Build or Buy: Deconstructing the Big Pharma Value Chain Thru M&A

Industry changes drive M&A. Currently, we are seeing a plethora of deals in the big pharma industry. Traditionally, the industry utilized a Vertically Integrated business model. The model combines the various links in the Value Chain within each firm including early stage R&D, sales and marketing, manufacturing, and distribution. Early stage R&D is high risk and expensive (more than 15% of annual revenues in some firms). The search for blockbuster drugs to justify such investment has become difficult given many former winners going off patent and weak development pipelines. Consequently, big pharma margins have suffered.

Early stage R&D relied on a big firm’s ability to fund the needed large expenditures. This has become more problematic given the weak governance and incentive structures in large bureaucratic firms. Consequently, firms have been considering alternative funding arrangements. Instead of developing drugs internally, they buy the new drugs from better suited smaller entities thru licensing, joint ventures or acquisitions. These early stage Incubator type firms would be funded by Venture Capital, Private Equity or Hedge Funds. This would allow big pharma to focus on its core competencies. Thus, the question or bet is what is the most efficient structure to undertake early R&D- in house or buy?

This question is at the heart of the recently announced $40B+ Valeant-Pershing Square  hostile joint venture buy-in for Allergan. Valeant's business model is based on buying versus developing new drugs-primarily thru acquisitions with Allergan being the largest by far. Valeant’s R&D expenses to revenues ratio is only 3%. Their stock price has increased 9 fold since the current CEO arrived in 2008 and embarked upon a serial acquisition program. The current bid despite being over 20X EBITDA promises to be minimally dilutive based on the large amount of R&D and SG&A cost savings planned.

Allergan uses the traditional integrated model. Its R&D to revenues ratio is 17% (almost $1B LTM). It also has a top heavy $2B+ SG&A cost structure characteristic of vertically integrated firms. Its stock had stagnated over the past years. The Valeant bid equals a price Allergan has not seen since 2008. It reflects the large strategic value gap inherent in Allergan based on its current strategy and asset combinations.

Allergan is expected to resist the offer. It has a Poison Pill, and is expected to seek possible white knights like Johnson and Johnson. If those fail, then it may embark an acquisition campaign of its own to make itself too big and ugly to buy like Jos A Bank tried. Valeant and Pershing established a significant 9.7% Toehold to cover the downside of losing he bid. How they accomplished this is an interesting application of good Lawyering.

Industry disruptors like Valeant are employing new business models to rapidly reconfigure industries undergoing structural change. They accept the change while targets resist change. Ultimately, history is on the side of change not resistance. Early stage drug R&D will continue. The questions is how and who will perform it.

 J

Costs, Benefits, Taxes and Culture

Mergers are once again filling the headlines of our financial papers and as one who writes a merger blog, there are plenty of things we could discuss.  The Omnicom Publicis merger appears in danger, reportedly due to the resulting tax structure of the deal (although one can suspect other issues as well).  

Taxes also figure in the the $46 billion dollar offer of Valeant for Allergan.  According to an article in the Wall Street Journal, Valeant changed its domicile to Canada after its 2010 merger with Biovail.  As a result, it's tax rate is below 5%, offering a huge competitive advantage over companies in the United States.  Allergan is headquartered in California, so one strategy would be to move the business to Canada.  

But the Valeant Allergan deal is also newsworthy because of the differing cultures of the two companies.  Allergan is more focused on research and development, while Valeant is focused on sales.  Indeed, the planned strategy of Valeant is to reap savings by slashing the R & D spending of Allergan.  Certainly there can be value in R & D and that brings us to the nexus of the items we've talked about.

Consider three aspects of the Valeant, Allergan deal: taxes, culture and strategy.  There are three major claimants on EBITA - bondholders, debt holders and the government.  Reducing taxes increases funds available to the other claimants and can result in significant gains for equity.  

Merging companies with clashing cultures, however, is fraught with problems and can dramatically increase integration costs.  In this case, however, it is clear that Valeant is well aware of the culture/strategy issues and not afraid to confront them.  

So lets consider the pieces: taxes, culture, costs, benefits and strategy.  The value of a company and the value of any deal always come down to the basics - cash flows and risks.  We estimate value by discounting expected cash flows at a rate commensurate with the risks.

