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                                                                              APRIL 15, 2002




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Cover Story




                                                     By Laura Santini




              E
                         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 work-
              ing. 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 defi-
              ciencies, 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 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 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             by Xcel Pharmaceuticals Inc. has been held up part-
                                    healthcare at CIBC World               ly due to the flap over Elan, as Elan’s sale of two
                                      Markets, “There are a lot            neurology products to Xcel is part of an accounting
                                        of specialty pharmaceuti-          investigation of the company, bankers say.
                                          cal wannabes that
                                           aren’t of critical mass         Blockbuster mania
                                            to grow their business            The big-cap drug companies’ fixation on block-
                                            in the future.”                busters, which took hold following the mega-merg-
                                                     In addition to        ers of 2000, has certainly given the specialty phar-
                                           murky growth                    maceuticals industry a lot of room to maneuver.
                                          prospects, specialty                In 2000, when Pfizer Inc. moved to acquire
                                          pharmaceuticals have             Warner-Lambert Co. in a $91.5 billion hostile
                                        been tarnished recently by         takeover, edging out a lesser bid by drug rival
                                      the high-profile woes of             American Home Products Corp., the landscape
                                     Shire Pharmaceuticals Plc             began to change. That same year, Glaxo Wellcome
                                   and Ireland’s Elan Corp. In             Plc merged with SmithKline Beecham Plc in a $78
                                   late February, Shire warned             billion deal.
                                              that generic competi-           Pfizer’s market capitalization today stands at
                                                   tion for Adderall,      $244.9 billion; Glaxo SmithKline’s is $146.4 billion.
                                                   its treatment for       Merck & Co. Inc. is valued at $126.8 billion. Eli
                                                   attention deficit       Lilly and Company and Bristol-Myers Squibb Co.
                                                   disorder, would         are valued at $85.43 billion and $62.42 billion,
                                                   force the compa-        respectively. And more mega-mergers are expected;
                                                   ny to hike spend-       weeks ago, Bristol became the subject of takeover
        CIBC’s Crowley:                           ing on marketing;        rumors among investors.
  ‘There are a lot of specialty                   the pre-earnings            As the big-cap pharmaceuticals business gets big-
                                                  release caused           ger, opportunities abound for companies that want
  pharmaceutical wannabes.’
                                                  Shire’s shares to        to concentrate on niche drugs. “For Merck, a $100
                                                  sink by nearly           million product represents less than 1% of sales.
            one-third. At Elan, the company’s off-balance-sheet            Yet, it is expensive to maintain drugs,” says Paul
            financing has come under regulatory and investor               Donofrio, an investment banker focusing on spe-
            scrutiny, in the wake of Enron Corp.’s collapse. Since         cialty pharmaceuticals for Banc of America




     A               s the big-cap pharmaceuticals business
                     gets bigger, opportunities abound for
                     companies concentrating on niches.
                 uncertainty about Elan’s accounting practices sur-
                 faced, its shares have plunged by more than 70%.
                                                                           Securities. Even if no further R&D is conducted for
                                                                           a particular drug, there are marketing, manufactur-
                     Uncertainty over Elan’s financing threw a spot-       ing and compliance costs associated with maintain-
                 light on accounting practices at other specialty phar-    ing these drugs, Donofrio explains.
                 maceutical companies, namely Biovail Corp. and               “A couple of years ago, a large-cap drug company
                 Galen Holdings Plc, based in Northern Ireland.            might have held onto these products, but now there
                 “When one company stumbles, it puts a negative            are other companies eager to get their hands on
                 cast on the entire sector,” says Thomas DeRosa, co-       them,” Deutsche Bank’s DeRosa says.
                 head of global healthcare at Deutsche Bank. And              Such drugs—with annual sales between $50 mil-
                 there have been other ramifications in the capital        lion and $100 million—are becoming the raw materi-
                 markets. For instance, an initial public offering filed   als for a new crop of specialty pharmaceutical com-
                                                                                               Healthcare Finance


