Despite a healthy 2006 and anticipation for a strong 2007, generic-drug companies still must be vigilant about managing growth.
Make sure your eyes aren't bigger than your stomach when contemplating acquisitions, or you could gag on debt, say credit-rating firms. Don't make deals just to get bigger, or you'll be stuck with extra costs without extra strategic advantages, equity analysts warn.
Generic-drug makers generally use acquisitions to reach foreign markets, where manufacturing costs are lower and where potential sales growth is faster than in the U.S. Big deals are tempting because the generics industry is consolidating and because companies don't want to be outdone by competitors.
"There's peer pressure," says Arthur Wong, a credit analyst at Standard & Poor's. Although acquisitions can improve manufacturing scale, "size doesn't get you all that much," he says.
To prove his point, Wong says four companies tracked by S&P have credit ratings within one notch of each other, even though their market capitalizations range from $2.7 billion to $29 billion. "It's a commodity business," says Wong, adding that there won't be any "breakaway winners" in the near future.
However, there will always be buying opportunities, and the biggest lure is the generic-drug business of Germany's
. The drug and chemical conglomerate put its generics division up for sale in January, and it's expected to select a bidder this month.
With $2.44 billion in generic-drug sales last year, Merck KGaA is one of the world's largest players. It offers an acquirer access to some 90 markets, with about 75% of sales coming from Europe and North America.
From India to Iceland to Israel, just about any company with a mortar and pestle has been cited by analysts as a potential buyer. But with a potential price tag of $6 billion to $8 billion, a deal for the Merck unit would raise the debt burden and/or dilute the equity of most companies.
Money Isn't Everything
Based on size, financial strength and deal-making history, the most logical acquirers would be Israel's
unit of Switzerland's
, the two largest generic-drug sellers.
But if the Merck unit doesn't provide a strategic addition, it may not be worth it to these giants, says Brian Laegeler, of financial research firm Morningstar. In addition to geographic expansion, Laegeler says, companies seek deals to develop -- or expand -- skills such as making injectable generics and biotech generics. Because Teva and Sandoz already have these skills in place, he wonders if they'll pursue Merck.
"Who knows if there's overlap in their products
with the Merck unit," Laegeler says. "Teva makes acquisitions for very strategic reasons -- not just to grow in size."
Teva, Sandoz and
( BRL) are "well positioned" in strategic skills, overseas manufacturing and a strong presence in Europe, Laegeler says.
is "in the running," but
has a "poor position," he says.
Bond-rating firms note that Barr, Mylan and Watson closed big deals in 2006 and early 2007. "We would be more comfortable if they took a breather," says S&P's Wong.
"They are still digesting," adds Michael Levesque, vice president and senior credit officer at Moody's Investors Service. He doubts they would make another big deal soon. The Merck unit would be much bigger than anything they have acquired.
Barr bought Croatia's
for $2.5 billion; Mylan bought a majority stake in India's
for $756 million; and Watson paid $1.9 billion for
. Analysts say Teva and Sandoz have fully digested recent, big acquisitions. Teva closed its $7.4 billion
purchase in early 2006. Novartis/Sandoz bought two companies in mid-2005 for $8.3 billion.
The Merck division is hitting the auction block after many generic-drug makers enjoyed a rich diet of U.S. patent expirations in 2006, such as U.S.-based
cholesterol drug Zocor and
This year's U.S. patent-expiration bonanza won't be as large, although generic-drug companies will fight over Pfizer's Norvasc for high blood pressure and
Ambien for insomnia. U.S. patent expirations on major drugs will slow down next year but will pick up dramatically in 2010-2012.
When opportunities for patent-expirations decline in the low-margin generics' business, the appetite for acquisitions increases. Still, it's hard to envision a U.S. company making a run for the Merck division.
Moody's Levesque says he isn't opposed to Barr, Watson or Mylan making certain acquisitions, even if the deals cost them a ratings downgrade by one or two notches. "I don't think it would impair their access to markets," he says. "It would raise their cost of borrowing."
However, current ratings show they lack the financial flexibility to make a major purchase. Each is rated Ba1, the highest noninvestment grade. Teva is two notches above investment grade at Baa2; but Teva "has more to lose" by making a deal that would imperil its investment-grade rating, Levesque adds.
S&P is a bit kinder in its rating assessments of Mylan, Watson and Barr. They have BBB-minus ratings, the last rung on the investment-grade ladder. Teva has a BBB rating. Each has a stable outlook except for Watson, whose outlook is negative. Higher ratings are reserved for drugmakers with more proprietary products.
S&P's Wong says Mylan, Watson and Barr would be better served by integrating recent acquisitions and, if necessary, making smaller deals. If they bid for the Merck unit, the extra debt would "sink
these ratings," and their "shareholders wouldn't be happy" with a deal that dilutes equity, he says.