Hikma’s FY 2012 results, which were out yesterday, made no direct mention of the company’s announcement on March 1st that it might sell its injectables business, but nevertheless provided considerable food for thought about Hikma’s future strategic direction. Analyst interest focused mainly on the impact of US product shortages, both on the upside (Hikma is currently benefiting from a market shortage of doxycycline, which has led to massive price hikes) and on the downside (how long can supra-normal margins in injectables last once companies like Hospira start to get their production facilities back on line?). There was also some discussion about M&A, but no great interest in the company’s statement that it intends to focus more broadly on the emerging markets and not just on MENA, to which end it has set up dedicated teams to look for acquisition targets or partners in sub-Saharan Africa and the CIS. Hikma also said that it was considering a sale of its US generics business, West-ward, once it has escaped from the clutches of the FDA (the generics division recorded an operating loss of $21m in 2012, thanks to a combination of remediation costs and lost sales). In our view, Hikma’s US generic operation – which has a highly opportunistic business model – has always sat rather uneasily within the group, so its sale wouldn’t be any great strategic loss. Financially, the case is less certain given the current situation with doxycycline, which appears to have its roots in a major manufacturing issue in China, where the bulk of the intermediates for the product are made. Hikma is fortunate enough to have its own API supply, which is why it is still on the market, so this product should be extremely cash-generative in the absence of a quick fix at the Chinese end. In any case, it is likely to take the rest of the year for Hikma to get a clean bill of health from the FDA, so it should be able to reap the benefit from doxycycline before making a final decision over West-ward.
If West-ward does go, Hikma’s US operations would be focused entirely on injectables, the division for which it says it has received unsolicited approaches. Analyst estimates for the value of this business have ranged up to $2.2bn, presumably based on the exotic multiple achieved by Strides Arcolab in the recently-agreed sale of its own injectables division, Agila to Mylan (more than 21x EBITDA if the earn-out is paid in full). However, Mylan bought Agila principally for its pipeline (plus its manufacturing assets, of course), so it can hardly be concluded that the Hikma business is worth the same. Indeed, fully half of Hikma’s injectables operations consists of the unit that it bought from Baxter in October 2010, for which we calculate it paid 7.3x EBITDA. Since then, Hikma seems to have done a good job of cutting costs and creating a pipeline, but that scarcely seems to justify a valuation three times as high.
In 2012, Hikma reported sales of $470m and an operating profit of $115m for its injectables unit. It does not split out EBITDA but this was probably around $140m, meaning that a pretty generous valuation for the business, using an EV/EBITDA multiple of 13 (roughly what Sandoz paid for Ebewe), would be $1.8bn. Not surprisingly, Hikma’s share price rose on the news of a possible sale (or, rather, it rose ahead of the news, prompting the announcement). This was presumably due to the prospect of the company realising the full value of one of its divisions, but possibly also because investors welcomed the prospect of Hikma returning to its MENA roots. We have noted before that there is a certain conflict between the desires of Hikma’s management (a global company) and of its shareholders (an emerging market play), so a sale of Hikma’s injectables unit would satisfy the latter if not the former, as it would both turn Hikma back into a pure MENA company and also give it a pile of cash that it could use to make further acquisitions, for instance in Turkey.
From an investor perspective, then, selling off injectables seems like a good move, but is it really? To start with, it is not clear whether Hikma is really contemplating the sale off all of the division or only part of it. We understand that the company is currently hiring an investment bank to run the sale process, but the precise scope of the transaction (if any) remains a mystery. In 2012, 63.0% of the sales of the injectables business came from the US, 16.5% from Europe and 20.5% from MENA. Separating out the US and European injectable pieces from the rest of Hikma should be fairly straightforward, as should carving out manufacturing (mostly in the US and Portugal, with small parts in Italy and Germany), but MENA is a different matter. True, injectables are mainly a tender business while Hikma’s main strength is in the retail market, but that doesn’t mean that local country managers in the MENA region will be happy to see their injectables portfolio and pipeline disappear. Without the MENA piece, the assets on offer will be a smaller (particularly from an EBITDA perspective, since we assume that the MENA segment is more profitable than the rest) and have lower growth potential, implying a significantly reduced price tag. This is particularly true given the question mark over pricing sustainability in the US, mentioned previously, which any potential buyers are likely to take into account.
On top of these concerns, having a pile of cash to spend is only a good thing if there is something to spend it on, otherwise it will just act as a drag on growth. And the main factor acting as a brake on Hikma’s historical M&A ambitions in MENA has not been lack of money but a lack of companies available to buy at a sensible price. Turkey, in particular, is a difficult place to do deals due to the highly inflated valuation expectations of owners and the absence of any compelling reason to sell. Hikma’s management is determined not to over-pay – as it should be – but it can’t conjure deals out of thin air. The idea of expanding into the CIS and (particularly) sub-Saharan Africa is interesting, but there are few large acquisition targets there and in any case, Hikma has only ever done bolt-on deals, presumably because they are more manageable and easier to integrate. Adcock Ingram of South Africa (currently capitalised at just over $1bn) might be one interesting possibility for a suddenly cash-rich Hikma, but it would be a big challenge to turn around and would require Hikma’s management to make a rapid leap up the learning curve of doing business in SA. The trouble is, if Hikma now announces that it won’t be selling off its injectable operation after all, its share price will deflate, which not ideal for shareholders either. The best solution from here would be a partial disposal (US and Europe) at a reasonable price followed swiftly by one or more deals in the emerging market that can deliver better growth than the injectables business would have done. But if Hikma doesn’t think that this outcome is possible to deliver, it should hang on to what it already has – sometimes there are things that are better than money.