Mylan (NASDAQ:MYL) has announced a much anticipated deal under which it will acquire specialty and branded generic drugs from Abbott (NYSE:ABT). Investors react cautiously optimistic to the announced deal, which is not really a surprise but does mark a big step for Mylan to achieve its long-term earnings targets.
Yet, given the strong momentum in recent years, high valuation, substantial leverage, and the consistent gap between GAAP and non-GAAP earnings, I will play it safe and won't consider an investment at current levels.
Mylan announced that it has reached an agreement with Abbott under which the company will acquire Abbott's specialty and branded generics business in non-US and developed markets.
Mylan will pay roughly $5.3 billion for the assets in an all-stock deal, which will involve the issuance of 105 million shares of Mylan to Abbott, giving it a 21% equity stake in the business.
The deal has been unanimously approved by the board of directors of Mylan, and is anticipated to close in the first quarter of 2015.
With the acquisition, Mylan will diversify its businesses and strengthen the asset base outside of the US. With additional sales channels, the company can obviously find new opportunities for growth and leverage those sales assets.
Included in the deal are more than a 100 specialty and generic pharmaceutical products in the areas of cardio/metablic, gastrointestinal, anti-infective/respiratory, CNS/pain and women's & men's health. With the deal, Mylan will own appealing products, including Creon, Influvac, Brufen, Amitiza and Androgel, among others.
Mylan stresses that several of these products are protected by patents and are hard to manufacture. These drugs generate sales all over the world, including Europe, Japan, Australia and New Zealand. Included in the deal is the sales organization with some 2,000 sales representatives in over 40 countries, as well as two manufacturing facilities.
Chairman Robert Coury stresses that the company has been looking actively at a wide range of opportunities before making this deal. The deal gives Mylan more exposure outside of the US, results in better diversification and allows for a more competitive tax structure.
Coury notes that the anticipated accretion and deleveraging following the all-stock deal gives Mylan continued financial flexibility for the future as well.
The acquired assets generate about $1.9 billion in sales, which values the deal at 2.8 times sales.
The deal is anticipated to be immediately and significantly accretive to Mylan's adjusted earnings to the tune of $0.25 per share. From this moment onwards, accretion is expected to increase until 2018.
Pre-tax operational efficiencies are seen over $200 million per annum by year three after the deal has been closed. With roughly 500 million shares outstanding following the closure of the deal, accretion a few years down the road could be much greater than the initial short-term estimate of $0.25 per share.
Part of the accretion is driven by tax synergies, with Mylan anticipating a 20-21% tax rate in the first year following the closure of the deal. Effective tax rates are anticipated to fall to levels in the high-teens thereafter. To achieve these synergies, Mylan will execute on the popular inversion move, effectively changing its official tax address to the Netherlands.
Valuation And Pro-Forma Business
In May, Mylan released its first-quarter results. The company ended the quarter with $243 million in cash and equivalents while having a $8.2 billion in debt on its balance sheet, resulting in quite some indebtedness.
The company has posted trailing sales of $7.0 billion on which it net earned $633 million after posting EBITDA of $1.6 billion. Including the $1.9 billion in anticipated sales and accounting for the impact of other deals and organic growth, Mylan anticipates $10 billion in annual sales for 2014.
Adjusted EBITDA is seen around $3 billion going forward. So far, trailing earnings per share came in around $1.60 per share. If we add to that the expected accretion of at least $0.25 per share, earnings per share are seen north of $1.85 per share. Taking into account the 105 million newly issued shares to Abbott, Mylan will have roughly half a billion of shares outstanding. This implies that earnings are seen above $900 million going forward, possibly reaching highs of close to a billion.
Trading at $51 per share, Mylan's equity will be valued at roughly $25 billion after factoring in the newly issued shares. This would value the business at 2.5 times anticipated sales and roughly 27-28 times anticipated GAAP earnings.
The leverage following the deal will be down given the all-stock financing, resulting in a 2.3 times ratio of debt to adjusted EBITDA. This should give the company enough financial flexibility for the future.
Strong Track Record And Ambitious Future Targets
Driven by deals, Mylan has aggressively grown its revenues over past decade. Back in 2004, the company posted sales of little less than $1.4 billion. Following the 2007 deal to acquire the generics business of Merck KGaA, it increased its sales to roughly $5 billion. Further modest deals, organic growth and the latest deal will allow the company to double sales again towards $10 billion.
Earnings came in at $335 million in 2004 and are set to nearly triple towards a current run rate of approximately a billion as a result of the deal. While this looks great, take notice that net profit margins are going down. While the company still operated with a net cash position back in 2004, Mylan's past deals have resulted in a net debt position of about $8 billion at the moment.
At the same time, those earnings have to be shared with more fellow shareholders, as the total share count has roughly doubled as well. Despite these issues, shares have risen from lows of around $10 in 2008 to current levels in their fifties.
The company remains optimistic, anticipating further growth. For 2018, it has set a long-term earnings target to report $6 in adjusted earnings per share.
Note that for the year of 2014, Mylan anticipates adjusted earnings of $3.25-$3.60 per share before the deal has been announced. GAAP earnings are seen structurally lower at $2.03-$2.22 per share. Therefore, the $6 headline EPS target for 2018 appears very nice, yet acknowledge that GAAP earnings are more likely to come in the $3-$4 area.
Investors like the deal for the accretion, tax synergies and reduction of relative leverage despite the further dilution of the total shareholder base. Mylan is the product of acquisitions and so far the company has done a solid job. While the size of the operations and earnings has grown a lot, cold hard GAAP earnings per share growth has been fairly limited.
In that light, a lot of the returns in the stock have been driven by multiple inflation, rather than real profit per share growth. In this light, I look at the adjusted earnings target for 2018 with skepticism, as the company has leveraged up the balance sheet to some extent as well in the meantime.
These reasons, the not so impressive organic growth and the high valuations on GAAP metrics, are enough for me to be worried and avoid the shares. This is despite admiring the company's track record, long-term guidance and expected accretion resulting from the deal.
I remain on the sidelines.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.