July 3, 2004
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Merger & acquisition: just another corporate reorganization cycle?

By Lorraine Ruff and David Gabrilska, Partners
Milestones, the critical thinking company
Seattle, WA

San Francisco, CA – There was a lot of talk about merger and acquisitions (M&A) at this year’s J.P. Morgan H&Q healthcare conference. The biotechnology industry has been around for 25 years and during that time there have been numerous M&A cycles, which take on more significance in the absence of IPOs.

Like Vertex Pharmaceuticals Incorporated (Nasdaq:VRTX) that acquired Aurora Biosciences Corporation (Nasdaq:ABSC) in July 2001, or Millennium Pharmaceuticals (Nasdaq:MLNM) that has completed four acquisitions since 1997, biotech companies continue to look for ways to enhance and expand their pipelines and commercial capabilities. Large-cap pharmaceuticals are looking for ways to increase revenue and earnings per share (eps) to meet stockholder demands they have created.

Biotech valuations have increased dramatically, giving the biotech industry clout and some choices that they may not have had before. Biotech valuations have been built on the differences between chemical vs. biological drug discovery and development approaches and novel technologies and tools that have optimized the drug development process and make it more efficient cost effective.

As we completed our first decade we found ourselves needing to scale the Vertex discovery engine across multiple gene families. The merger with Aurora Biosciences gave us product build-out capability, cash generation, and additional technology capability. While the deal resulted in 18 percent dilution for Vertex, we believe we will recoup by moving the price/earnings when the company becomes profitable. Joshua Boger, chairman and CEO, Vertex Pharmaceuticals Incorporated.

Industry watchers at the 20th annual J.P. Morgan H&Q healthcare conference in San Francisco report that the industry has entered another M&A cycle. Given the inherent redundancy in the biotechnology industry and a shortage of cash, it just makes sense for companies to merge to accelerate growth, build stronger patent estates, launch products and gain access to scientific, sales and marketing talent and markets. As small- and mid-cap biotech companies attain auctionable milestones, M&A provides exit strategies for companies who are unable to raise cash or attain critical mass. Others said that the current cycle is actually the front end of a new business model that some biotech companies have incorporated into their operational strategies.

Dialogues [between prospective M&A partners] will be up this year. We all need to find ways to establish successful relationships that lead to how to get to lower drug discovery and development costs, not just more revenues and eps. John Milligan, VP corporate development, Gilead Sciences

Kevin Starr, CFO of Millennium, said that the results of his company’s M&A strategy have established a catalytic foundation for the integration of molecular medicine into the mainstream of patient treatment and a solid financial base for his company.

"[Biotech companies] have the opportunity to significantly reduce costs associated with the discovery and development of new molecular entities (NME)," Starr said. "[We] don’t have to wait until Phase II to see if a drug will fail expanded toxicology trials. [We are able to] attain sustainable productivity to both harness technology and focus on the bottlenecks that historically have resulted in a 95 percent failure at the finish line," he said.

David Deming, managing director of J.P. Morgan H&Q healthcare investment banking, spoke of an underlying, almost pent up interest between large-cap pharmaceutical and biotechnology companies to engage in M&A activities expressly to stimulate and ensure growth.

"Large-cap biotechs are behaving like large-cap pharmaceuticals: both have to drive growth in revenue and eps. They can’t attain their growth needs internally. David Deming, managing director of J.P. Morgan H&Q healthcare investment banking

Do pharmaceutical companies know how to buy biotech? I believe there are some issues that relate to differences in multiples. Why take it on when you can in license?. Peter Winn, institutional investor, Credit Suisse

However, large-cap pharmaceutical companies may not be as active in M&A during 2002. Accounting disadvantages resulting from new accounting rules governing business combinations have created a disincentive for large-cap pharma to acquire biotech companies, making it a good time for large-cap biotech to make their M&A moves in 2002 without interference from large-cap pharma, according to Douglas Braunstein, head of global M&A at J.P. Morgan.

