Reviewing Bristol-Myers' $90 Billion Acquisition of Celgene

Large-scale M&A is nothing new to Wall Street, especially in the pharmaceutical industry. However, mega deals are often fraught with risks, so when a dividend stock announces an enormous purchase investors understandably get nervous.

On January 3, 2019, Bristol-Myers Squibb (BMY) announced it will be buying biotech giant Celgene (CELG) in a $74 billion deal ($90 billion including debt), one of the largest Pharma mergers in history. 

BMY's stock price plunged 10% on the news, sending a clear signal that the market isn't so happy that this dividend-paying blue-chip undertaking what could be a risky growth venture.

With Bristol-Myers now sporting its highest dividend yield (near 3.5%) in more than five years, let's take a closer look at this acquisition to see whether the combined company can remain a reliable dividend grower.   

Celgene investors will receive 1 share of Bristol-Myers for each share of Celgene they own, plus $50 per share in cash and a tradable contingent value right, or CVR. The CVRs entitle their owners to receive cash payments (potentially $9 per share) if three of Celgene's late-stage drugs hit certain regulatory approval milestones. 

In total, Bristol-Myers is paying a 54% premium to Celgene's January 2nd closing price, valuing the company at rather steep multiples of roughly 6 times forward revenue and nearly 18 times free cash flow.

Once the deal closes in the third quarter of 2019, Bristol-Myers shareholders will own 69% of the combined company. Bristol-Myers Squibb Chairman and CEO Giovanni Caforio will remain the head of the much larger company which will retain the Bristol-Myers name. Two Celgene board members will be added to Bristol-Myers' board of directors (13 total directors).

But given the size of this deal, and the apparently rich valuation Bristol-Myers is paying, investors are still nervous about whether this merger is ultimately a good thing. So here's a look at management's rationale behind one of the biggest M&A deals in pharma industry history.

At first glance, it might seem like Bristol-Myers overpaid for Celgene given the deal's rich premium. However, that's not necessarily true. 

Due largely to worries that its blockbuster multiple myeloma cancer drug Revlimid will lose patent protection in 2022, Celgene's shares had slumped nearly 40% in the 12 months prior to the announcement.

Thus Bristol-Myers isn't necessarily paying too much, especially given some of Celgene's unique assets and potential to improve its long-term growth trajectory.

For example, in early 2018 Celgene announced it was buying Juno Therapeutics for $9 billion. That deal was made to gain access to Juno's strong pipeline of cancer drugs (the highest margin part of the industry) including CAR-T cell therapies. CAR-T basically uses a genetically engineered form of a patient's own T-cells (part of the immune system) to fight cancer. Early studies show it's a more effective way to fight cancer, with fewer (though still some) side effects to traditional treatments like chemo and radiation.

But buying Celgene isn't just about oncology. Bristol-Myers has spent the last few years selling off four major business lines to focus almost exclusively on higher-margin specialty drugs.

The much larger Bristol-Myers would be one of the largest pharma companies with No. 1 market share in oncology (62% of revenue) and cardiovascular (17%) and a top-five position in immunology (11%; treatments for issues such as arthritis, which is one of the industry's biggest cash cows).

The new Bristol-Myers would immediately jump from $22 billion in sales to $33.3 billion (51% increase) and have about 33% global market share in oncology, immunology, and cardiovascular drugs.

What's more, acquiring Celgene would enhance Bristol-Myers' drug pipeline, bumping it up to 10 phase III (late stage) drugs, including six that are expected to launch within the next year or two.

Management believes these six drugs (two immunology and four oncology) will generate combined sales of $15 billion per year. That could potentially boost the firm's sales to nearly $50 billion per year and make Bristol-Myers the largest drug maker in the world.

The new company would also have 50 phase I and II (early and mid-stage) drugs in development including 31 oncology drugs and 10 immunology drugs (the most profitable and successful kind these days). As a result of this spike in revenue, despite a large increase in its share count to help finance the deal, Bristol-Myers' EPS is expected to jump over 40% in the first full year after the merger closes. 

Basically, if the deal is approved by regulators, the new Bristol-Myers will be a true global behemoth with nine drugs with over $1 billion in sales and one of the industry's best drug pipelines in oncology, immunology and inflammation, and cardiovascular disease. 

Bristol-Myers management also expects that by 2022 the company will be able to achieve $2.5 billion in synergistic cost savings which will drop directly to its bottom line (and help support the dividend).

But if this deal is potentially so great, then why have Bristol-Myers' shares been punished so badly? While large-scale M&A, in general, is hard to pull off, that's especially true in the riskier pharma industry.

According to the Harvard Business Review, 70% to 90% of mergers fail to deliver long-term shareholder value. Companies often overpay for assets and fail to realize cost synergies due to integration challenges. Simply put, combining giant companies is very hard to do well.

But it's important for pharma investors to realize that the unique nature of this industry makes frequent M&A essential to a company's long-term growth. For one thing, drug patents are granted at the start of the drug development process. While drug patents lsat 20 years, the development process itself can take as long as 10 to 15 years. 

Therefore, even if a drug is approved and becomes a blockbuster, drug makers only have a short window of time to cash in before generic or biosimilar competition will hit the market.

The average cost to develop and market a new drug is likely somewhere between $600 million and $2.7 billion, depending on the source. Not surprisingly, Joint ventures are frequent in this industry to spread the cost and risk of drug development.

Simply put, it's almost impossible for a big pharma company to be able to navigate the hamster wheel of drug patent expirations and achieve long-term growth through organic drug development efforts alone.

