How To Evaluate Healthcare Merger & Acquisition Deals

2015 was a record-breaking year for the number of mergers and acquisitions, or M&A, and 2016 doesn't look like it's going to slow down much from that pace.

In this episode of Industry Focus: Healthcare, Kristine Harjes, Michael Douglass, and Todd Campbell go over the three key factors that companies look at when it comes to M&A. Our analysts then apply the framework to some of the most famous healthcare M&A deals from last year and explain how shareholders will be affected by them and what they should be wary of.

A full transcript follows the video.

This podcast was recorded on Jan 6, 2016.

Kristine Harjes: Digging into deals, this is Industry Focus. Hello, everyone! I'm Kristine Harjes, your host of Industry Focus, healthcare edition. I've got Motley Fool contributor Todd Campbell on Skype, as usual, and I'm pleased to welcome into the studio with me special guest healthcare analyst Michael Douglass. Thanks so much to both of you for being here.

Michael Douglass: Good to be back.

Todd Campbell: Great to have you back on, Michael.

Harjes: So, we've discussed this before plenty of times: deals M&A, huge topic for 2015. It was the biggest year ever for mergers and acquisitions, both globally and just within healthcare. We did an M&A highlights episode on December 16th. I was chatting with Michael about the concept of M&A, and how to go about thinking about the strategy behind it. So, Michael proposed to me this really awesome framework, so we wanted to have him on the show to chat a little bit about it and maybe go through some examples from the year, and figure out exactly how you can apply this way of thinking about mergers to some very specific examples. So, Michael, without further ado, how are you thinking about M&A?

Douglass: Sure. So, I think when you really break down mergers and acquisitions, there are some very clear strategies that are involved. So, I think the decision-making around them seems to sort of fall around three axes. Those are what I would call intent, which is, what are you planning to do? What are you trying to get? Are you trying to get better at something that you're already good at, or get scale in that? Are you trying to get into something new? Are you trying to do a tax inversion?

I think the second piece, then, is, what's your risk appetite? Are you looking for really early stage small cap biotechs that everybody talks about in the growth space in healthcare? Are you talking about somewhat less risky biotech that are still not commercials? You've got your primary asset in phase 3, or phase 2 data's out, maybe even have phase 3 data out. Or, you're looking for a company that's already commercial, a big, already-successful company.

Of course, the amount you're going to pay is going to depend on how much your risk appetite is, which then gets us to the third piece, which is what I would call mechanism. That's thinking through, are you licensing a drug? When you're signing this deal, are you basically agreeing to be the marketing partner for this drug, so you're paying a royalty out? Is it a licensing plus equity investment, which is something that we see Celgene (CELG) doing a lot? I don't want to get too much into that, because we'll be talking about it more later, but it's very much something that Celgene does a great deal in their M&A when they're going after drugs, so they then get an opportunity to participate in a smaller-cap biotech's growth. So, their shareholders can benefit from that. Really, are you looking to buy them? Is this a straight-up purchase?

So, I think those three things interlock into this complicated mechanism for thinking about how these deals go through and how they work. And I think by looking along these three axes, we can categorize deals and understand them, and then look out for potential pitfalls.

Harjes: So, what I really love about this way of thinking about it is that it's very visual. I'm a very visual person, so of course, that's going to appeal to me. But you have your three axes, and not only is that a reminder that, oh, 3-dimensional thinking, we're so multi-faceted. Because, you know, you look at a deal sometimes, and something will stand out as, "Oh, they're doing this for tax inversion, that's all anybody wants to talk about." But there are the other two dimensions to it. And, I also want to point out that they exist on a spectrum, too. So you don't have binary options, three of them. You have an entire scale of, say, your risk appetite could range from very low to very high. Same thing for your other two axes, your intent and your mechanism. 

So, with that in mind, Todd, do you want to pick an M&A story from 2015, and we'll walk through it?

Campbell: Yeah. There were a ton.

Douglass: We're in kind of a target-rich environment.

