News that the Treasury Department is proposing rules to prevent tax inversion deals like the one between Pfizer (NYSE:PFE) and Allergan plc (NYSE:AGN) has sent shares of Allergan tumbling today. Pfizer hasn't officially abandoned the deal, but rumors are swirling that it's contemplating walking away. If it does, then Allergan investors may be left owning a company that's far too much like Valeant Pharmaceuticals (NYSE:BHC) for their liking.
Too close for comfort
I recently speculated that absent its deal with Pfizer, Allergan is as risky -- if not more so -- than Valeant. Now that this monkey wrench has been thrown at the merger by the Treasury Department, we may find out very soon if that's true.
As a reminder, Valeant shares are down more than 80% from their peak last year because of payer pushback stemming from its buy-reprice-relaunch strategy and the discovery of accounting mishaps.
Allergan isn't facing the same level of price or accounting scrutiny as Valeant, but its M&A appetite has been as voracious as Valeant's, and it's deal-making has saddled its balance sheet with a scary amount of debt. Specifically, Valeant's got $1.4 billion in cash and $30.9 billion in debt, a 21.46 ratio, but Allergan only has $1.1 billion in cash and $42.7 billion in debt, a ratio of 38.5.
Potentially more worrisome is that Allergan's current ratio, a measure of the company's ability to make good on short-term obligations if debtors come knocking, is worse than Valeant's. Allergan's current ratio is1.03, while Valeant's is 1.5.
Additionally, while Allergan's price increases aren't nearly as bald-faced as Valeant's, the company is still under the microscope for its pricing plans. Last summer, the Department of Justice requested insight into the company's generic drug pricing policies, including communications with competitors, and according to research from Deutsche Bank analysts, Allergan hiked prices on 40 drugs by an average 9.1% this year.
Treasury fights back
Allergan's debt burden is big but not enough to frighten away Pfizer, a Goliath boasting a balance sheet that's more than able to handle Allergan's obligations.
Pfizer's interest in Allergan, however, rests heavily in Allergan's international address.
By acquiring Allergan in a stock-swap deal, Pfizer planned to invert itself from a U.S. company to an Irish one, reducing its tax rate from the mid-20% range to the mid-teens and saving the company billions of dollars every year in the process.
These tax inversion deals, however, are increasingly being viewed by the administration as anti-American and therefore, efforts have picked up to prohibit them.
With that backdrop, the Treasury Department's proposed rule to stop tax inversions isn't surprising. Specifically, the Treasury Department plans to keep an acquiring company that ends up owning 80% or more of the target company from shifting its address outside the United States. Importantly to the Pfizer and Allergan deal, the Treasury is requiring that the percentage of ownership calculation excludes stock acquired within three years of the deal being signed. Since Allergan's recent deal-making includes Actavis' buying Allergan, which led to its name change, and the purchase of Forest Labs, there's a chance that Pfizer won't clear this hurdle.
If Pfizer walks away because of a change in tax inversion rules, the break-up fee it will pay to Allergan drops from $3.5 billion to $400 million. That's disappointing to investors who might have taken solace in knowing that Allergan's balance sheet would get a nice cash infusion that it could use to pay down debt.
Exclusing potential break-up fee monies, investors have to hope that Allergan's planned sale of its generic business to Teva Pharmaceuticals (NYSE:TEVA) goes off without a hitch. If it does, then Teva Pharmaceuticals will hand over $33.75 billion in cash, plus another 6.75 billion in its stock to Allergan. That cash could reduce Allergan's debt below $9 billion, giving it a 8.95 debt-to-cash ratio, and selling its Teva Pharmaceuticals shares could reduce that ratio by even more, but it's not clear that Allergan wants to do that given its previously said it likes the chance to continue benefiting from growing generics demand.
Investors may not, however, want to put too much faith in Allergan getting the cash from this deal. Yes, closing the deal gives it financial flexibility that could sidestep a Valeant-like run on the bank, but Teva Pharmaceuticals recently delayed the closing date for the deal in order to firm up support for it among regulators.
Overall, there's a lot of risk and moving pieces that investors will need to digest with this unfolding story and for that reason, investors contemplating buying Allergan shares on the drop might want to think twice. It may be better to focus on other ideas, at least until there's certainty on the generic business divestment.