Allergan (NYSE:AGN) is trying to avoid the hostile takeover by Valeant Pharmaceuticals (NYSE:VRX). One of Valeant's advantages is its low Canadian tax rate compared to US-based Allergan. Allergan can lower its tax rate by getting a tax inversion. This would require acquiring a company whose market cap would be at least 20% that of the combined company. Consequently, Allergan did approach Shire (NASDAQ:SHPG), an Ireland-based pharma, but was reportedly rebuffed in February. It was also reported that Allergan tried to sell itself to Sanofi (NYSE:SNY) and Johnson & Johnson (NYSE:JNJ); but those companies have refused to buy Allergan in its entirety. This article suggests that buying Perrigo (NYSE:PRGO) is a great option that might not have been considered.
Perrigo's durable competitive advantage
Perrigo has a durable competitive advantage unlike any other pharma. Perrigo makes store-brand OTC drugs, generics, nutritional products, diabetes products and animal-health products. Though Perrigo manufactures pharmaceuticals, it is best thought of as a fast-growing version of Kraft (KFT). This is because Perrigo commands great shelf-space at all retailers like Wal-mart, Costco, Target, Kroger, Walgreens, CVS, etc. Whenever you see a store-brand product near the pharmacy at such retailers, it is most likely made by Perrigo.
Once a company has been allotted such shelf space at retailers, it becomes impossible to dislodge. This is why it is like Kraft, except it grows much faster. This kind of competitive advantage is the reason Warren Buffett bought General Foods (Kraft's predecessor) in 1979 and quadrupled his investment in five years.
The 2014 Analyst Day presentation on Perrigo's website has all the information you need on Perrigo. It says that 72% of doctors and pharmacists themselves use store-brand rather than the original brand, i.e. educated consumers are more likely to use store-brand. The market share of store-brand has been increasing over the years.
All Perrigo does is piggyback on the products of the big pharma companies. For example, if Pfizer gets Lipitor approved for OTC, Perrigo will appear with its cheaper store-brand that the retailer will display alongside the OTC product. Its moat is like that of a railroad; the freight increases every year, but no one else has the distribution network. The essence of its moat is best described by Joe Papa in the latest earnings call transcript
The basic premise of what we're seeking to do, Jami, is simply saying we've got a great distribution channel with the large retailers, how do I get one more item on the truck that's at Perrigo today going to the large retailer that will be important to the retailer. Well, you may think that is a diversification. I simply would say to you that we believe that strategy allows us just to get -- be more important for our large retailers. And I think that is the overriding, what we believe, unique, sustainable, competitive position Perrigo has, is that we've got these relationships and distribution channel with the retailers. And therefore, by adding additional adjacencies, it allows us to have a longer-term stronger business with each of the retailers.
Joe Papa's hockey stick performance
Before Joe Papa joined as CEO in 2006, Perrigo's stock price and profit margins had been flat for years. After Papa joined Perrigo, Perrigo's chart turned into a hockey stick. Operating margins went from 9% to 23%, in addition to revenue increasing at the rate of 17% per year. Even if you had bought Perrigo at its 52-week high in 2006, you would have made 9 times your money at the 2014 52-week high. That is a compounded annual return of 31.6%. This is why Joe Papa should run the combined company - Perrigo shareholders would be more comfortable that way.
Perrigo on the bargain counter
Due to a mild flu season and flea/tick season, Perrigo missed Q3 expectations (Perrigo's fiscal year ends in June). In addition, Johnson & Johnson's flu remedies re-entered the market after they had been out due to recalls. On top of this, the Elan acquisition closed in December due to which Perrigo took a whole lot of acquisition-related charges this quarter. The slight revenue and earnings miss caused by these one-time factors led to a selloff in Perrigo last week. It is off by 25% from its 52-week high and trades at a trailing P/E of around 20.
Allergan buying Perrigo
Allergan has no takeover defenses. It doesn't have a staggered board, meaning that all directors can be replaced at the same time. Just 25% of investor votes are sufficient to call a special meeting of shareholders and Valeant already controls 9.7%. Allergan's takeover defenses were removed a few years ago by the activism of a small shareholder, as described in this article. I have covered why in my opinion Valeant's stock is overvalued in three articles, here, here and here.
But given that Perrigo shares are deeply undervalued right now, Perrigo's shareholders would need a big premium to the current market price. One way to find money would be to sell Perrigo's Tysabri royalties that it acquired as part of Elan. Perrigo gets 18% of the sales of Tysabri, Biogen Idec's (NASDAQ:BIIB) blockbuster multiple-sclerosis drug. This royalty stream is taxed at the rate of just 1%. Elan had sold half of the royalty stream it owned to Biogen for $3.25 billion before Elan was acquired by Perrigo. Lets assume the sale of the remaining half currently owned by Perrigo fetches $3 billion. This $3 billion can be paid out to current Perrigo shareholders as a dividend.
Allergan can probably come up with $11.6 billion in cash (I am using a ballpark estimate of $2.5 billion in 2014 EBITDA, $10 billion in total debt, $1.6 billion in net cash on hand). The rest can be in the form of Allergan stock. Allergan's stock has been kicked upward by Valeant's offer and Perrigo's has been kicked downward by short-sighted investors. It would be interesting to see what Perrigo might say to any potential Allergan offer, because there will be a big stock component. But Perrigo is just the right size to get a tax inversion. Its current beaten-down market cap is $17.3 billion. From Perrigo's point of view, it can negotiate nice terms due to Allergan's predicament.
Retaining Perrigo's fantastic CEO would go a long way towards appeasing Perrigo shareholders.
Other Irish pharmas
Actavis (ACT) is too big, Jazz (NASDAQ:JAZZ) and Alkermes (NASDAQ:ALKS) too small. Endo's (NASDAQ:ENDP) stock price is too high for its flat growth, therefore it may not be palatable to Allergan shareholders (Endo's high price is based on the hope that its new CEO who came from Valeant will turn Endo into another Valeant). I don't know of any other pharmas in low-tax jurisdictions that are large enough for Allergan's tax inversion.
Disclosure: I am long PRGO. 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.