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Big Pharma and biotech continue to need each other. But biotech is feeling slightly more confident as the options for IPOs get better, writes Peter Young.
Financial results and trends for any industry are mainly driven by operational business imperatives, but external factors can be significant as well.
Business issues include ongoing structural challenges in pharma and biotech such as a very different R&D/commercialization dynamic; changing relationships with patients and providers; shifts in patent laws and regulation, reductions in government spending and unpredictable behavior with regard to pricing, market access and IP. External factors include a global economy struggling to resume growth and financial stability; continuing government efforts to prevent a Euro zone economic and financial meltdown; political uncertainties linked to the phase-in of comprehensive health reform in the US; economic slowdown in emerging market economies like India and Brazil; and a positive surge in Western stock market valuations.
These external factors have had an enormous incremental effect on the financial trends in pharma and biotech this year and will continue to have an impact going forward.
A recent report "Pharma and Biotech Strategic, M&A, and Financial Trends Report" by Young & Partners covers the first three quarters of 2013 and the outlook for 2014. The report presents a separate view of both the pharma and biotech industries and tracks :
» The strategic and business environment for both industries
» Stock prices and P/E ratios within proprietary index groups of pharmaceutical and biotech companies
» Completed M&A deals of $25 million and up
» Issuance of non-bank debt and equity.
Looking back, pharma merger and acquisition volume in 2012 was fairly soft in terms of the number of deals and dollar volume. The slowdown was partly a function of a reduced number of larger deals across all industries as the uncertainties around the European economic crisis, the US presidential elections and fiscal cliff negotiations, and concerns about a slowdown in China. However, the strategic needs of Big Pharma were sufficiently strong to cause important, but smaller transactions to go forward.
Through the first three quarters of 2013, there was a further slowdown in dollar activity, but a similar pace in terms of the numbers of deals completed, bolstered by a surge in Asia. As of September 30, only one deal above $1 billion in value has been completed which was the acquisition of Bausch & Lomb by Valeant. Three other billion dollar plus deals had been announced, but not closed.
The slower pace is driven by a number of factors. As was the case in 2012, Pharma companies have been tentative with regard to larger acquisitions given the host of uncertainties they are facing. In addition, the valuations of publicly traded pharma companies have gone up considerably, making public company acquisitions more expensive.
Pharma share prices performed well in almost every sector. The Young & Partners ("Y&P") Generic index and the Y&P Ethical Pharma indices in the US and Europe were buoyed by a strong overall stock market. This has resulted in very strong P/E multiple increases from what were previously anemic levels languishing far below their very high levels in the 1990s and earlier.
Debt issuance by the Pharma industry fell significantly during the first three quarters of 2013 along with the drop in M&A activity. Over the past few years, much of the debt issuance in pharma has been tied heavily to larger M&A transactions. Equity issuance was also relatively modest, including IPO activity.
On the biotech side, M&A volume has historically been very weak and was at low levels from 2007 to 2011. Acquirers were selective and alternatives to M&A, such as partnering and licensing, played a prominent role. That changed in 2012 as biotech M&A picked up to 2006 levels and higher with the $10.3 billion Pharmasset deal and four other $1 billion plus transactions completed. This proved not to be sustainable. In the first three quarters of 2013, the number of deals has been healthy, but the dollar volume was very weak. A combination of high stock market valuations and the bidding up of prices for late stage biotech companies has dampened big Pharma's pursuit of certain biotech companies.
The stock market has renewed its ardor for the biotech industry. With relatively low market float, modest to moderate movements of capital into the biotech sector have caused very significant increases in the price of shares as investors have searched for places to invest in growth areas.
In terms of biotech financing, debt issuance has been at a virtual standstill as debt markets shun the biotech sector. However, the situation has been quite the opposite in terms of equity offerings. The strong IPO market generally, coupled with the equity markets' renewed attraction at least with biotech, resulted in a high level of equity issuance, including IPOs.
In the first three quarters of 2013, the S&P 500 did well, increasing by 15 percent, while the FTSE Euro Top 100 increased by 7 percent. The pharma industry did slightly better, the Y&P US Pharma index increasing by 18.9 percent over that same time period, while the Y&P European Pharma index rose by 12.4 percent, and the Y&P Generic index by 30.1 percent.
