As Valeant Pharmaceuticals International Inc., gears up for a proxy fight with Cephalon Inc., Chairman and CEO J. Michael Pearson lashed into the target company, noting that it "has a deteriorating set of assets, earnings and cash flows due to the upcoming risk of patent cliffs and generic competition for their products."

"We believe that Cephalon management is spending their cash unwisely as evidenced by their two recent deals, Gemin X and ChemGenex, and their continued investment in high-risk development programs," he said on a call with analysts on March 30 in which he outlined Valeant's rationale for pursuing Cephalon.

Cephalon's maturing product portfolio, strong balance sheet, and diversification, both therapeutic geographic, would provide Valeant with financial and strategic benefits, Pearson said. Even Cephalon's business model is an advantage for Valeant, precisely because it is so different and therefore, in Valeant's perspective, ripe for changing.

Cephalon executives haven't been available to comment. In a statement issued late on March 29, the company said that its board plans to meet to discuss Valeant's proposal, and that it will respond during the week of April 4. But Wall Street's initial reaction was favorable, with Valeant's stock up 5.7% on March 30 to close at $50.08, while Cephalon's stock rose 16.7%, closing at $75.44, or above the offer price, implying optimism that a deal will be struck at a higher price. Some analysts speculated that the price could go as high as $75 to $80 per share.

Valeant stated late on March 29 that it has offered to buy Cephalon for $5.7 billion in cash, or $73 per share. Valeant had hoped to negotiate quietly, but went public after Cephalon's board did not respond to three solicitations and after the company announced a spate of new, "risky" deals (Also see "Valeant Makes Hostile $5.7B Bid for Cephalon" - Pink Sheet, 30 March, 2011.) and (Also see "Cephalon Boosts Cancer Pipeline With Acquisition Valued At Up to $525 Million" - Pink Sheet, 22 March, 2011.). In particular, Pearson singled out the deals Cephalon announced on March 28 and March 29 as the kind of transactions which could "negatively impact our offer," and could, if Cephalon continues to make them, motivate Valeant to withdraw.

As a result, Valeant assumed a hostile stance and seeks to replace Cephalon's board of directors with representatives more friendly to its offer. Under the tender process, Cephalon has a limited time to respond and Valeant has a limited time to get shareholder support. All in all, Pearson stated that he does not expect a drawn out process and should have an outcome - either favorable or not -within 30 to 45 days.

Key to the decision will be Cephalon shareholders' reactions, which are not yet clear. In particular, analysts are watching the perspectives of the three largest long-term shareholders: Wellington (12.10%), Fidelity (8.7%) and T. Rowe Price (7.3%). Pearson said that his group has been in touch with all three, two of which "know it well," but would not elaborate. Fidelity and T. Rowe Price also hold 12.98% and 3.74% stakes in Valeant, respectively.

Cephalon At A Crossroads

The offer comes during a vulnerable time for Cephalon and its new chief executive J. Kevin Buchi, who took over following the untimely death of its founder and long-time leader Frank Baldino Jr. in December 2010 of leukemia ("[A#14110021104]). The company, which derives almost half of its revenues from its Provigil/Nuvigil (modafinil/ amodafinil) sleep disorder franchise, has been trying - with limited success to date -- to diversify and replenish its maturing product line as its lead asset, Provigil, faces generic erosion in 2012.

Indeed, Pearson pointed out that "Cephalon is facing a very tough 2012, quite frankly...and a huge portion of their sales will disappear. So whether they want to admit it or not, they face a big restructuring and we are actually pretty good at restructuring."

Despite the jolts, Cephalon has not publicly indicated any interest in selling itself. But since Baldino died, analysts said, takeover speculation has quietly circled the company. "When you lose a founder, especially a CEO who is as affiliated with a company as Frank was, it is a blow," said Eric Schmidt, an analyst with Cowen & Co. "Frank inspired confidence - he had started a successful company before - and now, this is a different company."

Valeant's CEO, on the other hand, has been at the helm for three years and has earned the board's confidence, judging by its recent decision to name Pearson chairman. Under his reign, Valeant's stock has seen compounded annual growth of 100%. Cephalon's stock, on the other hand, has zigzagged in recent years and was trading at a 12-month low prior to the announcement.

