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www.iddmagazine.com APRIL 15, 2002

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Cover Story

By Laura Santini

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xecutives at Bristol, Tenn.-based King Pharmaceuticals Inc. are in the pink these days. From King’s beginnings in 1994 as a family concern with $14 million in sales making pills for the big pharmaceuticals, it has morphed into a publicly traded company with an $8.18 billion market cap by selling brand-name drugs it buys from Big Pharma. Turning the castoffs of the big guns into gold may seem an unlikely strategy, but so far it is working. These days the bulk of King’s revenues, which totaled $872.3 million in 2001, come from the sale of 40 different drugs it has purchased from companies including Warner-Lambert (now part of Pfizer Inc.), Eli Lilly and Co. and Bristol-Myers Squibb Co. King’s roster of products treat hypertension and hormone deficiencies, among other ailments. King’s pioneering transformation from manufacturer to marketer—with 500 salespeople—coincided with a shift among the major drug makers toward so-called blockbuster drugs, or those racking up at least $1 billion in sales annually. With large-cap drug companies and biotech companies focused on the development of blockbusters, King seized the opportunity to buy drugs with sales ranging between $50 million and $100 million. Its strategy, in a nutshell, has been to snap up these products from the major drug makers and then boost sales by marketing them more aggressively. Now droves of so-called specialty pharmaceuticals companies are chasing King’s prescription for success. Wall Street is hyper over the possibilities, and no wonder. The strategy of these companies is perfect for investment bankers. Because these companies primarily buy drugs from others, they are constantly in the market raising capital, which they quickly deploy in M&A activity. Like King, these specialty pharmaceutical companies aim to buy lesser-selling products from major drug makers and double or triple sales by applying their own highly focused sales teams. The companies tend to concentrate on smaller-market treatments in areas such as dermatology, ophthalmology, women’s health and gastroenterology. But can King and its followers sustain the type of heady growth that investors have come to expect from them? Notwithstanding the King success story, and Wall Street’s enthusiasm for the burgeoning financing opportunities in this area, some doubt lingers as to whether many of these enterprises will be able to survive long-term in the drug business without in-house research and development teams to create new products. “It’s easy to do the first couple deals, but then it gets harder for a company to sustain growth,” says one investment banker, requesting he not be quoted so as not to turn off potential clients. “These companies are marketing machines. They do modest development, but most have not been successful as developers.”

Cover Story
Adds Peter Crowley, head of healthcare at CIBC World Markets, “There are a lot of specialty pharmaceutical wannabes that aren’t of critical mass to grow their business in the future.” In addition to murky growth prospects, specialty pharmaceuticals have been tarnished recently by the high-profile woes of Shire Pharmaceuticals Plc and Ireland’s Elan Corp. In late February, Shire warned that generic competition for Adderall, its treatment for attention deficit disorder, would force the company to hike spending on marketing; the pre-earnings ‘There are a lot of specialty release caused pharmaceutical wannabes.’ Shire’s shares to sink by nearly one-third. At Elan, the company’s off-balance-sheet financing has come under regulatory and investor scrutiny, in the wake of Enron Corp.’s collapse. Since by Xcel Pharmaceuticals Inc. has been held up partly due to the flap over Elan, as Elan’s sale of two neurology products to Xcel is part of an accounting investigation of the company, bankers say.

Blockbuster mania
The big-cap drug companies’ fixation on blockbusters, which took hold following the mega-mergers of 2000, has certainly given the specialty pharmaceuticals industry a lot of room to maneuver. In 2000, when Pfizer Inc. moved to acquire Warner-Lambert Co. in a $91.5 billion hostile takeover, edging out a lesser bid by drug rival American Home Products Corp., the landscape began to change. That same year, Glaxo Wellcome Plc merged with SmithKline Beecham Plc in a $78 billion deal. Pfizer’s market capitalization today stands at $244.9 billion; Glaxo SmithKline’s is $146.4 billion. Merck & Co. Inc. is valued at $126.8 billion. Eli Lilly and Company and Bristol-Myers Squibb Co. are valued at $85.43 billion and $62.42 billion, respectively. And more mega-mergers are expected; weeks ago, Bristol became the subject of takeover rumors among investors. As the big-cap pharmaceuticals business gets bigger, opportunities abound for companies that want to concentrate on niche drugs. “For Merck, a $100 million product represents less than 1% of sales. Yet, it is expensive to maintain drugs,” says Paul Donofrio, an investment banker focusing on specialty pharmaceuticals for Banc of America

CIBC’s Crowley:

