Deal opens door to a potentially lucrative market

INNOVATE or die: that is the choice facing pharmaceutical companies. In 2011 and 2012, over 35 blockbuster drugs will lose their patents, opening the way for cheaper generic rivals to steal market share and sales. As evidenced by the closure of Pfizer’s UK research site, most firms are retrenching under pressure from shareholders, who worry that high R&D spending isn’t translating into earnings.

There is still hope for niche drugs firms like Shire and Sanofi’s Genzyme, which focus on high-margin treatments for rare conditions. Shire’s purchase of Advance BioHealing (ABH) for $750m – just days before it was due to float – is an exciting deal that could be transformational for the firm.

ABH specialises in regenerative medicine, one of the most promising segments of the pharma market. On an enterprise value to sales metric, Shire is paying around four times sales, although it is the potential that matters most.

ABH’s Dermagraft, previously owned by Smith & Nephew, is the main draw. Currently used to treat diabetic leg ulcers, it generated $146m of sales in 2010 with gross margins of 80 per cent.

The market for diabetic leg ulcers, currently worth $3bn, is still relatively untapped, and the standard of care is awful. There are also signs that Shire could apply the technology to other conditions, such as venous leg ulcers, which too often lead to amputations.

With patent protection until 2021 and high barriers to entry for potential rivals, Shire’s aim of capturing a third of these markets is likely conservative. The deal will likely dilute earnings in the short term, but will be earnings enhancing by 2013 and beyond. Now is a good time to buy.