Valeant's Surprise Bid for Cephalon: Repeating a Growth Trick?

Includes: CEPH, VRX
by: EP Vantage

Valeant’s (NYSE:VRX) management team no doubt means what it says when it calls for a swift resolution to its surprise bid for Cephalon (NASDAQ:CEPH). By making its overtures public in the form of three increasingly frustrated letters sent over the last few weeks, the Canadian company clearly wants to get around the negotiating table.

However, after a month of rebuffs from Cephalon’s management, Valeant has decided to take its bid straight to the U.S. company’s owners. The fact that shares in both companies soared on the news yesterday morning shows a big appetite for the deal to happen, and with Cephalon rising $2 above the $73 offer price, a sweetened offer from Valeant could well be required.

Repeating the trick

Buying Cephalon would certainly be another transformative deal for Valeant. A combination of the two companies would have had sales of $4bn last year, rising to $5.2bn in 2016, according to EvaluatePharma forecasts. Valeant itself turned over $1.2bn last year, a figure analysts see rising to $2.9bn by 2016.

Having only last year merged with Biovail in a deal worth $4.5bn that doubled the size of the company, Valeant’s management team clearly sees the potential for doing something similar again – stripping out costs and adding scale with many small but relatively low risk products. (Biovail and Valeant join forces to drive growth, June 22, 2010).

It has already struck one deal in this vein this year: The €350m ($518m) acquisition of PharmaSwiss, which will add a strong branded generics and OTC business based in central and eastern Europe.

This strategy has been widely applauded by investors; since the Biovail deal closed at the end of September last year, Valeant’s market value has almost doubled, to $13bn today.

Valeant has managed to extract better-than-expected cost savings from the Biovail merger, and anticipates finding synergies worth $270m this year rising to $310m in 2012. Combined with a lower tax rate, largely due to moving its headquarters to Canada, and reduced R&D spending, the earnings power of the company has greatly improved.

On a conference call yesterday morning chief executive J. Michael Pearson said the company reckons annual synergies of at least $300m should be achievable from Cephalon. Should it be allowed to do due diligence and this figure rises, or its opinion of the company’s growth prospects improve, there is room for its bid to rise, he said.

Offer on the table

The offer on the table at the moment is $73 a share, equal to $5.7bn – a premium of 29% over Cephalon's 30-day trading average and higher than the stock has traded for the last two years, Valeant pointed out in its first offer letter, made public this week. The second letter, following the first rebuff, proposed buying the parts of Cephalon’s business not focused on oncology for $37 per share, or $2.8bn, on a cash-free and debt-free basis. This is an unlikely outcome, Pearson admitted on the call.

In the third letter, sent after this proposal was dismissed, Valeant said it believes Cephalon is spending its money on risky investments -- a sentiment no doubt shared by many of the U.S. company’s shareholders.

Cephalon stock, which closed at $58.75 on Tuesday, had lost 18% of its value over the last 12 months before yesterday’s surge – the stock actually neared Valeant’s offer in March last year, briefly rising above $70.

A series of acquisitions deemed high risk have not been well received, and seemingly done little to alleviate concerns about the impending loss of patent protection for Provigil. In fact, the first letter from Valeant indicates that the two companies first met to discuss “working together” on March 3. Since then, Cephalon announced the $225m purchase of Gemin X and a $231m move on ChemGenex (CXSP) – deals that are starting to look suspiciously like poison pills.

Thinking big

Cephalon investors are right to be concerned about life post-Provigil, the blockbuster wakefulness drug that looses patent protection next year. However, where they see a patent cliff, Valeant sees a cash cow that will allow it to quickly pay back the debt raised to fund this acquisition.

And behind Provigil is a suite of smaller products that fit nicely with its existing business model. In fact, had Cephalon not bought the branded generics group Mepha last year – at the time a move that seemed to be a departure from core strategy – Valeant might not be interested now.

Cephalon shareholders will be able to vote on this offer in about 20 days' time, so Valeant will know pretty soon what they think of the offer. Going public could force Cephalon to the negotiating table, and a higher and possibly agreed bid could still emerge.

However this ends, Valeant has signalled it is prepared to think big. Further deals were always expected ... but few will have been expecting a move of this size. Whether Cephalon enters the fold or not, this proposed transaction will certainly not be the last, and Valeant’s ambitious management no doubt already has its next move in mind.