Mylan's Costly Bid to Capture the Flag

Did Mylan Labs (NYSE:MYL) win the battle but lose the war? It outbid Teva Pharmaceutical (NASDAQ:TEVA) for the generic drug business of German pharmaceutical Merck KGaA, but the market has passed judgment that the win was too costly and sent Mylan's stock down 12% Tuesday.

The growth potential of the generics business is staggering and explains why these deals are getting more expensive. According to industry firm IMS Health, products going off patent in 2007 will have about $16 billion in estimated total sales, and that number will escalate to about $100 billion by 2010. Although initially criticized for spending about 2.5 times sales for Croatian drugmaker Pliva, Barr Pharmaceuticals (NYSE:BRL) simply may have been part of the vanguard in running up the price for greater access to the world generics business.

Rising cost of doing business
Mylan is paying around 2.7 times sales and 15 times EBITDA for Merck's generics business, in line with what German pharmaceutical Stada paid for Hemofarm last year. Teva has said that though Merck's generics would have dovetailed nicely with its own line of drugs, the price -- $6.7 billion, all cash -- just wasn't worth it. Iceland's Actavis also pulled out of the bidding for the Merck unit because of the cost, as did a private equity consortium. Mylan has countered that to get "quality assets" you have to pay up, but at a price tag 50% more than Mylan's own market cap, investors are noticeably worried. CEO Robert Coury, though, says a series of smaller acquisitions would have simply resulted in a manifold increase in merger risks.

Sandoz, the generics unit of Novartis (NYSE:NVS), has pursued the smaller acquisition route, scooping up Eon Labs last year and Lek, Sabex, and Hexal recently to give it an international footprint. Mylan isn't a stranger to smaller bids, either, as it just completed the acquisition of a 71% stake in Matrix Laboratories, which could benefit from the Merck deal as business is shuttled its way. The international arena is what everyone wants these days, which has some looking to see what, if anything, Watson Pharmaceuticals (NYSE:WPI) will do because it has virtually no international presence.

The danger, of course, is that Mylan won't be able to extract the cost savings from the generics deal that it has forecast, particularly in light of the debt it took on to do so. It seems the $250 million savings it's estimating from the transaction is high compared with what has been achieved elsewhere. Mylan will be offering up to $2 billion in equity and equity-linked securities -- a hybrid debt instrument whose return is connected to Mylan's stock -- to make the deal happen.

Heady days in generics
It's getting frothy in the generics market, and when companies are willing to exceed the usual going rate to structure creative, complex deals to make them happen, a boiling-over point usually isn't too far behind.

Management begins looking at industry growth rates and justifies its actions because of it. Coury told Reuters that, in one fell swoop, he was "able to achieve all the scale necessary in all the areas that are important to compete in the generics pharmaceutical space."

That may be, but at what cost to Mylan? Even Coury admits there's little overlap between Merck's generics business and its own. Realizing those cost savings predicted earlier may be harder when you can't pare back any redundancies. There's also the loss of exclusivity for Merck's Duoneb, which Mylan will be getting in the deal but will hit its margins hard because it accounted for 15% of the generics unit's sales last year. There have been five challenges to the patent by drugmakers, two of which have been settled. Also, Mylan is suspending its dividend.

Hype, hope, or heart?
There's a lot of hoping going on that within three years, the merger will start generating significant profits. Mylan expects the deal to dilute cash earnings per share next year, break even in the second, and generate some serious returns in the third. To do so, however, Mylan's going to have to integrate the generics unit perfectly. It's injecting serious dilution for current shareholders and making its debt more expensive. Standard & Poor's cut Mylan's credit to below investment grade and put the company on negative credit watch, meaning its ratings could fall further.

To keep it competitive with Teva, Mylan almost had to get this deal done. Had it allowed its rival to win the bidding war, there might have been no catching up to it. There are certain synergies that Mylan will realize through the acquisition. The vertically integrated API supply chain, for example, is a significant gain. Yet as consolidation has grown more rampant and prices rise, it may be that Mylan bought an expensive asset just before the bubble burst and won't be able to successfully blend it. For investors, it would hardly be consolation that it beat the competition but lost overall because of it.

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Fool contributor Rich Duprey owns shares of Barr but does not have a financial position in any of the other stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.