Thu, 15 May 2014
Recent M&A activity among health-care stocks indicates firms are homing in on core competencies and cost savings, but stock-buying ideas remain unclear.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The recent weeks have seen a number of large health-care deals announced. I'm here today with Matt Coffina--he's editor of our StockInvestor newsletter--to see what the implications could be for investors.
Matt, thanks for joining me.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: Matt, can you start off by telling us a bit about what some of these deals are and how they might be similar or different from each other?
Coffina: Sure. I'd say there are two big groups of deals that we're seeing. One would be a more traditional form of merger activity: Pfizer has made an offer for AstraZeneca. We also saw Valeant make an offer for Allergan. This is just more of the traditional sort of M&A: companies trying to get bigger, trying to achieve operating cost synergies, maybe trim down their combined pipelines, and so on.
The other kind of deal we've seen is a lot more asset swaps between companies. So, for example, Novartis just announced a whole series of these deals. They're going to form a joint venture with GlaxoSmithKline for their consumer products. They're going to give Glaxo some of their vaccines business. They're going to take on some of Glaxo's cancer drugs, and they're also divesting an animal health segment to Eli Lilly.
Basically, I think you're just seeing a lot of demand from investors for these companies to focus more on what they're best at or at least what they perceive themselves to be best at and to get out of the businesses where maybe they lack scale or they lack a market-leading position. It's hard to say what's driving this exactly. I think it's really a pendulum that's out there in the market where sometimes there's an investor demand for diversification.
Certainly the more diversified pharmaceutical companies did a lot better a few years ago when everybody was worried about the patent cliff. It was seen as a really strong point for a company like Johnson & Johnson or Novartis to have a lot of nonpharmaceutical segments. And now the pendulum is clearly swinging the other way, possibly due to perceptions of improved R&D productivity, that investors really want these companies to focus in on what they're best at. That's where we are right now.
Glaser: These deals are not exactly getting done at bargain prices. Do you have a sense of which ones you think are going to be successful that we should really root for and which ones investors may be a little bit more skeptical of?
Coffina: Another big driver, I think, of this recent wave has been Valeant Pharmaceuticals and other companies that have imitated their strategy, which is that they come in and relocate the earnings to lower-tax jurisdictions. They're able to cut out income taxes almost completely and they also just cut research and development expenditures and other operating costs to the bare bones, focusing more on sales efforts.
Now I don't know if this is a great way to build a business over the long run. I'm a little skeptical to be honest about what these businesses are going to look like after you really slash and burn the cost structure and stop investing in products for the future. There's a lot of easy money to be made in the short run, but I think we do have to be worried about what this is going to look like 10, 15, 20 years down the road.
But that said, I think that that's sort of an impetus for a lot of these deals also. And there is a lot of savings to be had, especially in the short run. So, Pfizer's acquisition of AstraZeneca looks like a very rich price, a significant premium to our stand-alone fair value estimate for AstraZeneca, but the reality is that Pfizer probably can come in and cut out a lot of costs and especially if they can pull off this tax inversion. So they want to relocate their headquarters to the U.K. where they would see a substantially lower tax rate on their own existing business. If they can pull that off, the synergies probably would justify a fairly rich premium that they're paying. Same goes for Valeant and Allergan.
We think that Novartis' recent set of deals also improved the fair value estimate slightly for Novartis. Other companies like Glaxo seem to have come out about even. So it's really more of a company-by-company basis for those asset swaps and those kinds of transactions.
By and large, I don't think that those are really going to move the needle much in terms of fair value estimates, but they probably are positive in the long run. Again these companies are focusing in on the areas that they know best and getting out of areas where they don't have scale advantages or where their economic moats aren't as wide.
Glaser: Do these deals impact your thoughts on where to invest in the health-care space?
Coffina: I think it's interesting and important for investors to keep an eye on a company like Valeant, because I think pressure is only going to continue to build as you see one company paying 20% or 30% tax rates and you have a competitor that's paying no tax at all, that's a pretty strong competitive advantage when you're going after acquisitions and trying to build up a product portfolio. Similarly, the slash-and-burn tactics on the cost structure, I think there's going to be a lot of pressure on other pharmaceutical companies to follow suit.
It doesn't have any clear implications to me about where to invest. One thing that might be worth keeping in mind would be pharmaceutical firms that are domiciled outside of the U.S. with some size that might be a target for a company looking to pull off one of these inversions. A company like Shire might come to mind on that front, but not any huge investment opportunities.
For our strategy, I would say I'm still more inclined to the more traditional strategy of investing in R&D, trying to build up a product portfolio that's going to really endure for the long run, and maybe being willing to accept somewhat lower margins in the short run to achieve that.
That said, I think the focused strategy really can work over the long run. A great example that comes to mind would be Novo Nordisk, a company that's focused on diabetes care for many decades at this point. And I think they really are the best at what they do. They're the best at selling and developing diabetes drugs and that's really paid off for them.
So if you do it right, I think it does pay to be a more-focused competitor. One more name that comes to mind that we own in our Tortoise Portfolio would be Abbott Labs. That's a very odd conglomeration of businesses at this point, after the spin-off of AbbVie. Abbott's remaining businesses don't necessarily make all that much sense together.
Those are the kind of companies that you could see getting involved in some kind of merger and acquisition activity, either as a target or a spinning off or just changing its business mix one way or another, which could potentially create value for investors, again depending on the terms which it would happen. Generally it's probably better to be a target than an acquirer because the target is going to get their immediate premium and depending on if you take stock or cash, you're not as much on risk for those synergies actually being realized than for the product portfolio holding up over the long run.
Glaser: Matt, I appreciate your thoughts on the subject today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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