In my previous article, I wrote about Perrigo's track record and durable competitive advantage. This article looks at Perrigo's firepower for making acquisitions.
Perrigo (NASDAQ:PRGO) closed its acquisition of Elan Pharmaceuticals in December 2013. Ever since then, Perrigo has said that it would need to de-lever before making any more acquisitions. But this ignores the liquidity and size of Tysabri royalties. Perrigo has hinted at selling all or part of these valuable royalties and using the proceeds for M&A. When this happens, it would serve as a catalyst for the stock price.
Elan Pharmaceuticals acquisition
Elan was an Irish company, and Perrigo obtained a tax inversion by acquiring Elan. Elan's main asset was its Tysabri royalties. Royalty Pharma, also an Irish company, made a final bid of $8 billion for Elan. Royalty Pharma specializes in investing in drug royalties. Since Elan had $1.8 billion in cash at the time and around $100 million in other assets, that worked out to about $6.1 billion for the Tysabri royalties.
Since Royalty Pharma was already an Irish company, it didn't need any further tax synergies. However US-based Perrigo could get tax synergies, and therefore, was able to outbid Royalty Pharma and acquire Elan. This excess value that Perrigo placed on these synergies is shown on Perrigo's balance sheet in the latest 10-Q as $2.088 billion of goodwill distributed over Perrigo's business units (see Page 12 of the 10-Q). The Tysabri royalties are valued by Perrigo at $6.111 billion (roughly the same as what Royalty Pharma valued it at).
Tysabri is the drug for multiple sclerosis that has the lowest relapse rate. Multiple sclerosis has no cure, and is disproportionately prevalent in Europe and the Americas. Tysabri was developed by Biogen Idec (NASDAQ:BIIB) in partnership with Elan Pharmaceuticals. Tysabri can cause a potentially fatal brain disease as a side effect. The rate of incidence of this side effect is 3 out of 1000. Therefore, other drugs are generally tried first on patients. Tysabri is used when patients have an "inadequate response" to other drugs. Biogen Idec has developed a test for the JCV virus to reduce the risk of contracting the brain disease.
The disease is so debilitating that despite the risk, Tysabri revenues continue to grow, as shown in Biogen Idec's 2013 10-K. Tysabri revenues were $1.526 billion, $1.136 billion and $1.079 billion in 2013, 2012 and 2011 respectively.
Tysabri is a large molecule biologic drug, and is therefore very hard to copy for generic drug companies. For example, Amgen's (NASDAQ:AMGN) Epogen drug has been hard to copy, and customers fear side effects from Epogen replacements. DaVita (NYSE:DVA), the dialysis company and one of the largest customers for Epogen, ignored generic competitors and recently signed a large 7-year Epogen contract with Amgen.
In its Q1 2014 earnings presentation, Biogen Idec revealed that Tysabri had sales of $1.656 billion over the preceding year. Biogen Idec has applied for Tysabri approval in Japan, and a decision is expected in 2014. Approval in Japan would boost Tysabri sales. While the introduction of Biogen Idec's oral medication, Tecfidera, has slowed Tysabri's growth, Biogen Idec expects the switch from Tecfidera to Tysabri to naturally slow. Tysabri is also in Phase III trials for the treatment of SPMS (secondary progressive multiple sclerosis).
Biogen Idec and Elan's Tysabri transaction
Biogen Idec and Elan shared rights to Tysabri. When Elan tried to sell a stake to Johnson & Johnson (NYSE:JNJ), it was sued by Biogen Idec. According to the agreement that Elan and Biogen Idec had, Elan couldn't transfer Tysabri rights without Biogen Idec's permission. The judge ruled in favor of Biogen Idec. Subsequently, Elan sold its rights to Biogen Idec in return for an upfront cash payment of $3.25 billion and an escalating royalty on Tysabri sales. The royalty is 18% of Tysabri sales starting May 1st 2013 for sales up to $2 billion, and 25% of sales above $2 billion. Soon after this transaction with Biogen Idec, Elan was acquired by Perrigo.
In my previous article, I wrongly valued Perrigo's Tysabri royalties at $3 billion, because I was unaware of the legal issues and the lawsuit.
Selling Tysabri royalties
The Tysabri royalties are not core to Perrigo's business. Anyone can own royalties, even pension funds or insurance companies. (Royalty Pharma has just 21 employees, and had tried to acquire Elan). But no one else has Perrigo's unique store-brand distribution network and competitive advantage. By making acquisitions, Perrigo can exploit its competitive advantage.
Perrigo values the Tysabri royalties at $6.1 billion, about the same as the value Royalty Pharma placed on it. The royalties are being amortized over 20 years. In its S-4 filing last year, Perrigo revealed that it expects free cash flow from these royalties of $133 million, $305 million, $350 million, $380 million and $403 million in fiscal years 2014, 2015, 2016, 2017 and 2018 respectively. The royalties are taxed at 1% until 2020, and at 12.5% thereafter.
Financially, it doesn't make sense for Perrigo to keep these royalties. It is expecting roughly a 5-7% return on this $6.1-billion royalty asset, whereas the rest of Perrigo's business earns a much higher return on capital. Therefore, Perrigo should sell these royalties to raise cash for acquisitions. By adding adjacent products to its portfolio, Perrigo can increase its profit margins. Bayer just bought Merck's OTC business at 21 times EBITDA, because scale is really helpful in this business.
Unlike companies such as Valeant Pharmaceuticals (NYSE:VRX), in its earnings releases, Perrigo clearly identifies the revenue generated from acquisitions versus revenue from new and existing products of its existing businesses. Perrigo has generated healthy organic growth. Over the last 8 years, Perrigo's revenue growth of 16% per year has been split equally between organic and inorganic growth. This shows a sustainable and successful acquisition strategy, with Perrigo's retailer network serving as the enabler.
Perrigo has a great track record of generating organic growth from past acquisitions; this justifies making more acquisitions. Its store-brand distribution network is a great durable competitive advantage. By adding more items to the trucks that leave from Perrigo's distribution centers to retailers, Perrigo has increased its operating margin over the last 8 years from 9% to 24%.
By making acquisitions, Perrigo can further use this competitive advantage and increase its profit margins and return on capital. With just $2.6 billion in net debt and an investment-grade credit rating, Perrigo has ample firepower. Keeping Tysabri royalties is not optimal for Perrigo due to the opportunity costs. The Tysabri asset, at $6.1 billion, is huge compared to Perrigo's market cap of $17.7 billion. This means there is a lot of upside for Perrigo's stock price. Mr. Market is currently giving away Perrigo at 21% below its 52-week high.
Disclosure: I am long PRGO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.