 92%, up from 88.4% for the six month medium premium and somewhat better than for the general market. However, these premiums are still one-third below that of the 52 week highs posted by the stocks of these companies still suggesting reasonable valuations in our opinion.
Source: HealthPoint Capital-Dec. 18, 2008
Source: HealthPoint Capital-Dec. 18, 2008
A couple of other points are worth mentioning. Pfizer (PFE) appears to be giving in to its fears that it will face generic competition in approximately one-third of its revenue base by 2012 that is currently proprietary. Even Lipitor, its largest product at $3.1 billion in revenues in Q4, decreased 8% year over year and loses its exclusivity in June 2011. Thus the rush to the altar with Wyeth (WYE). The combined companies will have 17 drugs with sales of $1 billion or more which will cover cardiovascular, oncology, women’s health, central nervous and infectious disease. On roughly $22.8 billion in revenues, Wyeth achieved a 29% pretax margin and better than a 19% net margin and Pfizer is betting that it can reduce costs and achieve even better incremental margins.
While perennial acquisition train, Johnson & Johnson (JNJ) still keeps broadening its product offering via the acquisition route, Boston Scientific (BSX), also prolific in the past, is on a siding somewhere, perhaps having grown weary of some of its past conquests such as Guidant. Medtronic (MDT) continues to make steady headway in filling in their product offerings with bolt on acquisitions of technologies it believes are adjunctive to its existing business. Abbott (ABT) has become more active in adding diversification to its product portfolio through acquisition.
It looks like even the venerable Merck (MRK) may be contemplating an acquisition which would mark a big departure from its strategy of growing “it” at home, “it” being new pharmaceutical products. Like most large pharmaceutical companies, Merck is also facing the daunting prospect of some of its most successful and profitable products passing into the “generic” realm. The company cited the loss of exclusivity on Fosamax, its osteoporosis drug last February and Merck faces the challenge of replacing Singulair, its very successful allergy and asthma drug in August of 2012. In total, Merck faces generic competition in about one-third of its revenue base over the next several years.
And even Procter & Gamble (PG) is in the game wanting to sell its $2 billion a year pharmaceutical business.
Although we believe valuations appear reasonable, we are not sure that the M&A activity has picked up enough to declare the bottom. As we stated at the beginning…the trough may be long and deep.