Stenham Asset Management senior analyst Bruce Harington says the healthcare M&A wave shows no signs of abating
Global healthcare M&A reached $265bn (€233.3bn) last week, 77% higher than at the same point of 2014, which was the largest year on record for healthcare M&A by a huge distance.
The model of the healthcare industry has changed in recent years. Rather than conducting all R&D internally, the large pharmaceutical and biotech companies are now acquiring growth. The big companies are waiting until late stage drug development, which they then add to existing product portfolios. The large groups have the distribution to fully capitalise on breakthrough developments.
There has been an unprecedented amount of innovation in biotech in recent years and with continued innovation in important areas like immuno-oncology, the drug innovation pipeline shows no sign of slowing.
Fundamentals supporting the recent M&A wave are likely to continue for the medium term, particularly with the cheap financing available. We have also seen sharp gains in the share prices of both the acquirer and the company getting acquired. This fact has not been lost on CEOs in the sector, which should encourage further M&A.
This sector has had a strong run of performance over the last few years, but valuations are still reasonable. Its 10% premium to the general market is near its longer term historical average, but it is one of the best growth areas of the market in an environment of scarce overall growth.
However, a number of the managers we invest in are identifying some frothy areas of the market. Pre-commercial stage biotech companies are highly valued – particularly those with drugs still at an early stage. These companies do not really have earnings currently, so are very reliant on sentiment.
The larger biotech companies, those that are profitable and have earnings, are still cheap relative to expected growth. While these companies are trading at about 20x earnings on average, which does not sound cheap, they are still very attractive as EPS is growing at more than 20% and they have a good runway of 3-5 years of these levels of growth.
A big driver for pharmaceutical companies since the turn of the decade has been the evolving stance of the FDA. For diseases that are life threatening, they have realised there is no point in holding these drugs up for relatively minor side effects. The regulator has been much more proactive in getting drugs approved for some truly terrible diseases. For example, the FDA has a fast track designation programme which can speed up the approval of high-priority drugs where there is an unmet medical need. The FDA attempts to make a decision within 60 days, which is much quicker than previously.
Elsewhere in healthcare, we are still a little wary on hospitals. Hospitals have been a huge beneficiary of the Affordable Care Act, commonly also known as ‘Obamacare’. The ACA has significantly boosted insurance numbers in the US, which has meant more people have been going into hospitals. However, there is a Supreme Court challenge underway on areas of the ACA, which could jeopardise Federal subsidies for millions of Americans. It is expected that you will have bipartisan agreement between the Democrats and the Republicans to find a workaround solution even if the Supreme Court decision goes against the ACA, but after the strong rise of hospitals, many people are now waiting on the sidelines to see what happens in court.