Campbell: Very much so! Record year for M&A deals in the healthcare space this past year. You had touched on this, these aren't mutually exclusive. When you look at these deals, there may be multiple reasons for doing a deal. And I thought one place to start so we can talk about some of these issues was with the granddaddy deal of them all for 2015: Pfizer's (PFE -0.46%) proposed acquisition of Allergan (AGN) in $160B combination.

Harjes: Yeah. This would create the largest pharma on the planet, looking at the potentially generating $25B in cashflow beginning in 2018. The two companies together would have 100+ mid- to late-stage programs. It's just a mammoth, colossal deal, and I think you are right on the money in starting in talking about this one.

Campbell: Yeah, you're talking about Pfizer combining $48B in sales with Allergan's $16B in sales to create a company that's doing $64B! With a B! In the sale of medicines that are widely used throughout the globe. Michael, we were talking about the different reasons behind some of these deals. You look at it and you say, "There are some things that Pfizer's getting in this deal, multiple things. They're getting new drugs. Botox, obviously, and some eye care drugs that are also important. But, they're also going to benefit from some potential tax savings that are associated with this deal."

Harjes: Yeah. When you look at intent on this deal, to me, that's what stands out, the tax savings. It's interesting, because when you listen to the two companies talk about it, they're kind of saying, "Oh, no, it's not really the tax, it's because of ... other strategic importances." And that's actually a phrase that I'm stealing from the conference calls, "strategic importance of the franchises."

Douglass: Yeah. Pfizer's Ian Read was actually quoted saying, "Once again, I want to stress that we're not doing this transaction simply as a tax transaction. We're doing this because of the strategic importance of the franchises, the revenue growth we believe we can get both in the U.S. and internationally, and the importance of this to combine the research approaches." Which to me really highlights the fact that, yes, tax is definitely part of it, but there's also this additional growth in areas that Pfizer hasn't been that involved in. So, to me, this is an opportunity to breach into some of these new markets.

Harjes: Just to back up a little bit and give the background about my tax is even coming into play here: Pfizer is a U.S.-based company. So, technically, the way the deal is arranged is that Allergan, which is based in Ireland, would be buying Pfizer. So, the company would be able to reland its headquarters over in a country that has a much, much lower corporate tax rate.

Douglass: That's the hope.

Campbell: Right. The U.S. corporate tax rate is currently 35%, which is the highest in the industrial world. Obviously, we employ a lot of people in our corporations to help lower those tax rates, so the effective tax rate for Pfizer is in the low-to-mid-20s. So, we'll say, 23.4%, I think, through the first nine months of the year. By moving their headquarters overseas, they think that they can reduce that to 17-18% over the first couple years, and maybe get it as low as 15% further out. If they were to do that, estimates peg the savings at about $2B per year, which is about what, by the way, the company says that they'll save in quote-unquote "synergies."

Harjes: So, having covered intent, and we've talked a little bit on mechanism...

Douglass: It's a purchase.

Harjes: Yeah, clearly. To be specific, Allergan shareholders will be receiving 11.3 shares of Pfizer's stock for each share they have of Allergan, which is kind of interesting, because if you look at the two share prices right now, they don't reflect that multiple. Right now, right before the show, I pulled some numbers. Pfizer is trading for $32, Allergan's at $306. That's a multiple of 9.6. You would think that, if this deal were done and set, Allergan should be trading for a multiple of 11.3, which would bring you to $359, which is almost an 18% premium over what it's actually trading for. So, clearly, there's some suspicion here about whether or not this deal will actually go through.

Douglass: Yeah. Or, there's a number of possible outcomes there. The U.S. has really push back against the whole tax inversion thing in general, so there's probably concerns about that. There are probably concerns about whether it'll actually go through. A number of possible things there. So, yeah, that's mechanism there. Thinking about risk appetite, this is a commercial-stage company buying another commercial-stage company. So, I would say that your risk of things totally imploding with this deal, if it were to go through, is fairly low, just because, when you compare this to a biotech in phase 1, your chance of success, essentially, with these drugs continuing to be marketed and continuing to do well is very high in comparison.

