How Pfizer and Allergan's Merger Got Busted By Washington

The U.S. Treasury Department proposed changes to rules affecting tax inversions earlier this week that effectively blocked Pfizer's (PFE -0.12%) $160 billion megamerger with Allergan (AGN). The change to rules governing the percentage of ownership a U.S. company can own of a post inversion foreign company is the latest attempt by Washington to block corporations from leaving for greener pastures.

In this clip from The Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes and contributor Todd Campbell offer up a simple explanation of why Pfizer wanted to combine with Allergan and how Treasury Secretary Jacob Lew managed to keep it from happening.

A transcript follows the video.

This podcast was recorded on April 6, 2016. 

Kristine Harjes: Todd, I don't know about you, but I have been racking my brain all morning for breakup songs.

Todd Campbell: I think this is the biggest breakup since Bennifer.

Harjes: This might be the biggest healthcare news we've had all year so far.

Campbell: Pfizer likes to make the big news, don't they? They did it last fall by announcing the deal, now they're doing it this spring, by exiting it.

Harjes: For sure, and we have got all the details for you, coming up on this episode. First, a quick shout out to the brainstorming help that I got this morning on Twitter, which, by the way, you ought to know our handle, which is, @MFIndustryFocus. Let's get this thing rolling. Todd, what's the quick and dirty?

Campbell: First, did you have a favorite song, or are you going to keep us in suspense?

Harjes: Do I have a favorite? You're going to hear my favorite at the very end of this episode.

Campbell: Okay, that's fine.

Harjes: I will leave you in suspense for a little bit.

Campbell: Excellent, excellent. Wow. Yeah, big news. I guess not unexpected. I mean, it's the biggest breakup since AbbVie exited its planned tax inversion deal with Shire, back in '14. They had hoped, obviously, to combine the two companies. I love how you called it, "PfizerGan." That's great.

Harjes: Which is, of course, Pfizer and Allergan.

Campbell: Yep, yeah. PfizerGan would have been huge! There's $160 billion deal that would have created a company with $65 billion in sales, and would have moved, at least for tax purposes, Pfizer's headquarters overseas to Dublin, Ireland.

Harjes: Yeah, and that's really where the crux of this issue is. There's always been some speculation that the government, the US government, might block this deal over antitrust concerns or over the fact that, "Oh hey, maybe we don't want to lose all of our tax revenue from Pfizer." I would say that Allergan investors ... I don't know, there is some implication that the market might have been under-pricing Allergan a little bit, compared to where Pfizer had put them at with this deal, which would have--

Campbell: Yeah, the arbitrage there was huge, right, Kristine?

Harjes: Yeah. Yeah, exactly. That implied that there was a little bit of doubt that this was going through, but the executives of both companies were very confident in their words about how they absolutely expected this to go through. I don't think it was until overnight on Monday, when investors truly heard it through the grapevine that the new U.S. Treasury regulations were going to come out, and pretty much put the kibosh on this deal.

Campbell: Wait, wait, Kristine, did you just say that management was overly optimistic?

Harjes: I don't want to say "overly." I was as optimistic as them, so maybe I was overly optimistic, too. Really, given the guidelines that had existed, you would have thought that this deal was going through, but they completely rewrote the terms; changed the rules of the game.

Campbell: The goalposts got moved. Absolutely. Washington doesn't want to lose their tax revenue. I can't say that I blame them. Last fall, you saw the Treasury Department issue a bunch of new rules trying to thwart planned tax inversions. On Monday, they did it again. Only this time, they designed it specifically to kill this deal. Sure enough, they succeeded. They dealt a death-blow with a stroke of a pen.

Harjes: Yeah, and of course, they said that this wasn't specifically for this deal, but ...

Campbell: Right!

Harjes: The press release itself says that they're not focused on a specific transaction, but rather a loophole within the industry. This is a loophole that's been used quite a bit, where you get these foreign companies "buying-up" U.S. companies so that they can use the tax percentages of the foreign countries. That's actually kind of an interesting detail here, where Allergan, the smaller company, was technically buying Pfizer.

Campbell: I know, crazy, right? Here's Allergan with $15 billion in trailing 12 month sales. You've got Pfizer doing $50 billion, and Pfizer obviously being a lot larger in terms of market cap company than Allergan. The reason that they did that was because, at the time, they were trying to skirt the rules that the Treasury had put in place that would restrict their ability to move their tax domicile from the U.S. to Ireland. It's a really kind of a wonky set of rules, but we should probably get into that for our listeners.

Harjes: I'm going to have you lay that out. There's a lot of numbers in there.

Campbell: Yeah. Okay, well you know what? Let's try to make it really, really simple. In order for you to successfully invert to another country for tax purposes, the U.S. company shareholders can't own more than 80% of the combined entity, once the deal is done. If you own between 60% and 80%, you get hit with some tax penalties, so ideally, you want to structure the deal so that the U.S. owners of Pfizer shareholders wouldn't own more than 60% of the combined PfizerGan. The way that they did the deal was they structured it so that Pfizer shareholders would own 56% of the combined entity, thereby putting them below that 60% threshold and nicely below the 80%.

Harjes: Yeah, nice buffer zone, too; a whole 4%.

Campbell: Right, keeping it right in the skin of their teeth. Unfortunately, one of the thing that they didn't count on was Jacob Lew at the Treasury Department.

Harjes: Yeah, so really the game-changer here, was the fact that now with these new rules, essentially the last three years of Allergan's inversion-type actions, are being discounted. This is a company that has grown by acquisition. It used to be known as Actavis. When it was Actavis in October, 2013, they took over Warner Chilcott. That was an $8.5 billion transaction, which moved their tax home to Ireland to begin with. Then a couple years later, July, 2015, they acquired Forest Laboratories for $28 billion. Finally, they took over Allergan itself, for $70.5 billion, and that's where you get the name change over to Allergan, as we know it today. With these new rules, they're essentially discounting the value of those acquisitions from the value of Allergan.

Campbell: Right. Basically they're telling Pfizer, that, "Hey, when you do that calculation, guess what? You know how big Allergan is? Well, you know how big it got over the last three years because of its acquisitions? Those acquisitions don't exist. So do your math again." Sure enough, I'm sure that Pfizer crunched those numbers every way they possibly could, and weren't able to get it below that 60% threshold.