Japan M&A: Prescription for growth

Japanese pharmaceutical companies – some of the most sophisticated and cash-rich in the world – are shopping abroad for targets to enrich their drug pipelines and counter the uncertain outlook for sales in Japan. But sellers are still insisting on hefty price-tags, despite slowing economic growth and depressed equity markets.

On the face of it, Japan’s greying population looks like good news for the country's pharma businesses. More than one-fifth of Japanese people are over 65 and, according to the CIA World Factbook, the country has the world’s third longest life expectancy at 82 years. But these positive demographics are not providing Japanese drug-makers with the earnings bonanza they may have hoped for.

To the contrary, the Japanese government, which is faced with medical bills that are forecast to rise to ¥56 trillion ($522 billion) by 2025 from ¥33 trillion in 2005, is implementing a variety of measures to bring down its healthcare costs and is hard at work thinking of new ways to make cuts. And this focus on healthcare is only intensified by the skyrocketing national debt and budget deficit.

Current cost-cutting measures include reducing the prices of medicines, trying to increase the substitution of generics (cheaper versions of brand-name drugs that are made and marketed after the original patent has expired) and opening the market in Japan to more competition from international firms. Earlier this year, Japanese prescription drug firm Shionogi warned investors that onditions in the prescription drug market in Japan are “forecast to become even more challenging with the national health insurance price revisions implemented in April this year, which reduced prices by an average of 5.2% across the industry”. Shionogi and other Japanese drug majors are having to find ways to address both the current dire macro-economic issues and the company specific fact that many of their prescription drugs are due to go off-patent soon. Japanese pharmaceutical firms are now counting on to the benefits of using M&A as a solution.

“One factor [driving the trend for outbound M&A] is that there are limited domestic growth opportunities,” says Yoshihiko Yano, head of M&A at Goldman Sachs in Tokyo. “Companies are cash-rich and are in a good position to conduct acquisitions; the business has also been international to begin with.” Indeed, Japan’s pharmaceutical majors have collectively paid more than $20 billion during the past 12 months to buy overseas firms.

“Leading Japanese healthcare companies have carefully mapped out their strategies for strengthening specific therapeutic franchises, extending global reach and securing access to promising R&D pipelines and/or distribution channels,” reckons Steven Thomas, head of M&A for UBS in Japan. “They have always envisaged that execution of these plans could be accelerated through strategic M&A and therefore have been well prepared when attractive targets have become available.”

The current market conditions might reasonably be expected to throw up some good buying opportunities as the credit crisis has limited the ability of many rival buyers to raise debt, especially the private equity firms that were responsible for bidding up so many M&A deals during the past few years. The share prices of many of the targets have also traded down significantly recently. All of which suggests that this should be a buyer’s market. But that is not the case. Buyers are still having to pay aggressively, perhaps because sellers are well aware of how valuable they are to their Japanese suitors.

Valuing the targets

Late last year, Eisai shelled out $3.9 billion for Minnesota-based MGI Pharma, a bio-pharmaceutical firm, to expand in the US. Eisai was hungry for new products as the patent for its leading Alzheimer’s drug, Aricept, which accounted for around 37% of Eisai’s $5.7 billion sales last year, expires in 2010. The acquisition strengthened Eisai’s oncology business by adding MGI’s portfolio of cancer drugs and built further on Eisai’s smaller acquisition in the US earlier in 2007, when the Japanese major paid $325 million for Morphotek.

The price Eisai paid for MGI Pharma represented a 23% premium to MGI’s last close and a 38.7% premium to MGI’s share price the day before it confirmed that “it would explore strategic alternatives”.

Just three months later, Takeda Pharmaceutical took over Nasdaq-traded Millennium Pharmaceuticals for $8.8 billion. Takeda, a company with more than 200 years of operating history in Japan, faces the prospect of about 50% of its drugs going off-patent. It now plans to make Massachusetts-headquartered Millennium its worldwide centre for oncology – Millennium’s key drug, Velcade, is a market leader for treatment of patients with cancer of the plasma cells and has been outperforming analysts’ expectations. Takeda also gains access to a pipeline of drugs under development for oncology and inflammation.

The $25 per share Takeda offered for all of Millennium’s shares represented a premium of more than 50% to Millennium’s last traded price before the deal was announced and a 157% premium to its 12-month low.

Daiichi Sankyo’s quest for growth took the Japanese firm shopping in India and, in a change from the US-bound acquisitions, the target was a generics firm. In June, Daiichi bought a controlling interest in Ranbaxy Laboratories, India’s largest pharmaceutical company. It will pay between $3.4 billion and $4.6 billion for a majority stake in the Indian firm. The deal values Ranbaxy at $8.5 billion.

