Large companies like Actavis have done it, small companies like Auxilium have done it, and huge companies like Medtronic have done it (and Pfizer wants to do it). Now count mid-cap specialty pharmaceutical company Salix Pharmaceuticals (NASDAQ: SLXP) is among the companies using M&A to shift their formal headquarters to a country with a lower tax rate.
While there's more to Salix's merger with Cosmo Tech than just a tax inversion, that's the value driver to the transaction. This move appears to add about 5% to 10% to Salix's value, but it also makes it less likely that the company gets a buyout bid of its own, and that may be disappointing to some investors.
The deal
Salix announced on July 8th that it had reached an agreement to merge with Cosmo Tech, a subsidiary of Cosmo Pharmaceuticals. While Cosmo Pharmaceuticals is an Italian specialty pharmaceutical company that shares Salix's focus on GI ailments/treatments, its shares are listed in Switzerland and Cosmo Tech is headquartered in Ireland (such are the gymnastics that companies will go through to avoid taxes).
This is an all-stock deal that will see Salix shareholders owning slightly less than 80% of the combined company once it is complete – tax inversions require a minimum of 20% ownership of the foreign shareholders, so this was about as close as Salix could cut it and still qualify. Salix shareholders will get one share of Salix Pharmaceuticals plc for every Salix share they own and it will be a taxable event for current shareholders (which has to sting more given the nearly 150% two-year run in the shares).
This deal values Cosmo at around $2.1 billion and adds no meaningful revenue to Salix, nor does it offer cost synergies; Salix will not be using Cosmo as a launching pad for a direct sales effort in Europe. With that, the deal will be dilutive in 2015, slightly accretive in 2016, and more accretive in the further years.
Why Salix would do this deal
Salix is doing this deal for two primary reasons – to lower its future tax bills and to improve the profits from the drug Uceris.
With an effective tax rate in the high 30%'s, Salix has one of the highest tax burdens of the specialty pharmaceutical space. Not only does that now appear wasteful in this newly tax-obsessed operating environment, it also makes the company a target for an aggressive buyer like Valeant that can use its lower tax rate to generate a positive return from M&A while still offering a premium to the target's shareholders (the lower tax rate figures prominently in the company's efforts to force a merger with Allergan).
Redomiciling to Ireland will bring the effective tax rate down into the 20%'s over time. While the company won't be moving much (if any) of its current IP to the Irish tax structure, it's definitely an option for IP acquired in the the future and something that Actavis and Valeant have both done. Salix has already declared its intention to be acquisitive in the future and this move clears the deck for more earnings accretion from future deals.
Salix is also going to benefit from the elimination of royalties on Uceris, a drug it markets for ulcerative colitis. Management believes that this can be a $500M-plus drug by the end of the decade and eliminating the royalty to Cosmo will boost the gross margin into the 90%'s.
Last and maybe not least, Salix is acquiring two pipeline candidates. Rifamycin MMX is in Phase 3 development for traveler's diarrhea and Phase 2 development for diverticulitis, the latter of which could be a $500M opportunity. Methylene blue MMX is in development as a contrast agent for colon cancer screening and could also be a significant contributor if Phase 2 data that indicated more polyp and adenoma detection hold up. It is also possible that Salix may find additional uses and applications for that MMX drug release technology.
The bottom line
I do expect Salix to generate meaningful profits in the coming years from products like Xifaxan and Uceris (and possibly Relistor), so lowering the tax rate on those future earnings does add to Salix's present day value. Net of the dilution (and including the higher gross margin on Uceris, but excluding sales from Cosmo's pipeline), I believe this transaction adds 5% to 10% to Salix's value.
On the other hand, this deal forces shareholders into a taxable event and while the dilution and taxes are certain, the future benefits are less so. What's more, this transaction does knock away one of the advantages that companies like Actavis or Valeant could use in an attempt to acquire the company, making it less likely that Salix gets acquired. Net-net, it's a positive move for Salix but not one that I think investors will necessarily all be equally happy to see.
