Stockwatch: Limited Acquisition Headroom At Specialty Pharma
Executive Summary
Debt-fueled acquisitions helped Teva, Shire and Allergan report well-received fourth-quarter earnings. But sector circumstances have changed since 2016 and the ability to grow by debt-funded acquisition is now severely restricted.
As fourth-quarter earnings season trundles on, the focus is moving away from the financial reports of big pharmaceutical companies to their specialty pharmaceutical counterparts and then finally onto loss-making biotechnology companies. With the missed fourth-quarter sales and 2017 guidance of big pharma threatening sentiment for the rest of the sector, specialty pharma took on the role of a linebacker last week. Headline results were better than I had expected.
Teva Pharmaceutical Industries Ltd.'s fourth-quarter earnings report followed the recent departure of its CEO so expectations were not high. (Also see "Teva CEO Steps Down While An Integration Hangs In The Balance" - Scrip, 7 Feb, 2017.) Despite being in the middle of the perfect specialty pharma storm with the added concern that the CEO's departure was linked to fourth-quarter sales or profit, Teva managed to pull a rabbit out of a hat and deliver reassuringly positive results.
Sales and earnings were up about 4% and 1% respectively, ahead of analysts' consensus estimates, while its 2017 projections of sales and (admittedly non-GAAP) earnings were maintained. Teva's $973m generally accepted accounting principal (GAAP) loss versus its $1.5bn non-GAAP profit was a reminder to investors to prepare for the reconciliation of these numbers when companies report. Teva should probably be given a bye in this respect since the accounting effects of its $40.5bn acquisition of Allergan PLC's Actavis generics division are still rippling through its financial statements and there are far worse and regular exploiters of non-GAAP accounting than Teva. The company's stock price ended the week up a whopping 12.8% against the more pedestrian 2.6% rise in the NYSE ARCA Pharmaceutical Index. Like its results, Teva's share price jump had a number of influences but the maintenance of its dividend featured highly. While there were obvious reasons to be cheerful about Teva's results, 2017 guidance and dividend commitment, there are also reasons to be cautious. Teva's guidance appeared not to assume further generic drug price erosion or multiple generic 40mg Copaxone (glatiramer acetate) entrants.
When Shire PLC delivered what the analysts from Citigroup called a "solid fourth-quarter and guidance", the specialty pharma trend started by Teva at the start of the week appeared to be more than a one-off. Shire's fourth-quarter sales and earnings were 1% and 3% ahead of analysts' consensus estimates, respectively. (Also see "Shire's Record Year Bolstered By Baxalta, But Shows Across-The-Board Growth" - Scrip, 16 Feb, 2017.) The mid-point of Shire's full-year 2017 sales guidance range was in line with analysts' consensus estimates while the mid-point of its earnings guidance range was 2% below consensus estimates.
Like Teva, Shire is something of a building site after its $32bn acquisition and integration of the sales and earnings of Baxalta Inc. and I was struck by a common undertone at both companies. The high level of debt that was needed to fund the acquisitions last year looks to have a different risk profile with two or three interest rates possible in 2017. Both companies had debt reduction narratives in their results and both calmed stock and debt holders by declaring acquisitions were not a priority in the immediate future. In Teva's case, any deterioration in its branded or generics business outside its maintained guidance could force a dividend cut – unpalatable to those investors who just basked in its maintenance – if debt covenants are not to be breached. Shire's de-leveraging plans for the year would be aided by the absence of generic competition to its ulcerative colitis drug Lialda (mesalamine), which the analysts from Cowen recently assumed was unlikely before 2019. The intellectual property on Lialda had seemed robust after Shire's defense last year but last week the Federal Circuit Court of Appeals reversed the lower court's earlier decision in favor of Shire and ordered that the generic version of Lialda from Actavis did not infringe Shire's patents.
The debt-mediated acquisitions of Teva and Shire may result in an uncomfortable time depending on their generic pressures in 2017 but – as both companies alluded to in their results – they have certainly limited their borrowing headroom and appetite for further substantive M&A.
Allergan – the architect of Teva's increased debt burden – reported fourth-quarter results that initiated the specialty pharma rearguard action this earnings season. Allergan's sales and earnings were 2% and 4% ahead of analysts' consensus expectations, respectively. (Also see "Allergan Confident About Continued Growth, Swats Down Competition Concerns" - Scrip, 9 Feb, 2017.) Admittedly, Allergan's guidance on earnings growth had been reset down at the end of 2016 but its more recent results provided an opportunity to revise up 2017 sales and earnings forecasts that were, respectively, 2% and 1% above the mid-points of what had become analysts' full-year consensus estimates.
Since the divestment of its subsequently pressured generics and Anda Inc. distribution businesses – transactions that look in retrospect to be strategic masterstrokes – Allergan has been remaking itself with a large number of transactions that rival the pace of even Celgene Corp.'s deal-making activity and have cost at least $10bn in cash up-fronts alone. While many of these transactions – like the $2.5bn paid for Zeltiq Aesthetics Inc. and $2.9bn for LifeCell Corp.'s regenerative medicine business – were in Allergan's traditional specialty strategy, if I were in business development at Allergan, I would be kicking myself that the acquisition of Novartis AG's Alcon Inc. eye care business is out of reach. This is because Alcon's total purchase price was $51bn and Allergan's net debt now stands at $19.5bn in addition to its recently committed $10bn share buy-back. There is probably little headroom left for a large transformative acquisition like Alcon.
If I were a healthcare investment banker I would expect that the part of my address book that listed specialty pharma CEOs will grow cobwebs over the next year or so.
Andy Smith gives an investor's view on life science companies. He joined the commercialization, pricing and market access group of ICON PLC in February 2017. He has been the lead fund manager of four life science–specific funds, including 3i Bioscience, International Biotechnology and the AXA Framlington Biotech Fund, and was awarded the techMark Technology Fund Manager of the year for 2007.