Valeant Offers A Princely Sum For Cephalon

By Stephen D. Simpson, CFA | March 31, 2011 AAA

The news Tuesday evening that Cephalon (Nasdaq:CEPH) had received a bid was not all that surprising. Cephalon had long been a fixture on analysts' short-lists of biotech/specialty pharma companies that could be sellers in M&A transactions. To see the bid come from Valeant (NYSE:VRX), though, was surprising as few people had talked about this pharma company as an active bidder in high-value deals.

That said, and while the deal is far from a sure thing at this point, this deal makes quite a bit of sense and may be the best opportunity for Cephalon shareholders to get value for some time.

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The Terms of the Deal
After what appears to be weeks of frustrated attempts to strike a friendly deal, Valeant went public with an unsolicited bid of $5.7 billion for Cephalon. This deal would deliver $73 a share in cash to Cephalon shareholders, an amount that Valeant would fund with debt from Goldman Sachs (NYSE:GS).

All in all, it does not look like a bad bid for Cephalon. It represents a 24% premium to Cephalon's prior close, and a 12% premium to the consensus analyst price target on the shares (for the very little that those are often worth). The deal also represents an EV/EBITDA of just under five and a forward P/E of over eight on 2011 earnings and almost 13 on 2012 earnings.

What Valeant Would Be Getting
Those valuation ratios may look low, but there are a few extenuating circumstances to consider. First, as those P/E ratios indicate, earnings are projected to fall relatively soon on the patent expiry for Provigil. Additionally, Cephalon has a rather iffy late-stage pipeline - most of the late-stage trials are line extensions and there are no likely new product launches until 2013 or so. (For related reading, see 6 Drug Companies With Expiring Patents In 2011.)

Valeant has some relatively special factors that could make this a successful deal. Valeant enjoys a low tax rate due to certain assets being held in Barbados, and the company has a demonstrated history of stripping costs out of deals and running a very tight ship. What that all means, then, is Cephalon's earnings are arguably worth more to Valeant than to other possible suitors.

This deal not only gives Valeant a chance to chop overhead, but also add some products to the pipeline. Prior to the Valeant-Biovail merger, Valeant had cut back on drug development and Biovail had become more focused with its product development. Adding Cephalon, then, will bring in products like Treanda (oncology) and Nuvigil, as well as potential drugs for conditions like eosinophilic asthma, lupus, and cancer.

All of that does come with some risk, though. Cephalon is trying to transition patients from Provigil (which is about to go off patent) to Nuvigil, and that conversion rate seems to be about 40% so far. Moreover, Treanda could see similar competition in 2015. On top of that, Cephalon does not bring a lot in early-stage capabilities; the company has pursued an in-licensing strategy not so different than Forest Labs (NYSE:FRX) and has had to look for licenses and deals in the past to recharge the pipeline.

Will a Deal Happen?
By going public, Valeant has certainly ratcheted up the pressure on Cephalon's management and board of directors, and that is not likely to be welcome. At the same time, there would seem to be little risk in Valeant's bid and Cephalon may have a hard time convincing shareholders that the deal is flawed. All of that said, Cephalon is clearly in no hurry to sell and will likely pressure Valeant to up the bid. And while Cephalon investors may be hoping for a rival to offer a superior bid, those same hopes came to the surface in the Forest Labs - Clinical Data deal and Pfizer's (NYSE:PFE) bid for King Pharmaceuticals and nothing happened (though there is still about a week for something to happen with Clinical Data).

The Bottom Line
The Valeant-Cephalon deal does not look like the sort of bid that should get uninvolved investors all that excited. It looks like a win-win for both parties, but that is largely because Valeant has an uncommon degree of operating efficiency to leverage Cephalon's more modest prospects.

That is not all that helpful, then, for investors in other specialty pharma businesses like Endo Pharmaceuticals (Nasdaq:ENDP), Salix (Nasdaq:SLXP) or Warner Chilcott (Nasdaq: WCRX). Still, it does reinforce the idea that there are drug companies on the prowl, companies looking to squeeze synergies from scale and/or push more product through their existing channels. That may offer some downside protection to investors, but it isn't likely to get anyone all that excited about the offer prices. (For more, see Measuring The Medicine Makers.)

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