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N V E S T M E N T D E A L E R S D I G E S

www.iddmagazine.com

APRIL 15, 2002


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Cover Story

Executives at Bristol, Tenn.-based King Pharmaceuticals Inc. are in the pink these days. From

Kings 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 work-

ing. These days the bulk of Kings 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.), EliLilly and Co. and Bristol-Myers Squibb Co. Kings roster of products treat hypertension and hormone defi-

ciencies, among other ailments.

Kings pioneering transformation from manufacturer to marketerwith 500 salespeoplecoincided with a

shift among the major drug makers toward so-called blockbuster drugs, or those racking up at least $1 bil-

lion 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 Kings 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, womens 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 Streets 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.

Its 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.

By Laura Santini


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Cover Story

Adds Peter Crowley, head of

healthcare at CIBC World

Markets, There are a lot

of specialty pharmaceuti-

cal wannabes that

arent 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 Irelands Elan Corp. In

late February, Shire warnedthat generic competi-

tion for Adderall,

its treatment for

attention deficit

disorder, would

force the compa-

ny to hike spend-

ing on marketing;

the pre-earnings

release caused

Shires shares tosink by nearly

one-third. At Elan, the companys off-balance-sheet

financing has come under regulatory and investor

scrutiny, in the wake of Enron Corp.s collapse. Since

uncertainty about Elans accounting practices sur-

faced, its shares have plunged by more than 70%.

Uncertainty over Elans financing threw a spot-

light on accounting practices at other specialty phar-

maceutical 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, co-

head of global healthcare at Deutsche Bank. And

there have been other ramifications in the capital

markets. For instance, an initial public offering filed

by Xcel Pharmaceuticals Inc. has been held up part-

ly due to the flap over Elan, as Elans sale of two

neurology products to Xcel is part of an accounting

investigation of the company, bankers say.

Blockbuster maniaThe big-cap drug companies fixation on block-

busters, which took hold following the mega-merg-

ers of 2000, has certainly given the specialty phar-

maceuticals 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.Pfizers market capitalization today stands at

$244.9 billion; Glaxo SmithKlines 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 big-

ger, opportunities abound for companies that want

to concentrate on niche drugs. For Merck, a $100million product represents less than 1% of sales.

Yet, it is expensive to maintain drugs, says Paul

Donofrio, an investment banker focusing on spe-

cialty pharmaceuticals for Banc of America

Securities. Even if no further R&D is conducted for

a particular drug, there are marketing, manufactur-

ing and compliance costs associated with maintain-

ing 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 Banks DeRosa says.

Such drugswith annual sales between $50 mil-

lion and $100 millionare becoming the raw materi-

als for a new crop of specialty pharmaceutical com-

CIBCs Crowley:There are a lot of specialtypharmaceutical wannabes.

A

s the big-cap pharmaceuticals businessgets bigger, opportunities abound forcompanies concentrating on niches.


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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 agree-

ment 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 under-

scored the desperation of Bristol-Myers to secure a

future pipeline of billion-dollar products. (When the

Food and Drug Administration initially rejectedImClones 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 drugsCorzide and Corgard, both beta block-

ers used to treat heart patients, Delestrogen, an

estrogen replacement therapy, and Florine, a corti-

costeroid for treating patients with Addisons dis-

easecomplemented Kings roster of cardiology,womens health and endocrinology treatments.

Indeed, Kings 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, esti-

mates Ben Lorello, head of healthcare

at UBS Warburg. In this particular

deal, Bristol-Myers approached

King, and the two companies nego-

tiated 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 FrenzyKings 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 pharma-

ceuticals from Warner-Lambert,

in addition to buying Altace,

from Hoechst Marion Roussel

(now Aventis SA). A year

later, King acquired the antibi-

otic Lorabid from Eli Lilly. In

2000, the company bought

another specialty pharma concern,

Jones Pharmaceuticals, in a stocktransaction valued at $3.4 billion,

again hiring CSFB as its adviser.

The purpose of the deal was to

add products to Kings

lineup, bankers say.

Well acquire any

product that we can

promote into the pri-

mary care market,

says a King

spokesman.Unlike many spe-

cialty pharma com-

panies, King doesnt

shy away from competing with big drug companies

in a major market. Kings biggest seller, a hyperten-

sion drug, falls within cardiovascular treatments, a

major market. But King applied a unique sales

strategymake the pitch to primary care

physicians, not just cardiologists.

Today, most prescriptions for Kings

hypertension medication,

Altace, are written by primary

care physicians. The com-

pany follows the same

strategy for all its drugs.

Kings growth has

spurred other specialty pharma-

ceutical companies, which previously

may have concentrated exclusively on generic drugs

or drug delivery mechanisms, to replicate the com-

panys product acquisition model. People have

looked at King and said, Why cant I do that?

Wachovias Hudson says.

BofAs Donofrio:Earnings are more predictable

for companies with productsbecause development is risky.


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Cover Story

Because R&D is minimal at

specialty pharmaceutical com-

panies, their most important

resource, bankers say, is a

management team that is

well connected to the large-

cap drug industry. Contacts

become even more important

as competition for products

heightens. CIBCs 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, ofmore recent deals, such as

Kings acquisition of Jones.

Bankers say big-cap

pharmaceutical com-

panies these days

have an edge in ham-

mering out product

acquisition terms.

Large-cap pharma

has a lot of cash. That

gives them an edgebecause they arent 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 underwrit-

ers. 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 Horizons

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 Sanofi-

Synthelabo 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. Brand-

name products continue to drive spending, despiteinroads 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 Wachovias data.

For some clue as to the wealth of products avail-

able for possible acquisitions by specialty pharma-

ceutical 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 ofAmerica, 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 products patent life

also factors into the size of a deal, Banc of

Americas Donofrio says. The longer the patent,

the higher the asking price. Development poten-

tial can also jack up the price. If a specialty phar-

maceutical company has the capability to refor-

mulate 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 youre going to take a product that

wasnt selling before, you need a good sales force

to convince doctors to think differently now,

Donofrio says, explaining that many drugs target-

ed by specialty pharma are not promoted by exist-

ing big-cap drug parents. Their sales reflect doctors

Essex Woodlands Currie:There is so much money; the

shortage is not capital butgood management.


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