Valuations have also increased significantly, with the most dramatic increases occurring in the ethical pharma sector. The Y&P US Pharma index P/E ratio increased from 18.6x at the end of 2012 to 23.5x at the end of the third quarter of 2013. The Y&P European Pharma index increased similarly from 15.1x to 21.4 x over that same time period.
The Y&P Generic index increase was less impressive, increasing by a small amount from 22.9x to 23.6x over the same time period. This was partly driven by earnings increases.
These multiples have improved, but they are still dramatically down from where they were just a number of years ago, when the pharma industry was viewed very differently. The pharma industry was once viewed as a stable, profitable, high growth industry. The industry is now viewed as far less stable with industry uncertainties everywhere and predictable, profitable growth a distant memory.
The significant turnaround this year has been welcomed by investors and the industry.
We will see even more positive changes when the industry regains its footing, which depends in turn on when the market has confidence in the industry's structural stability going forward.
In the first three quarters of 2013, 29 deals were completed worth $11.6 billion versus 38 deals completed, worth $30.9 billion, during all of 2012.
This represents a significant slowdown in dollar activity, but a similar pace in terms of the numbers of deals completed, bolstered by a surge in Asia. The one deal above $1 billion in value was the acquisition of Bausch & Lomb by Valeant for $4.6 billion. The next largest deal was only $879 million; the acquisition of Guangzhou Baiyunshan Pharma by Guangzhou Pharma.
In comparison, there were five deals valued at over $1 billion (equity value) in 2012, primarily strategic deals: Couckinvest NV's acquisition of Omega Pharma NV for $1 billion, Sandoz's acquisition of Fougera for $1.5 billion, TPG Capital's acquisition of Par Pharmaceutical for $1.9 billion, GlaxoSmithKline's acquisition of Human Genome Sciences for $2.8 billion and Bristol Myers Squibb's acquisition of Amylin Pharmaceutical for $5.1 billion.
However, there are signs that the pace is picking up. As of September 30, 2013, the value of the deals announced but not closed was $29.9 billion (17 deals), the largest of which is Amgen's acquisition of Onyx.
Pharma companies have generally been perceived as strong cash flow generators, so investors have, thus far, felt comfortable lending to the industry in their pursuit of yield. Borrowing levels have been more a function of the issuers' needs.
In the first three quarters of 2013, non-bank debt issuance was $25.4 billion compared to $50.9 billion for all of 2012, a significant decrease in activity. This is directly related to a slowdown in M&A activity and the related financing that would have been required.
Equity issuance in the first three quarters of 2013 showed a meaningful increase on a very small base, with $4.6 billion of equity issued compared to just $3.5 billion for all of last year. There were three IPOs in the first three quarters of 2013.
Although the equity issuance activity has been modest, it has not been due to a weak overall IPO market since the IPO market for life sciences has been strong this year. Instead, it is because Pharma's need for public equity capital has generally been limited.
Against a backdrop of strong general market performance, the Y&P Large Cap Biotech, Y&P Mid Cap Biotech, and Y&P Small Cap Biotech Indices did exceptionally well in the first three quarters of this year, increasing by 58 percent, 68 percent and 161 percent, respectively. This is a continuation of their strong performance last year.
Equity markets have fallen in love with the biotech industry again. With relatively low market float, modest to moderate movements of capital into the biotech sector have caused significant increases in the price of shares as investors have searched for growth areas to invest in.
For some time, market sentiment towards the biotech industry was decidedly mixed, except for established biotech companies and companies with positive late stage data. But the sentiment changed last year and continues this year.
Given the perception that Big Pharma needs to fill its product pipeline, Biotech M&A activity has been chronically modest for the last couple of years, with just a few exceptions.
In the first three quarters of 2013 there were 21 biotech M&A deals completed worth $6 billion. This compares to 19 deals worth $19.7 billion for all of 2012. Dollar volume has fallen, but the number of deals has increased. The dollar volume decrease was largely due to Gilead's acquisition of Pharmasset in 2012 for $10.4 billion. But it was not the only large deal last year. Dainippon Sumitomo acquired Boston Biomedical for $2.6 billion and BMS acquired Inhibitex for $2.1 billion.