panies. By applying a sales force focused on only one     IPO led by Credit Suisse First Boston. “I
field, say dermatology, the companies seek to boost       give credit to King Pharmaceuticals for
sales, sometimes doubling or tripling the revenue.        starting the product acquisition
   A look at the strategies of Bristol-Myers and King     trend,” says John Hudson, head of
illustrates the point. Desperate to fend off the threat   healthcare at Wachovia Corp.
to its bottom line posed by generic drug companies,          In 1998 alone, the company
Bristol-Myers signed a landmark $2 billion agree-         acquired 15 branded pharma-
ment with biotech company ImClone Systems Inc.,           ceuticals from Warner-Lambert,
whose prostate cancer drug, Erbitux, promised to          in addition to buying Altace,
rise to blockbuster status once regulatory approval       from Hoechst Marion Roussel
was granted.                                              (now Aventis SA). A year
   The terms of the Bristol/ImClone deal grabbed the      later, King acquired the antibi-
attention of Wall Street and investors and under-         otic Lorabid from Eli Lilly. In
scored the desperation of Bristol-Myers to secure a       2000, the company bought
future pipeline of billion-dollar products. (When the     another specialty pharma concern,
Food and Drug Administration initially rejected           Jones Pharmaceuticals, in a stock
ImClone’s Erbitux application, Bristol-Myers stock        transaction valued at $3.4 billion,
was roiled, and its future prospects appeared grim,       again hiring CSFB as its adviser.
leading to the recent merger speculation.)                The purpose of the deal was to
   At the same time, the drug behemoth has sought         add products to King’s
to shed smaller products, selling four brand-name         lineup, bankers say.
drugs to King Pharmaceuticals for $286.5 million.            “We’ll acquire any
The drugs—Corzide and Corgard, both beta block-           product that we can
ers used to treat heart patients, Delestrogen, an         promote into the pri-
estrogen replacement therapy, and Florine, a corti-       mary care market,”          BofA’s Donofrio:
costeroid for treating patients with Addison’s dis-       says a King                 ‘Earnings are more predictable
ease—complemented King’s roster of cardiology,            spokesman.
women’s health and endocrinology treatments.                 Unlike many spe-
                                                                                         for companies with products
Indeed, King’s biggest product, Altace, is an ACE         cialty pharma com-           because development is risky.’
inhibitor used for treating hypertension.                 panies, King doesn’t
    “A $100 million product is considered tiny by a       shy away from competing with big drug companies
large-cap company, but it probably generates 80%          in a major market. King’s biggest seller, a hyperten-
gross margins: probably $40 million in pretax             sion drug, falls within cardiovascular treatments, a
profit and $25 million in earnings,” esti-                major market. But King applied a unique sales
mates Ben Lorello, head of healthcare                             strategy—make the pitch to primary care
at UBS Warburg. In this particular                                       physicians, not just cardiologists.
deal, Bristol-Myers approached                                             Today, most prescriptions for King’s
King, and the two companies nego-                                               hypertension medication,
tiated terms without the help of an                                               Altace, are written by primary
investment bank.                                                                     care physicians. The com-
   Meanwhile, to continue its promotion                                               pany follows the same
of Altace, King launched a direct-marketing                                          strategy for all its drugs.
campaign last month featuring golfer Jack                                               King’s growth has
Nicklaus and is projecting sales of between $400                             spurred other specialty pharma-
million and $500 million (a 40% to 75% increase)                        ceutical companies, which previously
for 2002.                                                 may have concentrated exclusively on generic drugs
                                                          or drug delivery mechanisms, to replicate the com-
Acquisition Frenzy                                        pany’s product acquisition model. “People have
  King’s aggressive acquisition strategy was aided        looked at King and said, ‘Why can’t I do that?”
by the cash it earned from its 1998 $87.5 million         Wachovia’s Hudson says.
 Cover Story

