In case you missed it, last week we witnessed the biggest pharma acquisition ever, involving Pfizer (NYSE:PFE) and Allergan (NYSE:AGN), which is set to create the largest pharmaceutical company on the planet.
Creating a giant
Under the terms of the deal, Allergan shareholders will be receiving 11.3 shares of Pfizer stock for each Allergan share they currently own. The premium, based on the closing price of Pfizer's stock the day before the deal announcement, values Allergan at nearly $364 per share, or about a 16% premium.
The headline numbers behind this deal are enormous -- and I'm not just talking about the magnitude of this merger of megacap companies. Pfizer anticipates that cost synergies could gallop past $2 billion annually, that the two companies would have a combined 100-plus mid- and late-stage developing programs, and that by 2018 the company would be generating $25 billion in free cash flow.
But the biggest number of all is what's expected to happen to Pfizer's effective tax rate. Allergan, based in Ireland, is subject to a considerably lower peak marginal corporate tax rate than corporations in the United States. The way the deal is structured will allow Pfizer to redomicile its headquarters to Ireland, thus reducing its effective tax rate in the year following the completion of the deal from 25% to a range of 17%-18%. This alone could save Pfizer in excess of $1 billion annually.
This type of deal is known as a tax inversion. Although tax inversion deals can help acquirers save money by paying less in taxes, lawmakers frown on it as an effort to skirt paying corporate taxes in the United States. In fact, the U.S. Treasury Department has implemented changes to curb tax inversion deals over the past year-and-change. These new regulations made it harder to transfer U.S.-based operations overseas, and they deem that the acquired overseas company must own more than 40% of the new combined company for the acquiring company to qualify for relocation. With Allergan shareholders expected to own 44% of the new Pfizer, the deal would appear to meet spec with the Treasury Department. Final regulatory approval is still pending.
Three companies that could be tax-inversion targets
If the Pfizer-Allergan tie-up demonstrates anything, it's that we've probably not seen the last of the tax-inversion deals among U.S. companies. Even though it takes just the right recipe to make a tax inversion deal work, I'd posit that the following three companies could find themselves as acquisition targets for the purpose of a tax inversion.
Delphi Automotive (NYSE:DLPH)
Healthcare isn't the only sector where investors should be looking for possible tax inversion deals. Auto parts supplier Delphi Automotive, which is based in Ireland, could make for an attractive acquisition target.
Following its reorganization and a resurgence of the automotive industry within the U.S. since the recession, Delphi now has a manageable $2.7 billion in net debt, generated close to $1.9 billion in operating cash flow over the past 12 months, and is expecting to see its EPS grow by a double-digit percentage throughout the remainder of the decade. Within the U.S., automakers are on pace to peak at 18.2 million units sold by 2017, according to IHS Automotive, putting Delphi -- a manufacturer of vehicle electrical systems, thermal systems, and operational controls such as infotainment systems -- right on track to succeed.
Who might be interested? It could be a long shot, but Johnson Controls, an auto-parts supplier primarily focused on batteries and interior combustion engine components, may want to take a look at Delphi. Both companies share common core customers in Ford and General Motors, and a combination could potentially diversify their product portfolios while simultaneously saving on production costs and possibly boosting their combined pricing power. Of course, there would also be sizable tax savings for Johnson Controls. This is pure speculation at this point, but Johnson Controls has been looking for strategic ways to boost value, and this might be one method to consider.
This may come as no surprise, given that Pfizer actively pursued it (unsuccessfully) last year, but in spite of the Treasury Department's tougher tax inversion laws, U.K.-based AstraZeneca should remain on the radar as a possible acquisition target.
AstraZeneca has a growth problem that may only be cured by merging with a similarly sized pharmaceutical giant. Patent losses, or imminent losses, for anti-psychotic Seroquel, cholesterol-lowering pill Crestor, and heartburn medication Nexium have wreaked havoc on AstraZeneca's top and bottom line, bringing into question whether the company can grow before the decade ends.
What AstraZeneca does have is a growing diabetes franchise, which it acquired in full from a joint venture with Bristol-Myers Squibb. This franchise could be the perfect dangling hook, along with tax benefits, for another megacap drug developer. Ideas here might include Merck, which has preferred bolt-on acquisitions as opposed to large mergers but does have a solid diabetes franchise, or AbbVie, which is attempting to add balance to its product portfolio, which is heavily reliant on anti-inflammatory Humira. Don't be surprised if the AstraZeneca buyout rumors begin swirling again following the Pfizer-Allergan deal.
Jazz Pharmaceuticals (NASDAQ:JAZZ)
Ireland-based Jazz Pharmaceuticals has looked like an appealing acquisition target for a while. The biggest issue has been its varying $8 billion to $11 billion valuation, which means that Big Pharma companies would be excluded from treating Jazz Pharmaceuticals as a tax inversion candidate (i.e., Jazz shareholders wouldn't own 40% or more of the combined company). The solution might be for a slightly smaller company to purchase Jazz, or for an acquirer to pay a hefty premium.
Jazz offers a lot of upside as an acquisition target. If it's able to relocate, a purchaser would be privy to Ireland's exceptionally low corporate tax rates. Additionally, a buyer would gain access to Jazz's specialty-drug portfolio led by narcolepsy drug Xyrem. Specialty-drug developers such as Jazz have retained remarkable pricing power for drugs that treat only a limited pool of patients. For instance, Jazz increased the price for Xyrem by roughly 840% between 2007 and 2014, helping to pad its pockets and push Xyrem ever closer to becoming a blockbuster drug. Specialty drugs also tend to be well protected from generic competitors.
Considering the potential that Jazz's EPS could practically double from $8.43 last year to more than $16 by 2018, this is a company that should remain on your radar (and the radar of mid- to large-cap drug developers) going forward.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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