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FTSE 350: Pharma merger frenzy continues

With Shire announcing its Baxalta deal just days into the new year, consolidation continues across pharmaceuticals and biotechnology
January 28, 2016

Mergers and acquisitions have dominated the pharmaceuticals and biotechnology sector lately, and there's little indication that 2016 will be any calmer. Only 10 days into the new year speciality pharma group Shire (SHP) managed to agree a takeover of US biotech Baxalta (US:BXLT) for a whopping $32bn (£22bn). Shire first made its interest in Baxalta known last year, but an initial offer was rejected by Baxalta's bosses in July, forcing Shire to turn hostile in August with a renewed all-share offer worth $45.23 a share. That equated to a total deal value of $30bn, but the offer didn't pass muster with Baxalta's shareholders, who demanded a cash portion to sweeten the deal.

Despite Shire's move, there are doubts about how 2016 will live up to the past two years when it comes to M&A activity in pharma and biotechnology. There are certainly signs of market fatigue. Shares in Shire haven't performed well since news of Baxalta first hit the headlines last summer. Similarly, Anglo-Swedish giant AstraZeneca's (AZN) stock is down more than 10 per cent year on year despite two billion-dollar deals towards the end of last year.

Big pharma is under constant pressure to innovate and develop new medicines to supplement top-line growth when existing medicines lose their exclusivity rights. But development is time consuming, expensive and often unsuccessful. So management teams have to decide when an acquisition - usually of a smaller one-product company - could make better sense financially.

Others, such as AstraZeneca's main rival GlaxoSmithKline (GSK), have spent the past couple of years drastically realigning their business model to better cope with the industry's challenges. Chief executive Andrew Witty signed a deal with Swiss group Novartis (NOVN) in 2014 which saw the two groups swap a number of assets. That's left Glaxo looking like a consumer-led business focused on volumes rather than research and development. Its reputation as a stellar income stock is also under pressure. Its dividends are due to stay flat until the end of the 2017 financial year at 80p, with no promises made beyond that point. That payout represents more than 100 per cent of the group's free cash flow and, according to JPMorgan, that's set to go up to 104 per cent by 2020. For the current financial year the payout ratio, including a 20p special dividend, is a staggering 474 per cent of free cash flow.

But GlaxoSmithKline isn't the only large pharma stock with problems. Last year we called the recovery at British pharma business BTG (BTG) too soon. The company is struggling to get its new varicose veins treatment, Varithena, off the ground in the US; a slow-burning process that involves convincing physicians to prescribe the product, while health insurers dither over reimbursing the cost.

This hasn't been helped by the fact that Varithena hasn't been issued a J-code by US regulators - something that would allow health insurers to understand what costs need to be covered, and thus settle reimbursement claims more efficiently. Pricing is a tetchy issue in pharmaceuticals and biotechnology, even more so since Hillary Clinton tweeted about her intended crackdown on drugs companies that inflate prices for life-saving medicines.

Market newcomer and Reckitt Benckiser spinout Indivior (INDV) is also facing pricing woes, specifically from potential generic copies of its buprenorphine medication Suboxone Film. Aggressive pricing by branded competitors meant that Suboxone has lost a number of accounts with US health insurers, which the company predicts could result in "modest erosion" in market share in the next six months. That's left investors hanging much of their hope on the group's future product pipeline, the sales potential from which is far from certain. Since we advised offloading the stock at 195p in November, the shares have lost nearly 15 per cent in value.

On the biotechnology side, the sector faces a growing challenge from the rise of biosimilars - biotechnology's equivalent of generic copies of traditional, chemical pharmaceuticals. We looked at this issue in depth towards the end of last year, but if investors choose wisely it could be as much an opportunity as a threat.

 

Company nameShare price (p)Market value (£m)PE ratioDividend yield (%)1-year performance (%)Last IC view
AstraZeneca4,31354,51547.74.1-8.7Hold,4,692p, 29 Dec 2015
BTG6052,31736.70-25.3Sell, 517p, 10 Nov 2015
Circassia Pharmaceuticals290827NA09.9Buy, 277p, 25 Nov 2015
Dechra Pharmaceuticals99988024.91.715.6Buy, 957p, 8 Oct 2015
Genus1,38884724.41.411.2Hold, 1,373p, 8 Sep 2015
GlaxoSmithKline1,39067,69014.95.8-3.4Sell, 1,345p, 26 Nov 2015
Hikma Pharmaceuticals2,0064,00019.40.8-11.2Hold, 2,387p, 10 Sep 2015
Indivior1631,1684.81.32.1Sell, 195p, 12 Nov 2015
Shire4,22325,02312.70.4-11.3Hold, 4,054p 11 Jan 2016
Vectura Group17370939.3018.1Hold, 171p, 17 Nov 2015

Favourites

Since last summer, the market hasn't been behind pharmaceutical or biotechnology stocks. Pricing scandals and merger malaise have weighed on our top picks, but we're hoping for a pick-up in 2016. We still rate allergy specialist Circassia Pharmaceuticals (CIR), which is up around 14 per cent year on year, and drug developer and respiratory expert Vectura (VEC), which we recommended buying as far back as May 2014. Out of the two big pharma groups, our vote goes to AstraZeneca. Don't forget veterinary pharmaceuticals group Dechra Pharmaceuticals (DPH), either, which is putting up a heroic effort to grow its top line despite headwinds in Germany.

Outsiders

We're currently advising investors to offload shares in GlaxoSmithKline and Indivior, both of which are facing significant internal and external challenges. Things for Shire will be tricky in the short term, too. While we think the valuation looks compelling following the shares' derating, there's pressure on chief executive Flemming Ornskov to complete the Baxalta deal smoothly.