The past several years have been a busy time for big pharma, as it digests numerous acquisitions. In the past 12 months, there have been at least nine buyouts of drug companies for more than $1 billion, with AstraZeneca's (NYSE:AZN) more than $15 billion buyout of MedImmune leading the way.
The European pharmaceutical sector has been particularly busy consolidating, with every major old-world pharmaceutical firm the product of a major acquisition or merger. This week, rumors have swirled that Swiss-based Novartis (NYSE:NVS) will make a $73 billion offer for Germany's Bayer (NYSE:BAY).
With somanyacquisitions in recent months, I wondered what a good pharmaceutical acquisition would look like. How can we tell whether a big pharma's fancy new biologic or RNAi technology acquisition just flushed a billion dollars down the toilet?
Secrets of a savvy acquisition
One of the better articles on pharmaceutical acquisitions came from an enterprising group of economists from Emory University. They analyzed the stock performance of 160 pharmaceutical companies that made acquisitions from 1994 to 2001, discerning which types of acquisitions led to unusually good stock market returns in subsequent years.
1. How informed is the purchase?
According to the study, the most overwhelmingly important factor in a successful acquisition is how much the buyer knows about its prospective purchase. This knowledge could come from an ongoing marketing or development partnership, an out-licensed compound, or even a venture capital stake with the buyout target.
When drugmakers are intimately aware of at least some part of their partner's business operations, they're more likely to know about risks they might otherwise overlook, and thus less likely to overpay for their partner. This bodes well for deals like Eli Lilly's (NYSE:LLY) acquisition of partner ICOS earlier in the year, since the companies have been longtime collaborators on the erectile dysfunction drug Cialis.
2. How well does the purchase complement the buyer's operations?
When OSI Pharmaceuticals (NASDAQ:OSIP), whose lead drug treats lung cancer, acquired eye-disease specialist Eyetech in 2005, many investors and analysts called it a horrible deal, predicting that it destroy value for OSI shareholders. Analysts have been proven right; shares of OSI have fallen 27% since the acquisition, and the company is now trying to shed its Eyetech assets.
This journal article reached the same conclusion about what would occur to OSI following the Eyetech deal. Deals that acquirers make outside their research specialty didn't correlate with increased shareholder value.
On the other hand, acquisitions of drugmakers focused on the same therapeutic categories strongly correlated with better returns. So if you see oncology-focused Genentech (NYSE:DNA) start buying up drugmakers trying to treat cardiovascular diseases, you might want to pare back your expectations for its shares. But investors can take solace that Genentech's numerous oncology deals in recent years are more likely to pay off.
3. How is the deal financed?
Equity deals somewhat outperformed cash and debt acquisitions. The study's authors speculated that equity deals better align the acquirer and acquisition's interests. Companies that oversell themselves to prospective buyers will feel a greater obligation to perform well, and suffer more in the event the purchase proves sour, if their payment takes the form of stock.
4. How strong is the buyer?
Deals made by drugmakers facing patent expirations on their lead products, or with weak pipelines, tended to display far smaller chances of successful acquisitions. The study theorized that such firms' relative desperation for new products leads them to overpay for assets, or make riskier deals, in an effort to show some sort of progress to shareholders. That bodes ill for large-cap pharmas like Pfizer (NYSE:PFE), which will need to recoup billions of dollars in sales in the coming years as its top drugs lose patent protection.
Final thoughts on the pharma frenzy
Those are the main variables correlating to successful pharmaceutical acquisitions. Still, remember that even acquisitions that pay off aren't necessarily the best use of a drugmaker's cash or shares. A dividend or share buyback may yield greater benefits in the long run, so investors still need to make their own analysis of a deal's overall merits. In cases where a buyout is the best option, the four factors above strongly signal whether that buyout will prove foolish or Foolish.
On Monday, I'll use these criteria to examine several current deals, and see whether they're likely to pay off for investors.
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Eli Lilly is an Income Investor recommendation. Pfizer is an Inside Value selection.
Fool contributor Brian Lawler does not own shares of any company mentioned in this article. The Fool's disclosure policy is always a smart option.
