This Big Pharma Just Went to the Dogs, and That's Great News for Shareholders

Following a week of vigorous M&A activity, this struggling Big Pharma stands out as perhaps the biggest winner.

Apr 24, 2014 at 12:03PM

I honestly struggle to think of a week as exciting as what we've witnessed over the past few days in terms of merger and acquisition activity (and rumors) within the pharmaceutical sector.

Over the weekend there were rumblings that Pfizer was readying to make a $101 billion bid to acquire U.K. rival AstraZeneca. The informal talks have stopped, but the sheer notion that such a huge merger was even a remote possibility greatly improved investors' appetite for risk.

Then, early Tuesday morning, Novartis announced a sweeping reform and refocusing of its operations via the $14.5 billion acquisition of GlaxoSmithKline's oncology unit, the sale of its vaccine unit to Glaxo for $7.1 billion, and the sale of its animal health division to Eli Lilly (NYSE:LLY) for $5.4 billion.  

Finally, on Tuesday as well, we learned that Valeant Pharmaceuticals had made a hefty bid to acquire Allergan for 0.83 Valeant shares and $48.30 in cash for each share of Allergan. Overall, the deal was worth $46 billion when it was announced. Allergan has since adopted a poison pill to prevent the attempted takeover by Valeant and hedge fund manager Bill Ackman.

Like I said, it was a remarkable week, but it was crucial for one Big Pharma in particular: Eli Lilly.

LabsSource: Eli Lilly.

Eli Lilly's "parade of failure"
In my opinion, Eli Lilly's development pipeline is the weakest among Big Pharma.

The company's experimental Alzheimer's disease therapy solanezumab didn't meet its primary endpoint in a late-stage study in 2012 (although it is being studied further in an investigator-sponsored trial overseas in early onset Alzheimer's). Then, in 2013, enzastaurin missed its primary endpoint in a phase 3 trial for diffuse large B-cell lymphoma; edivoxetine failed to meet its primary endpoint as an add-on therapy for major depressive disorder in a late-stage study; and in September ramucirumab missed its primary endpoint in a breast cancer study. This parade of failure hasn't gone over well with investors who are itching for Eli Lilly to find ways to replace revenue from drugs that are losing patent protection.

The good news is that Lilly may have found the smartest solution imaginable. Instead of purchasing a small or midsized biopharmaceutical for its pipeline, and risking it failing as well, the company invested in one of the most stable and growing sources of cash flow imaginable -- the animal health business.

Not cheap, but a genius move
The purchase price for Novartis' animal health division wasn't cheap at $5.4 billion, or roughly five times last year's sales, but it makes a moat of strategic sense for Eli Lilly.

Livestock

Source: Ryan Thompson, Wikimedia Commons.

Novartis' animal health division is particularly focused on the commercial market in 40 countries, providing anti-parasitic medication and vaccines for livestock. This isn't to say Lilly's Elanco didn't have this focus already, but it will greatly expand Elanco's presence around the world with regard to vaccines, and give the company a larger commercial presence. The move also better positions Eli Lilly to get its foot in the door in emerging markets that offer a more robust growth rate than the established markets where it conducts the majority of its business.

Combined, the two businesses will be capable of somewhere in the neighborhood of $3.5 billion in sales this year, instantly making Lilly the second-largest global animal health provider behind only Zoetis, which is expected to bring in more than $4.7 billion in revenue this year.

As you might imagine, there are some huge advantages to this combination beyond just the cost synergies which should help boost Eli Lilly's bottom line. Let's look at a few of those benefits.

The benefits of a larger animal health company
To start, larger companies have more pricing leverage. Just as pharmacy-benefit managers negotiate drug prices with Big Pharma, prices for animal health vaccines and medications are determined in similar fashion. This means a larger company can use its clout and market share to its advantage when it comes to pricing therapies high enough to earn a healthy profit.

The second point is that patents and competition within the animal health sector simply aren't comparable to what we see in drugs intended for humans. There are a finite number of truly global animal health players, and few of them really compete with each other on a disease-to-disease basis. This means that even when a patent expires there won't necessarily be a generic version of the drug to take its place. Since branded pharmaceuticals yield better margins than generics, we're talking healthier margins for a longer period of time.

Lastly, as it relates to the companion animal segment, many people have adopted our dogs, cats, and other animals as members of their families. One important aspect of this thinking is that many pet owners are willing to pay whatever is necessary to ensure the health of their "family member," thus giving animal health companies plenty of pricing and demand leverage.

The proof is in the numbers
The growth in pet expenditures is absolutely phenomenal. According to the American Pet Products Association, some 62% of U.S. households currently own a pet, and expenditures have increased from less than $30 billion in 2001 to an estimated $55 billion in 2013. This steady growth of about 5% per year is highly sustainable given the need for livestock as the planet's population grows, and as more pets are adopted into households domestically and around the globe.

Keep in mind this is just one fix for Eli Lilly, and it certainly won't solve the company's mammoth patent cliff issues. However, it's the first major step I've seen the company take in the right direction in I can't even remember how long. While I'm still not sold on Eli Lilly's current valuation, my view of the company has certainly improved following this astute acquisition.

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Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool owns shares of, and recommends Valeant Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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