M&A news usually has a short shelf life. However, the complex deal structure, the industrial rationale and the wisdom behind the merger of DSM Pharmaceutical Products and Patheon, announced on November 19, 2013, deserve a closer look.

JLL, a private equity fund, acquired a 27% stake in Patheon in 2007 through convertible preferred shares for $150 million. The company’s Enterprise Value was just shy of $700 million with sales of $635 million and an EBITDA of $75 million. Five years later, the company closed its fiscal year 2012 (ending in October 2012) with $750 million in sales, a mere 3% CAGR over the 2007-2012 period and its EBITDA held stubbornly low at $71 million (-1% CAGR over the same period). Since then, Patheon acquired Banner, a gelatin-based dosage formulator for $255 million, and the merger with DSM catapulted its valuation to nearly $2 billion.

The merger was the brainchild of Patheon’s CEO Jim Mullen and JLL Partner Michel Lagarde on one side and the former President of DSM Pharmaceutical Products (DPP) Alexander Wessels and DSM’s M&A head Michael Wahl on the other. What made the deal rather unique is that DSM sought synergies across DPP’s formulation business, which represents only one-third of DPP’s sales. In a more classical approach, they could have sought a merger leveraging its main API business with a European or Indian API partner, but they realized that the value is sometimes hidden in less obvious places.

To put things into perspective, DPP has one of the most respected U.S.-based franchises in parenteral fill-finish, a weakness in Patheon’s current technology portfolio, yet a crucial business area holding a strong growth potential. This is all the more important since FDA warning letters have ravaged the parenteral business ecosystem over the past six years. It even led to the shutdown of the leading U.S. parenteral CMO (Ben Venue Labs) as well as harmed other leading industry players. In this context, DPP’s parenteral business was the key enabler for the transaction. In addition, DPP’s cytotoxic technology platform is particularly valuable to Patheon, which lacks such capabilities.

Complementing Patheon’s $1 billion service offering by leveraging DPP’s smaller—albeit intrinsically value-adding—$200 million-plus parenteral fill-finish and cytotoxics business unlocked remarkable value for both parties. It ultimately allowed DSM to create future options, including exiting the pharma business at a respectable valuation, something it had been rumored to seek for years. M&A deal-making at its best! In comparison, DSM’s other pharma joint venture, established with Sinochem in 2011 and covering the antibiotics business, has yet to deliver its promise.

Looking now at the facts of the deal: it is true JLL is paying itself lavishly at a 64% premium of Patheon shares and flipping its ownership from its current fund to a new one, actions all financed through bank debt. The Financial Times’ LEX column¹ did not omit to acknowledge this. By some accounts, JLL’s current fund will triple its money², a hefty profit for a business that stagnated for the six years before Mr. Mullen’s arrival. Yet, DSM was also able to extract a valuation of $670 million for its business while some financial analysts, such as Deutsche Bank in 2012, valued its business at less than half. DSM still has to write off $160 million in an impairment charge, mostly goodwill from the Catalytica acquisition 13 years ago. All things considered, this is a good deal for DSM shareholders and an even better deal for JLL’s.

The industrial logic of the newly combined business makes sense. On the one hand, having the financial investor holding majority ownership (JLL owns 51% of the new entity) while the industrial investor takes a back seat (DSM owns 49%) may be questioned. But on the other, DSM/Patheon is effectively the second largest contract formulator in the industry behind Catalent, and leads in many market sub-segments. The current Patheon team has a track record in running such a large-scale business and unlocking its value. The clear leadership structure will ensure a “lean-and-mean” management approach.

With pro-forma sales of $1.7 billion and a good technology coverage with pooled strengths in both oral and parenteral services, the combined DSM/Patheon entity will still need to fill a major gap in its manufacturing footprint in BRIC countries; most likely achieved through a follow-on acquisition or cooperation. DPP’s Fine Chemicals unit, primarily manufacturing APIs and intermediates (with sales ranging around $500 million), may be spun-off to an API-focused contract manufacturer and the proceeds could be used either to reduce the high level of debt carried by the entity or to finance an acquisition in the BRICs.

The CMO business has become one of scale. DSM/Patheon, breaching the $1 billion glass ceiling reached only by four other organizations (Lonza, Catalent, DSM/Patheon, and Aenova) is, in itself, a potential driver of future growth. We believe larger CMO players will ultimately outperform their smaller peers. In addition, the DPP carve-out from the larger DSM conglomerate will, in all likelihood, result in an improved cost structure and a higher cash flow. Short of a drastic event (like a warning letter), DSM/Patheon may reasonably be expected to deleverage its debt and its inflated valuation.

In summary, the DSM/Patheon deal is a masterful demonstration of financial wizardry relying on the industrial logic of achieving economies of scale. Solid and rigorous post-merger integration and execution will determine whether another round of value gets created for its shareholders.

References

1. The Financial Times. November 19, 2013. DSM / Patheon: scale story http://www.ft.com/intl/cms/s/3/5176748c-511a-11e3-9651-00144feabdc0.html?siteedition=intl#axzz2qHaPMXTV
2. The New York Times. November 19, 2013. An Odd Spinoff by Royal DSM: http://dealbook.nytimes.com/2013/11/19/an-odd-spinoff-by-royal-dsm/