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Shares of Perrigo Company (NYSE:PRGO) are selling off after the healthcare provider of over-the-counter and generic prescription products announced the acquisition of Irish-based Elan Pharmaceuticals (NYSE:ELN).

The fair addition ends the long and nasty bidding war for Elan's management which has been fencing off a competing bid from Royalty Pharma. The deal has plenty of advantages for Perrigo, yet the overall valuation is not appealing enough for me to pick up shares at this point in time.

The Deal

Perrigo Company announced that it has entered into a definitive agreement to acquire Elan Pharmaceuticals in a $8.6 billion deal. Net of the cash position of Elan, the deal values the Irish company at $6.7 billion.

Shareholders in Elan stand to receive $6.25 per share in cash and 0.07636 shares in "New Perrigo", valuing Elan's shares at $16.50 based on Friday's closing price. This represents a 10.5% premium compared to Elan's ADR closing price on Friday. Elan's shareholders will hold a combined 29% stake in the newly formed Perrigo company, while its current shareholders will own the remaining 71%.

The deal will create a global healthcare accompany which has geographic scale and scope to expand into the future.

Perrigo's Chairman and CEO Joseph C. Papa commented on the rationale behind the deal, "Through this transaction, Perrigo establishes a diversified platform for further international expansion. We believe this transaction is compelling for Elan shareholders and fully takes into account the value of Elan's assets, including a large cash balance and a double-digit royalty claim on Tysabri®."

The deal is expected to be immediately accretive to Perrigo's earnings per share in 2014 as the transaction will result in after-tax operating costs synergies and tax savings of more than $150 million per annum.

The deal has been unanimously approved by the board of directors of both companies and is expected to close by the end of this calendar year. The newly created company will be incorporated in Ireland.

Valuation

Perrigo ended its third quarter with $300.8 million in cash and equivalents. The company operates with $1.38 billion in short and long term debt, for a net debt position which approaches $1.1 billion.

Perrigo has arranged bridge finance commitment of $4.35 billion from Barclays and HSBC to finance the deal. These bridge loans will be repaid through the issuance of new debt and Elan's cash on hand.

Revenues for the first nine months of the year came in at $2.57 billion, up 9.9% on the year before. Net income rose by 13.1% towards $323.5 million. At this rate Perrigo is on track to generate revenues of $3.5 billion for the year, on which it could earn about $450 million.

Factoring in a 7% correction on Monday, with shares trading around $125 per share, the market values Perrigo at $11.8 billion. This values the firm at 3.4 times annual revenues and roughly 26 times annual earnings.

Perrigo pays a quarterly dividend of merely $0.09 per share, for an annual dividend yield of 0.3%.

Some Historical Perspective

Shares of Perrigo have had a great run over the past decade. Between 2003 and 2007 shares have mostly moved in a $10-$20 trading range. From that moment onwards shares rose steadily as they broke through the $100 level in 2012. In recent days, shares hit fresh all time highs around $134 per share, currently exchanging hands at $125 per share.

Between 2009 and 2012, Perrigo has grown its annual revenues by a cumulative 60% towards $3.2 billion. Net income nearly tripled to just over the $400 million mark last year.

A Superior Offer

Perrigo's offer represent much greater value compared to Pharma Royalty's hostile offer. Royalty Pharma was willing to pay $13 per share in cash and pay contingent value rights which could be worth as much as $2.50 per share if Tysabri hit certain milestones.

Perrigo's $16.50 offer implies a 6.5% premium over Royalty Pharma's latest offer. While the $6.25 cash component is less than that of Pharma Royalty, investors in Elan will have the opportunity to participate in the upside of the deal, as they will hold a 29% stake in the new company. With shares of Perrigo trading around $125, the implicit offer value has declined to $15.80 per share.

Investment Thesis

The deal is a transformative deal for Perrigo. Essentially the company receives royalties from Tysabri, the multiple sclerosis treatment drug, in exchange for $6.7 billion. The company will receive 12% royalty payments on the drug, which generated annual sales of $1.6 billion, resulting in royalty payments of $192 million per annum at the moment.

In May of 2014, royalty percentages will increase to 18% on net sales up to $2.0 billion, and 25% on sales above the $2 billion mark. Perrigo anticipates sustainable cash flows going forward thanks to solid barriers of entry. Sales of the product have risen by 19% on average over the past four years. As such, Perrigo could anticipate royalty payments to rise significantly in the coming years.

Elan sold a 50% interest in Tysabri to Biogen (NASDAQ:BIIB) earlier this year for $3.25 billion.

Besides receiving stable royalty payments, Perrigo gets access to Ireland's lucrative tax system. Corporate tax rates are just 12.5% in Ireland compared to 35% in the US. The company can furthermore offset $2 billion in profits against tax deductions in Ireland. There is a bit of potential for operating synergies as well, notably in back office and Research & Development functions.

Perrigo expects to take $70 million in restructuring and integration charges. On top of the cake, Perrigo gets access to a Phase II central nervous system product, called ELND005, and several minority investments.

As a result of the deal, Perrigo expects to operate with 134 million shares outstanding, valuing the equity of the firm at roughly $17 billion. While the deal will hardly add to Perrigo's $3.5 billion in annual revenues, net earnings of $450 million will increase significantly on the back of the royalty payments. Combined with lower tax rates, reflected in the $150 million synergy estimates, earnings could rise towards $750 million in the coming years.

This would value Perrigo's equity at 22-23 times annual earnings. The deal is more than fair as Perrigo gets access to growing cash flows, lower tax rates and potential upside through minority holdings and the development of ELND005. Yet investors are not really optimistic as Perrigo's market value dropped by some $700 million in a response to the deal.

I think the deal is more than fair, given the reasons mentioned above, and this should boost the appeal of Perrigo's stock. Yet the overall valuation is not compelling enough for me to pick up any shares at this point in time.

Source: Perrigo Company - Elan Deal Brings Advantages At A Fair Price