There is arguably no corner of the market that's more conducive to merger and acquisition activity right now than the biotechnology sector.
M&A gone crazy
The trailing 12 months have brought a veritable parade of deals, with AbbVie buying Pharmacyclics for $21 billion, Teva Pharmaceutical gobbling up Allergan for a whopping $40.5 billion, and Celgene acquiring Receptos for $7.2 billion. This is just a small sample of the deals that have been announced, and it doesn't even take into account the unsuccessful multi-billion takeover bids that were launched. According to research firm DealLogic, the value of M&A in biotech is already up to $270.9 billion through mid-August, and it looks well on its way to surpassing the all-time record high of $277.4 billion in M&A activity set last year.
Earlier this week, another M&A deal was concluded in biotech -- but this one shouldn't raise too many eyebrows.
The deal involved Valeant Pharmaceuticals (NYSE: VRX) purchasing privately-held Sprout Pharmaceuticals for approximately $1 billion in cash (in two separate $500 million payments), as well as a share of future profits based on sales milestones for its recently-approved libido drug for women, Addyi (dubbed the "female Viagra"). The deal came just a day after the Food and Drug Administration approved Addyi to treat hypoactive sexual desire disorder, with the drug expected to reach peak annual sales within the U.S. of approximately $100 million, according to at least one analyst's estimate. Valeant has suggested the deal should be accretive to its bottom-line beginning in 2016.
Emulation is the purest form of flattery
The reason this deal isn't raising too many eyebrows is that Valeant's primary method of growth has been acquisitions -- and it's a strategy that's paid off well for the company that it's emulating, Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B).
Warren Buffett's Berkshire is the conglomerate model that all others try to copy, even Valeant. Berkshire currently has around five dozen subsidiary companies across multiple sectors (energy, healthcare, consumer goods, transportation, and so on), which not only add to its bottom-line when the U.S. and global economy is clicking, but also act as a buffer when things aren't looking so bright.
Berkshire's strategy is also successful because Buffett and his money managers are always on the lookout for products or services that can essentially sell themselves and require little oversight. In other words, Buffett and Berkshire buy brand-name or basic-need products that require little upkeep or have an inelastic demand (think Kraft Foods or Heinz), and allows the existing management structure of a company to continue to grow the business. In a nutshell, this hands-off approach is Berkshire Hathaway's formula for success.
But there's an area of the market where even Buffetts dare not venture: biotech.
Valeant attempts to become "biotech's Berkshire"
Valeant is looking to emulate Berkshire's success by acquiring a diverse portfolio of biopharmaceutical assets in high-growth indications that can essentially sell themselves.
Since current CEO J. Michael Pearson took the helm in 2008, Valeant has completed more than 100 acquisitions according to Fortune, with many of the small- and midcap variety (or what I like to call "bolt-on" acquisitions). Valeant's largest acquisitions to date include its announced purchase in February of Salix Pharmaceuticals for $10.1 billion and its 2013 deal to buy privately held Bausch & Lomb for $8.7 billion. The Salix deal allowed Valeant to get its hands on irritable bowel syndrome drug Xifaxan, which may have peak annual sales potential of near $2 billion, while the acquisition of Bausch & Lomb added to Valeant's focus on the high-growth areas of dermatology and eye care.
Since 2008, Pearson has transformed Valeant into a monster, with annual sales growing from $757 million to $8.3 billion in 2014. Based on estimates from Wall Street, Valeant's top-line sales are projected to nearly double to $15.5 billion by 2018. Profits, on the other hand, are expected to more than double to an estimated $20.54 per share by 2018 from a reported $8.34 per share in 2014. And there's even reason to believe that Wall Street's estimates could be conservative if Valeant is able to keep up its torrid pace in regard to acquisitions.
Based on commentary from Pershing Square's Bill Ackman in May -- keep in mind that Ackman is a substantial shareholder in Valeant, so he has some obvious biases -- he believes Valeant has transformed into more of a "platform" company capable of executing on $7 billion to $20 billion in acquisitions on an annual basis. Ackman went on to suggest that Valeant's still attractive valuation stems from investors not understanding how to properly evaluate these deals.
If there's one thing that Valeant has succeeded in doing, it's diversifying its product portfolio to a handful of indications. A growing life expectancy in America that coincides with baby boomers retiring in record numbers should increase eye care product demand, while better diagnosis of dermatological disorders -- coming as access to medical care expands -- will help with sales of the company's nearly mile-long list of dermatology products. These are just some of the many examples of how Valeant could see growth continue over the long run.
Two notes of caution
Of course, growth by acquisition does come with two concerns for Valeant.
First, there's the ability to integrate so many new businesses at once. Although business integration is designed to save on costs with the elimination overlapping operations, it can take a few quarters, or even years, to fully realize cost savings associated with an acquisition. However, integrating multiple businesses at once can lead to unexpected hiccups that investors may be unprepared for.
The second concern is Valeant's financing of its deals. As of mid-year, Valeant was sporting a little less than $1 billion in cash and a ridiculous $30.9 billion in debt. This isn't to say that Valeant isn't generating substantial cash flow -- it's produced $2.34 billion in trailing 12-month operating cash flow -- but its $30 billion net debt position could constrain future deal-making or put pressure on profits if Valeant is having to funnel substantial portions of its revenue to make interest payments. The alternative -- issuing shares and diluting existing investors to raise cash -- isn't necessarily a better option, either.
Personally, I believe Valeant stock does have the potential to move higher, but I also would suggest that investors approach an investment in Valeant with a long-term view. Even if Ackman is correct and Valeant can aggressively acquire businesses on an annual basis, the potential for dilution, an increase in debt, or integration issues are concerns that can't be ignored, and they'll likely keep the stock from getting too far ahead of itself.