This Deal Could Shake Up the Generic Drug Business

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Many market-watchers are scratching their heads about the pharmaceutical industry's latest blockbuster deal. Although it had been expected to make such a move for some time, Perrigo Company (NYSE: PRGO) is not regarded as the "ideal" buyer for Dublin-based Elan (NYSE: ELN). Both firms operate as generic drug-makers, but the synergies between the two are not immediately obvious. 

Moreover, Elan is coming off of a long, painful battle to defend itself against a hostile takeover bid. Although it is heartening that the company was able to punch back against an offer that probably would not have been in its shareholders' best interests, Perrigo's enthusiasm for a far more expensive bid is questionable. It is possible that Elan's management team was financially and emotionally exhausted after the recent tussle and chose to accept a somewhat undervalued offer as a result. In any event, this deal offers some interesting opportunities that investors would do well to examine further.

About Perrigo, Elan, and the competition

Allegan, Michigan-based Perrigo is a medium-sized company that specializes in nutrition supplements and generic drugs. Although it has a diversified mix of products and operates four distinct divisions, the company's focus on "whole-body" care allows it to tell a compelling story to investors and differentiate itself from the competition. Meanwhile, Elan is a much more specialized firm that concentrates on developing and marketing psychiatric drugs and palliative treatments for patients with late-stage dementia.

Perrigo's interest in Elan probably lies in the broad-market promise of the latter company's development-stage drugs. Ultimately, it may wish to turn these compounds into widely available, relatively affordable generic treatments.

These two companies compete with Parsippany, New Jersey-based Actavis (NYSE: ACT). Operationally, Actavis has much more in common with Perrigo. Indeed, it will be on the shortlist of potential bidders in the event that the Perrigo-Elan deal falls through. Like Perrigo, Actavis has a robust portfolio of generic and "biosimilar" drugs that mimic the effects of brand-name products. The deal with Elan could give the slightly smaller Perrigo a leg up in its ongoing battle with Actavis.

With a market cap of $18.2 billion, Actavis is nearly 50% larger than Perrigo and more than double the size of Elan. However, it is significantly less profitable than its Midwestern competitor: In 2012, Actavis lost $563 million on total revenue of just under $7 billion. By comparison, Perrigo earned $430.5 million on roughly half of Actavis' revenue. As a more "experimental" firm that recently gave up much of its marketable portfolio, Elan lost $532 million on just $57 million in revenue. With $2 billion in cash on hand, it will soon run into a liquidity shortage. Meanwhile, Actavis is burdened with $6.4 billion in debt. Perrigo has just $1.3 billion in long-term obligations.

How the deal is structured

This cash-and-stock deal values Elan at roughly $8.6 billion. Under its terms, Perrigo will issue cash payments of $6.25 per share in addition to .07636 Perrigo share for every Elan share that it acquires. At Perrigo's current price, this represents a total offer of about $16 per share. Relative to Elan's current share price, it provides a premium of just under 2%. Of course, this is subject to change. 

Synergies and benefits

This deal will provide a massive short-term boost to Perrigo's bottom line: As part of the transaction, Perrigo will move its headquarters to Dublin and reap millions of dollars in annual tax savings as a result. While it will maintain its U.S. presence, the residence change could provide Perrigo with the cash flow that it needs to develop Elan's promising pipeline. 

In addition to the "tax residence" move, Perrigo's pickup could offer some long-term synergies. For starters, it will gain access to a 12% royalty stream from Elan's Tysabri drug. Elan's revenue from this former blockbuster have been greatly reduced by cash-raising equity sales, but the multiple sclerosis treatment remains one of the best drugs in its category.

Additionally, Tysabri and the other compounds in Elan's pipeline are naturally synergistic with Perrigo's existing basket of neurological and psychiatric drugs. In the long run, the combination could produce cost savings that approach $100 million per year.

Effect on the competition and long-term prospects

As a generic drug firm, Perrigo must accept lower margins than its brand-name peers. This deal will provide it with access to higher-margin compounds and allow it compete on equal footing with diversified firms like Actavis. Although Perrigo will not transform into the next Pfizer on the back of this transaction, it will find itself in a far better competitive position. Similar-sized pharmaceutical firms with aging pipelines or uninspiring generic portfolios will be most vulnerable to the combined firm.

This deal offers something for everyone. In addition to a 2% arbitrage premium, its tax benefits could boost Perrigo's profit margins by several percentage points. In turn, the company could begin to trade at higher multiples. Additionally, the combined company will enjoy some compelling synergies that are sure to attract new investors. While it seems like an odd marriage, the Perrigo-Elan combination could be one of the most exciting pharmaceutical deals of 2013.

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