Harjes: Yeah. You know what you're getting with Allergan, it's a mature company.

Campbell: They're looking at it, saying, "This is a great cashflow deal. Yeah, we're paying a lot in multiple to sales to do the deal, but at the same time, this is going to kick out a tremendous amount of cashflow that we can use to either do additional deals down the road, or to continue to return money to shareholders via dividends and buybacks.

Douglass: Yeah.

Harjes: So, let's change subjects a little bit and talk about a different set of companies. Michael, do you want to choose one?

Douglass: Yeah, sure. Let's do Celgene and Juno (JUNO). I talked about Celgene a little bit earlier, sign-posting, I can't resist. But, what Celgene did with Juno is that signed this 10-year developing and marketing agreement. Celgene pays $1B up front, that includes $150M for the drug and equity investment in Juno of $850M, for a little bit more than 9M shares at $93 per share. Clearly, right there, we know our mechanism. This is a licensing plus equity investment deal. And Celgene gets to name a board member to Juno's board of directors. And, Celgene gets the potential to actually increase its stake in Juno over the next several years, assuming certain conditions are met and approval by everybody, etc. So, there's a lot of optionality for Celgene here to grow its presence with Juno's success. So, your mechanism's very clear.

Harjes: Yet complicated.

Douglass: Yet complicated, yeah. Thinking about risk appetite, Juno is largely a fairly early stage company. You've got some assets in phase 2, you've got a lot of assets in phase 1. So, I would consider this to be on the riskier end. It's very much along the lines of Celgene, where, in a lot of ways, they kind of behave almost like a VC, where they'll basically go into these early stage companies, pay a relatively small amount upfront to then have all this optionality if one thing pans out. It's very much a biotech investor's way of investing. And it's panned out very well for Celgene. Not that they do that solely, but that's been one of their big strategic focuses over the last few years.

Harjes: So, in looking at this deal with Juno, how are you thinking about intent? You touched on a little bit we're coming you could have a lot of upside. But what exactly is going on with Juno?

Campbell: I just think that playing a good amount of educated defense, they make a lot of money, obviously, treating blood cancers. And CAR-T, which is what Juno has under development, is a new way of attacking various cancers, and a lot of them are right up in the wheelhouse of what Celgene already markets into. These drugs that Juno's working on will reengineer or supercharge your immune system to be able to better recognize cancer and destroy it.

So, I think part of it is Celgene's looking at it and saying, "This could be a competitive threat down the road. We can get some pretty cheap optionality here, let's go ahead and get exposed to it." So, yeah, it's a riskier deal, but I guess you could look at the intent of it as saying, "Okay, we already market into these very successfully. If it's successful, we could leverage that and be able to really ramp these up quickly, and at the same time, we protect ourselves against a future competitor."

Douglass: Yeah, I would definitely say, when you're thinking about intention, in my head, it's either, you're gaining scale in areas of current expertise, which is, in a lot of ways, safer, because it's an area of expertise. You already know how things work, so you can make a very good educated guesses. If you're moving into a new disease area, or a lot of new disease areas, kind of like Pfizer is doing with Allergan, that does introduce some potential risk, because it's not your core area of expertise.

Now, of course, if you've got a company with drugs already on the market, like Allergan does, then it's like, "Okay, well, we already know what works, we already know what sales it's bringing in, we can model that pretty reasonably." And then, of course, financial engineering is kind of its own special beast with, I'm sure, lots of in-house counsel and tax lawyers being involved. But I would definitely view this as gaining scale, gaining additional firepower in an area of current expertise for Celgene.