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s the big-cap pharmaceuticals business gets bigger, opportunities abound for companies concentrating on niches.
Securities. Even if no further R&D is conducted for a particular drug, there are marketing, manufacturing and compliance costs associated with maintaining these drugs, Donofrio explains. “A couple of years ago, a large-cap drug company might have held onto these products, but now there are other companies eager to get their hands on them,” Deutsche Bank’s DeRosa says. Such drugs—with annual sales between $50 million and $100 million—are becoming the raw materials for a new crop of specialty pharmaceutical com-

uncertainty about Elan’s accounting practices surfaced, its shares have plunged by more than 70%. Uncertainty over Elan’s financing threw a spotlight on accounting practices at other specialty pharmaceutical companies, namely Biovail Corp. and Galen Holdings Plc, based in Northern Ireland. “When one company stumbles, it puts a negative cast on the entire sector,” says Thomas DeRosa, cohead of global healthcare at Deutsche Bank. And there have been other ramifications in the capital markets. For instance, an initial public offering filed

Healthcare Finance

panies. By applying a sales force focused on only one field, say dermatology, the companies seek to boost sales, sometimes doubling or tripling the revenue. A look at the strategies of Bristol-Myers and King illustrates the point. Desperate to fend off the threat to its bottom line posed by generic drug companies, Bristol-Myers signed a landmark $2 billion agreement with biotech company ImClone Systems Inc., whose prostate cancer drug, Erbitux, promised to rise to blockbuster status once regulatory approval was granted. The terms of the Bristol/ImClone deal grabbed the attention of Wall Street and investors and underscored the desperation of Bristol-Myers to secure a future pipeline of billion-dollar products. (When the Food and Drug Administration initially rejected ImClone’s Erbitux application, Bristol-Myers stock was roiled, and its future prospects appeared grim, leading to the recent merger speculation.) At the same time, the drug behemoth has sought to shed smaller products, selling four brand-name drugs to King Pharmaceuticals for $286.5 million. The drugs—Corzide and Corgard, both beta blockers used to treat heart patients, Delestrogen, an estrogen replacement therapy, and Florine, a corticosteroid for treating patients with Addison’s disease—complemented King’s roster of cardiology, women’s health and endocrinology treatments. Indeed, King’s biggest product, Altace, is an ACE inhibitor used for treating hypertension. “A $100 million product is considered tiny by a large-cap company, but it probably generates 80% gross margins: probably $40 million in pretax profit and $25 million in earnings,” estimates Ben Lorello, head of healthcare at UBS Warburg. In this particular deal, Bristol-Myers approached King, and the two companies negotiated terms without the help of an investment bank. Meanwhile, to continue its promotion of Altace, King launched a direct-marketing campaign last month featuring golfer Jack Nicklaus and is projecting sales of between $400 million and $500 million (a 40% to 75% increase) for 2002.

Acquisition Frenzy
King’s aggressive acquisition strategy was aided by the cash it earned from its 1998 $87.5 million

IPO led by Credit Suisse First Boston. “I give credit to King Pharmaceuticals for starting the product acquisition trend,” says John Hudson, head of healthcare at Wachovia Corp. In 1998 alone, the company acquired 15 branded pharmaceuticals from Warner-Lambert, in addition to buying Altace, from Hoechst Marion Roussel (now Aventis SA). A year later, King acquired the antibiotic Lorabid from Eli Lilly. In 2000, the company bought another specialty pharma concern, Jones Pharmaceuticals, in a stock transaction valued at $3.4 billion, again hiring CSFB as its adviser. The purpose of the deal was to add products to King’s lineup, bankers say. “We’ll acquire any product that we can promote into the primary care market,” says a King ‘Earnings are more predictable spokesman. for companies with products Unlike many spebecause development is risky.’ cialty pharma companies, King doesn’t shy away from competing with big drug companies in a major market. King’s biggest seller, a hypertension drug, falls within cardiovascular treatments, a major market. But King applied a unique sales strategy—make the pitch to primary care physicians, not just cardiologists. Today, most prescriptions for King’s hypertension medication, Altace, are written by primary care physicians. The company follows the same strategy for all its drugs. King’s growth has spurred other specialty pharmaceutical companies, which previously may have concentrated exclusively on generic drugs or drug delivery mechanisms, to replicate the company’s product acquisition model. “People have looked at King and said, ‘Why can’t I do that?” Wachovia’s Hudson says.