And cash flows can be increased in two major ways - growing the revenue or reducing the costs.  Both can be viable strategies and the success of any deal will hinge on the correct estimation of the costs and benefits and implementation of the specific tactics to bring them to fruition.  Both companies have been successful following different paths.  The question here is whether it makes sense for the paths to converge.

The market is predicting a higher, successful bid as the Allergan's stock price on Monday closed well above the $153. value offered by Valeant.  Valeant's stock price rose dramatically as well.  It will be interesting to follow this deal.  

All the best,

Ralph

Responding to Low T

The T in question is the Competitive Advantage Period and not testosterone. It is time in which a firm can invest at returns exceeding its cost of capital. T, or moat as used by Warren Buffett, is the driving factor underlying tech firm high valuation multiples. It is based on strategic barriers including technology, First Mover Advantages and regulation. (Also, see our previous post: Find your sustainable competitive advantage.)

It has a dramatic valuation impact as it declines when firms or industries mature. T eventually fades for most industries as they experience Regression to the Mean due to competitive forces such as new entrants and substitutes. Firms like Apple can have several years of remaining T; whereas, firms like Hewlett Packard’s T is largely gone. This fact is reflected in their widely differing valuation multiples. In fact, you can view T as the number of years a firm has before it undergoes a fundamental corporate change like a LBO, recapitalization or sale.

The current flurry of tech related deals presents insights into how firms are handling the rapid changes in T. These firms are based upon rapidly changing technology life cycles, which can be measured in terms of dog years. Firms can respond this development in two distinct manners. The first is to accept and mature gracefully and increase shareholder distributions as IBM has done. 

Alternatively, you could try to adapt by either developing new products like Apple or acquiring new products and technologies as is Facebook –see Crisis. The acquisition approach is to be distinguished from weak acquirers such as Hewlett Packard seeking to hide declining performance.

Tech firms like Google are investing in strategies which just happen to be executed thru acquisitions. Unlike Cisco which pioneered this strategy, these new transactions are much larger. 

The transactions have two objectives. The first is to acquire skills and technologies faster and cheaper than could be internally developed. The second to pick technology winners early and help them develop early as Facebook is doing with its Oculus Acquisition. In these efforts Real Option Valuation is used to supplement traditional Discounted Cash Flow analysis.

There are many risks involved with the acquisition approach. For example can you the right targets? Can you properly execute the transactions? Can you grow the acquired technology fast enough and large enough? How will your competitors respond?

The jury is still out on how this plays out. It is fascinating to watch.

J

Agency Theory,Corporate Governance and Acquisitions

We’ve mentioned that one of the ways going private creates value is through improved governance.  In fact, governance is strongly linked to mergers and acquisitions.  Consider the following:

Governance involves aligning the interests of owners and managers.  A merger changes the ownership of target and possibly bidding firms.  Thus, it creates possibilities for altering the alignments that previously existed.

Governance issues are called agency problems in the academic literature because they involve agents (the CEO, the board and management) working on behalf of the owners (shareholders).  Agency problems occur naturally because the best interests of owners may not coincide with those of the agents they hire.  Good governance seeks to align these interests. 

In future posts, we’ll spend more time on some of the potential agency conflicts that arise naturally in corporations and in particular in mergers and acquisitions.  They include, but are certainly not limited to:

CEO compensation.  It is natural for an executive to desire more and for owners to want to pay what is justified.

Consumption of perquisites by the executive team.  A sole proprietor may have a Spartan office and fly coach.  If he/she does not, they bear 100% of the costs of any perquisites.  This is not true for the CEO of the typical large corporation who probably owns less than 1% of the equity and hence bears that proportion of the costs of perquisites.  Suddenly the private jet looks more appealing.

Resistance to mergers.  A merger in the best interests of shareholders may nevertheless cost a target CEO his or her job.  Enough said.

Acquiring for the sake of building the empire.  An executive may desire to expand the empire for personal reasons.  After all, the size of a company is linked to measures of ‘prestige’ like being part of the ‘Fortune 500.’  And, of course, there is a strong link between size of the firm and size of the CEO’s pay.

Getting caught up in deal fever and overpaying.  We’ve noted a good deal becomes a bad deal at some price.  Most of us have encountered a bidding situation, on eBay or elsewhere, where we’ve gotten caught up in the momentum of bidding and gone beyond our preset upper limits.  Ego can also becomes a factor in heated bidding wars.  Neither of these situations is best for us as individuals and they certainly aren't best when playing with shareholder's money.

