Are These Healthcare Stocks Top Takeover Targets?

Following Gilead Sciences' (GILD 0.07%) decision to buy Kite Pharma (NASDAQ: KITE) for $11.9 billion in cash, we couldn't help but wonder what other healthcare stocks could be takeover targets, too.

In this episode of The Motley Fool's Industry Focus Healthcare podcast, contributor Todd Campbell joins host Kristine Harjes to discuss how Juno Therapeutics' (JUNO) pursuit of a safer CAR-T cancer drug could make it a merger and acquisition target and how Mazor Robotics' (MZOR) robots are disrupting spine surgery and catching Medtronic's (MDT -1.12%) eye in the process.

A full transcript follows the video.

This video was recorded on Sept. 6, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's September 6th, and I'm your Healthcare show host, Kristine Harjes. I have healthcare contributor Todd Campbell on the line. Todd, what's on your mind today?

Todd Campbell: Buyouts, buyouts, buyouts!

Harjes: Yeah, I can see why. Last week, you were talking to my colleague Michael Douglass on this show about Gilead Science's acquisition of Kite Pharmaceuticals. So, this week, we figured we would continue the trend a little bit by highlighting some stock we think might be the next takeover candidates. After that, we'll discuss the demise of Teva Pharmaceutical (TEVA), a stock that shed half its value just last month. But first, Todd, I feel like the biotech space is particularly talked about in terms of buyout speculation. Why do you think that is?

Campbell: People like to hit home runs in this industry. [laughs] You know? By the nature of the beast, with clinical trials failing and successes being rare, and failures being more frequent, when people go in and buy biotech stocks, they tend to be more risk tolerant. Wouldn't you agree, Kristine?

Harjes: Yeah, sure. And, investors should be pretty risk tolerant if they're going to enter particularly clinical-stage biotech space. I don't know, it confuses me why there's so much speculation and hope for buyouts, because if it were me and I was buying one of these companies that had what I thought could be a blockbuster drug, I wouldn't want it to get bought out. I would want all that upside of them potentially bringing it to market and actually succeeding. But maybe that's a long-term, short-term difference.

Campbell: Yeah, but Kristine, it's not like consumer goods, where you're dealing with a brand like Coca-Cola. All of biotech is driven by patent expiration or protection. With innovation moving so quickly, you may have a great, innovative product, but how long will that innovation keep you ahead of the competition that's coming up the pipeline behind you? From a corporate standpoint, [I think there are] some reasons why you've got entrepreneurs who are saying, "Let's ring the register and be willing to sell," and from the acquirer standpoint, you've got people saying, "OK, we've got patents expire in, what's the next big thing and can we bring it into our fold to offset that risk?"

Harjes: Yeah, you're right, I can totally see why both sides of the equation would be interested in it. I guess my hesitation is, why do investors push for it so much? I think it's more just the fun of speculating, and that's exactly what we're about to do, is speculate a little bit on who we think could be the next big buyout. One place where there's been a ton of hype around potential acquisitions is none other than the CAR-T space. As a refresher, Kite Pharma, as I mentioned earlier, was bought by Gilead Sciences, it's a CAR-T cancer drug developer. On Kite's acquisition, a bunch of the other CAR-T developers also had their share prices pop, which to me is very indicative that people think that some of these other smaller players might also get acquired.

Campbell: Yeah, that move up in Juno was pretty insane, wasn't it, Kristine?

Harjes: Yeah, I was pretty happy to see it. A long time ago, I realize I probably should have had my money in Kite instead of Juno, but I'm still sitting on my Juno shares. I was definitely a happy camper that day.

Campbell: Yeah, I think we got, what, a 40% move up in the span of a couple of days? Obviously, investors were extrapolating, "If Novartis gets their CAR-T approved, and Kite theoretically gets its approved in November, and Gilead just spent all this money acquiring Kite to be able to get that upside, and then Juno, Juno has these CAR-T drugs, too, and maybe those drugs will be even better. So, perhaps I should get involved with that!"