Daiichi, a leader in cardiovascular therapy, has already warned investors that it is under pressure as its main blood pressure treatment drugs have been affected by the same price cuts Shionogi referred to in its own investor guidance. And despite Daiichi’s efforts to diversify geographically, it still earns 60% of its revenues within Japan. Delhi-headquartered Ranbaxy is a leading player in off-patent generic drugs.

The pharmaceutical market in Japan is expected to grow between 1% and 2% this year while is it growing by more than 10% in emerging markets such as India and China. Spurred by rising demand for generics, Ranbaxy has given guidance to analysts that it expects revenues to rise by about 18% and profits to increase by up to 25% this year, figures that are obviously very attractive to Daiichi. Lowering costs is also an obvious benefit. Daiichi has suggested that it will move some of its research, development and manufacturing from Japan to low cost sites in India.

The agreed price of Rs737 ($16.34) per share, at which Daiichi will buy both existing and new Ranbaxy shares, represents a premium of 31.4% to the last traded price before the deal was announced and a premium of 146% to its 12-month low.

Then, in September, Shionogi bought Georgia-based Sciele Pharma for $1.4 billion. Sciele focuses on cardiovascular, diabetes, women’s health and paediatrics. Its army of 770 full-time sales staff and rich pipeline of proprietary products should help Shionogi to further penetrate the US market. Shionogi also says Sciele will help it to win approvals for its own drugs in the US.

The price of $31 per share that Shionogi offered for all of Sciele’s outstanding shares represented a 61% premium to Sciele’s most recent closing price before the acquisition was announced and an 84% premium to its 12-month low.

“Japanese companies are paying aggressively given the lack of other growth opportunities,” agrees a specialist. “This can be viewed more as a premium for survival, rather than as part of an aggressive growth strategy.”

Getting it right

Part of the reason Japanese firms have been able to easily absorb the premiums is the strength of the yen relative to a weak dollar. Another driver is access to capital. Japan’s pharmaceutical majors are sitting on piles of cash. In terms of debt funding they also have access to Japanese banks that are flush with funds and eager to support the global ambitions of their own.

Getting the valuation right and securing the financing to close the deal may be the most public part of an M&A deal, but it is only the first step for the acquirers.

“Post M&A integration is crucial,” says Goldman Sachs’s Yoshihiko Yano. Cultural issues are always tricky in M&A and often the trickiest to manage in cross-border acquisitions as working styles differ hugely around the world.

“Strong commitment from top management to the postacquisition operations [is critical for these acquisitions to succeed],” says Yohtaro Hongo at J.P. Morgan Securities. Hongo goes on to explain that all four Japanese buyers have CEOs with experience of working outside Japan. Further, Takeda and Eisai are both already managing big US businesses, so their new acquisitions “should not create any new cultural challenges”.

UBS’s Thomas agrees with Hongo: “The major Japanese pharma companies have always had heightened global exposure with a very long history of interaction with overseas partners on licensing deals and senior executives often spending many years based in the US or Europe.” But to make the acquisitions succeed it is also crucial that the Japanese buyers manage to retain the staff key to these acquisitions – the visionary management teams, R&D departments, scientists, sales and distribution personnel.

“Careful attention to incentivisation arrangements for key target management and employees is a major focus during negotiations,” says Steven Thomas, head of M&A for UBS in Japan, suggesting adequate attention is being paid to this aspect.

The Japanese buyers that have bought in the US will also have to effectively use the distribution networks of their targets to enhance sales of their own drugs. In Daiichi’s case, analysts say the Japanese firm will try to peddle Ranbaxy’s generics in Japan, where penetration of off-patent drugs is currently quite low.

If careful attention is paid to all these factors there is every reason for Japanese pharmaceuticals firms to succeed with their acquisitions and justify the capital they are committing. And the momentum created by healthcare  players could spill over to other Japanese firms operating in industries facing similar challenges domestically.

“We are seeing [M&A] activity across the board now, from the power/commodities area to technology, general industries and even financial services,” corroborates UBS’s Thomas. “Any sector where domestic growth is potentially limited and ideas and technology are transferable across borders is a candidate for enhanced outward M&A activity.”

If the experience in Japan’s pharmaceutical sector is indeed replicated across other industries it will lead to a rush of outbound M&A from the country. And the next few years could just be the golden era of M&A, which bankers covering Japan have been waiting for.

Reporting contributed by Dan Slater.

This story was first published in the M&A supplement that was distributed together with the November issue of FinanceAsia magazine.