Breaking Down Pfizer's Break-Up With Allergan

After Treasury Secretary Jacob Lew and his peers at the Treasury announced changes to tax laws that make it more difficult for companies to relocate overseas, Pfizer (PFE 2.40%) decided to walk away from its merger megadeal with Allergan plc (AGN). Washington moving to prevent losing out on billions of dollars in tax revenue isn't too surprising, but Allergan investors still headed for the exits once the news broke. Could this be a once in a lifetime buy opportunity?

Motley Fool analyst Kristine Harjes and contributor Todd Campbell discuss the ins and outs of this failed deal, and what it may mean for these two companies in this edition of The Motley Fool's Industry Focus: Healthcare podcast.

A full transcript follows the video.

This podcast was recorded on April 6, 2016. 

Kristine Harjes: PfizerGan is good as Pfizer gone, on this healthcare edition of Industry Focus.

Welcome to the show. I'm your host, Kristine Harjes, and it is Wednesday, April 6th. Calling in to break down this morning's big breakup news in the healthcare sector is Motley Fool contributor, Todd Campbell. Todd, I don't know about you, but I have been racking my brain all morning for breakup songs.

Todd Campbell: I think this is the biggest breakup since Bennifer.

Harjes: This might be the biggest healthcare news we've had all year so far.

Campbell: Pfizer likes to make the big news, don't they? They did it last fall by announcing the deal; now they're doing it this spring, by exiting it.

Harjes: For sure, and we have got all the details for you, coming up on this episode. First, a quick shout out to the brainstorming help that I got this morning on Twitter, which, by the way, you ought to know our handle, which is, @MFIndustryFocus. Let's get this thing rolling. Todd, what's the quick and dirty?

Campbell: First, did you have a favorite song, or are you going to keep us in suspense?

Harjes: Do I have a favorite? You're going to hear my favorite at the very end of this episode.

Campbell: Okay, that's fine.

Harjes: I will leave you in suspense for a little bit.

Campbell: Excellent, excellent. Wow. Yeah, big news. I guess not unexpected. I mean, it's the biggest breakup since AbbVie exited its planned tax inversion deal with Shire, back in '14. They had hoped, obviously, to combine the two companies. I love how you called it, "PfizerGan." That's great.

Harjes: Which is, of course, Pfizer and Allergan.

Campbell: Yep, yeah. PfizerGan would have been huge -- a $160 billion deal that would have created a company with $65 billion in sales, and would have moved, at least for tax purposes, Pfizer's headquarters overseas, to Dublin, Ireland.

Harjes: Yeah, and that's really where the crux of this issue is. There's always been some speculation that the government -- the U.S. government -- might block this deal over antitrust concerns, or over the fact that, "Oh hey, maybe we don't want to lose all of our tax revenue from Pfizer." I would say that Allergan investors... I don't know, there is some implication that the market might have been underpricing Allergan a little bit compared to where Pfizer had put them at with this deal, which would have...

Campbell: Yeah, the arbitrage there was huge, right, Kristine?

Harjes: Yeah. Yeah, exactly. That implied that there was a little bit of doubt that this was going through, but the executives of both companies were very confident in their words about how they absolutely expected this to go through. I don't think it was until overnight on Monday, when investors truly heard it through the grapevine that the new U.S. Treasury regulations were going to come out, and pretty much put the kibosh on this deal.

Campbell: Wait, wait, Kristine... did you just say that management was overly optimistic?

Harjes: I don't want to say "overly." I was as optimistic as them, so maybe I was overly optimistic, too. Really, given the guidelines that had existed, you would have thought that this deal was going through, but they completely rewrote the terms; changed the rules of the game.

Campbell: The goalposts got moved. Absolutely. Washington doesn't want to lose their tax revenue. I can't say that I blame them. Last fall, you saw the Treasury Department issue a bunch of new rules trying to thwart planned tax inversions. On Monday, they did it again. Only this time, they designed it specifically to kill this deal. Sure enough, they succeeded. They dealt a death blow with a stroke of a pen.

Harjes: Yeah, and of course, they said that this wasn't specifically for this deal, but...

Campbell: Right!

Harjes: The press release itself says that they're not focused on a specific transaction, but rather a loophole within the industry. This is a loophole that's been used quite a bit, where you get these foreign companies "buying up" U.S. companies so that they can use the tax percentages of the foreign countries. That's actually kind of an interesting detail here, where Allergan, the smaller company, was technically buying Pfizer.

