Pfizer Inc.; market cap as of 27/11/2015: $202.7bn
Allergan plc; market cap as of 27/11/2015: $126bn

 

Introduction

On November 23, 2015, Pfizer Inc. (NYSE: PFE) and Allergan plc (NYSE: AGN) announced that their boards of directors have unanimously approved a definitive merger agreement under which Pfizer will combine with Allergan in a stock transaction currently valued at $363.63 per Allergan share, for a total enterprise value of approximately $160bn, based on the closing price of Pfizer common stock of $32.18 on November 20, 2015. Allergan shareholders will receive 11.3 shares of the combined company for each of their Allergan shares, and Pfizer stockholders will receive one share of the combined company for each of their Pfizer shares. The combination is the biggest-ever pharma merger and it will give birth to a pharmaceutical giant with a global footprint, based in Ireland and with a corporate tax rate between 17% and 18%.

The deal did not come as a surprise as we are witnessing a record year for healthcare mergers and acquisitions, taking their cumulative value in 2015 to more than $600bn. However, this would be the first full-scale combination between two top-20 pharma groups since Pfizer bought Wyeth and Merck acquired Schering-Plough in 2009. Pfizer has been hungry for another transformational deal and this one just might feed it.

Pfizer Inc.

Pfizer Inc. is a global biopharmaceutical company, currently headquartered in New York. The Company’s portfolio includes medications and vaccines, as well as consumer healthcare products. Pfizer’s commercial operations mainly consist of two businesses:

  • Innovative Products, which include the Global Innovative Pharmaceutical segment (GIP) and the Global Vaccines, Oncology and Consumer Healthcare segment (VOC).
  • Established Products, consisting of the Global Established Pharmaceutical segment (GEP). Its research focuses on six areas, which include immunology and inflammation, cardiovascular and metabolic diseases, oncology, vaccines, neuroscience and pain, and rare diseases. In addition, it focuses on biosimilars.

Its key biopharmaceutical products include known brands like Lipitor and Viagra. Pfizer also counts popular over-the-counter consumer health products such as Emergen-C, Advil, Centrum and Imedin. The Consumer Healthcare business focuses on various geographic markets, such as the United States, China, Canada, Germany, Italy and Brazil.

In the last 15 years, Pfizer spent $257bn for acquisitions to boost its R&D and pipeline, starting with the $112bn takeover of Warner-Lambert in 2000. In this period, Pfizer also purchased Pharmacia for $60bn, and it was involved in the last combination between two top-20 pharma groups, in 2009, when it paid $68bn to buy Wyeth. In this last case, even though today Pfizer’s revenues are the same as they were before the deal, Pfizer hit the savings target for the deal and offset patent expiries losses. Considerations on the less than 10% increase in Pfizer’s market cap can however raise shareholders’ concerns. More recently, Pfizer acquired Hospira for $17bn in an all-cash transaction, which could confer the company a leading position in the sterile injectable business. Before confirming talks with Allergan, Pfizer unsuccessfully considered the takeover of GlaxoSmithKline, which would have been roughly on the same scale as the current deal because of GSK’s market cap at $105bn, and its status as largest drug maker in the UK. A year and half earlier Pfizer had attempted a $118bn hostile bid for the number 2 group in the country, AstraZeneca, which failed mainly because of political opposition in Britain and concerns for its hostile nature.

Allergan plc

Allergan plc is a diversified global pharmaceutical company headquartered in Dublin, Ireland. It is considered to be a leader in “growth pharma”, after its newfound focus on branded pharmaceuticals. In late 2014 Actavis announced the purchase Allergan for $66bn and in June 2015, three months after completion, it changed its name from Actavis plc to Allergan plc, and began its rebranding campaign.

Allergan’s brand portfolio is made up of products in the categories of dermatology and aesthetics (Botox being among the best known), CNS, eye care, women’s health and urology, GI and cystic fibrosis, cardiovascular and infectious disease

Over the last years, Allergan has been very active in the M&A landscape, completing its transformation in a specialist branded drugs. Actavis (now Allergan as previously explained) completed a $23.6bn acquisition of Forest Laboratories in 2014, as well as a $8.5bn takeover of Warner Chilcott in 2013. In October 2015, it bought Kythera Biopharmaceuticals for $2bn.

