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Watson Deal for Schein Far From Elementary

By Brian Graney (TMF Panic)
May 25, 2000

Branded and generic drug maker Watson Pharmaceuticals (NYSE: WPI) went into merger mode today and agreed to acquire troubled industry peer Schein Pharmaceutical (NYSE: SHP). While the terms of the agreement are rather convoluted and the final price tag will hinge on Watson's stock price prior to the closing of the deal, the minimum value of the deal is around $643 million, or $19.50 per share. Based on that low-end valuation, Schein is fetching a 16% premium to its closing price of $16 13/16 yesterday. Investors are apparently not expecting that low valuation to stick, however, as Schein was bid up beyond $20 per share in early trading.

The deal brings to a close an ugly couple of years of business history for Schein, which has had both of its sterile dosage manufacturing facilities shut down in the past two years for not operating within the FDA's current good manufacturing practices (cGMP) regulations. As a result of the manufacturing disruptions, total revenues from generic products went down the tubes by 20% in fiscal 1999. The problems also prompted Schein to cut its workforce by 16% and put the company up for sale earlier this year. This is the family history that Watson is marrying into. With Germany's Bayer Corp. and certain members of the Schein family owning about 74% of the firm's shares, don't expect any weird shareholder issues to get in the way of today's bailout.

Given Schein's rap sheet with the FDA and its lingering manufacturing issues, it's not immediately clear what Watson will do with the company's problem facilities once the deal is completed. Certainly, there are some synergies to be obtained from bringing Schein's generic business into the fold and bringing its manufacturing processes in line with those already in place at Watson's own $300 million-a-year generic unit. However, judging from the wording of the press release announcing the deal, Watson's real interest appears to lie in Schein's small but fast-growing branded drug business.

Branded product sales accounted for 50% of Watson's total revenues last year, with the main focus on products for the dermatology and women's health areas. Over the past three years, branded product revenues have jumped from $150 million to nearly $350 million thanks in large part to acquisitions. Over at Schein, sales of the company's branded iron management products jumped 38% in the most recent fiscal year to total $137 million. That growth has caught Watson's eye. "Schein's strength in the nephrology [related to the kidneys] marketplace is an excellent example of capitalizing on a niche, specialty branded pharmaceutical program," Watson's Chairman and CEO Dr. Allen Chao commented. "This specialty focus is a core element to our current brand product strategy."

Concentrating on faster-growing, higher-margin branded drugs seems like a rational strategy for Watson. Further, sticking to niches should allow the company to survive in the drug-making ecosystem without interfering too much with the larger, "big pharma" predators lurking out there. Schein's INFeD and Ferrlecit injectable iron supplements seem fairly defensible as they are used in conjunction with Amgen's (Nasdaq: AMGN) blockbuster Epogen red blood cell-boosting drug, which is used to combat anemia in kidney dialysis patients. In the drug world, a company could do a whole lot worse than offer what amounts to an effective tag-along product to a well-established blockbuster drug.

Iron management revenues could also get a boost once Schein's second-generation Ferrlecit product gains a national Medicare reimbursement code from the Health Care Finance Administration. Earlier this month, the HCFA issued a decision memorandum supporting national coverage of Ferrlecit, although analysts believe the official reimbursement code may not be received until early next year. By that time, investors should have an early indication as to whether Watson's decision to take on all of Schein's operations -- and not just its branded drug business -- was Sherlock Holmes-smart or not.

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