Campbell: I know, crazy, right? Here's Allergan, with $15 billion in trailing 12-month sales. You've got Pfizer doing $50 billion, and Pfizer obviously being a lot larger in terms of market-cap company than Allergan. The reason that they did that was because, at the time, they were trying to skirt the rules that the Treasury had put in place that would restrict their ability to move their tax domicile from the U.S. to Ireland. It's a really kind of a wonky set of rules, but we should probably get into that for our listeners.

Harjes: I'm going to have you lay that out. There's a lot of numbers in there.

Campbell: Yeah. Okay, well you know what? Let's try to make it really, really simple. In order for you to successfully invert to another country for tax purposes, the U.S. company shareholders can't own more than 80% of the combined entity once the deal is done. If you own between 60% and 80%, you get hit with some tax penalties, so ideally, you want to structure the deal so that the U.S. owners of Pfizer shareholders wouldn't own more than 60% of the combined PfizerGan. The way that they did the deal was, they structured it so that Pfizer shareholders would own 56% of the combined entity, thereby putting them below that 60% threshold, and nicely below the 80%.

Harjes: Yeah, nice buffer zone, too -- a whole 4%.

Campbell: Right, keeping it right in the skin of their teeth. Unfortunately, one of the things that they didn't count on was Jacob Lew at the Treasury Department.

Harjes: Yeah, so really, the game changer here was the fact that now with these new rules, essentially, the last three years of Allergan's inversion-type actions are being discounted. This is a company that has grown by acquisition. It used to be known as Actavis. When it was Actavis in October, 2013, they took over Warner Chilcott. That was an $8.5 billion transaction, which moved their tax home to Ireland to begin with. Then, a couple years later -- July, 2015 -- they acquired Forest Laboratories for $28 billion. Finally, they took over Allergan itself, for $70.5 billion, and that's where you get the name change over to Allergan, as we know it today. With these new rules, they're essentially discounting the value of those acquisitions from the value of Allergan.

Campbell: Right. Basically they're telling Pfizer, that, "Hey, when you do that calculation, guess what? You know how big Allergan is? Well, you know how big it got over the last three years because of its acquisitions? Those acquisitions don't exist. So do your math again." Sure enough, I'm sure that Pfizer crunched those numbers every way they possibly could, and weren't able to get it below that 60% threshold.

Harjes: This is really interesting to me, too, because Pfizer had said that this deal is not about the tax inversion. They were saying that it's more about bolstering up their business, and you hear all this talk about potentially breaking up Pfizer into different business units. Now, all of a sudden, this tax scenario doesn't work, and Pfizer tells Allergan to, "Go your own way." So now what?

Campbell: Yeah. Is this the kind of a case where the lesson that we're going to learn from this is that management sometimes fibs or stretches the truth, or whatever? You're right! When this deal got announced, Pfizer had slide upon slide upon slide touting how excited it was to get Allergan's Botox, and all of these drugs that are used to treat Alzheimer's, and depression, and everything else, and this huge pipeline that Allergan would bring to PfizerGan. Sure enough, when push came to shove, eliminating the chance to go from 25% effective tax rate to 17% tax rate is what killed $160 billion deal.

Harjes: Yeah, and Ian Reid, the CEO of Pfizer, his words actually did say something to the effect of, "While it's not only about the tax rate, if that part of it were to fall through, then the price point might be a little bit different." What do you think? Do you think we're going to see another attempt from Pfizer, just at a different price?

Campbell: You know, I would have thought that those negotiations already happened, and for whatever reason, either Allergan looked at it and said, "No, we're worth more on a stand-alone basis." Or Pfizer said: "You know what? We're really, really not that interested."

Harjes: Yeah, that makes sense.

Campbell: Surprise, surprise! We wanted the tax break, and now we're not getting it.

Harjes: Yeah, that's what I thought of.

Campbell: We're going to walk away now because we have an opportunity to do it, relatively cheaply. Usually break-up fees are in the billions of dollars. AbbVie paid Shire, I think it was $1.7 billion or $1.8 billion when they called off their tax inversion deal. This one Kristine, was what? A rounding number?

Harjes: It was $150 million.

Campbell: Yeah, here's some walking around money.