Most importantly, in July 2015, the company had announced the sale of its generics business to Teva for $40.5bn in cash and stock, which provided Allergan with cash to pay down debt and will allow the company to strategically focus more on brand-name drugs. Allergan’s Generics portfolio comprises more than 1,000 generics, branded generics, established brands and over-the-counter products.

 

Deal structure

As previously stated, Pfizer is paying $160bn, including debt. Namely, Allergan shareholders will receive 11.3 shares of the combined company for each of their Allergan shares, and Pfizer stockholders will receive one share of the combined company for each of their Pfizer shares.

Although the transaction is completed on a share by share basis, Pfizer’s stockholders can choose to receive cash instead of stocks of the combined company. This option is subject to the condition that the aggregate amount of cash paid for the transaction is between $6bn and$12bn. If the amount of cash requested by the shareholders is greater than $12bn, it will be distributed proportionally among them. Additionally, if all of the $12bn of cash is used, it is expected that Pfizer’s stockholders will hold a portion accounting for roughly 56% of newly formed entity which actually makes this inversion doable.

It is predicted that the transaction will not impact Pfizer’s EPS in 2017 and that it will have a modest accretive effect in 2018. In 2019 the accretion will account for a 10% increase in EPS, while in 2020 the impact is expected to be between 15% and 20%. However, these bullish estimations include the effect of the accelerated share repurchase program that will take place in Q1/Q2 of 2016, as Pfizer can still buy back shares for $5.4bn according to its repurchase authorization.

This merger would give Pfizer better access to billions of cash it holds overseas and allow for more share buybacks, dividend payments and business development. It is worth mentioning that the transaction is not expected to have an impact on Pfizer’s existing dividend level on a per share basis as the combined company intends to use its combined cash flow to continue the support of an attractive payout ratio of approximately 50%. Another thing to note is that the deal includes $8bn in debt.

The completion of the transaction is still subject to the approval of both the regulators of U.S. and of the E.U. and the approval of the shareholders of the companies.

Deal Rationale and Political Implications

The key driver of the deal is the benefit from tax savings that Pfizer could achieve by moving its domicile to Ireland, where Allergan is based. Indeed, the deal, which represents the biggest ever “tax inversion”, is structured in a way that allows the U.S. company and its counterpart to reincorporate overseas as a consequence of the merger in order to avoid American corporate taxes. By doing so, Pfizer would benefit from a reduced effective tax rate of 17% to 18% compared to around 25.5% in 2014. Indeed, beacuse the US tax system makes companies pay extra tax when they repatriate foreign profits, the inversion will help Pfizer to unlock offshore profits accounting for at least $128bn, causing the company to save potentially tens of billions of dollars of tax. Moreover, the deal is likely to generate a one-off earnings windfall of up to $21bn and help the company escape from potentially big US tax bills in the future. The shareholders of Allergan, on the other hand, were satisfied with the profit forecasts provided by Pfizer and Allergan and the scope for share buybacks, which could be huge given that the combined company will have access to an estimated $66bn of cash. Also, many investors expect the combined company to generate annual cash flow in excess of $25bn from the start of 2018.

The bid for Allergan is the second attempt for a tax inversion deal after the company abandoned an offer for Anglo-Swedish AstraZeneca for $118bn just 18 months ago because of a fierce pressure coming from British politicians.

Why then did Allergan become the most interesting solution available on the market for Pfizer? There are two the main features that caused the company to be so attractive. First of all, the fact that it is based in Ireland provides the opportunity, long sought by Mr Read, Pfizer’s chief executive, for the company to move its domicile out of the U.S. to a jurisdiction characterized by a lower tax rate. The way Ireland’s tax system works is that tax is due only on business conducted in the country. This means that Pfizer would not face any extra tax bills on its foreign profits in the future. Any extra tax paid at Ireland’s 12.5% rate would depend on whether the tie-up resulted in extra activity in Ireland, where Pfizer will have its principal executive office, while its global operational headquarters will be in New York..

The second reason is to be found in the rules that govern the so-called “inversions” which impose that the original shareholders of the non-U.S. company must own a stake of at least 40% in the combined entity. Under these conditions, Allergan represents one of the few overseas firms big enough to allow Pfizer to accomplish such an ambition.

