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Mergers: the happy union?

We have been through a spate of mid-cap mergers in the pharma and biotech sectors in western Europe and I think this will continue in the UK, comments Navid Malik, pharma analyst at broker Collins-Stewart

We have been through a spate of mid-cap mergers in the pharma and biotech sectors in western Europe and I think this will continue in the UK, comments Navid Malik, pharma analyst at broker Collins-Stewart.

For example, Shire Pharmaceuticals is an obvious bid candidate for a bigger pharmaceutical group that badly needs to bolster its short and medium term new drug portfolio. I can't see any further consolidation among European mid-caps in the pharmaceutical or biotech sectors - at least for the following year or two.

We look to be in a period of settling down with the mergers that have already taken place in such large numbers, but that's not to say that more mergers won't take place - I think they will, in the UK, at least.

The mergers that Malik is referring to are those of Pfizer and Powder Med, Gilead and Myogen, Nycomed and Altana, Merck KgaA and Serono, UCB and Schwarz Pharma, Bayer and Schering; two of which are already showing promising synergic results. These mergers - like most others - were driven by three powerful forces at work in the market, namely the chance to bolster drug pipelines, increase profits and implement strategic decisions.

Deals that work

Although city analysts believe it is too early to tell if these mergers are producing the results intended, there are some indications of how they are faring.

There is no doubt that the Merck KGaA and Serono merger has reduced Merck's dependence on its chemical operations. Although taken by surprise at the time of the USD 3.3bn bid for Serono, the market has increasingly warmed to Merck KGaA, a global pharmaceuticals and chemicals group that is not linked to the US-based Merck & Co. At first it was seen as a classic case of mid-cap European pharma firms combining to gain more leverage in the world market place, reducing rising R&D costs and competing more effectively in an aggressively competitive market place.

Before buying Serono, market sentiment was that Merck KGaA was overly dependent on its chemical operations. Wisdom not without reason as the chemical business was responsible for one third of sales - but also delivered half of the operating profit. This was due to Merck supplying nearly three-quarters of the chemicals required by the LCD flat-panel industry - a risky business considering how technologies change. As a result of the merger, two-thirds of profits this year will come from pharmaceutical sales.

Business mix

It was an inspired strategy, as the vast cash revenues from the chemicals side of the business can now be ploughed into a sector growing at three times the rate of traditional drug markets.

This has transformed Merck's business mix and consequently its growth prospects. Merck owns a potential blockbuster in Erbitux, the drug for treating colon cancer. Recent trials with Erbitux have shown that it is more effective than its main competitor Vectibix, which is owned by Amgen. There have thus been major synergy benefits from the Serono purchase and Merck can look forward to robust sales growth from Ertibux and Rebif, the drug for treating multiple sclerosis.

The financial consequences of the Merck-Serono merger have been substantial. Citigroup estimates that earnings from the combined group in 2009 will double.

Rapid integration

Bayer's merger with Schering has also brought about quick financial results. The group believes its underlying EBITDA margin will exceed 22 per cent by 2009, and the earnings forecast for Bayer Healthcare has improved as a result of the integration of Bayer Schering Pharma happening faster than anticipated.

Looking back, the merger was a steal of a deal for Bayer, which bought Schering AG for EUR 16.3bn in an opportunistic move. Bayer had not actually planned to buy Schering - it pounced when rival Merck KGaA pulled out of the bidding process. While opportunistic, there was a business rationale to the merger as the two firms do complement each other, having followed similar development paths.

Bayer also secured a promising drug pipeline as part of the deal. Werner Wenning, chairman of the Bayer board of management commented: The Schering takeover was a further development of our business portfolios and we are proceeding faster than expected with the integration. We are confident to achieve synergy effects of more than EUR 800m - compared with the previously planned EUR 700m - by 2009.

Bayer's drug research is now focusing on oncology, cardiology, women's healthcare and diagnostic imaging.

Ones to watch

Shire Pharmaceuticals offers the basic ingredients for a successful merger. The company is growing organically and by dint of astute acquisition, having recently scooped up New River Pharmaceuticals for GBP 1.3bn. This was a critical deal for Shire in the lead-up to its launch of Vyvanse, the new attention deficit hyperactivity disorder (ADHD) drug. The purchase gave Shire full control over Vyvanse, which it originally in-licensed from New River in 2005. Vyvanse is a potential blockbuster drug and will replace Shire's existing ADHD drug, Adderall XR, which will soon confront generic competition.

