Good Medicine

Arrow Pharmaceuticals (AWP: $2.46) and Sigma Company (SIG: $11.29) this week announced plans for what can arguably labelled the perfect merger. Arrow is a specialty generic pharmaceutical developer and marketer and Sigma is a wholesale pharmaceutical distributor, manufacturer and marketer of over-the-counter (OTC) pharmaceutical products. The combined entity gives Sigma greater exposure to the high growth business of generic pharmaceuticals. For Arrow, it’s an opportunity to crystallize some of the value that has been rapidly created by this dynamic pharmaceutical group and allows it to cement its position as one of the leading generic players in Australia through the combined entity.

The Duchen family (Arrow Chairman David Duchen and Arrow Managing Director Paul Duchen) have now, for the second time built a generic pharmaceuticals business from scratch and sold it off to a larger player. David Duchen formed the first generics business in Australia, Alphapharm, in 1982 and sold this business to E Merck, completed in 1999, for an undisclosed sum. In January 2000, Arrow Pharmaceuticals was formed, with about 30 staff from Alphapharm, including Paul and David Duchen and the head chemist, Stewart Cheng. In five and a half years, the group built a company generating sales of $337 million a year and returning a profit of $26 million a year. The business now has a market capitalisation of $780 million.

The merger is not an exit for the Arrow founders, with the key managers locked into a four year service agreement with Sigma. Sigma also receives a seven year licensing agreement from the London-based Arrow Group developing the generics pipeline. The Arrow Group owns 38% of Arrow Pharmaceuticals and employs 59 scientists and technicians that develop the new generic products. David Duchen will become a non-executive board member of Sigma and Arrow will have an additional seat on the board.

LIMITED COST SAVINGS FROM SYNERGIES

There are not many cost saving synergies to come from the merger. Paul Duchen will become General Manager of Generics, and distribution of the generics will continue through Arrows distribution centres. Sigma benefits from the existing Arrow sales teams, currently generating $337 million of sales from Arrow Generics (11), Sigma generics (14), and 31 branded and private pharmaceutical products sold on behalf of local and international pharmaceutical companies. This sales team will also be able to extend the penetration of Sigma’s OTC products, which currently generate $125 million a year in sales.

Sigma manufactures Arrow’s generics and will continue to do so, however by combining the two groups, it will allow the new entity – to be renamed Sigma Pharmaceuticals – to reduce its cost base and become more competitive with Alphapharm and any potential new overseas entrants into the generics space.

ECONOMY OF SCALE

The merger gives the combined entity improved economy of scale, with a combined market capitalisation of $2.4 billion and creates one of Australia’s top 100 companies. It also strengthens Sigma’s management team, making it better placed to seek other OTC acquisitions in Australia. The combined entity will have pharmaceutical sales in excess of $600 million, giving Sigma less dependence on the very low margin wholesale distribution business.

The merger terms appear to have been well negotiated, giving Sigma better access to the high growth generics industry through Arrow at a slight market discount for Arrow stock. Sigma shareholders will own two thirds of Sigma Pharmaceuticals and Arrow shareholders will own one third in a scrip-for-scrip transaction.

DOMINANT AUSTRALIAN PHARMACEUTICAL GROUP

Bioshares in the past has labelled Arrow as one of the most impressive businesses in this sector. Sigma has now perhaps similar views on an excellent acquisition that Sigma shareholders should be very pleased with. Both companies have created exceptionally strong shareholder value in recent years. Total shareholder returns for Sigma have been 47% a year since August 2000, and for Arrow, the shareholder return since listing in October 2002 has been a stunning 58% a year. The combined entity creates a formidable company that will be very competitive and will be in a position to dominate the Australian generic and OTC pharmaceutical industry.

Bioshares recommendation: We advise investors to accept the current offer from Sigma. Bioshares ceases its formal coverage of AWP and will not formally cover Sigma Pharmaceuticals.

Reproduced by permission from Bioshares 113 (August 26, 2005)

Bioshares is Australia's only independent weekly biotech and pharma stock report, now into its sixth year of publication (www.bioshares.com.au). If your would like to read some back issues please contact David Blake via email atblake@bioshares.com.au.