Thursday, May 3, 2012

Cash-equity equivalence for pharma.

Pfizer says they're looking for acquisitions around $4B. They've had a bit of success buying assets of that size, but that buyout space is becoming crowded - every big pharma would be happy to acquire meaningful but not humongous assets of that size to pave over their patent cliff.

But why is it that PFE or any other big pharma is willing to splash out billions for acquisitions when internal R&D budgets are under pressure? Here's why big pharmas have more incentive to buy innovation externally than fund it internally:

1. Risk/reward & timing: An investment in internal R&D might pay-off in ~5 years, whereas acquiring assets (particularly approved products) are a "sure thing." Until R&D becomes more predictable or higher reward, pharma will always be oriented to lower-risk, shorter term rewards.

2. Financial expectations: all big pharmas are sensitive to the almighty EPS (earnings per share.) An investment in internal R&D has a current cost to EPS and uncertain rewards, while an acquisition often has (understated) current costs and overstated future rewards. (Depending on synergy, more broad distribution, etc.)

3. Access to excellence: No offense to (internal) pharma researchers, but by buying assets, big pharma can buy from the top research efforts in the world. An acquisition likely has a tremendous concentration of focused expertise - be it in the target or disease of interest. Who knows more about diabetes, BMS, or Amylin, or who knows more about transgenic expression systems, Protalix or Pfizer? Internal R&D efforts can of course be high-quality, but most are very, very broad, and by definition somewhat dilute.

4. Internal inefficiencies. Pharmas have expensive structures and high legacy costs. Take another look at this chart from my February post "R&D Efficiency," indicating that pharma spends ~$5B in R&D per FDA approved drug.

In contrast, every biotech big or small is targeting a cost per drug approval in the hundred of millions, not billions, indicating their efficiency advantage. (As an example, Amylin - rumored as an acquisition target of BMS for ~$4B - probably spent between $500m and $750m in developing Bydureon, suggesting that they, if representative, are ~8X more efficient than BMS' historical internal efforts.

5. M&A accounting: this is the big one - our tax laws have a massive preference for equity-based M&A. Pfizer has ~$70B in cash on hand and generated an additional $20B in operating cash in 2011, while investing ~$10B in R&D (which includes cash payments to development partners, so this figure is not entirely internal R&D.) PFE has ~7.5B shares outstanding

Consider 2 scenarios for PFE:

-PFE increases cash R&D spending by $10B/year.

Financial result: EPS falls by about $1 per share.(-80%). (Assume $10B more in R&D is offset by $2.5B less (ballpark) in taxes.)

-PFE buys 2 companies (such as 2 x Amylin) for $5B in PFE stock. (Each.)

2 x Amylins would contribute ~$1.3B in new revenue (using 2011) figures, and while Amylin loses a small amount of money, Pfizer would likely assert that they would cut some overhead, and increase sales using PFE's sales force, eliminating the annual operating loss in the short term. Longer term, PFE grows sales (@ a profit margin in excess of 90%), and cuts Amylin overhead and R&D by $750M per year.

To fund the deal, PFE issues 442,000,000 new shares at current prices, or a roughly ~5% increase in shares outstanding, slightly diluting EPS in the near term. However, the acquired assets could  increase PFE's annual earnings by $1B roughly in the second year (assuming ~20% increase in revenues, with the costs detailed above, making the deal quickly accretive (=~12% EPS). Also: post-merger accounting may lead PFE to write-off half ($5B) of the M&A value as "goodwill." This is a hit to book (GAAP) earnings, but has, in effect, a cash benefit, as corporate taxes are reduced by the write-off of goodwill. End result: small near-term share dilution, medium term EPS increase due to the acquired assets and a lower tax bill, without spending much/any cash.

M&A is even more advantaged by the tax rules that reward share repurchases. If PFE repurchased $10B in stock (tax-free) instead of spending the same amount on R&D, EPS would be increased as the denominator shrinks.

My original goal was to calculate an equivalence between cash and equity ("$1 cash = $10 in equity spent in M&A," or something like that, but it seems that the ratio is more like $1 to infinity., advantage M&A.

With math like that, and the other advantages outlined above, it is almost surprising that Big Pharma does ANY internal R&D.

No comments:

Post a Comment