Given the choice, a pharma would rather give away $100m (in investment) vs. an eps point. Most mergers don't work when you compare growth rates and most companies slow down after an acquisition. Matt Murray, Alliance Cap

Instead, pharmaceutical companies are in the "rent vs. buy" mode. They typically negotiate a minority investment that gives them access to product and they pay cash in milestones payments vs. money to biotech shareholders. However, Braunstein expects pharmaceutical companies will "step up M&A activities in 2003" and predicts that large-cap pharmaceutical companies will use their 1 – 8 points in price/earnings over large-cap biotech companies to their advantage. "They will be aggressive and opportunitistic," he predicts.

As informed by the new accounting rules -- see, Statement 141, Business Combinations -- pharmaceutical companies could find themselves needing to evaluate past goodwill accounting. Under the new accounting pronouncement, goodwill identified in prior business combinations may no longer be amortized.

"But in 2003, they are beyond the goodwill loses, the political heat [2002 mid-term elections and a possible focus on drug pricing] is off, multiples go up, stock is more valuable, and there’s less dilution when they acquire," explained Edward Drosnick, partner and director of SEC practice at the accountancy of Moss Adams in Seattle.

Dennis J. Purcell, senior managing partner, Perseus Soros BioPharmaceutical Fund, LP, believes that the benefits that accrue to large-cap pharma in revenue and eps growth outweigh the downside of short-term accounting disadvantages.

"Pharmaceuticals companies simply need the growth. "If they don’t participate in the M&A activity, they probably will not meet revenue and [eps] and could actually find themselves competing against large-cap biotechs. That [scenario] could create some nice exit strategies for small- and mid-cap biotech companies," Purcell said.

Industry watchers agreed that there are very few M&A transactions that serve as models per se, that most are still on a case-by-case basis. For instance, Amgen needs revenue and eps growth. In its guidance statement to shareholders and investors regarding the announced Amgen/Immunex merger, it projected "long-term product sales growth rate to the low 30s and cash EPS growth rate to the mid-20s, driven by potential ENBRELŪ sales of $3 billion or more by 2005." (Acquisition information available at: amgen.acquisitioninformation.com

Amgen/Immunex Acquisition Key Financials
  Amgen LTM* Immunex LTM Pro Forma 2002**
Annual Revenues $3.8 Billion $861 Million $5.5 Billion
Net Income $1.1 Billion $154 Million $1.5 Billion
Cost Synergies Estimated cost synergies are expected to total more than $200 million in 2003, and more than $250 million in 2004.
Last Twelve Months as of September 30, 2001
** Based on H2 2002 close

"Success has been in a positive and parallel fashion with the number of biotech drugs coming to the marketplace," Deming pointed out. "Biotechnology has become an established business sector; it represents 1.5 percent of the S&P and is a bona fide driver for drug discovery.

"The watch out is there are still rocky times ahead, not measurable, but with substantive volatility," Deming said.

While Deming’s "watch out" is cautionary, Milestones sees opportunity in the "heads up’’:

Biotechnology as an established business sector, measured by estimated annual drug revenues of $25 billion and more than 90 drug candidates in Phase II and Phase III clinical trials, has already begun to feed the large-cap pharmaceutical and biotech appetite for revenue and eps growth. (For industry statistics going back to 1994, please visit www.bio.org/er/statistics.asp.

M&A provides corporate reorganization opportunities on a transaction-by-transaction basis, but as we were to learn throughout the week, it also provides an evolving catalytic basis upon which molecular-based drugs are monetized.

Biotech companies have the opportunity to significantly reduce costs associated with the discovery and development of new molecular entities by harnessing technology to address the bottlenecks that historically have resulted in stunning failure at the finish line. As Millennium’s Kevin Starr pointed out: "we don’t have to wait until Phase II to see if a drug will fail expanded toxicology trials."

The biotech sector’s increasing valuations are giving these companies negotiation options in partnering and M&A transactions that they haven’t had before, including intra-sector consolidation, and some intriguing growth scenarios.

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