Why Biocon is valued less than its own biosimilars subsidiary

Valuation guru Aswath Damodaran once famously said there is one trigger that he looks for to sell stocks he owns. “You do a big acquisition, I’m out of your stock. I don’t care what justification you give me. Because I know my history. If you do a big acquisition, the odds are loaded up against you.”

The professor probably carries that as an investment talisman based on empirical evidence of mergers and acquisitions (M&As) historically, most of which fail or end up with an implosion for the acquirer. Even for multi-cornered deals many face the ‘winners curse’.

Indeed, that is true in the developed markets even though we have several such cases in India as well. Remember Tata Steel-Corus, which gave the Indian company bragging rights and vanity pedestal of striking India’s biggest overseas acquisition?

To be fair, it’s not correct to look at all M&A activity as value destroyer. There are many examples where companies have tactfully used inorganic expansion to scale up and indeed drive the oft repeated ‘synergy’ in business.

But the reality is that shareholders do fear big deals that need to be financed via debt. In fact, public shareholders do get spooked by most big deals, at least the equity owners of the acquirer.

There have been several deals in the past where such fears have led the management team of the would-be acquirer to balk and let an opportunity slip out of the hand. Whether it is lack of adequate investor relations to assuage concerns or a missing compelling element to go after an asset, public shareholders can drum down a stock enough to shake up a board decision.

One such case study material was Apollo Tyres’ $2.5 billion deal to buy Cooper Tires that came unstuck. Not in the same league but last year Aurobindo Pharma scrapped a deal to buy Cronus Pharma after its shares crashed.

Kiran Mazumdar Shaw, chairperson of Biocon, would be hoping her biotechnology does not meet the same fate for the deal announced earlier this week.

Biocon-Viatris deal

On Monday, biotech major Biocon said its subsidiary Biocon Biologics Ltd agreed to buy the biosimilars assets of US-based Viatris for $3.335 billion (Rs 25,000 crore) in a deal that it will partly finance with help from its existing investors at a valuation sharply higher than before.

The privately held unit of Biocon Ltd is making the cash-and-stock acquisition to ramp up its global biosimilars portfolio, the Mumbai-listed biopharmaceutical company said in a statement.

Viatris was formed through the combination of Mylan Inc. and Upjohn (previously a division under Pfizer). The company is headquartered in Pennsylvania, the US.

Biocon Biologics will pay $2.335 billion in cash and issue $1 billion worth of compulsorily convertible preference shares (CCPS) to Mylan. Viatris will also pay $50 million to fund certain capital expenditures.

Mylan will acquire a stake of at least 12.9% in Biocon Biologics after the conversion of the CCPS, Biocon said.

Biocon Biologics will arrange the cash portion by raising $800 million in equity capital from its existing private equity and sovereign fund shareholders and the remaining through debt or equity or a combination. Of the cash payment, debt comprises around $1.8 billion.

Viatris is expecting $875 million in estimated revenue and $200 million in operating profit for 2022. This means Biocon Biologics is acquiring the company at an implied valuation of 3.8 times its estimated revenue. Its revenue is expected to reach $1.1 billion next year with EBITDA of $250 million.

“The deal will enable BBL to attain a robust commercial engine in the developed markets of the US and Europe and will fast-track our journey of building a strong global brand. It will also make us future-ready for the next wave of products,” said Biocon’s Mazumdar-Shaw.

The deal, which is awaiting certain regulatory approvals, is expected to close in the second half of calendar 2022.

Stock market reaction

Shareholders didn’t take kindly to the news. Biocon stock was battered 12% on the day of the announcement and has slid further over the last two trading sessions.

At the current price, Biocon is valued at Rs 39,937 crore ($5.25 billion). Interestingly, the Mylan deal values Biocon Biologics at $7.75 billion, much more than its parent. Biocon would own around two-thirds of the unit after the stake dilution to Mylan and its stake would be worth around $5.16 billion.

Notably, Biocon also owns a 70% stake in Syngene International, which separately commands a market cap of Rs 21,312 crore ($2.8 billion).

To be sure, it is not unusual, companies get a holding company discount even though a sum-of-parts valuation would suggest the parent company should be worth a lot more.

Biocon said the acquisition will help it become a vertically integrated biosimilars leader and accelerate its direct commercialization strategy for existing and future biosimilars portfolio. The deal will push Biocon up the value chain to realize full revenues and profits from this business, the company said.

Currently in the emerging markets, it is present across the value chain but in the developed markets it has gaps in the regulatory, supply chain and commercialization aspects.

With this deal, Biocon will acquire Viatris’ rights for all biosimilars assets, including its in-licensed portfolio, an option to buy its rights in bAflibercept, its global commercial infrastructure and transition services for a two-year period.

But experts caution that even as the deal would be a strategic fit, it comes at a cost and has execution risks.

Uphill task

Mylan’s execution has been below expectations and a successful vertical integration with better results shown by Biocon would be critical. On the flip side, Biocon would face an uphill task in gaining market share in the fiercely competitive biosimilars market.

The competition has meant a secular decline in prices for biosimilars that has been sliding around 5% quarter on quarter. American biopharma firm Amgen, which was founded two years after Biocon, has been particularly aggressive and emerged as one of the lowest priced suppliers in the market.

One brokerage house, which has a ‘reduce’ rating on the Biocon stock, sees limited scope for a revenue surprise with no new major pipeline assets, except the ones already factored-in in the near-term launches – bevacizumab, bAspart and adalimumab. In turn, this restricts the earnings upgrade potential.

While Biocon has a strong financial risk profile with low gearing and healthy debt protection metrics, it faces uncertainty from payoffs in the research and development (R&D)-driven model for development and commercialisation of biosimilars and novel molecules besides susceptibility to regulatory dictats.

It has diversified revenue across generics, biosimilars and research services though biosimilars comprises nearly half of the total. This was also due to a decline in the generics business in the first nine months of fiscal 2022, because of operational and supply challenges posed by the pandemic, continued pricing pressure in the US for the formulations portfolio as well as a slower than expected ramp up of demand for APIs.

But Biocon’s long-term growth potential is expected to be anchored on its biosimilar and novel biologics segments, in both semi-regulated and regulated markets. These units require large investment for R&D and capex.

Risks and uncertainties

To be sure, Biocon remains exposed to long gestation periods and uncertainty regarding timing and extent of returns on investments on new molecules given the nature of the drug discovery model. Gross R&D and net R&D (net of capitalisation) were 12% and 10%, respectively, of operating revenue excluding Syngene, for the first nine months of fiscal 2022, a tad lower than the previous year.

Moreover, the R&D expenditure will increase over the medium term, driven by expenses on clinical trials and R&D to build a robust product pipeline.

“The uncertainty regarding revenue visibility and return on the R&D expense exposes the company to investment risk. However, it has achieved critical milestones in previous fiscals with approvals for biosimilars and launch in regulated and semi-regulated markets in partnership with Viatris, leading to strong revenue growth,” according to rating agency CRISIL.

“The extent of ramp up, particularly in the regulated markets, will be a key monitorable,” CRISIL said.

For now, the divergence in private and public market valuations would ensure the lower market cap of Biocon compared to the sum of parts of its stake in Biocon Biologics and Syngene would continue.