It was perhaps the highest-profile merger ever to grace the wires: Pfizer (NYSE:PFE), one of the world's largest pharmaceutical companies by revenue, and Allergan (NYSE:AGN), Ireland's largest pharmaceutical company, were set to become the largest pharmaceutical company in the world.
When first announced back in November you could cut the buzz surrounding this deal with a knife. The deal, which was structured as a reverse merger with Allergan "acquiring" Pfizer, was designed to give each Allergan shareholder 11.3 shares of Pfizer common stock for each Allergan share they owned. When announced, Allergan would have been valued at $160 billion, or $364 per share. Furthermore, the deal was going to create a pipeline with over 100 mid-and-late-stage products, lead to double-digit percentage earnings accretion by 2020, and produce more than $25 billion in operating cash flow by 2018.
However, the lynchpin of the merger was the $2 billion in expected cost synergies. These synergies were primarily going to be realized with Pfizer redomicilng its headquarters to Ireland. In a process more commonly known as a tax inversion, Pfizer relocating its headquarters to Ireland would have exposed it to a substantially lower corporate income tax rate. Comparatively, U.S. corporations pay one of the highest corporate income tax rates in the world.
But that dream is now dead, and the deal-killing stroke was delivered in a major surprise by the U.S. Treasury Department.
How the Treasury Department delivered its "death blow" to PfizerGan
After the Treasury issued more than 300 pages worth of changes to corporate tax inversion laws on Monday, Pfizer and Allergan declared their deal dead. Two key changes took direct aim at the Pfizer-Allergan deal, although the deal itself wasn't mentioned by name or focused on during the release of these new regulations.
First, the deal went after so-called "serial inverters," or companies that built themselves up through a series of tax-inversion acquisitions. The government's new regulations disregard the assets of companies acquired by serial inverters over a trailing three-year period. What this meant for Allergan is that its merger with Actavis, its $25 billion buyout of Forest Laboratories, and its 2014 acquisition of Warner-Chilcott for $5 billion, wouldn't be figured into its merger with Pfizer. Ultimately, this reduced the value of Allergan to just $106 billion, far below the 40% equity threshold required for Allergan shareholders to hold in order for a tax inversion and subsequent redomiciling of Pfizer's headquarters to take place.
Secondly, the Treasury Department announced that it was tightening regulations surrounding earnings stripping, or the practice of inverted companies lending money to their U.S. subsidiaries and then using the deductible interest in the U.S. to lower the amount of income that'd be subject to the U.S.'s 35% corporate income tax rate.
Treasury Secretary Jack Lew had this to say,
"After an inversion, many of these companies continue to take advantage of the benefits of being based in the United States -- including our rule of law, skilled workforce, infrastructure, and research, and development capabilities -- all while shifting a greater tax burden to other businesses and American families."
Per the Treasury, all deals as of Monday and after will be subject to the new guidelines.
Four things we learned watching the Pfizer-Allergan drama unfold
The Pfizer-Allergan failed merger will certainly go down in the history books as memorable for a variety of reasons, and the termination of the deal will cost Pfizer $150 million. But more important, the failed merger taught us four important lessons.
1. Never discount the X-factor
First, no matter how perfect things look, there's always an X-factor that could disrupt things. Just days ago I was touting how there could be an unbelievable arbitrage opportunity given the discount Allergan was trading at compared to the value of 11.3 Pfizer shares. I deemed there to be little in the way of operational overlap between the two companies; I didn't see much danger in Teva Pharmaceutical's acquisition of Allergan's generics business for $40.5 billion delaying the merger; and I certainly didn't see U.S. lawmakers having the gall to pass tougher inversion regulations when the prior two attempts to tighten tax inversion law danced around the edges. Oh how wrong I was.
2. Tax inversions are as good as dead (at least in the near-term)
Secondly, we learned that the government is done beating around the bush when it comes to U.S. companies taking advantage of tax inversion opportunities. The new regulations all but ensure that tax inversions of the magnitude we've witnessed in recent years (e.g., Medtronic-Covidien) are likely dead. It's possible that smaller-case inversions may still be sought, but the tax benefits of relocating to an overseas market have been severely crimped.
Speaking more broadly (beyond Pfizer-Allergan), I believe this also puts the kibosh on any near-term hope that any regulation could be passed which would allow for foreign earnings to be repatriated at a reduced tax rate.
3. It really was about the tax benefits (and Ian Read is a terrible fibber)
From the day this deal was announced in November through March all I consistently heard from Pfizer's CEO Ian Read was how this deal was about so much more than just tax savings. It was about growth and combining two very innovative pipelines to drive growth over the next decade. In fact, here's what Read had to say to CNBC's Meg Tirrell the day the deal was announced when he was questioned about whether this deal would go through if the tax benefits weren't there (bolded emphasis is my own):
"This deal is not just about tax benefits. This is about great franchises. Brent [Saunders, CEO of Allergan] can talk about the franchises Allergan has in a second. I'm excited about it. Our two businesses are established businesses and our innovative pharmaceutical, it gives it greater growth... It's a really strategic deal from that point of view. If the benefits from tax weren't there, I would still try to do the deal, but I suspect the price would be different."
Yet here we are announcing the death of the Pfizer-Allergan deal a little over five months later because the highly coveted tax breaks are being taken away by new Treasury regulations. In the end it really was all about tax-cost savings, and Ian Read is a pretty bad fibber.
4. Both companies will be just fine over the long run
Most importantly, I believe shareholders can take solace in the fact that both companies should be just fine operating as separate entities for many years to come.
Pfizer has been benefiting from growth in cancer drug Ibrance, and it could soon catch a boost from a line of developing biosimilars, as well as the potential approval of its experimental cancer immunotherapy avelumab, which is being developed with Merck KGaA.
Allergan's multiple deals leading up to 2016, including its ongoing generic drug unit sale to Teva, should allow it to grow its EPS by close to 15% per year throughout the remainder of the decade. Its niche therapeutic targets in dermatology and women's health, along with central nervous system drugs, should allow Allergan's growth to continue unfettered.
When all is said and done, these two companies will put their break-up scars in the rearview mirror pretty quickly. Investors, though, may be less forgiving.