Acquiring another company and its drug portfolio and development pipeline is simply part of this industry's nature to reduce risk (save years of time and potentially billions of dollars of R&D spending which has an uncertain ROI).

That's why both Bristol-Myers and Celgene, like all big drug makers, have been frequently buying rivals to enhance their own new drug development pipelines. In the last five years alone Bristol-Myers has bought six major drug makers, not counting Celgene.

Wikipedia has an interesting diagram here showing the acquisitions both companies have made. Here's a look at Bristol-Myers' M&A history:

With pharma acquisitions, there's always risk that a promising drug will fail at any point in the approval process. For example, AbbVie (ABBV) recently took a $4 billion impairment charge on the $10 billion Stemcentrx acquisition it made in 2016; the firm's promising Rova-T cancer drug failed in an important late-stage clinical trial (thus reducing the drug's eventual peak annual sales forecasts).

Only time will tell whether management's decision to bet big on Celgene is a good  one, but let's review what this mega deal means for Bristol-Myers' dividend safety and growth.

Bristol-Myers has paid uninterrupted dividends for more than 25 consecutive years, and this deal should not threaten management's impressive track record. But while the dividend continues to look safe, the firm's spike in leverage means dividend growth will likely remain weak (BMY's five-year annual dividend growth rate is just 3%).

As you can see below, this merger is going to require Bristol-Myers to issue $32 billion in new debt, plus assume $20 billion of debt already on Celgene's balance sheet. Therefore, Bristol-Myers' total debt level will rise from $7.3 billion today to approximately $59.3 billion.

Thus upon closing of this deal Bristol-Myers' net leverage (net debt/EBITDA) ratio will soar from 0.2 today (one of the lowest in the industry) to around 4.0. That's far above the industry average leverage ratio near 2.0 as well as the 3.0 level we prefer to see most companies remain below. Its also the highest leverage Bristol-Myers will have had in more than a decade.

Fortunately, the higher debt load does not appear likely to threaten the dividend. While the jump in expected leverage reduced Bristol-Myers' Dividend Safety Score from 99 to 79 (still a solidly safe rating), the firm's payout ratio and free cash flow prospects continue to look healthy, providing a nice margin of safety. 

Specifically, management expects to generate $45 billion of free cash flow in the first three years following the merger's close. Bristol-Myers' share count will increase to help fund the acquisition (Celgene investors to each receive one share of BMY, increasing the share count from 1.6 billion to 2.4 billion), resulting in around $3.9 billion of annual dividend payments based on the dividend's current rate ($1.64 per share).

In other words, assuming the dividend is frozen or grows very slowly (1% per year), Bristol-Myers' cumulative free cash flow payout ratio over the next three years would actually sit below 30% ($11.8 billion of dividends divided by $45 billion of free cash flow = 26%), presumably leaving over $10 billion per year in retained cash flow that can be used for deleveraging and share buy backs.

At that pace, management could pay off 42% of the firm's merger-related debt within two years, and all of it within five. With that degree of financial flexibility, it seems very unlikely that management would consider cutting the dividend to free up cash for faster deleveraging or higher drug development investments.

However, the firm's credit rating (A+ at S&P and A equivalent at Moody's) might suffer. Moody's has already said it might cut its rating one notch (to BBB+ equivalent) due to the large amount of debt Bristol-Myers is taking on. S&P has indicated that it is also placing Bristol-Myers' A+ rating under review for a downgrade (also one notch). And given the immense size of the bridge loan needed to close the deal, the company's interest costs will rise significantly.

Fortunately, Bristol-Myers Chief Financial Officer Charles Bancroft (a 35-year company veteran) told analysts during the conference call the company will “still have a very strong balance sheet” and promised to deleverage “pretty quickly.” In fact, S&P and Moody's say they expect the drug maker's leverage to fall dramatically within two years of the deal closing.

Mr. Bancroft also reaffirmed "our continued commitment to our dividend as evidenced by our announcement a month ago on our 10th consecutive annual increase, which will benefit shareholders from both companies."

While Bristol-Myers' dividend continues to look safe, and possibly will keep growing each year (to maintain the company's growth streak), investors need to remember that the firm's historical dividend raises have been rather stingy at just one cent per quarter per year. 

That translates to a growth rate of about 2.5% per year and is likely to continue for the foreseeable future until the company's deleveraging is complete. 

Even afterward investors should probably expect Bristol-Myers to deliver relatively slow (2-4%) dividend growth now that the firm is so heavily focused on specialty drugs, which provide high-margin revenue but are often more volatile due to patent expirations.

All large M&A deals come with meaningful risks, especially in the pharma industry. But at the same time, well-executed acquisitions are an essential way that many drug makers grow. Thus it's important for investors in this space to trust that their company's management is well versed in structuring large and complex deals in a way that will generate profitable long-term growth.

Bristol-Myers has a long and impressive track record of making wise capital allocation decisions (including acquisitions) over its 161-year history. What's more, the strategic rationale behind buying Celgene appears to be solid.

While the firm's substantial increase in debt will require aggressive deleveraging in the coming years, Celgene's $15 billion per year in estimated future free cash flow should provide it with ample resources to comfortably pay down its merger debt while continuing to provide a safe and slow-growing dividend.

Ultimately, management deserves the benefit of the doubt with their acquisition of Celgene. Investors who are comfortable with Bristol-Myers' risk profile (which includes most of the same risks all big drug makers face) should not let the stock's recent selloff shake their confidence.