A Shift in Health-Care M&A Activity

Traditionally, mergers and acquisitions in the health-care sector involve companies seeking to better leverage their existing infrastructure. Companies tend to stick to therapeutic areas they're already in, where they have a sales force and relationships with physicians. More recently, however, we've seen companies create value by making tax-driven deals--either doing a tax inversion (in which a firm acquires a company in a lower-taxed country and then re-incorporates to that country) or buying overseas companies facing higher tax rates and moving those acquisitions to their home base.

To build an understanding of what the rest of 2014 might hold for M&A activity in health care, I recently talked with Morningstar health-care analysts Damien Conover, David Krempa, and Michael Waterhouse on May 31. Our discussion has been edited for clarity and length.

Question: What makes a successful merger in the health-care sector?

Conover: Two key things make a successful merger. The first is staying in the same operating therapeutic area, which allows for cost synergies, so you're able to reduce cost. Sometimes, you can get some revenue synergy there, too, as you start to layer in products that are similar to the audiences that might want more selection of products.

A second step of a successful merger, from the shareholders' standpoint, is making sure that not all the purchase price goes to the target, but that the benefits of the acquisition are equally shared. In some of the mergers we've seen, that balance is off, but it's there in some of the other mergers.

Question: How do you incorporate patent expirations and generics? Do those issues factor into a company's decision to make an acquisition? And how do you guys incorporate pipeline opportunities?  Abbott (ABT) spinning off  AbbVie (ABBV) comes to mind.

Waterhouse: This is an industry where there's not much pricing power, so generally we view economic moats driven by economies of scale. There's a lot of incentive to get as big as possible and have as much of a geographic breadth as possible.

Conover: When we think about economic moats for big pharmaceutical firms, the engine really has to be the ability to bring the next generation of products to the market, to enable these firms to continue to have excess returns. When those pipelines slow down, big pharmaceutical firms rely more on M&A. It could be smaller bolt-on acquisitions, or it could be a bigger acquisition.

Question: Is  Sanofi (SNY) an undervalued firm? What do you think the market's missing? Or, what's the misprice in your mind?

Conover: We really like two things about Sanofi. We think its insulin franchise is underappreciated by the market. One of its key products, Lantus, is one of the firm's key drivers, and we expect very strong growth there. We think the market is looking too much at some potential competitors and not appreciating how entrenched insulin is once it's used by a patient.

The other piece is the pipeline: It's not appreciated the way it should be. By 2019, we think more than 1 billion euros more will be produced from the pipeline than the consensus is right now. While Sanofi has had some setbacks with its pipeline, we think those setbacks will only delay some launches. These products will still go on to be very successful.

Question: Speaking of diabetes, how do you view  DaVita HealthCare Partners (DVA) as a potential  Berkshire Hathaway (BRK.B) candidate?

Waterhouse: I would be surprised to see a deal here, but I guess you truly never know with Berkshire. When I think of what Warren Buffett has done historically, I always think of him getting into companies with great brands and potentially a lot of pricing power. That said, I guess he has shifted recently to more infrastructure-type investments, with utilities and railroads and things like that.

But I think we would agree that there is a certain amount of attractiveness for DaVita in that diabetes is a big contributor to dialysis and DaVita is one of the largest dialysis providers in the world, along with  Fresenius Medical Care (FMS). You're looking at a very strong volume growth trend, just due to the issues of diabetes and high blood pressure around the world and rising rates of the need for dialysis services.

But one thing we highlight a lot when we discuss this company is that an overwhelming proportion of those patients are very ill. There's a lot of Medicare and Medicaid pricing. You're looking at a situation where, especially as there are concerns over the sustainability of health-care budgets here in the United States, these companies could face considerable reimbursement pressure. DaVita has kind of a hard path ahead of it, just to maintain that bottom-line profitability.

Question: At the other end of the spectrum, when it comes to elective procedures, can you discuss the situation with  Allergan and  Valeant Pharmaceuticals (VRX)?

Krempa: Valeant is looking to acquire Allergan, and this is an example of the dynamics that drive good M&A. We see significant operational synergies and a tax component to this deal. Both companies have existing products and sales forces in ophthalmology, dermatology, and the aesthetics market. There would be a lot of value created if this deal were to happen.

On the tax side, Valeant has one of the lowest tax rates in the industry, paying a single-digit tax rate, and Allergan has one of the highest in the specialty pharma area, with a tax rate in the mid-20s. There would be definitely a lot of tax savings there, as well.

But so far, Allergan's board has not been interested in selling the company. It's going to be a hostile process. It's going to be a long, drawn-out battle. We think there's still a lot of uncertainty, but we'd still lean towards the side of the deal happening eventually, just because Valeant already has a 10% stake in Allergan through their joint venture with Pershing Square, and we think it's actually going to be a very attractive price for the Allergan shareholders, and they have few alternatives.

Question: I've read that Allergan might be either looking for a white knight or might consider a corporate action to make the firm less valuable to an acquirer.

Waterhouse: We've always thought Allergan would be an attractive takeover target, just because it does have a big exposure to the durable cash pay markets. You've seen this company maintain a very impressive growth streak, even though you had a lot of macroeconomic headwinds. I think that just speaks to the resiliency of the very affluent customer base, in general, that Allergan caters to.

Allergan still has essentially a monopoly in its Botox franchise. That is just an incredible cash-flow engine. I think there are some concerns if you get an activist in here who wants to start slashing a lot of this business. Some of that may be a legitimate way to run the business. Allergan has admitted that it can cut more costs and grow the bottom line even faster. But I do think some investors are struggling with the thought of if you cut too deep and really start to ruin the brand that this company has created over the years, is, I think, a legitimate concern in some regard.