BofA’s Donofrio:

Cover Story
Because R&D is minimal at specialty pharmaceutical companies, their most important resource, bankers say, is a management team that is well connected to the largecap drug industry. Contacts become even more important as competition for products heightens. CIBC’s Crowley notes that when Dura Pharmaceuticals Inc. (acquired by Elan in 2000) bought the dermatology business from Glaxo, it was bidding against 35 contenders. Prices for products are also on the rise, a result, some bankers say, of more recent deals, such as King’s acquisition of Jones. Bankers say big-cap pharmaceutical companies these days ‘There is so much money; the have an edge in hammering out product shortage is not capital but acquisition terms. good management.’ “Large-cap pharma has a lot of cash. That gives them an edge because they aren’t as desperate, plus there is now more capital chasing after opportunities to acquire products,” says Stan Blaylock, co-head of global healthcare banking at Deutsche Bank. As competition for these products heats up, investment banks are called upon not only as M&A advisers, but also as lenders and underwriters. Take Roswell, Ga.-based First Horizon Pharmaceutical Corp., another aggressive acquirer of drug company products. In May, the company will launch hypertension drug Sular, for which it paid AstraZeneca $185 million. The deal was funded by a bridge loan from First Horizon’s investment banker, Deutsche Bank. First Horizon, with 13 branded products for treating hypertension, gynecological conditions and gastroenterological disorders, also has a shelf registration for a follow-on offering of 6.5 million shares. Deutsche Bank, Banc of America, J.P. Morgan Chase and Thomas Weisel Partners are named as underwriters on the deal. In 2001, First Horizon was similarly aggressive on the financing and acquisition front. It paid $52.5 million in cash to purchase the Prenate line of prescription prenatal vitamins from SanofiSynthelabo Inc., which reported at the time that the products generated $16.6 million in 2000. A few months prior to the acquisition, First Horizon raised $77.2 million in a follow-on equity offering underwritten by Banc of America, J.P. Morgan and Thomas Weisel. Enormous increases in drug consumption are also contributing to hikes in acquisition prices demanded by big-cap pharmaceutical companies. In 2001, the pharmaceuticals industry in the U.S. generated between $125 billion and $185 billion in sales, according to estimates by Wachovia. Compare that with approximately $80 billion in sales raked in by the industry in 1998. Brandname products continue to drive spending, despite inroads by generic companies and prescription benefit managers to coax doctors and pharmacies to switch to generic versions. For instance, although 42% of overall prescriptions were for generic drugs in 2001, they represented only 8% of total sales last year, according to Wachovia’s data. For some clue as to the wealth of products available for possible acquisitions by specialty pharmaceutical companies, consider that of the top 1,200 drugs on the market in the U.S., only 200 bring in sales over $100 million. According to Banc of America, those 200 products constitute around 70% of overall drug sales. If big-cap drug companies intend to focus primarily on the upper echelon of the drug market, specialty pharmaceuticals could potentially capture anywhere from $41.25 billion to $61.05 billion in drug sales, bankers estimate. Greater demand by consumers is not the only element driving up acquisition costs for specialty pharmaceutical companies. A product’s patent life also factors into the size of a deal, Banc of America’s Donofrio says. The longer the patent, the higher the asking price. Development potential can also jack up the price. If a specialty pharmaceutical company has the capability to reformulate a product or change how it is delivered to the patient, the owner of the drug may negotiate more aggressively. Finally, existing sales figures play a role. “If you’re going to take a product that wasn’t selling before, you need a good sales force to convince doctors to think differently now,” Donofrio says, explaining that many drugs targeted by specialty pharma are not promoted by existing big-cap drug parents. Their sales reflect doctors’

Essex Woodland’s Currie:

Healthcare Finance

willingness to prescribe the product without a formal pitch or marketing material.

Enter private equity
Even though costs may be going up, there’s no shortage of money available. A healthy portion of it is coming from private equity funds. “Specialty pharmaceuticals is very significant for us,” says Jim Currie, senior partner at Essex Woodlands Health Ventures. Investing around $30 million in the sector, Currie’s fund has provided financing to several specialty pharmaceutical companies, including Richwood Pharmaceuticals Inc. (now part of Shire), PediaMed Pharmaceuticals Inc. and Integrity Pharmaceuticals. “There is so much money in the area, the shortage is not capital but good management,” Currie says. “Most business plans are the same old thing: an oncology team from some big company wants to start up a specialty pharma company and contract a sales force,” he adds. Currie says he is presented with a greater number of business plans for specialty pharmaceutical startups today than ever before. Because prices on products have risen, he says, it is crucial that management possess accurate projections about how much sales might be increased under a company’s stewardship. For his part, Currie says he looks for an ability to triple sales within 18 months of an acquisition. Product development is also key, Currie believes. Rather than invest in companies whose sole mission is to acquire products and then lift sales through a more aggressive marketing campaign, Essex seeks to invest in companies that rely on a combination strategy of acquiring and developing products. “I just don’t see the benefit of spending $300 million to buy products without developing one’s own products,” he says. After awhile, the acquisition well dries up as a source of future earnings, he explains. In certain instances, specialty pharmaceutical companies also develop a drug further to make it more “patient-friendly,” lowering the dosage or creating a patch to be used instead of tablets. Medicis Pharmaceutical Corp., for instance, boosted sales of acne medication Dynacin by creating a 75 milligram capsule in 1999, cites Michael Tong, specialty phar-