Harjes: Yeah. I think there are a couple of different ways people might be looking at this. The first is, Gilead might not be finished buying CAR-T developers. I think there are some people out there who look at Gilead's strategy here and say, "They're not done, they don't want just Kite. They want to build an entire oncology franchise built around cellular therapy," which is exactly what you heard John Milligan say on the conference call regarding the Kite acquisition, that they're looking to do this, to see other companies they could fold in and augment what they've already built by buying Kite. So, this is that string of pearls acquisition technique where, instead of making one enormous splashy purchase, you can tuck in a couple of companies here and there, and they definitely have the money to do that. And, on the other side of that coin, you could also have speculation that someone else is going to buy Juno. I'm not sure who exactly that would be, but it could be Celgene.

Campbell: I'll throw a name in the mix there, Kristine.

Harjes: Who are you going to throw?

Campbell: I'll say Celgene.

Harjes: Yep. [laughs] 

Campbell: Why not?

Harjes: They've already been looking at Juno in terms of partnerships.

Campbell: Oh, absolutely! Correct me if I'm wrong, but they took a stake in it previously when it inked its deal on CAR-T development. I think Celgene has shown that it loves to tie itself to the wagon of emerging biotechnology. They don't have an internal CAR-T option. They do have some collaborations, one with bluebird bio, which was another stock that rallied significantly following the news on Kite. We've discussed that one on the show previously. So, they've got a couple deals externally for CAR-T, but they don't have anything internally. And since they've already shown that they want to be a major player in cancer, you could see that as being a possibility. But, I always get so nervous when we start talking about ifs and buts and whens and what ifs.

Harjes: Yeah, you sound like you're about to throw out some caveats.

Campbell: Well, yeah. If you look at what's been happening with CAR-T, Juno, I'm not going to call it and also-ran, but they went from being a front-runner to now being in, we'll call it third place. Their JCAR015, they had to shutter development of that. That was their lead product candidate, and they had to shutter development when safety risks caught up to them. Specifically, people were dying because of brain swelling. They had some patient deaths because of brain swelling. Well, they've now shifted their focus to JCAR017, which is a very intriguing drug. It's next generation CAR-T, and they think it could be safer. But, it's not like they've necessarily proven that out. They're not at the same stage as, say, Kite was, with a pending FDA application, or that Novartis was with their CAR-T in getting unanimous support from an adcom committee. So, I think there's a significant amount of risk with all the remaining CAR-T players, and that does make me a little bit cautious on the idea of them being a buyout.

Harjes: Yeah. And they're, appropriately, a lot smaller than Kite. At their inflated market cap, Juno and bluebird are both around less than half the size currently. And that, of course, reflects the fact that they are earlier stage. Even bluebird is super early, but they also have this entire side gene therapy program. One more name that I want to mention, because Todd, you brought up the safety risks involved here with CAR-T, and this company that I think has a really a novel way of addressing the safety risks is so, so tiny. They're only $350 million in market cap, which, for Gilead to purchase them, that would be pennies to them. This company is called Bellacom. They have an interesting molecular switching technology that could potentially make it best-in-class down the road, but way down the road. It'll be years. Their lead candidate could maybe hit the market in 2019. So, super interesting technology that could potentially improve the outcomes of some of these CAR-T therapies, things like stem cell transplants, which often have complications. But, this, again, is an extremely early stage company. I'm not even sure if Gilead would be interested in them, because it's so tiny that it probably won't even be a needle mover.

Campbell: Yeah. A company like Gilead, they like to focus on companies that are a little bit further along in their development, a little bit closer to market, where they can see a return on their investment in a relatively short period of time. They tied their wagon to Kite right now. I think, unless one of these other companies comes out there and shows that they really have dropped-dead better efficacy, better safety. Safety is going to be key in CAR-T, Kristine. I think that's the differentiator.

Harjes: Well, that's a bunch of the Juno theory right now, that they're not going to be first but they might be safest.

Campbell: Exactly! And if they are the safest, that's critical, because right now CAR-Ts are getting approved for use in refractory disease, heavily pretreated patients, these patients don't have a lot of treatment options. If they want to be able to tap into the much larger pool of cancer patients and move that up into earlier forms of treatment, they need to be able to prove that these drugs are safe. Now, in clinical trials, I think Juno has shown some really interesting interim results that suggest, possibly, it may have a better safety profile than, say, Kite's Axi-Cel. But, you need to roll this out in more patients, you need to evaluate this because we interim stuff that we saw in JCAR015 looked good, too, right?