The reduced number of large deals is partly due to the very high stock market valuations and the bidding up of prices for late stage biotech companies which has dampened the pharma company pursuit of certain biotech companies. Also, for much of this year biotech companies have had an attractive IPO climate as the alternative to a sale option.
Although pharma and biotech executives believe that there should be a great deal of M&A activity, pharma companies are accomplishing many of their strategic goals using other alternatives to M&A such as licensing and partnering.
Interestingly, earn-outs have become a major portion of transactions this year, featuring in 13 of the 21 deals completed. Although earn-outs or "structured acquisitions" involving contingent payments have been common in biotechnology M&A deals, they peaked in 2011 and fell to 32% of biotech deals completed last year. This has changed dramatically thus far in 2013, surging to 62%. The primary reason has been an increased need to bridge the value gap between buyer and seller.
Interestingly, as of September 30, the value of deals announced but not closed was only $500 million (with one deal). This suggests continued weakness looking forward in biotech M&A volume.
Debt financing has been close to a standstill. Only $492 million of non-bank debt was issued in the first three quarters of 2013 compared to $794 million for all of 2012. This is a continuation of an almost non-existent debt financing market for a number of years.
Equity issuance volume in the first three quarters of 2013 was much stronger, with 78 offerings worth $5.9 billion compared to 85 offerings worth $5.6 billion for all of 2012. This puts the industry ahead of last year's pace in terms of both number of deals and dollar volume.
The IPO market has become exceptionally strong recently with a surging stock market and very positive biotech stock price performance. First three quarters 2013 issuance includes 29 biotech IPOs totaling $2 billion. This is a huge increase over the 13 IPOs in 2012 and the 6 in 2011.
Although there have always been long periods between the periodic biotech IPO frenzy that happens from time to time, this time around the inactive period was particularly long. The real question will be how long this peak period lasts. At least in the past, the peak periods have been relatively short.
The business outlook for pharma companies is mixed, as pharma companies struggle to realign themselves to a new business model that will work. The solution will be different for each company.
Although the pharmaceutical industry has been less affected by global economic conditions compared to most industries, going forward the impact will be more prominent as governments attempt to control healthcare costs as part of their deficit reduction efforts. The revenue challenges will be tied directly to the difficulties in getting drugs approved, reimbursement challenges, patent expirations, weak product pipelines, and failing business models.
The stock market has partially forgiven the ethical pharma industry due to an overall bullish attitude toward the equity market. But real turnaround in valuations will require structural changes that investors believe will be effective. Generic pharma companies, however, are being treated well by investors, but with caution as the revenue cliffs that once were just the terrain of the ethical pharmaceutical companies are now migrating to the generic sector as well.
Pharma M&A will continue to be active, but modest in terms of the size of deals. There is a desire to make deals strategically focused. Although there have been a few announced large deals recently, such as Perrigo/Elan, Amgen/Onyx and Actavis/Warner Chilcott, these are not mega transactions.. We do not see many mega deals happening in the next couple of years. We do expect companies to continue to divest non-core assets and review established product lines.
The major debt refinancings were completed quite a while ago and new debt issuance will depend on the number and size of M&A transactions that will have to be financed. Non-investment grade debt will be issued more sporadically.
Equity issuance will continue to be modest primarily because pharma companies generally do not need equity. So even though the IPO and general equity issuance markets have revived, pharma issuance of public equity will remain limited.
Biotech companies are continuing to demonstrate their ability as a group to be effective at developing new drugs and diagnostics methods, but the challenges that face drug development generally will confront biotech companies as well.
Historically, the biotech industry's relationship with the debt and equity markets has been volatile. The good news is that the current love affair that the equity markets have with biotech companies shows no sign of slowing down on both the stock market and the equity issuance fronts.
The primary biotech M&A theme will continue to be pharma and big biotech acquisitions of biotech companies for pipeline enhancement. Historic M&A volume has been modest as, pharma and big biotech continued to use non-M&A methods to achieve their pipeline goals, much to the detriment of biotech companies seeking an exit. M&A volume will likely continue to be modest, particularly with the existence of numerous external uncertainties that will tend to dampen biotech M&A for a period of time. The heavy activity will be in the form of partnering, licensing and shedding of more non-core assets.
Peter Young is President and Managing Director of Young and Partners, an international investment bank serving the pharma, biotechnology, and chemical industries. He can be reached at email@example.com.