Mylan Goes on a Drug Binge

Some snakes can swallow animals that are much bigger than themselves, and apparently so can some generic drugmakers. Mylan Laboratories (NYSE:MYL) announced yesterday that it was buying German pharma Merck KGaA's much-larger generics drug business.

The $6.7 billion all-cash deal will more than double the size of Mylan, which has an under-$5 billion market capitalization. Merck's generics segment's $2.4 billion in 2006 sales is nearly double Mylan's 2006 fiscal year top-line results.

Mylan will pay for the deal by issuing up to $2 billion worth of stock and stock-related debt. In an industry where size does matter, this deal gives the new, combined Mylan much more weight in terms of top-line sales than its competitors like Barr Pharmaceuticals (NYSE:BRL) and Watson (NYSE:WPI).

Since 2005, the generic drug industry in general, and Mylan in particular, have been on a consolidation spree. Every major generic drugmaker, from  Teva (NASDAQ:TEVA) to Barr to Watson, has made at least one major acquisition.

This consolidation frenzy is good for Mylan and the industry, since it allows both for bigger economies of scale, and the generic manufacturers to spread the high fixed manufacturing and legal costs of generic drug development across a bigger revenue base, which should bring improved operating margins and bigger profits. With operating margins of only 18% last year, there should be efficiencies (and thus extra income) for Mylan to wring out of Merck's operations. Indeed, Mylan is guiding for $250 million in cost savings through the merger by the end of three years post-merger.

Did Mylan overspend and overleverage its balance sheet in order to get Merck's generics business? Some other generic drugmakers think so and bowed out of the bidding for Merck's generics business because of the high price tag. Barr paid nearly 2.5 times trailing-twelve-month revenues when it acquired Pliva last year for $2.5 billion, and Mylan is paying nearly the same at 2.7 times Merck's generics revenues for last year.

Despite such rudimentary analysis, it's hard to say at this point how good of a deal this is for Mylan shareholders. But in the generic drug industry it's either eat or get eaten by rivals, and Mylan has obviously chosen to be the bigger fish and make the acquisition in order to continue operating independently.

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Fool contributor Brian Lawler does not own shares of any company mentioned in this article. Barr is a Stock Advisor recommendation. The Fool has a disclosure policy.