Amidst high-profile deals like Pfizer's pursuit of AstraZeneca, Actavis's acquisition of Forest Labs, and Valeant's (NYSE:BHC) pursuit of Allergan, it might be easy to forget that it is not just large companies that can benefit from tax inversion deals that lead to a company reestablishing its headquarters in a lower-tax jurisdiction. Auxilium (UNKNOWN:AUXL.DL), a small specialty pharmaceutical company, has thrown its hat into the tax inversion ring with an announced acquisition of Canada's QLT (NASDAQ:NVLN). Investors did not universally cheer the news, though, and it's unclear just how much benefit Auxilium will really see from this move.

The deal
Some analysts and investors have been looking for Auxilium to put itself up for sale, but instead of announcing the sale of the company Auxilium announced that it will acquire Canada's QLT in an all-stock transaction. Auxilium is giving QLT shareholders 24% of the combined company and the nature of the required deal structure means that Auxilium shareholders will be getting 3.14 shares of QLT for each Auxilium share. For QLT shareholders, this represents a 25% premium to the prior day's close.

Assuming the deal closes as anticipated, the resulting company will be Canadian in name only, as Auxilium will maintain its offices in Pennsylvania and delist QLT from the Toronto Stock Exchange.

Benefits versus costs
Just because the deal is structured as an all-stock transaction does not mean that Auxilium shareholders aren't paying a price – namely the dilution of cutting QLT's shareholders in for almost a quarter of the new company. That dilution is worth about $3 per share today and that is the most certain part of the transaction.

Tax inversion deals are designed to take advantage of a lower tax rate and moving the tax jurisdiction from the U.S. to Canada should lower Auxilium's effective tax rate by about 10% (to the mid-20%'s). This benefit is not likely to amount to a lot right away, though. The company has generated losses for most of its corporate history and has accumulated net loss carryforwards that would have shielded income for some time anyway. If Auxilium becomes more profitable in the future (and/or acquires other businesses that bring in profits), this benefit will grow with time, but I'd estimate a value of around $1.50 to $2.50 today.

Finally, Auxilium gets to acquire QLT's remaining cash – about $140 million as of the last quarter. QLT will probably burn about $5 million in the second quarter, but assuming the cash burn doesn't accelerate (and/or that the closing isn't delayed), Auxilium will get about $2/share of cash in the deal. Does Auxilium need the cash? The company is in a significant net debt position (around $473 million), but should start generating free cash flow on an annual basis this year. That said, cash on hand could be a useful tool if Auxilium wants to find additional deals.

QLT does have a development stage retinoid program for eye disease, but Auxilium will license this out if it can. QLT also has a potential royalty stream owed to it by Valeant if that company secures approvals for new indications of Visudyne, a drug originally developed by QLT for wet age-related macular degeneration.

What now?
Auxilium has some meaningful operational challenges. Testim, the company's testosterone replacement product, is going into decline with branded and generic competition and though Stendra seems to be off to a decent start, it's not expected to be a blockbuster. Xiaflex, the company's drug for Peyronie's and Dupuytren's contracture, will also likely be hard-pressed to exceed $250 million in revenue though the market potential is theoretically near $1 billion.

That brings into question whether management can execute on its vision to be a urology-focused specialty drug company. On the other hand, there is no reason that Auxilium cannot launch additional acquisitions (a la Valeant or Endo International PLC) and leverage those acquired profits through a lower tax base.

The bottom line
Absent further acquisitions of approved and marketable drugs or significant outperformance from existing drugs like Testim, Xiaflex, or Stendra, Auxilium is looking at a thin margin of accretion from this deal. As I said before, the dilution from the deal is a guarantee and the cash from QLT is pretty solid, but the tax benefits require operational improvement to really maximize.