Harjes: You know, Michael, you mentioned financial engineering. That reminds me of one of the most interesting parts of this deal. When it first came out, one of our Motley Fool healthcare writers, Brian Orelli, wrote this really awesome article where he dug into the actual financials behind the deal. And the way it was stated and the way everybody interpreted it when it was first announced was, $1B deal, it's $150M upfront plus $850M for 9.1M shares, which, as you mentioned earlier, would value at about $93 per share. This was a substantial premium to what Juno was trading for at the time. So, there was this whole big discussion around, why is Celgene paying so much for the shares of Juno?

And I'll quote from Brian's article, because he did a fantastic job of walking through exactly why that's not the way to go about thinking about it: "The reason for the 9-and-some-million shares is to give Celgene an approximately 10% stake. But the $93 price tag is completely meaningless. Imagine in Celgene paid $1 per share for the 9M shares, and paid an upfront payment of," and he gives a very specific number, 990M and some, "while the drug licensing terms remain the same. So, investors could have freaked out and thought that Juno was giving away 10% of the company for nothing, but the results of that transaction would be exactly the same. Where Celgene gets 10% of Juno, Juno gets $1B." So, that $93 price tag, while it was right there in the announcements, was kind of meaningless.

Douglass: Yes. In a lot of ways, it really truly was. And I'm glad you brought up that point.

Harjes: I'd love to encourage our listeners to check out that article. If you want me to send you a link to it, happy to do so, please email us at [email protected]. This was an article written by Brian Orelli. So, one last thing before we sign off. I wanted to follow up on a company that we talked about pretty recently on the podcast that had some interesting news. Todd, do you want to go from here?

Campbell: I think it's the perfect time to mention this, because one of the things we're discussing is the various ways that companies tie up with one another. One of those ways is through licensing deals. And one of the most talked about drugs to make it to market in 2015 was MannKind's (MNKD -0.48%) Afrezza, a drug that has a circuitous path to approval, it's an inhaled insulin, a lot of people thought this could reshape dramatically how diabetics treat themselves on a daily basis. They inked a deal, Sanofi (SNY -0.39%) did, with MannKind, Sanofi being the co-marketer. They licensed the rights to the drug to market the drug and to split costs and potential profit. Unfortunately, the deal didn't pan out. Even though the FDA approved Afrezza, and it's been on the market since last February, sales have been anemic.

Harjes: So, Sanofi, as was their right, walked away. They said no.

Campbell: Yeah. We had talked about this in prior episodes, and it's been written about on the Motley Fool website, about how Sanofi had the option to exit the partnership in January, and that was certainly a real risk, given that the sales warrant ramping up. One of the other things that investors always have to look at, and say, "Okay, does the licensing deal make sense? If the drug isn't going to sell, is there a risk that the value in the company that's licensing the drug is going to change dramatically if that person walks away?" And that's exactly what we've seen over the course of the past week, as Sanofi's made its announcement that it's stepping aside. So, I think investors have to realize that just because a company license is a drug doesn't necessarily mean that it's going to be a slam dunk, that's the company who developed the drug is going to thrive.

Douglass: Yeah, there are tremendous risks all across the board. And, by the way, Kristine and Todd are both being a little bit humble about this whole thing, so I'm going to go ahead and talk it up a little bit. You both, on a previous episode, had basically been like, "We don't really see it being that likely that Sanofi's going to stay in this deal," and you were right. Here at The Motley Fool, we believe in calling ourselves out when we were wrong, and it happens. It's happened to all of us. But I just want to call out the two of you for nailing this one.

Harjes: Thank you very much, Michael. Probably a good time to remind everybody that people on the show could have interest in the stocks they talk about. The Motley Fool could have formal recommendations for or against, so as much as I know you want to put your faith in just what Todd and I say from here on out, don't buy or sell stocks based solely on what you hear.

So, with that, I guess that brings us to a close. I want to thank you so much, Michael, for being on the show as a special guest. I hope you come back with regularity. And thank you for presenting this framework, I think it's a really helpful way I thinking about a theme that was huge in 2015 and looks to be pretty big for 2016. Todd, thank you as well, as always, for your contributions. And folks, thanks for listening!