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


willingness to prescribe the product without a for-       maceuticals analyst at Wachovia Corp.
mal pitch or marketing material.                          Although 50 mg and 100 mg capsules
Enter private equity                                      already existed, Medicis sold 75 milligram
   Even though costs may be going up, there’s no          Dynacin by arming its sales reps with
shortage of money available. A healthy portion of it      data showing greater effectiveness with
is coming from private equity funds. “Specialty           the changed dose, Tong says.
pharmaceuticals is very significant for us,” says Jim
Currie, senior partner at Essex Woodlands Health          Development Conundrum
Ventures. Investing around $30 million in the sec-           Oddly, specialty pharmaceutical com-
tor, Currie’s fund has provided financing to several      panies not involved in heavy product
specialty pharmaceutical companies, including             development are currently valued higher
Richwood Pharmaceuticals Inc. (now part of                by the market than companies with sig-
Shire), PediaMed Pharmaceuticals Inc. and                 nificant product development in their
Integrity Pharmaceuticals.                                budgets. Bankers agree that most
    “There is so much money in the area, the short-       specialty pharmaceutical com-
age is not capital but good management,” Currie           panies will insist they
says. “Most business plans are the same old thing:        engage in product devel-
an oncology team from some big company wants to           opment to avoid being
start up a specialty pharma company and contract a        perceived as primarily
sales force,” he adds.
   Currie says he is presented with a greater number
                                                          “drug marketing firms.”
                                                          Differences abound among
                                                                                          UBS Warburg’s Lorello:
of business plans for specialty pharmaceutical start-     these companies in terms              ‘A $100 million product is
ups today than ever before. Because prices on prod-       of the resources they are            considered tiny by a large-
ucts have risen, he says, it is crucial that manage-      willing to commit to prod-           cap company, but it proba-
ment possess accurate projections about how much          uct development. A typical
sales might be increased under a company’s steward-       big-cap pharmaceutical
                                                                                                 bly generates 80% gross
ship. For his part, Currie says he looks for an ability   company will plow 10% to                           margins.’
to triple sales within 18 months of an acquisition.       20% of total sales into
   Product development is also key, Currie believes.      research and development,
Rather than invest in companies whose sole mis-           analysts say, so specialty pharmaceutical compa-
sion is to acquire products and then lift sales           nies with significantly less than that on their bal-
through a more aggressive marketing                       ance sheets are considered light on product devel-
campaign, Essex seeks to invest in                        opment.
companies that rely on a combina-                                    The lower valuations are partly explained by
tion strategy of acquiring and                                        realizing that development costs represent
developing products.                                                          a drain on a drug company’s earn-
   “I just don’t see the benefit of                                             ings. “Investors tend to be short-
spending $300 million to buy                                                        term, and earnings are more
products without developing                                                             predictable for companies
one’s own products,” he says.                                                            with products because
After awhile, the acquisition well                                                          development is risky,”
dries up as a source of future earn-                                                         explains Donofrio.
ings, he explains.                                                                            “People think, ‘What
   In certain instances, specialty pharmaceutical                                      does a specialty pharma
companies also develop a drug further to make it                                  company know about
more “patient-friendly,” lowering the dosage or cre-                        research?’” CIBC’s Crowley says.
ating a patch to be used instead of tablets. Medicis                    Biotech, with its emphasis on break-
Pharmaceutical Corp., for instance, boosted sales of      through drugs that eventually will become blockbuster
acne medication Dynacin by creating a 75 milligram        sellers, represents a completely different type of invest-
capsule in 1999, cites Michael Tong, specialty phar-      ment, bankers in specialty pharmaceuticals maintain.
Cover Story

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




       S            ome bankers expect that in a few years
                    specialty pharmaceuticals and biotech
                    companies will start collaborating.
                  ing the company with Reliant’s existing products       investors: “From a doctor’s perspective, it’s a good
                  and sales force. “The strategic rationale is exceed-   thing if specialty pharma companies are focusing
                  ingly clear-cut,” Reikes says. In December,            on underpromoted products that help patients get
                  Alkermes made a $100 million investment in             better.” Wall Street feels the same. IDD




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