In weeks when investors have been searching for superlatives, Rule Breaker portfolio holding Amgen (NYSE: AMGN) and Seattle-based Immunex (Nasdaq: IMNX) added another one: the largest acquisition of a biotech drug maker to date, a $16.7 billion bite as of yesterday's closing.  

Yes, this tops even the news so important to readers of this column that David Gardner will pitch his tent outside of the multiplex tonight to snare the first tickets to the Lord of the Rings: Fellowship of the Ring, which premieres tomorrow. Have fun, David, and we'll be right behind you (we already saw Harry Potter)!

The new merger joins two other biotech buyouts this month. Portfolio holding Millennium Pharmaceuticals (Nasdaq: MLMN) announced on Dec. 6 that it would buy COR Therapeutics (Nasdaq: CORR). Briefly the largest purchase of a biotech by a biotech, the deal's $2 billion price tag on the day of the news topped the $1.5 billion sticker price MedImmune (Nasdaq: MEDI) had offered to pay for Aviron (Nasdaq: AVIR).

Amgen proffers 0.44 shares and $4.50 in cashola for each Immunex share. American Home Products (NYSE: AHP), which owns 41% of Immunex, has agreed to support the deal, and will be an 8% owner of the combined beast. At Amgen's close yesterday at $59.49, the deal was worth $16.7 billion. The combined market caps of the companies is $79 billion, launching the new entity into stratosphere of the world's top ten drug makers, which other than Amgen are also diversified health care companies. A new big pharma may be born, but the stock is no better an investment.   

Amgen's view
First off, Amgen's press release made me groan. It promises that the deal will only dilute cash earnings by 5%. Cash earnings? That's EBITDA, which should be called Earnings minus Everything, or at least minus Expenses, because that's what ITDA (interest, taxes, depreciation and amortization) are. Ignore it. After all, how many of you live on what you are paid, and how many on what you have left after taxes? 

The company also asserts that "With the acquisition, Amgen expects to accelerate its five-year annual percentage growth in product sales to the low 30s from the low 20s, and accelerate its annual growth in cash EPS to the mid-20s from the low 20s." I've maintained before that the previous rosy scenario, even if proved true, provides questionable opportunities for Rule Breaker returns. Amgen sports the astronomical valuation of 70 times trailing-12-months free cash flow (historical averages for the S&P 500 range roughly between 15 and 25), and a P/E of 56. Examining the deal ruthlessly, it provides insufficient support for the current valuation to give this portfolio a significant return over at the very least the next five years, let alone beyond.

A word (or more): When we look at buying a Rule Breaker, we rarely have a company with profits and free cash flow, and we apply the criteria a venture capitalist might use. Amgen was a rare company we bought when flush and fast-growing. Its financial situation and business maturity make it easier to gauge its potential with traditional valuation measures.

Deal sets high bar for company
Amgen will issue 0.44 new shares for each of Immunex's 544.6 million, for a total of 239.6 million. That's 23% of Amgen's current 1.05 billion share count, and 15% of the two companies' current combined share count. Roughly, Amgen shareholders will need to see a 23% increase in value to make up for the dilution. This doesn't even take into account any reduction in Amgen's value due to the cash payout, which at $2.45 billion is about 209% of Immunex's cash and short-term investments. 

Amgen shareholders get Immunex, which right now is largely Enbrel, an injectable rheumatoid arthritis treatment slated to sell $750 million this calendar year, with growth limited only by manufacturing capacity (which the company is addressing with facilities purchased from American Home Products that will be on line in 2002). But Enbrel isn't worth it. Here's why. 

Is Amgen paying a fair price?
Amgen is taking $16.7 billion, primarily based on its high valuation, and deciding that Immunex is the best place for its money. This is no different from you taking $1000 from your savings and investing it in Junior's orthodontia or Sally's home chemistry lab. You've decided that you have a better place for the money, one that will provide a better return. 

If you were Amgen's CEO (which means you would be making more green stuff than either you or I probably make now, but you would also spend your days doing things we might rather not do!), you know that you can invest absolutely risk-free in ten-year treasury bonds, earning a little over 5%. But you're not in business to do that, and your shareholders expect more. Let's say that at the bare minimum you won't consider an investment that provides less than a risk-adjusted 10% pre-tax return each year. The company has led shareholders to expect much more than that, but even 10% will make my point.  

We'll assume three things: First, Immunex gives you Enbrel, even though the company obviously has in-process research and development for other drugs. Second, patents on Enbrel are good to 2011, after which generic or other competition will reduce its revenues to squat in a couple of years. And third, Enbrel provides a 50% net margin to Amgen, because all of its expenses are behind it except selling, general, and administrative.

Immunex says that Enbrel is on track to provide $750 million in year 2001 sales, and between $900 million to $1.3 billion in 2002. Let's use three scenarios for the present value of 10 years of patent-protected Enbrel revenues and three years when the generics barge in:

Year From           Enbrel Sales  
Now    Reasonable    Optimistic     Whoopee!
1(2002)$1.0 bil.     $1.0 bil.     $1.3 bil.  
2       1.25          1.5           2.0
3       1.5           2.0           2.5
4       2.0           2.5           3.0
5       2.0           2.5           3.5
6       2.0           3.0           4.0
7       2.0           3.0           4.0
8       3.0           3.0           4.0
9       3.0           3.0           4.0
10**    3.0           3.0           4.0
11***   0.75          0.75          0.75
12      0.5           0.5           0.5
13      0.25          0.25          0.25

10%**     $5.83 bil.     7.00          9.18 
*patent protection expires **discount rate, and assuming a 50% net margin.
***Generic competition kicks in

You can do this at home, using a spreadsheet (I used Excel) and do either of the following.

  • In Excel, for each year, present value = (yearly revenues*net margin)/(1 + discount rate)^number of years from now. "^" is "raised to the power of." Add up the present values.
  • Or, use the NPV (net present value) function, where NPV(discount rate, year1 revenues, year2 revenues, .... final year revenues).
  • Don't forget to divide each year's revenues in half, reflecting 50% net margins. 

If you use a 15% or 20% discount rate, the numbers decline farther than the $5.83 billion to $9.18 billion estimated here. This means that at the very least, Amgen believes that some or all of the following provide the other $7.52 billion to $10.87 billion that Amgen is paying for Immunex: 

  • Enbrel is going to be more successful than these estimates.
  • Immunex's in-process research and development is worth at least the remainder of the $16.7 billion in present value.
  • The efficiencies from the deal provide significant savings.

And Amgen's press release does trumpet these, more or less. Some considerations for Amgen investors are that Immunex has another $250 million or so in trailing-12-months revenues from other products, but it lacks a great late-stage product pipeline -- the FDA eliminated hopes that Enbrel would be approved for chronic heart failure in April. The company also brags $1 billion in cash and short-term investments and no debt, though Amgen is paying cash equal to more than double Immunex's savings account. If the oral version of Enbrel in early development is successful? Could be huge, but enough to provide us a significant upside to a stock selling for 70 times trailing-12-months free cash flow? As any grade-schooler will tell you, N-O spells no.  

The more things change...
Ruthless (where's Ruth?) conclusion? The Immunex deal will do little or nothing to change the current valuation risk for Amgen shareholders at its eye-popping current valuation. Nothing in this deal changes my analysis in April that Amgen is not on track to provide anything near Rule Breaker returns in the next five years or more.     

When we find a better place for the portfolio's money, I'll urge that we move the Amgen stake.

Have a most Foolish day!

Tom Jacobs (TMF Tom9) checks his stocking each day for volume. At press time, he owned shares in Millennium Pharmaceuticals. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.