Conflicts between classes of capital.  Less obvious are the conflicts that can exist between equity holders and debt holders.  In a share repurchase, for example, equity holders may gain at debtholders expense.  This can occur when the collateral protecting the debt holders (including cash) is reduced for share repurchase.

These are but a few of the potential conflicts that must be handled carefully in mergers and related transactions.  In a subsequent post, we'll talk about the incentives created when an owner (say an institution) holds both debt and equity in a deal.    

Ralph

International Valuation: Around the World in 80 Steps

Valuation is critical to M&A. If you know the target’s value you can evaluate its price. Most of the MergerProf value discussions have centered upon the developed world-especially the United States. Developed nations use the valuation techniques championed here and taught in most business schools. People from emerging and developing countries sometimes ask if these techniques work in their markets. The answer is yes, but with important implementation caveats. The United States and the developed world are blessed with good quality readily available data. This aids in the implementation of the theory. Nonetheless, for emerging markets it is possible to establish workable cost of capital and other valuation estimates.

All valuation boils down to three questions:

1)     What are the cash flows: use the standard recipe of EBIT(1-t)+depreciation-

       (CAPEX+Working Capital Increases)

2)     When are they paid or received: gets to the time value of money based on a “risk

        free” government bond rate.

3)     How sure are we in the estimates: concerns the risk premium

The combination of 2 and 3 above give us the rate used to discount the cash flows. So for a Chinese company looking at another Chinese firm in a purely domestic transaction the procedure is relatively straightforward. There is a Chinese government rate and betas can be estimated from foreign peers. Damodaran's website provides useful country market risk estimates.

It gets more complicated when looking at cross border transactions involving two or more countries. The following discussion is limited to countries in emerging versus developing markets. The later have  difficult to gauge legal and political risks (e.g. expropriation and limited rule of law). In these countries, use a country risk premium or a modified payback rule-get your investment back ASAP before the local government blocks your returns.

Let’s turn to a simple situation of a U.S. firm buying a Brazilian firm. Two approaches as follows:

1)     Local Approach

     a)     Forecast local Brazilian Real cash flows
     b)     Determine local discount rates using project specific betas and capital structures
     c)     Calculate discounted Real cash flows using local Real rates
     d)     Spot the discounted Brazilian Real cash flows back into USDs in the FX market

2)     Centralized Approach

     a)     Forecast local cash flows
     b)     Convert the local Real cash flows into USDs using Interest Rate Parity
     c)     Discount the converted cash flows with USD home currency rates using project

             specific betas and capital structures into a USD project present value

The second approach is more common. Executives prefer to think in home currency terms, and accounting considerations favor this approach as well.

Taxes are a major consideration in structuring cross border transactions. Shifting taxable income to low rate countries thru various tax structures is a major reason U.S. firms have so much cash “trapped” offshore. Taxes also impact the repatriation of cash thru withholding taxes. My advice-get good legal and accounting tax experts.

As my favorite philosopher Yogi Berra noted-in theory there is no difference between theory and practice, but in practice there is. The same is true for international valuation. Get the cash flows right, and then think about the specific cross border risks that could block the receipt of those cash flows.

j

Do Bad Bidders Become Good Targets?

We all have our favorites, from food to songs and so it is with titles to academic articles.  Today’s post features one of my favorites, “Do Bad Bidders Become Good Targets?”  The answer, in a very interesting article by Mark Mitchell and Ken Lehn, is yes. 

We’ve argued before that the best takeover defense is to not leave money on the table.  The analysis of this article follows this logic.  Companies that lose money through bad acquisitions are wasting shareholder value and are likely to be targets themselves.  The complete article can be downloaded here.  The abstract is shown below.

“Do Bad Bidders Become Good Targets?”

by Mark Mitchell and Ken Lehn

This paper empirically examines one motive for takeovers: to change control of firms that make acquisitions that diminish the value of their equity. Firms that subsequently become takeover targets make acquisitions that significantly reduce their equity value, and firms that do not become takeover targets make acquisitions that raise their equity value. Within the sample of acquisitions by targets, the acquisitions that reduce equity value the most are those that are later divested either in bust-up takeovers or restructuring programs to thwart the takeover. This evidence is consistent with theories advanced by Robin Marris (1963), Henry G. Manne (1965), and Michael C. Jensen (1986) concerning the disciplinary role played by takeovers. 

All the best,

Ralph