Pearson has built a reputation as somewhat of a rogue in the pharma industry. Yet, his strategy has been consistent; in talks with Wall Street analysts, he has cautioned against "falling in love with assets," and "betting on science." Instead, he has advocated for a low-cost operating structure, geographic and product diversification, and low-risk, low-cost product development programs that "avoid the big guys in the areas where they are strong." Valeant bets on "management," he has repeatedly told Wall Street.

To buy Cephalon, Pearson said Valeant would need to take on an additional $6.7 billion in debt, causing its debt level to spike from $4.5 billion to $11.2 billion and its leverage ratio to jump to just over 4.1 times equity after the transaction. That level is not uncommon in many industries, but it is high for pharma. Still, it did not seem to be a deterrent to analysts, and Goldman Sachs, which is advising Valeant, has given the transaction a letter of "high confidence" that the money can be raised. Moreover, Valeant believes that ratio could return to 3.6 within a year after the merger closes, because it plans to use cash flow from Cephalon's mature products to pay it off.

Valeant's Bet On Diversification, Management And Constant Change

Valeant's interest in the company lies in the deal's attractive financial structure, as well as Cephalon's diversity and presence in two therapeutic areas where Valeant has positions also - pain and central nervous system diseases. Pearson explicitly pointed to Cephalon's European branded generics business, which is relatively new and was built largely from its 2010 acquisition of Mepha, as an asset that would fit well with Valeant (Also see "Cephalon Buys Swiss Generics Firm Mepha, Talking Up Diversification" - Pink Sheet, 1 February, 2010.).

The price Valeant is offering - a premium of 29% over Cephalon's 30-day trading average - does not depend on success of Cephalon's business development transactions or pipeline, he said. Indeed, Valeant is likely to sell those assets and dissolve deals.

But a key attraction is Cephalon's mature, but highly profitable, products. Fentora (fentynal buccal tablet), a pain medication, and Provigil together generate more than $1 billion in cash, which will be used strictly to pay off a significant portion of debt, Pearson said. Both drugs face near-term patent cliffs, however, so their contribution to the transaction would be of limited duration.

Moreover, Pearson also indicated that, at the right price, he would be interested in selling the oncology franchise, which is dominated by the hematological oncology drug Treanda (bendamustine). "Oncology is a very competitive area where a lot of companies are very interested...we would certainly be open to selling or partnering it. But it is a great business and we would also be open to keeping it," he said.

The deal is driven, therefore, largely by favorable financials based on cash flow, tax advantages, and gains from synergies. Pearson would not discuss the tax implications, noting that Valeant has "made some assumptions," but needs to do more due diligence to finalize its plan. Valeant's low tax rate, which it gained when it bought the CNS-focused specialty pharma company Biovail for $3.3 billion in June 2010, however, is likely an important factor in making the economics work (Also see "Tax Benefits Highlight Announced Merger Of Valeant And Biovail" - Pink Sheet, 21 June, 2010.).

Cowen & Co. analyst Ian Sanderson has estimated that while Cephalon has a tax rate of roughly 33%, the Valeant tax rate is now in the mid single teens, roughly 12% to 15%.

Synergies could also help the deal's economics--Pearson said he expects Valeant to obtain synergies of $300 million or more by combining the companies, and many analysts believe that is a conservative estimate. Cephalon also has about $1 billion in cash on its balance sheet. Given these factors, and taking into account the cost of the debt financing, the deal could be valued at roughly 7 to 7.5 times Cephalon's cash flow, which is below the 10 times average multiple comparable companies have traded at, Sanderson said.

Under rules of consent solicitation, Cephalon now has a maximum of 10 days to respond to Valeant's offer to shareholders, once that is formalized, and up to another 10 days to provide Valeant with a record date. Shareholders of record on that date will have an opportunity to vote on the Valeant proposal. If shareholders don't favor the deal, Valeant "will move on and there's other opportunities," said Pearson. "And if there is support, we are ready to move quickly."

--By Wendy Diller (w.diller@elsevier.com)

Valeant CEO Outlines Takeover Rationale, As Cephalon Stays Mum

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