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Summary

  • Allergan is a debt-free, fast-growing company.
  • Allergan has options for easily fending off the takeover.
  • Allergan can increase shareholder value while staying independent.

Introduction

Allergan (NYSE:AGN) is a rapidly growing, debt-free pharmaceutical company based in California. Allergan has obtained many FDA approvals over the last few years leading to accelerating revenue growth. Allergan's organic home-grown revenue growth rates over the last 5 quarters clearly show the acceleration Q4 2013 15.6%, Q3 2013 12.9%, Q2 2013 10.9%, Q1 2013 9%, Q4 2012 8.1%. Allergan is also expected to get even more approvals for drugs such as Levadex and Ozurdex in the next few quarters.

Seeing this, Valeant (NYSE:VRX) has made a hostile takeover offer consisting mostly of Valeant's stock. I have covered the many problems with Valeant stock, such as its stagnant organic revenue growth, high leverage, etc., in my two previous articles, titled "Valeant Skating on Thin Ice" and "Valeant's Low Returns on Capital and other Problems".

Given Allergan's focus on inventing new drugs and Valeant's focus on financial engineering, this is a mismatch. Valeant has promised to cut off most of Allergan's R&D, therefore Allergan can be expected to try to stay independent. This article discusses the options that Allergan has for fending off this hostile takeover.

Valeant's offer

Valeant is offering $48.3 in cash and 0.83 shares of Valeant for every share of Allergan.

Valeant is going to fund this by taking on $15 billion in new debt. This is the central idea of Valeant's offer - they are going to leverage an unleveraged company. In other words, Allergan doesn't have a mortgage, but Valeant is going to take out a mortgage on Allergan's assets. Valeant already has $17 billion in debt of its own, so the proposed combination would have a total debt of $32 billion.

This is what corporate raiders would do in the 1980s LBO boom. They would target unleveraged companies and buy them by heavy borrowing on the assets of the targeted company itself. To defend themselves proactively, companies would take on debt before being targeted. Already leveraged companies were less appealing to the raiders.

Leveraged dividend or share repurchase

Leverage is one of the options for Allergan. Allergan has a conservative, debt-free balance sheet. But in these times such things are not appreciated; the financial crisis is already a distant memory. Interest rates are at record lows and the bond markets are bubbly. While taking on a lot of debt is an unpleasant thought for the long-term, Allergan should bear in mind that Valeant would do it anyway.

Allergan can borrow a whole lot of money and pay a big dividend to shareholders. Allergan shareholders would be pleased that they do not have to share Allergan's riches with Valeant shareholders. That is, the benefit of taking on say $9 billion in debt would accrue entirely to Allergan shareholders. This is the simplest and fastest way to fend off the takeover.

Allergan can also do a share buyback. This may be more tax-efficient for shareholders, but will take more time to implement. The dividend has the advantage that it will immediately get the money out of the door to shareholders. This is essentially what Valeant is proposing indirectly' Valeant will take out the mortgage on Allergan and give the money to Allergan shareholders by dubbing it as the $48.3 cash component of its takeover offer. Valeant has no cash of its own to spare because it is already leveraged to the hilt.

If Allergan takes on a lot of debt on its own, it makes it much harder for Valeant. Valeant would be able to make only an all-stock offer for Allergan, because Valeant is already leveraged to the limit as far as debt-rating agencies are concerned. Any increase in Valeant's leverage will trigger a debt downgrade causing higher interest rates for Valeant. Allergan's shareholders have already expressed reservations about the value of Valeant's stock, so Valeant would be out of the game.

Allergan has around 300 million shares outstanding. Allergan has net cash of $1.6 billion ($3billion cash minus $2 billion debt). Allergan can announce a dividend of around $30 - $40 per share with borrowed money. Allergan showed operating cash flow of $1.7 billion last year, and that cash flow would doubtless grow in 2014.

Allergan's stock will spike up immediately in anticipation of the dividend. Even without Valeant's offer hanging in the air, Allergan's stock price will maintain its level.

Raising drug prices

Raising drug prices will give an immediate boost to Allergan's earnings. Allergan should remember that Valeant will raise prices on day 1 anyway. For example, when an analyst asked why Valeant was paying 3.7x sales for Precision Dermatology, Valeant CEO Michael Pearson replied that there was "significant pricing opportunity on day 1 which will bring that multiple way down."

Since Botox must be cash-pay, this would be easy to do. Allergan wouldn't have to deal with pharmacy benefit managers and insurance companies. Allergan should push through a price increase as high as the market can bear.

Most of Valeant's organic growth comes through price increases. Valeant revealed this in response to an analyst's question in one of its conference calls. In Valeant's 2013 10-K, Valeant says "In the Developed Markets segment, the revenue increase was driven primarily by price". The Developed Markets segment is 74% of Valeant's revenue.

By increasing prices, Allergan can do what Valeant will do anyway. The increased earnings will make Valeant's offer look worse.

Get a tax inversion

By acquiring a foreign company whose market cap is at least 20% more than that of the combined company, the acquirer can change its tax country. The US tax code has the disadvantage that profits earned in foreign countries are taxed at a high rate. The US corporate tax rate is also one of the highest in the world.

Valeant got its tax inversion in 2010 by acquiring Biovail in Canada. This gives it an advantage over US-based pharmas. Valeant can buy a US-based pharma company and immediately report higher profits from day 1 because the tax rate of the US-based pharma would change overnight to Valeant's low single-digit tax rate.

Allergan can buy Irish companies such as Shire (NASDAQ:SHPG) or Perrigo (NYSE:PRGO). Perrigo is a generics company; Allergan is not. But this option must be considered because Valeant is a generics company anyway. Jazz (NASDAQ:JAZZ) and Alkermes (NASDAQ:ALKS) are two other Ireland-domiciled pharmas - but they are too small compared to Allergan to get the tax inversion.

Acquiring other companies or getting acquired

I don't have any visibility into these possibilities. But Allergan's first-class dermatology and ophthalmology drugs should be appealing to an acquirer. An acquirer would also be able to leverage Allergan's assets in the same way that Valeant is proposing to do.

Allergan can also use its dry powder to make a large merger or acquisition. It can take on debt while doing so. By becoming larger, Allergan would put itself out of Valeant's reach.

Because of the flood of approvals in recent years and the guaranteed FDA approvals of Levadex and Ozurdex over the next few quarters, Allergan's stock has a lot of value and Allergan can easily raise debt. Allergan's organic growth is accelerating sharply.

Conclusion

Allergan has all the trump cards because of its fantastic drug portfolio and pipeline, and its debt-free balance sheet. It should be easily able to fend off this takeover if it plays its cards right. Despite what Valeant may say, Allergan has all the options.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.