To offset the generic threat, Shire also clinched a deal with Barr Laboratories, the generic drug manufacturer. Barr Laboratories has agreed to keep its generic competitor drug to Adderall XR off the market for some time yet.

New River also has other potential money spinning drugs in its R&D portfolio, such as Elaprase for Hunter's syndrome, the first drug from the TKT acquisition to hit the market. It was launched in the US last August and is now going through the European regulators.

Shire made a pre-tax profit of USD 317m on sales of USD 1.8bn for the year ended December 2006. In the previous year Shire made a loss of USD 492m on sales of USD 1.6bn.

Broker Canaccord is looking for pre-tax profits of USD 416m in 2007 and earnings per share of USD 0.56 (compared with USD 0.57 in 2006) rising to USD 474m and earnings per share of USD 0.63 in 2008. High and rising profits and sales are an obvious attraction to any bidder, particularly when it is being produced by a strong drug portfolio, and with more drugs to come in the pipeline.

Navid Malik favours AstraZeneca as a bidder for Shire. AstraZeneca hasn't been acquisitive recently and are trying to bolster their biologicals programmes - antibodies, proteins and vaccines. Shire would make a good fit in the protein area, he explains.

Another potential link up is Biocompatibles International and Medical Solutions. Both companies are in the business of alleviating cancer and a merger would throw up a number of synergy bonuses.

Synergy benefits

Biocompatibles is a medical device specialist that treats heart problems and cancer by delivering medicines more effectively. It developed the 'Precision bead' to treat liver cancer locally. The advantage of the bead over conventional chemotherapy lies in the benefit that patients get the same drug effects but with fewer side effects.

Biocompatibles' share price has been recovering, after falling by a third in September 2006, when Abbott Laboratories cut off its ZoMaxx heart stent, which contained Biocompatibles' technology. While Biocompatibles won't get any royalties from this deal, it has enabled it to concentrate on its main product - the drug-eluting beads for primary liver cancer, colorectal cancer and liver secondaries.

Data from the trials of the beads in primary liver cancer patients - using chemotherapy drug Doxorubicin - has been good, with 89 per cent of patients surviving for two years, in comparison to 63 per cent with conventional chemotherapy.

The market for primary liver cancer patients is worth USD 400m. The drug-eluting beads are also used for colorectal cancer, which has even higher market potential.

Biocompatibles made a loss of GBP 6.3m on turnover of GBP 5.9m in the year to 31 December 2006. This compares with a pre-tax loss of GBP 6.7m on a turnover of GBP 3.4m in the previous year. Brokers forecast a loss per share of GBP 0.18, compared with a loss per share of GBP 0.15 in the previous year. Revenues are expected to rise by 51 per cent in the current year.

The fact that Biocompatibles is so well funded is rare in the biotech sector. It has net cash of GBP 30m in its coffers. Its other great advantage is that its products are deemed to be medical devices, not drugs, so they can be sold on the market before obtaining any regulatory approval.

Medical Solutions (MS) has a cash pile of nearly GBP 15m, which provides an obvious attraction. The money came from the sale of its Dubai operations in November 2006 for GBP 13.2m in cash. The company made a pre-tax loss of GBP 2.3m and revenue of GBP 6m in the year to end December 2006 against a pre-tax loss of GBP 3.6m and revenue of GBP 5.7m in the previous year.

MS also has a useful drug business which would fit in with that of Biocompatibles and offer significant synergy benefits. Having sold off its Dubai operation, MS is focusing on bolstering its cytology (cervical screening) and tissue-abnormality pathology services. The latter is increasing its scope into the diagnosis and treatment of cancer.

Although the NHS accounts for over 90 per cent of its income, MS still has some leeway as screening targets are not yet being met. MS currently claims nearly 50 per cent of the market for liquid-based cervical cancer screening in England and Wales ñ estimated to be worth GBP 10m.

MS has a market price-tag of GBP 13.8m at a share price of GBP 0.07. To secure an agreed bid, Biocompatibles would have to offer a premium of 30 per cent to the market share price.

The Author
Malcolm Craig is an investment commentator and freelance financial journalist

9th August 2007

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