Editor's note: As of 10:00 a.m. EST on April 5, 2016, Allergan's stock price has fallen an additional 17% that is not reflected in this article, which was published before the market opened. For additional information on the news and subsequent price movement, click here.
Say what you will about the stock market, but it's generally efficient when it comes to pricing stock acquisitions and mergers.
Depending upon the nature of an acquisition, the company about to be purchased usually trades within a tight proximity of the agreed upon price. If it's a cash deal, there's often a very small gap (or no gap at all) between the current trade price and the buyout price. Cash-and-stock deals, or all-stock deals, tend to have more leeway since the value of the deal is constantly in flux and dependent on the value of the buying company's share price. However, these deals still often trade within a few percentage points of the actual deal price as noted in an M&A press release.
In other words, finding instances where investors can take advantage of an arbitrage opportunity where the market has mispriced a merger or an acquisition tend to be somewhat rare. However, we may be witnessing one right now.
This arbitrage opportunity could yield a 24% gain
In November, global pharmaceutical giants Pfizer (PFE 1.00%) and Allergan (AGN) announced they were going to merge and create the largest pharmaceutical company on the planet. In the merger press release the combined entity was touted as having $25 billion-plus in operating cash flow potential by 2018 and more than 100 mid-and-late-stage programs in development, and is expected to lead to approximately $2 billion in cost synergies, namely as a result of Pfizer redomiciling its headquarters to corporate-tax-friendly Ireland, where Allergan's headquarters is located.
Under the terms of the announced deal, which is structured like a reverse merger, Allergan is actually the buyer, which is necessary so Pfizer can legally redomicile its headquarters. The deal is structured such that Allergan shareholders will receive 11.3 shares of Pfizer stock for each share of Allergan that they own. The day the deal was announced, Allergan would have been valued at almost $364 per share. But things have changed in a big way.
As of Wednesday, March 30, Allergan shares closed up $1.42 per share to just $274.94. Comparatively, Pfizer, which has also traded lower since the merger announcement on Nov. 23, 2015, closed at $30.07 per share. Based on the original terms of the agreement at 11.3 Pfizer shares for each Allergan share, the current deal value works out to $339.79, or a 24% premium to where Allergan closed on Wednesday. Assuming the deal does indeed go through, and Pfizer's share price doesn't decline by more than 19% from Wednesday's closing price, a shareholder in Allergan would wind up netting a profit. The current arbitrage opportunity, as noted above, is a whopping 24%!
Why the market is blatantly mispricing this deal
You might be wondering why there's such a gap between the announced deal price and the current Allergan share price? More than likely, it's investor skepticism that the deal won't go through. However, I believe skeptics could be way off in this instance.
To begin with, Pfizer and Allergan have very few overlapping business operations, which is one reason why the cost savings from this deal were so low at just $2 billion annually. Allergan is best known for dermatology, women's health, gastroenterology, and central nervous system therapeutics. In contrast, Pfizer is known for oncology, cardiovascular diseases, immunology and inflammation, vaccines, and neuroscience. There should be next to no concerns for regulators about diminishing competition because Pfizer and Allergan find themselves to generally be on opposite ends of the therapeutic spectrum.
Nonetheless, U.S antitrust officials recently launched an investigation into potential overlapping businesses between the two companies. With the exception of biosimilars (biologic drugs designed to mimic the therapeutic effect of a branded drug), which itself is a burgeoning market that antitrust regulators have no prior cases to compare to, I don't view this to be much of an issue. And, for what it's worth, both Pfizer and Allergan expected the probe.
Secondly, there's concern about whether or not a tax inversion of this magnitude (the aforementioned redomiciling of Pfizer's headquarters to Ireland) will be allowed by Congress. U.S. lawmakers have done what they can in recent years to discourage domestic companies from moving their headquarters to foreign markets in order to reduce their corporate tax bills.
However, this deal fits all the qualifications of an allowable tax inversion. It's being completed as an all-stock deal (Allergan shareholders receiving 11.3 shares of Pfizer per Allergan share held), and the smaller of the two companies, Allergan, will still hold 44% of the shares of the new company (regulations require ownership of 40% to 60%). On these merits, the deal passes spec.
Additionally, it would take nothing short of a new tax inversion law passed in Congress to stop Pfizer and Allergan's deal from happening -- and with the inability of Congress to pass much of anything these days, the likelihood of such legislation gaining support seems unlikely before the end of this year.
The third and final reason this deal appears to be so badly mispriced has to do with Teva Pharmaceutical's (TEVA 0.00%) purchase of Allergan's generic drugs unit for $40.5 billion. Teva cautioned Wall Street and its shareholders just a few weeks prior that its acquisition of Allergan's generic unit was going to take longer than initially planned. What once was an end-of-March closing date may now be extended to June.
The reasoning? The Federal Trade Commission in the U.S. may want Teva to shed some of its assets for competitive purposes. In February, Teva announced what would amount to around $1 billion in asset sales in the EU, U.S., and Middle East to appease regulators, but an FTC thumbs up has yet to be given.
Pfizer's and Allergan's merger isn't going to move forward until the presumably less complicated Teva acquisition of Allergan's generic unit is complete. This delay could mean a longer waiting period in the Pfizer-Allergan merger. Nonetheless, with the deal slated to close in the second half of 2016 anyway, all parties appear very committed to moving forward.
Time to consider Allergan?
Although there's always that unforeseen X-factor that can come out of nowhere and surprise Wall Street and investors, Allergan shares are looking like an intriguing arbitrage opportunity, with the deal looking more likely to go through than not in my opinion.
And even if the deal were somehow not to go through, Allergan is an attractive company in its own right, with projected annual revenue growth as a stand-alone company in the mid-to-high single-digit percentage range between 2016 and 2020, and as much as $22+ in EPS expected by fiscal 2019. Even at its current share price Allergan is valued at less than 16 times forward earnings, which may not be overwhelmingly cheap, but is still reasonable and suggestive of additional long-term upside.
Is it time you considered Allergan for your portfolio?