Harjes: Yeah. You definitely need a bigger sample size.

Campbell: Oh, yeah, absolutely! Whenever it comes to investing in clinical-stage companies, I really do caution investors chasing the news and trying to buy something simply because it's running up because of something that's happened to another company. It's a risky way of investing. I think you're better off saying, do I like the technology, after doing the research? Reading everything there is on The Fool about Juno, am I convinced that this company has a better mouse track? If you think that's the case, then be a little patient, wait for shares to balance out a little bit. They've had a big run up. And then pick your spots. Again, keep it to a small, diversified position in your portfolio.

Harjes: Yep. Let's pivot pretty hard here away from CAR-T and go over to the robotic surgery market, where Todd, you brought up to me another company that you think might be a very good buyout candidate.

Campbell: Kristine, we spent a lot of time talking on the show about companies in biopharma. We don't really talk as much about companies in med-tech. And I thought it might be interesting to go out and try to find a company in med-tech that fits three criteria. I wanted to find something that's a little bit off the beaten path, something that's disrupting an industry. I also wanted to find something that already has a product on the market that's delivering sales growth, and I wanted to find a company that was already being shown some interest or some love by a larger company that could potentially become and acquirer. And when I put all that stuff up in the mixing bowl, the name that popped out for me was Mazor Robotics, a robotics company that's reenvisioning the way surgeons do spinal surgery.

Harjes: At first, when I looked at this company, I was like, "Oh, well, Intuitive Surgical, they're just going to dominate this space, why would I ever be interested in a smaller player?" But, it turns out that there's actually two pretty separate markets. Mazor has the Mazor X and the Renaissance System that helps surgeons perform spine and brain procedures, which is pretty different from what Intuitive Surgical -- which, if listeners aren't familiar with them, they are the Goliath in robotic surgery. But, Intuitive focuses on gynecological, urology, and general surgery.

Campbell: Right, more laparoscopic stuff.

Harjes: Right. So, what Mazor is improving the accuracy of surgeons when they're doing these surgeries, it reduces complications, it minimizes the need for inner operative X-rays, which is great because that will lower the radiation doses that patients are exposed to, and it leads to a faster recovery and less postoperative pain. All good stuff there.

Campbell: Which is very important. You have to remember that these procedures are being reimbursed by Medicare and Medicaid at fixed rates. So, the more that hospital can reduce, say, recovery times, get patients in, get patients out, avoid complications that may end up having them return to the hospital where they're not likely to get reimbursed as much from Medicare and Medicaid, the better. I equate this company, Mazor, to where Intuitive Surgical was maybe five years ago, in the stage of, OK, we're at the tipping point where we've invested a lot of time, effort, and energy over the course of the last few years, and trying to establish ourselves with those first-mover surgeons, the ones who are saying, "yes, I want to be on the cutting edge of technology." And now we're getting to a point where there's enough clinical data and papers published and things going on that it's becoming a little bit more mainstream. You're reaching that tipping point where more hospitals may go out and start buying these machines, which are relatively expensive machines. They can run $800,000 to $1,000,000. So, it's a big investment for these hospitals and surgery centers. I think that's what we're seeing now. We're seeing Mazor generate pretty rapid growth for its latest system, which is the Mazor X.

Harjes: Which is a win-win, because the more hospitals and surgery centers that you can get into, you not only have the sales from the systems themselves, you also get roughly $1,500 per procedure in disposables sales. That's that razors and blades model that we talked about with Intuitive Surgical. Plus, you also get the service contracts. So, at this point, Mazor just wants to sell the most of these machines that they can to continue getting in that constant revenue from the procedure sales and from the service contracts. So, what they've done is, they've enlisted a little bit of help.

Campbell: Yes. And this brings us to the big company that's showing it some love part of the segment, where we step back and say, what's the spine market look like? And, if this company is disrupting the spine market, what players in spine right now are paying attention? And the company that is really paying attention is Medtronic. Medtronic cut a deal with Mazor last year to start using its sales force to generate out leads that would get surgeons at the hospitals that it calls upon to go check out Mazor's system.