Harjes: Yeah, that's pocked change. Maybe not to you and me, but for Pfizer.

Campbell: Yeah, I mean for Pfizer it is -- absolutely. You saw numbers being tossed around yesterday. They were going to be, "Oh, they'll get $300 or $400 million. Oh they'll get a billion. Who knows what they'll get."

Harjes: Yeah, I think I saw up to a billion and a half.

Campbell: Yeah, and you know what? It basically said, "Tell you what, we know you racked up a lot of legal fees. We'll pay for your legal fees."

Harjes: Mm-hmm (affirmative). Yeah, and then, that's where you get that $150 million, which is really not a whole lot of money. Pfizer has already tried to do a tax inversion deal in the past with AstraZeneca, and that failed, and now you have this Allergan deal, which also has failed. Do you think there's any sense of, "Never mind, I'll find someone like you," and they might look to another acquisition, either for tax reasons, or otherwise?

Campbell: You know, it would have to be a really big company now, I think, based on these rules. Could they tie up with somebody like a Glaxo? Let's start some rumors, right? Could they tie up with a Glaxo? Could they go back to AstraZeneca again, and say, "Hey, how about us now? How do you like us now?" Sure, anything's possible. Pfizer has, arguably, one of the best balance sheets in pharma. They're sitting on an absolute mountain of cash, and that cash is just getting bigger and bigger every quarter. I don't know. They've got enough things going on where I think that the corner has turned for them, and they can continue to grow for the next few years.

They've got new drugs that are coming out. They're selling pretty quickly. The drag and sales from losing Lipitor's patent protection, that's pretty much come to an end. They've cut a lot of costs. You know what? Investors could get a nice big windfall in the form of extra buybacks, or a hike in the dividend. Pfizer may decide, "Hey, you know what? You guys have wanted us to split off our generics business, or our existing products business for a while. Maybe we'll spin that out."

Harjes: Yeah, that's definitely the thing to watch next with Pfizer -- is whether they do split into two distinct business units. The one being the one that you just mentioned, which is Global Established Pharmaceuticals, and the other one is Innovative Products. There has definitely been a lot of speculation about Allergan being of use to that split by bolstering both sides of that portfolio. Either way, Pfizer says that it will still make a decision about any potential separation by the end of this year.

Campbell: Yeah, stay tuned. I'm sure that they will be in the news some more from here on out, right?

Harjes: Absolutely.

Campbell: Pfizer likes to surprise us with big news, so I wouldn't count Reid out. Of course, that brings us to: Okay, if Pfizer's going to be hunky dory on its own, what will it mean for Allergan, right?

Harjes: Yep, that was absolutely my next question. Is Allergan, at this point, channeling Kelly Clarkson's, Since U Been Gone, I Can Breathe, or is Pfizer more like Beyonce's Irreplaceable? What are they going to do next?

Campbell: Yeah, Allergan is... they need a few things to go right for them, but they do have some very intriguing drugs that are in the pipeline. They've got a drug for migraine coming through the pipeline, that could be a billion-dollar seller. They've got some new depression drug coming through the pipeline, that could be a billion-dollar seller. Botox, of course, is a multi-billion dollar blockbuster, and they think they can get it approved for additional indications that could move the needle.

This year, they're expecting sales to grow in the low double digits, so they're going to go from $15 billion in sales to roughly $17 billion in sales. Solid growth, you know. Then, of course, how much of that translate into earnings, just will depend a lot on how good they are at cutting costs.

Harjes: Estimates have them growing earnings at 15% a year for the remainder of the decade.

Campbell: Which would be great. They had talked about, in prior investor calls, they talked about $25 a share. Today on his call, the CEO of Allergan said, "Hey, you know, we'd love to get to $30 a share." Right?

Harjes: Of course they would.

Campbell: The thing that we have to remember, too, is that we've got non-GAAP EPS and GAAP EPS, and because Allergan's been so acquisitive, it's really hard to say, "Okay, what's their real earning power absent all these acquisitions?" Okay, if they earn $15 or $20 or $25 on a non-GAAP basis, what does that mean on a GAAP basis? Last year, they lost money if you do it on a GAAP basis.

Harjes: That's kind of crazy, yeah. That does, of course, demonstrate that you probably should look at both. I think the other maybe yellow flag for this company is, if you take a look at their balance sheet, they do have quite a bit of debt; but there's a caveat with that, with the potential sale of their generics unit to Teva (TEVA 0.63%).