It is the only wide-moat company on our specialty pharma list, and the growth rate has been quite impressive. I would say that we've always thought this company would eventually be a likely takeover candidate by someone, especially some of the big pharma names out there, like  Johnson & Johnson (JNJ) and  Novartis (NVS). Either could potentially be a white knight, although there have been rumors that that probably won't happen at this time. But also Allergan still has, I think, roughly $3 billion on the balance sheet, so pursuing another deal seems highly likely.

Question: That transitions nicely into the deal with  Pfizer (PFE) and  AstraZeneca (AZN). I wonder if you could just talk about your view on both companies separately and also the deal, which was shot down.

Conover: Pfizer had begun negotiations with AstraZeneca toward the end of 2013, and it became public that Pfizer was going to make a bid for AstraZeneca toward the latter part of the first quarter and into the second quarter. The motivation for Pfizer had a lot to do with cost-cutting. By bringing in another big pharma, there's a lot of overlap, and you can cut a lot of salespeople. You can cut some R&D. You can streamline manufacturing. It's what Pfizer has done in the past with Wyeth, Pharmacia, and Warner-Lambert.

There were secondary drivers, including expanding Pfizer's pipeline. The pipeline as a standalone entity was not that strong considering Pfizer's size, and Astra has lately been making some very good strategic moves with its pipeline.

When Pfizer made the bid for AstraZeneca, we thought it was very likely that the deal would go through. AstraZeneca thought the bid was too low and undervalued the company. Subsequently, Pfizer raised the price and gave some assurances about keeping jobs in the United Kingdom, which was also another concern of AstraZeneca and some of the politics around a cross-nation or an international merger.

Those concerns of not being able to get the value that they wanted largely stopped the deal and, under U.K. takeover laws, are now going to stop Pfizer from making another bid for six months. We believe it's very likely Pfizer will come back and make another bid for AstraZeneca.

As Astra was rejecting Pfizer, the company was also putting out very optimistic projections to support why it needed a higher valuation. Right now, the investment community's looking at AstraZeneca through a pretty optimistic lens that management has set. Over the next six months, I think there's a very strong likelihood that AstraZeneca has a few step-backs, and that will cause the valuation of AstraZeneca to come down and allow Pfizer to come back in with a very similar bid, but with a lower valuation on Astra, which potentially could allow the deal to go through.

Question: Let's talk about tax inversions. How important an element is this in an M&A deal?

Krempa: The first real interest in an inversion tax play was Valeant doing an inversion with Biovail back in 2010. Now here we are a few years later, and we're seeing several similar deals. We've seen at least a half-dozen of them in the last 18 to 24 months--inversions like  Actavis and Warner Chilcott,  Perrigo (PRGO) and Elan. And now, we're seeing it with the potential for the Pfizer and AstraZeneca deal.

Conover: In some cases, the strategy outside of the tax angle is very minimal. For example, take the Perrigo and Elan deal. Strategically, it was very hard to see the rationale. But from a tax standpoint, it made a lot of sense.

Question: It seems like it's come up a lot on the industrials, as well. It's an attempt to get around the United States' worldwide tax system, in which a firm pays U.S. taxes on its foreign-derived income--a company is always going to pay the U.S. tax rate unless they permanently reinvest those funds.

Conover: It's become such a big issue that there are U.S. politicians starting to talk about limiting the ability to do the tax inversion and making it harder. Maybe not completely closing the window, but making some more hurdles that would make it much more challenging. Hard to tell whether or not those initiatives by government will come to actual law, but there has been more interest in creating these laws.

Krempa: We saw inversions really take off after Valeant successfully executed one, and I'm sure these other companies were saying, "Valeant's got this big advantage over us." Maybe their boards were pushing management. Once competitors were doing it, everyone else wanted to do it, too. They didn't want to be left behind.

Conover: Valeant was able to get a very low tax rate because its tax is run through Bermuda.

Krempa: Right, Valeant holds a lot of its intellectual property offshore. Biovail had already done a lot of tax prep work, moving all its IP offshore, before the inversion. It has benefited a lot more than other companies. But for other companies, it's still some benefit, but not as extreme.

Conover: Another factor is growing cash flow generation from outside the United States for a lot of U.S. firms. It just becomes a better strategic idea to do some of those tax savings, because you have so much of that cash coming overseas.

Question: Are there any stocks that you guys think are undervalued, regardless of their future of either getting acquired or making an acquisition?

Krempa: One company we like on my coverage list is  Icon (ICLR). It's a clinical research organization, so it helps drug companies develop their products and run clinical trials. The stock got hit a little bit lately with the news of the potential AstraZeneca and Pfizer deal. People had some concerns about the impact that would have on R&D spending and what kind of issues it would cause to ICON in the near term. But it doesn't look like that deal will happen in the near term, and even if it does go through eventually, we believe it could be a long-term positive for ICON by driving greater outsourcing.

Waterhouse: I think  Illumina (ILMN) is an interesting company. We think llumina is currently monopolizing the genome sequencing space. This industry is extremely fast-growing, and potentially just entering a phase now where it's becoming largely accessible to the larger population and potentially disruptive to a lot of the current diagnostic tests that are on the market. You're looking at probably close to a 20% compound annual growth rate on the top line for this company over the next few years. That's a name we like, but at this point we'd say it's hard to accumulate. We'd prefer there to be a little bit bigger margin of safety.

Krempa: Another one we like is  Cooper Companies (COO), which makes contact lenses. It's an attractive cash pay market. It doesn't have the pricing pressure from government payers or the pharmacy benefit managers. That alone makes it as an attractive company. It trades at a significant discount to its intrinsic value, but it is also a potential takeover target.

This article originally appeared in Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.