Harjes: Yeah. This is a partnership that had initially the responsibility for the two of these two companies to both be marketing these machines through the end of this year. Then, it had some options that came at the end of the year. But, we actually just found out earlier this week, I believe it was, that Phase II of the agreement is already going to kick in, which means that Medtronic will take over the exclusive rights to distribute the Mazor X system, and it'll also make another investment in the company.

Campbell: Right. It was kind of like a courtship. You went out on a date to see if the two of you liked each other. You had Medtronic giving some very preliminary training on Mazor's system, learning a little bit about it, and then of course, starting to talk about it with the people they were calling upon and get those people to go. The way that the deal had structure originally was, if the Phase I portion of the deal had gone well, then you would advance to Phase II, where Medtronic takes over 100% of all the marketing of it. But that wasn't expected to happen until February of 2018. Instead, they're doing it now. So, that tends to show you a little bit of the opportunity that Medtronic thinks there is for the Mazor X, and how it thinks it may dovetail into its own spine platform, which includes things like, say, the implants that are being used by this system during these surgical procedures, and some of the other componentry that's used by this system during these procedures. You have Medtronic doing $649 million in quarterly sales tied to spine alone. And you have Mazor possibly on the cusp of contributing much more meaningfully to that number over time, now that Medtronic is taking over the responsibility of marketing them. Which, by the way, is global marketing, which is huge, because up toward now, Mazor has really only penetrated the U.S. market. It's not very well penetrated outside the U.S.

Harjes: Yeah. I haven't even seen ex-U.S. numbers as projections from Mazor, but within the U.S. alone, the opportunity is still huge. Last year, they only used the system in 5,000 different procedures in the U.S., but they estimate that the total addressable market in just the U.S. is 500,000. So, stretch that out to the global opportunity, and yeah, absolutely, this opportunity is enormous.

Campbell: Yeah, I don't know if this is going to get to the size of an Intuitive Surgical. I think there's a likelihood that at some point, Medtronic maybe just swoops in and buys up the company lock stock and barrel. It's already, Kristine, as part of these deals, putting its money where its mouth is and buying shares in Mazor.

Harjes: Yep. The equity stake is also huge, just as a vote of confidence from Medtronic, which is a Goliath in the space.

Campbell: Right. There are three tranches that Medtronic took advantage of. They bought some shares at $11.42, which has worked out really well for them. They bought another 4% at $21.84. Now, they have a third tranche that they're buying at $38.46. Once they're all said and done, they're going to already own about 12% of Mazor, with a potential to take that up to between 14 and 15% because of some warrants.

Harjes: We'll be watching to see if that ever hits 100%. Onto the second segment of today's show where we answer the question, what the heck happened with Teva last month?

Campbell: I feel like we've seen this movie before, Kristine.

Harjes: With Teva?

Campbell: Yeah. A company goes out, spends a lot of money on acquisitions, gets heavily indebted, sales start to fall, next thing you know ...

Harjes: Yeah, here we are. Teva has a lot going on right now, but we will unpack all of that. As a reminder, back in August 2016, Teva bough Actavis, which is Allergan's generic business. This was largely funded by debt. Now, fast forward a little bit to today, and that's gotten them in some trouble.

Campbell: Yeah, a little bit. The timing of it ... it looked like a really good deal at the time. It was a $40 billion deal, with some of it being done in Teva stock, and the rest of it being done in "cash." They borrow the money because, "Why not, the interest rates are low, I can go out and buy this money and finance it with the sales growth and the cash flow." That thinking is wonderful as long as you don't stumble and cash flow doesn't start to decline.

Harjes: Yeah. When Teva reported earnings on August 23rd, its stock dropped 24% right away, which was due to a confluence of negative news in the earnings report. The most relevant one to this generics business was them saying that because of customer consolidation and increased competition from other generic drug makers, they're just not getting the prices that they're used to. Apparently, the negotiations that they went through on their contract renewals led to a 6% overall price decrease. They expect that to continue eroding through the rest of the year. So, that's alarming on its own, but I'm also really worried by the fact that management didn't really seem to see this coming.

