Actavis takes 'specialty pharma' route to health

Move over GlaxoSmithKline. There is a new pharmaceuticals giant in town.

After completing its $70bn acquisition of Botox maker Allergan last week, Actavis overtook GSK to become the world's eighth-largest drugmaker by market capitalisation.

The ascent of Actavis, based in the US but domiciled in Ireland, speaks to the rise of a different category of drugs company, loosely known as "specialty pharma" by investors. There is little agreement on what it takes to be classed as "specialty", an outdated definition that used to denote a company's strong relationship with specialist physicians rather than family doctors.

Today, "specialty" is a category best divided in two. On the one side, there are the big, lean operators, often uninterested in much of the scientific research that leads to the discovery of life-altering drugs. Instead of investing billions to find a cure for cancer, they grow through serial dealmaking, assisted by cheap debt and the ultra-low tax rates they enjoy as a result of having completed "tax inversions".

Actavis is the biggest, followed by Canada-based Valeant and, according to some, Shire, the Anglo-Irish drugmaker, although it is trying to recast itself as a research-driven biotech company. Mallinckrodt and Endo, both based in low-tax Dublin, are smaller, but have proven themselves to be serial acquirers.

On the other side are the companies that the first group wants to buy, usually focused on a single drug or therapeutic area, and often valued between $5bn and $15bn.

Ideally, they will be headquartered in the US, where the headline corporation tax rate is 35 per cent, meaning a buyer from a lower-tax jurisdiction can achieve big savings on completing a deal. Often they have little choice but to put up the white flag, as their high tax rate makes it difficult to compete with overseas rivals, while a White House crackdown has made it almost impossible to pursue their own inversions.

Until recently, the pool of specialty targets included Salix, a gastrointestinal drugmaker that is selling itself to Valeant, and NPS Pharma, which was acquired in January by Shire.

Perrigo, which makes over-the-counter cold medicines and antihistamines, is often mentioned as a takeout candidate, as is Jazz, the maker of a narcolepsy drug, although both are already domiciled in Ireland. Some analysts and bankers also think Mallinckrodt could turn from hunter to hunted.

By buying these companies, the specialty acquirers get to pick up medicines that are proven to work, often achieving quick cost savings by sacking many of the scientists who invented them. Yet the so-called "roll up" strategy relies on two things - cheap debt, and steady supply of potential targets.

Some analysts warn the specialty pharma playbook will need to be rewritten when the Federal Reserve raises interest rates and ultra-cheap debt dries up. Actavis funded its Allergan deal with a $21bn bond offering, the second-biggest corporate debt offering on record after Verizon's $50bn issue. Valeant raised $10.1bn through the sale of a junk bond - again the second biggest of its kind - to help pay for its $15.8bn purchase of Salix.

A more pressing concern is the shrinking pool of potential targets, a product of two years of frenetic dealmaking. Valeant only managed to seal the Salix deal after it raised its offer to $173 a share in response a counterbid from Endo. It was a remarkable outcome for Salix, which was beset by an accounting scandal in November that pushed its shares below the $92 mark.

Bankers and executives say the intensity of the competition for Salix, not widely seen as a top-drawer asset, sends a strong signal that the acquisitive specialty groups are running out of prey.

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Brent Saunders, chief executive of Actavis, agrees, describing the pool of speciality targets as "depleted", although he believes it will be replenished as big pharma carves out unwanted assets, and as smaller biotechs uncover new drugs.

A dearth of deals and an increase in the cost of debt could force specialty drugs groups to become more like big pharma, with a focus on investing in existing assets rather than acquiring new ones. Mr Saunders insists Actavis already has a strong belief in science, although he defends its decision to eschew the genuine drug discovery pursued by the likes of Eli Lilly and Pfizer.

"I think people confuse drug discovery with innovation and research. It is just one component of R&D," he says. "Our goal is to be the best in the seven-year journey from discovery to commercial. That's R&D - and we're going to spend a billion-seven in 2015 on those activities."

Analysts are less sure that Valeant will be able to make a similar transition. Pharma groups typically spend 15 per cent of their sales on research and development, whereas last year Valeant spent $246m - equivalent to 3 per cent of its revenues.

In an interview with the Financial Times last year, J. Michael Pearson, Valeant's chief executive, likened his approach to the tech industry, where many of best innovations come from small Silicon Valley start-ups.

"Our role is to develop, approve, and do great commercial. Innovative scientists don't like working for big centralised companies," he said, pointing to the proliferation of drug discoveries at small biotech groups in California and Massachusetts.

"It is a mistake to think of Valeant as a drug company," says Ronny Gal, an analyst at Bernstein. "It is really a financial construct that happens to be in the pharmaceuticals business."

That "construct" has proved lucrative for Valeant's biggest investors, which include ValueAct, the activist fund manager, and Pershing Square, the vehicle managed by hedge fund billionaire Bill Ackman. Its shares have jumped from $14.51 five years ago to $204 today.

Yet critics say the lean and mean specialty model is not built for longevity, given its reliance on debt-fuelled acquisitions and steep cuts to investment.

"It is all sustainable? That's the hundred thousand dollar question," says Mr Gal, who likens Valeant to a lightweight car made out of flimsy metal. "As long as the road is straight, they'll be fine. But if they have to make a hard turn, something is going to go wrong."

Price crackdown could target specialty pharma

The price of drugs is an issue that has climbed up the political agenda in the US, after Gilead, a California-based biotech group, launched a $1,000-a-day pill for Hepatitis C.

The received wisdom has been that specialty pharma groups, which often make cheaper drugs for less serious illnesses, would be insulated from any attempt to drive down prices. The next target in any crackdown would be expensive therapies for cancer and heart disease, or so the theory goes.

However, some analysts offer a counter-theory. If the employers and insurers who foot the bill for US healthcare decide they have an obligation to pay up for novel life-altering therapies that cost billions to develop, they could look to generate savings on many of the drugs marketed by specialty pharma.

"If there is not enough to pay for new drugs and people decide to economise, then they could go for those drugs where the value added is less obvious," says Ronnie Gal, an analyst at Bernstein.

An ointment for nail fungus made by Valeant, called Jublia, is often singled out as a drug that is too expensive: a 4ml bottle costs $539, about nine times more than some other antifungals.

Actavis is also coming under fire for using tactics that critics allege keep drug prices artificially high. In December, Eric Schneiderman, New York's attorney-general, won a preliminary injunction against the company, which prevented it from instigating a so-called "forced switch" on Namenda, its Alzheimer's drug.

Actavis had stopped selling the pill and told doctors to move patients to a newer version, Namenda XR, ahead of the launch of a generic version of the medicine.

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