Campbell: One of the biggest concerns that I have with this company, because again, I think investors need to always look at these "What could go wrong?" kind of scenarios. One of the things that I get a little big nervous about, although of course, Allergan says, "We're on track. This deal is going to close." They're trying to sell their generics business to Teva, and if that deal goes through, they're going to get a check for $33 billion and some change. They're going to get another $6.75 billion worth of Teva stock. If they get that, and the deal closes without a hitch, that makes that huge $42 billion in debt that's on their balance sheet become a lot more manageable.

They've got $1.2 billion in cash, and $42 billion in debt. That's not very good. Getting this money in from Teva would be game changing for the balance sheet. Of course, that assumes that this goes through.

Harjes: Yeah, I was just going to say, if I had asked you a couple of days ago which deal was more likely to go through, the Allergan and Pfizer one or Allergan and Teva, what would you have said?

Campbell: Woo hoo, great question! I don't know. I was a little bit more... I was more worried probably about the FTC review of this generics sale.

Harjes: Really? Okay. Then that's definitely kind of nerve-wracking.

Campbell: Only because there's been a lot of push-back on generic drug-price increases. Last summer, the Department of Justice actually sent an inquiry to Allergan asking about it, how it was pricing its generic drugs, and other generic drugmakers have received similar subpoenas. They're very concerned about the chance for monopolies in generic drug industry with that backdrop -- what could happen with generic drug prices.

Harjes: That probably does a lot to explain Allergan's current share price. I have been scratching my head a little bit because, before the Pfizer plans were announced back in November, Allergan was trading at above $300 a share. They're now at $245. You would think that they would have traded higher than they had been previous to this news being announced; but they dropped a good 15% on the news. To me, that's like, "Well, before, when it was a stand-alone business, you had it valued at one place. They say they're going to merge with Pfizer and you devalue them. And then the merger breaks up and they're trading even lower." I think you might have the key there, that it's more doubt about this Teva deal.

Campbell: If Valeant Pharmaceuticals taught us anything, it's this whole idea of acquire, acquire, acquire, throw a ton of debt on the balance sheet. It may not be such a good thing, right? It's good until it isn't.

Harjes: Yeah, the Allergan CEO, Brent Saunders, has been very clear that he does not want his company to be associated with Valeant, which you could say has a similar model of being very acquisitive. Of course, Allergan, at least according to Saunders, has much more of a reliance on actual R&D.

Campbell: Yeah, they spent about a $1.5 billion, I think, on R&D last year. It's certainly not the same level as you'd see with a Pfizer or a Johnson & Johnson or something, but it's a good amount of money, and they do have some intriguing specialty drugs making their way through. I would agree with you on that front that their pipeline certainly has more potential than, say, a Valeant, if you will. Again, deleveraging that balance sheet is going to be important. One of the things that Allergan CEO really, really hammered home on that conference call today was, "We're going to do whatever it takes to maintain our investment grade rating." So keep an eye out there for what Moody's says about Allergan after this deal has now been scuttled.

Harjes: Yeah, it's definitely good advice. I will also put a little bit more of a positive commentary from Saunders in there, just about how strong their pipeline is. He pointed out that they have 70 mid-to-late stage programs, including 14 expected approvals, and 16 regulatory submissions, in 2016 alone. You do have a good number of question marks with this business, but hopefully, they don't get hit out of the blue again with something unexpected, maybe such as the Teva deal falling through. Hopefully, they can be singing the Gloria Gaynor karaoke favorite, "I Will Survive." That's my last bad music reference I'm going to make on this show, just so you all know.

Campbell: Yeah, they're going to be fine, just as long as this Teva deal goes through, I would think. The book value of the company is like $189 a share. You're not paying a lot more than book. If you're using a non-GAAP EPS estimate, it's about 14. The shares are trading around 14 times for EPS estimates. Not bargain basement, but certainly not a sky-high valuation.

Harjes: Right. There you have it, folks. That's our take on what may just be the biggest healthcare news so far in 2016. If you have comments or questions, feel free to email us at [email protected]. Thanks so much, Todd, and thanks to our listeners. Hope I don't get any terrible breakup songs stuck in your head for the rest of the day. We will talk to you all next week.

As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.