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Size Does Matter

By Benjamin Shepherd on August 3, 2016

 

Right now, my wife and I are in the market for a new car and doing the usual dance of “what do we need now and will probably need in the future.” We have a one-year old, and we also take care of an elderly relative.  We need to transport three adults and a child on a regular basis. We’re also fairly avid do-it-yourselfers, so we need hauling capacity, too. We also live just a few miles from some great lake and river fishing, which has me determined to own a boat sooner rather than later.

All of these needs helped narrow our choices down to extended-cab pickups, but not all are created equal. The difference comes down to horsepower.

If all we were ever going to do was load the family up for trips to the grocery store and church, the 268 horsepower of the typical family sedan with a 3.5-liter V6 engine would more than suffice. But if we’re loading the family into the pickup with all our gear in the bed and my dream boat hitched to the back, we’re going to need the pickup’s 385 horsepower with a 5-liter V8 to move all that weight at a reasonable speed.

As it happens, I’m not the only one in the market for more horsepower, so are the world’s largest drug companies.

News broke yesterday that Biogen (NSDQ: BIIB) is being courted by at least two potential suitors. A leading maker of multiple sclerosis and cancer treatments, Biogen also has an attractive pipeline of potential new drugs to treat neurological disorders. It also has a market capitalization of $75 billion and more than $11 billion in annual revenue.

The trend in the pharmaceutical and biotech industries over the past few years has been for companies like Merck (NYSE: MRK), which already has the horsepower of a freight train engine, to buy up small companies with a promising drug. But with about $40 billion in annual revenue, even if that promising drug proved to be a blockbuster, it just wouldn’t add enough horsepower to accelerate earnings. And if the drug turns into a bust, your portfolio risks losing its oomph from the bad investment.

Finding Horsepower in Mergers

Merger and acquisition deals in the healthcare industry as a whole rose 14% last year, hitting a record $563.1 billion. Both the total number of deals and the average value of each transaction were up, as bigger companies get bought up. Again, everybody was looking for more horsepower.

It makes sense that Merck is one of Biogen’s potential suitors. If Merck were to acquire a company with even $1 billion in annual revenue, that’s just a 2.5% gain. If it manages to buy Biogen—and that’s a big if, as regulators have scuttled some big healthcare deals over tax and antitrust worries—that would add more than 27% to annual revenue, a hefty pickup in power.

The world’s biggest pharmaceutical companies are generally considered stodgy investments, precisely because their growth has been incremental over the past few years. Frankly, with revenue for the majors running at $40 billion or more, it’s mathematically impossible for them to add enough new drugs through their own research and development to move the needle on revenue and earnings.

As the majors look to really boost their potential energy, we’re going to see more of these big deals that turn freight trains into bullets.

Updates

On the earnings front, GlaxoSmithKline’s (NYSE: GSK) second-quarter report was a mixed bag thanks to the Brexit.

Because of the plunging pound, the drugmaker recorded a $2.4 billion charge due to liabilities that became more expensive with the falling currency. That said, the weak currency also drove quarterly revenue 7% higher to $9.2 billion as most of the company’s sales are outside of the U.K. Overall, though, including the one-time charge, Glaxo posted a 12.7 cent per share loss.

Investors, who anticipated the Brexit effect, don’t seem perturbed by the loss, and shares are up better than 2% since the announcement. CEO Andrew Witty said the company expected core earnings, which exclude one-time items, to grow between 11% and 12% this year. The company also plans to invest roughly $366 million at current exchange rates to boost capacity at three of its U.K. production facilities, which will help the company take advantage of the weaker pound.

GlaxoSmithKline remains a buy up to $54.

 

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