Monday, April 28, 2014

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.


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