Apart from tax reductions, the two companies declared that they expect to benefit from $2bn per year of increased efficiencies within the next three years. Furthermore, the combined company will benefit from a broader innovative portfolio of leading medicines in key categories and a platform for sustainable growth with diversified payer groups. A combined pipeline of more than 100 mid-to-late stage programs in development and greater resources to invest in R&D and manufacturing is expected to sustain the growth of the innovative business over the long term. Moreover, the CEO of Allergan said the combination would provide access to about 70 additional worldwide markets for Allergan products, such as Botox wrinkle treatment, Alzheimer’s drug Namenda and dry-eye medication Restasis.

The announcement of the deal and the implications it carries raised a political debate over the ethics of this decision.

However, there is still some uncertainty around the regulatory approval of the deal as the Obama administration is pushing for the implementation of anti-inversion measures aiming at fueling a negative reaction of the investors with respect to the transaction. In case the Obama administration firmly opposes the deal, it is realistic to expect that the deal will be structured as a reverse merger, with Allergan technically buying Pfizer as opposed to the original intentions according to people close to the group. Indeed, considering that the vast majority of profits generated by the company come from activity outside of the US, it is easy to understand the commitment that Pfizer will put into the realization of the inversion.

What’s next?

After completing the deal, presumably in the second half of 2016, the new merged company may decide to carve out a business and split into a value and a growth company: one will focus on highly profitable branded drugs while the other would sell older medicines that face fierce competition. As a consequence, after carving out and its older medicines’ divisions, the branded part of the company would be highly diversified, thus it will have to struggle against a large number of rivals on several fronts. It would produce top-selling drugs pertaining to different therapeutic fields, from Allergan’s wrinkle treatment Botox, to medicines that treat major illnesses such as cancer, Alzheimer’s and inflammatory conditions such as arthritis.

Expectations Vs. Reality

Ian Read claims this deal would benefit the American science; it would position the company better worldwide by making it more competitive and would, therefore, create more value for the shareholders. One might wonder about the market’s negative reaction, with Pfizer closing down 2.7% and Allergan falling by 3.6% to $301.7. The fact is, many got disappointed by the way this deal was finalized.

To begin with, the investors were expecting Pfizer to separate its branded drugs business sooner. With this immense acquisition, it would take years before it would be ready for such a move. The reason is that the companies will need time to integrate. Both of them are big and so are their cultures. You can put two people in the same bed but will they have the same dreams. And so, Pfizer announced that the separation would probably happen in 2018 and not sooner. The second point is that many analysts have been expecting larger synergies and so the $2bn announced synergies sound very humble. Also, the company will be making cuts in R&D budget by approximately $666,000 over the next three years to reach those synergies, which does not create real value. Moreover, the investors were hoping for extra buybacks, but they got disappointed fast as there was no added buyback on top of what Pfizer is already doing. Instead Pfizer said it would begin a relatively modest $5bn buyback in the first half of next year.

Is this Behemoth likely to spur more mega-mergers?

The Allergan deal fits into Pfizer’s plan to have a more focused business in the future. Namely, the company announced that it plans to separate its branded drugs from the generic, easy-to-copy ones. This deal would allow the company to improve and enrich its branded drugs portfolio before the planned separation. This could mean that the deal itself would not influence the mega-merger spree. On the other hand, Pfizer’s competitors such as Johnson & Johnson, Merck and Amgen, would be left at disadvantage with their high tax rates if the deal goes through. Indeed, there are some interesting candidates for more inversion deals such as GSK, which rebuffed a takeover approach from Pfizer in recent months, and an obvious one, AstraZeneca. Even so, it does not seem that those companies are willing to go for such deals as they believe that there will be a tax reform after next year’s presidential election. Namely, in September 2015, Jeb Bush, the current presidential candidate, has unveiled tax reform proposals to cut the number of income tax bands, eliminating loopholes and lowering the US corporate tax rate from 35% to 20%.

Even if they might not plan to make similar deals, pharmaceuticals are not ready to give up their merger streak yet. Last month, J&J said it was open to deals as it wants to deploy its $17bn of net cash, while Amgen is looking for an acquisition of up to $10bn. Moreover, there are other top biotech groups such as Gilead, Biogen and Celgene which are also likely to strike a deal in search of assets that would boost their growth.

Financial Advisors

Guggenheim Securities, Goldman Sachs Group Inc., Centerview and Moelis & Co. worked with Pfizer on the transaction. Allergan was advised by Morgan Stanley MS and J.P. Morgan Chase JPM & Co.

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