Campbell: No. I don't think a lot of the industry did, to be fair. I think some of the pharmacies themselves have been surprised by the impact of falling generic pricing. I think you've seen it throughout the entire supply chain. The reality is this is the situation we're in today on September 6th. We have a company that's a mammoth, it's a Goliath in generic drugs, that now has this rope around its neck in the form of this big debt payment that it has to make. That's going to force it to make some pretty drastic decisions. They've decided to cut their dividend substantially.

Harjes: 75%, yeah.

Campbell: Yeah, which is something that income investors never want to hear. You can almost hear the shares being flushed out of income portfolios on that news. And they have all sorts of other problems right now with the share price, because Allergan, as part of that deal, got a whole bunch of shares in Teva. They don't want those shares, so they're planning on unloading them in the open market, selling them. So, you have that weight on the share price as well. So, you have a pitch situation where you have generic drug price compression hurting margins and crimping cash flow, interest expense rising because of all of this debt, and a lot of shares becoming available for sale that's affecting the supply and demand for the pricing of the individual shares. Throw on top of all that, Kristine --

Harjes: Yeah, we're not done yet. If you had asked me a year ago, "What is Teva's largest problem?", I would have said the fact that Copaxone, which is a huge part of their branded business -- we talked about Teva as a generics business, but it actually does have a branded segment as well that is dominated by this one multiple sclerosis drug, it's the most popular MS drug in the world, and it's going to come off-patent as early as next year. It could be facing unbranded competition, dragging down its profits from this drug. So, we've had our eye on that forever. And all of the sudden, that problem is just one of many.

Campbell: Right, they went from 20mg to 40mg so they could improve the dosing schedule, that protected market share for a couple of years. Now, there's been ongoing patent disputes between them and some generics that have some people thinking that you could end up with a 40mg competitor in relatively short order. This is a billion dollar a quarter drug. At one point, it was racking up $4 billion in sales. And in the second quarter, sales were down I think 12% in the United States to $843 million. This is a significant potential headwind at a time where the company doesn't need any more significant potential headwinds.

Harjes: Yeah. I'll also know that they are still looking for a permanent CEO. The guy that they have right now is not anything other than an interim president and CEO after the old CEO stepped down last February. Todd, to wrap up this segment, when you're looking at this company, it has gotten really cheap if you look at it on an earnings multiple basis. Do you think it could be a value player right now?

Campbell: A value player or a falling knife, take your pick. I don't know. Whenever you look at these metrics, they're either trailing 12 month metrics, which really don't reflect the situation that Teva's moving into, or they're based on forward estimates, which could very well not pan out depending on how this business ends up performing over the next few quarters. It's very hard to say it's cheap at 3X earnings per share if those are earnings per share could end up getting revised 50% lower. So we just simply don't know. You're right, it's trading at a price to book value that's less than one. It's trading at a low single-digit P/E ratio. But, the current ratio is also less than one, which means it doesn't have a whole heck of a lot of wiggle room in the short-term when it comes to financing its short-term or paying its short-term obligations. Do I think that Teva Pharmaceuticals is going to disappear? I guess, push come to shove, no. Am I willing to bet more than 1% of my portfolio on it? [laughs] I think that's the way you have to look at it. You have to say, "Maybe this is cheap, and I think it's going to come out on the other side. And certainly, there are big demographic trends at support generic prescription volume over time. Maybe I'll put 1% of my portfolio in it, and if it ends up tripling or quadrupling from these levels over a course of five or 10 years, yay, I'm rewarded."

Harjes: Yeah. You also have that dividend yield that, at this point, is looking kind of insane. I want to say it somewhere around 7%. But, I agree with the hesitation in your voice that says this one is likely to be a falling knife.

Campbell: Yeah. Kristine, that dividend yield, though, is based on the trailing, not the forward, I don't think. And now that they've cut the dividend, I don't think it's yielding nearly as much. I don't think it's nearly as attractive on that. Over time, you could get into a situation where cash flow stabilizes, they have a plan to restructure by selling some units, raising some cash. If they can do those kind of things, and cash flow grows again, maybe the dividend starts increasing, and that will be one of the key drivers that makes the stock go much higher. But, it's a very high risk-reward stock in my opinion.

Harjes: Absolutely. That'll do it for today's show. Before we sign off, a quick reminder that you can always reach out to the team through The Motley Fool Podcast Facebook group, or by email at [email protected]. 

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!