Barclays Expects M&A In Specialty Pharma To Continue, Likes Valeant And Jazz

In a report published Wednesday, Barclays analyst Douglas Tsao detailed why he believes that M&A activity within the Specialty Pharmaceutical sector is expected to continue. According to Tsao, much of the consolidation seen in the industry has been driven by "strategic considerations" rather than the availability of low-cost debt financing. As an example, generic drug makers need to gain scale, offset price declines and gain and gain manufacturing ass to create more complex products. Another example includes a specialty pharmaceutical company that pursues M&A activity to sustain earnings growth momentum and reduce product and market concentration. M&A activity in the sector also had an objective of achieving a lower tax rate and the ability to access overseas cash balances, known as "inversion" transactions. However, recent changes in U.S. Treasury rules essentially eliminates advantages associated with this kind of transaction.

Tsao continued that the high grade pharmaceutical sector is trading at a 14 basis point premium to the U.S. Corporate Index, marking a 40 basis point drop from 2012. According to the analyst the compression is attributed to a reduction in average ratings (15 to 20 basis points) caused by the increased inclusion of lower-rated credits in the index such as

and downgrade of high-rated issuers such as

due to "aggressive" shareholder-friendly activities. In addition, the sector has a 34 percent longer-duration debt, and current valuations are pricing in new issue concessions associated with financing transactions that have yet to be completed. "This suggests that despite the significant amount of M&A over the past few years, the investment grade pharmaceuticals sector is not pricing in much of a discount to reflect M&A-related uncertainty," Tsao wrote. "We believe that investors have generally gotten comfortable with the idea that consolidation in the sector is unlikely to cause meaningful deterioration in the credit quality of issuers, other than to drive issuance, which has performed well. That said, given the sector's higher duration – OAD of 8.1, versus 7.0 for the index – its performance will also be influenced by the evolution of the 10-30s curve."

Tsao recommended

as the market is just beginning to appreciate its improved organic growth prospects that is likely to drive earnings upside and multiple expansion in its share price. Valeant has been defined by its "aggressive asset-driven strategy," but the company has shifted its strategy as its cash flow generation enabled it to target assets with greater growth potential, such as

Valeant has also shown a willingness to invest in sales and marketing to support product performance. Tsao also recommended

as it is a "best-in-class" name in the specialty pharmaceutical space. The analyst added that he likes the company's organic prospects for its base baseness along with the launch of defibrotide in the U.S. next year. In addition, Jazz retains "significant" balance sheet capacity and a track record for deals that create "significant" economic value.