maceuticals analyst at Wachovia Corp. Although 50 mg and 100 mg capsules already existed, Medicis sold 75 milligram Dynacin by arming its sales reps with data showing greater effectiveness with the changed dose, Tong says.

Development Conundrum
Oddly, specialty pharmaceutical companies not involved in heavy product development are currently valued higher by the market than companies with significant product development in their budgets. Bankers agree that most specialty pharmaceutical companies will insist they engage in product development to avoid being perceived as primarily “drug marketing firms.” Differences abound among ‘A $100 million product is these companies in terms considered tiny by a largeof the resources they are willing to commit to prodcap company, but it probauct development. A typical bly generates 80% gross big-cap pharmaceutical margins.’ company will plow 10% to 20% of total sales into research and development, analysts say, so specialty pharmaceutical companies with significantly less than that on their balance sheets are considered light on product development. The lower valuations are partly explained by realizing that development costs represent a drain on a drug company’s earnings. “Investors tend to be shortterm, and earnings are more predictable for companies with products because development is risky,” explains Donofrio. “People think, ‘What does a specialty pharma company know about research?’” CIBC’s Crowley says. Biotech, with its emphasis on breakthrough drugs that eventually will become blockbuster sellers, represents a completely different type of investment, bankers in specialty pharmaceuticals maintain.

UBS Warburg’s Lorello:

Cover Story
Bankers are reluctant to discuss which companies are more driven by product acquisitions than development, for fear of turning off potential underwriting business. One recent merger of two specialty pharmaceutical companies has grabbed the attention of bankers in the sector, particularly because of the $1 billion price tag for the target company. Last month Alkermes Inc., a drug delivery company, purchased Reliant Pharmaceuticals in a stock deal valued at $1 billion. The market hasn’t greeted the merger warmly. Alkermes’ stock, trading in the $28 to $30 range before the March 21 announcement, has ‘People have looked at King lost around 25% of and said, ‘Why can’t I do that?’ its value, trading at $22.46 April 11. Peter Reikes, head of healthcare at SG Cowen Securities Corp., which advised Alkermes, defends the deal by saying it will bring long-term benefits to Alkermes’ product development initiatives, providReliant, so the decision to merge the companies was anything but impulsive, he suggests. For the moment, financing deals and product acquisition deals with big-cap pharmaceutical companies is plentiful. Salix Pharmaceuticals Ltd., a specialty pharmaceutical company focusing on gastroenterology, just raised $50 million in equity in a deal done jointly by UBS Warburg and Wachovia. Despite the market’s apparent preference for sales initiatives over development, development represents an important component of a company’s longterm growth prospects, Currie insists. Development of acquired products often helps boost sales, for instance. In addition, developing new products lends credibility to a company’s pursuit of market share in a particular medical specialty. Finally, some bankers expect that in a few years specialty pharmaceutical companies and biotech companies will start collaborating. In such a scenario, biotechs would look to specialty pharma companies for two things: sales and marketing expertise plus the development potential to convert biotech’s often injectible products into more patient-friendly forms. How all this affects the average consumer is yet to be played out. Bankers cheer that the marketing muscle provided by specialty pharmaceutical companies helps meet the needs of patients suffering from relatively rare diseases and disorders. And some doctors agree. Adds Dr. Dan Dubin, healthcare strategist of Leerink Swann & Co. and president of MEDACorp., a consultant for institutional

Wachovia’s Hudson:

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ome bankers expect that in a few years specialty pharmaceuticals and biotech companies will start collaborating.
investors: “From a doctor’s perspective, it’s a good thing if specialty pharma companies are focusing on underpromoted products that help patients get better.” Wall Street feels the same. IDD

ing the company with Reliant’s existing products and sales force. “The strategic rationale is exceedingly clear-cut,” Reikes says. In December, Alkermes made a $100 million investment in

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