Following an unlikely model, consumer healthcare M&A creates investment opportunities

A case of déjà-vu

02 May 2018

There are not many obvious parallels between tobacco and healthcare, but when it comes to investment opportunities, there is one trend where healthcare – particularly consumer healthcare – appears to follow tobacco’s lead: a multi-year industry consolidation.

 A wave of multi-billion-euro mergers and acquisitions is washing through the industry, not unlike the raft of merger and acquisition (M&A) deals in the tobacco sector two to three decades ago, as companies seek to protect or boost margins, look for scale benefits or refocus on their core business. It is a trend that could well prove profitable to investors, argues Andrew King, chief investment officer European equities.

The consumer healthcare business, also known as the over-the-counter (OTC) business, is undergoing a transformation similar to the experience of the tobacco sector 20-30 years ago and developments seen in the beer industry some 15 years ago.

consumer-healthcare-productsThe M&A activity is driven by a range of factors. The market leader, US-based Johnson & Johnson, is seeking to protect its top position, while the Europe-based runners-up – Bayer (from Berlin), GlaxoSmithKline (GSK) and Reckitt Benckiser (both UK-based) – have stated goals of becoming the number one and have been active on the buy side[1].

 

Sellers improve focus, buyers add market share; margin gains on both sides

For the sellers – often pharmaceutical companies such as Pfizer and Novartis – it is a case of concentrating on their core business of primary drugs. For Novartis, for example, the recent sale of its USD 13 billion stake in its OTC joint venture to partner GSK means it can now concentrate on the development and growth of its core businesses, including vaccines and oncology drugs.

Pharmaceutical companies are also facing a slowdown in consumer health product sales, rivalry from white-label producers and margin pressure from smaller, lower-cost producers. With the OTC business typically lagging the primary drugs business in size, divestment has become an appealing choice.

 An added attraction is the ability to offload assets in a seller’s market where consolidation and market share grab are driving up valuations to historically high levels of 19-20 times EV/EBITDA (enterprise value/operating earnings before interest, taxes, depreciation and amortisation).

 While from a buyer’s perspective such pricing may look like a deterrent, the OTC businesses for sale often lend themselves to successful incorporation. This helps to make it relatively easy to realise synergies from merged distribution, e.g. in supermarkets or on the high street, integrated marketing and joint innovation/product development.

 

Size matters: greater pricing power

An improved marketing and sales position vis-à-vis retailers, for example, can give (new) owners who are already in the OTC business leverage in markets that are often still highly fragmented. A mix of greater pricing power and cost savings from synergies supports margins and adds to the attractions of M&A.

 Retailers themselves have been buyers. Selling consumer healthcare products typically does not involve the skills required for dispensing primary drugs, which makes adding these healthcare products to retail or supermarket ranges relatively straightforward. Increasingly, OTC drugs have slipped into the domain of fast-moving consumer goods (FMCG) – with its highly developed marketing techniques – and out of the science-dominated field of drug research and development.

 More relaxed regulation, a greater focus on preventative healthcare (and with it, self-medication) in the face of the austerity pressures on government budgets and growing demand from an ageing population have also encouraged the adoption of OTC businesses in the FMCG segment. In addition, sales growth rates in the OTC domain are outpacing the more sluggish rates in FMCG, while the business tends to be more profitable as well.

 Top 10 Global OTC Consumer Health industry structure

top-10-global-otc-consumer-health-industry-structure

HHI: Herfindahl Hirschmann index; Source: BNP Paribas Asset Management, September 2016

 

Consolidation begets consolidation

The consolidation trend in consumer healthcare is ongoing. After the Merck KGaA sale and GSK buying Novartis out of its OTC venture – two sizeable recent deals (see box) – further divestments are on the cards. Pfizer’s consumer unit is still on the block with leading players reportedly eyeing what is estimated to be a deal worth up to USD 20 billion.

deal-making-examplesSource: BNP Paribas Asset Management, Novartis; April 2018

At the same time, there appears to be room for plenty of smaller deals as well. Further top-level industry concentration could come in the shape of Reckitt, which in February 2017 bought consumer health group Mead Johnson in a USD 17.8 billion deal, spinning off its slower-growth home and hygiene division to focus completely on consumer health and revive group sales growth.

 It appears clear that the consolidation trend has further to run. From an investor perspective, such trends and the resulting pricing power can create appealing opportunities by investing in the beneficiaries of M&A, be they the buyers or the actual or perceived acquisition targets.

 

Consolidating industries offer up investment opportunities

For us, a pivotal tool in assessing whether an industry is in consolidation mode is the Herfindahl Hirschmann index (HHI). We use this when picking stocks for our ‘best selection’ portfolios[2] as we assess industry structure and market share trends, as we have done for industries ranging from consumer health, tobacco and beer to industrial gases, coatings and agrochemicals.

 In our view, the most interesting opportunities involve industries in transition, where the benefits of consolidation have to yet materialise fully, where increased pricing power has yet to play out and where the strategic appeal of target companies has not yet been reflected in the share price.

 We believe consolidation improves pricing power, margins and therefore profitability. Market leaders can typically protect their margins and tend to have resilient earnings that are less susceptible to cyclical and other shocks. This should lower the investment risk.

 Such features make investing in stocks in consolidating industries an attractive proposition. We have seen this in the tobacco and beer industries and expect to see it again in the consumer healthcare business.


[1] The companies referred to in this article are mentioned for illustrative purposes only; BNP Paribas Asset Management funds may or may not hold positions in these companies. Their inclusion in this article is not intended as a solicitation of the purchase of securities and does not constitute any investment advice or recommendation.

[2] For more on BNP Paribas Asset Management’s global and European best-selection, use the fund finder on www.bnpparibas-am.lu or your country website.