Ominous Signs For Valeant In The Allergan Q2 Earnings Call

| About: Allergan plc (AGN)

Summary

Allergan's CEO looks set to make an acquisition. I haven't seen him this open-minded and aggressive about acquisitions before. He is confident of making his moves before any special meeting.

EPS benefit from any acquisition made by Allergan would have twice the effect compared to a deal with Valeant, because Allergan's cash-rich balance sheet won't be shared with Valeant shareholders.

Allergan's cuts and improved EPS are facts. Valeant's synergy hypotheses are just vague opinions. Valeant has managed to avoid describing exactly what it would cut - both R&D and SG&A.

Valeant has repeatedly said it is confident the deal will happen. If the deal doesn't happen, any investors who buy into Valeant based on such assurances will be sorely disappointed.

Because Valeant's proposal would have Allergan shareholders owning just 44% of the combined company, Valeant would have to more than double any move Allergan makes. Therefore this deal won't happen.

I took notes from Valeant Pharmaceuticals' (NYSE:VRX) June 17th call for this article.

Allergan about to be rid of Valeant?

Allergan's (NYSE:AGN) CEO sounded far more confident in Allergan's Q2 earnings call about making acquisitions than he has in the past. In the past, he would say things like tax inversions were not a priority and that strategic fit was the priority. (Although even as he said this, he was bidding for Elan Pharmaceuticals and Shire even before Valeant showed up. Both Elan and Shire are tax-domiciled in Ireland. Maybe he would say stuff like that to not weaken his bargaining power.)

Allergan's CEO said on Monday: "So I will just give you the conclusion, that I think that whatever we need to do can be done before a special meeting is held."

Given how cautious and conservative Allergan's CEO is, I suspect he must be close to bagging a deal. Any acquisition made by Allergan would have more than twice the benefit for Allergan shareholders compared to a combination with Valeant. This is because Allergan's shareholders would be owning just 44% of any combination with Valeant, whereas a standalone Allergan need not share the increased profits from an acquisition with Valeant.

As analyst David Maris pointed out, cuts that Allergan makes for Allergan shareholders would need to be divided by 0.44 to be compared to any move Valeant would make to a combined company. The same logic applies to profit increases from acquisitions also. As a result, I believe Allergan is about to get rid of Valeant. Valeant will have to more than double any move by Allergan to match Allergan (since 1 / 0.44 = 2.3).

An acquisition by Allergan would increase Allergan's EPS a lot more because Allergan's current EPS forecasts exclude any potential acquisitions. Right now Allergan's balance sheet is sitting idle.

2015 EPS forecasts

Allergan's 2015 EPS forecast is now $8.2 to $8.4. In the June 17th call, when an analyst asked Valeant for its 2015 EPS forecast, Valeant replied that it was "a bit premature to talk about 2015." Another opportunity for analysts to probe Valeant on its 2015 EPS will be Valeant's Q2 earnings call next week.

Due to the anniversary of the B&L acquisition next month, the gap between Valeant and Allergan will grow with every quarter. I don't know how long Valeant can avoid giving its 2015 EPS forecast.

Valeant's chicken-and-egg problem

Valeant arranged a presentation for analysts on June 17th. Valeant's stock price had fallen from $134 to $117 over the previous 10 days. These excerpts are from what Valeant's CEO said in the June 17th call. I guess Valeant's goal was to project a sense of confidence that this deal will happen so that it can attract arbs. Valeant's main hope for this deal lies with arbs. I think Valeant hasn't been able to gather enough shareholder support. It has not yet reached the threshold despite having the tender open since June 18th. This is what Valeant's CEO, Michael Pearson, said on June 17th within just one hour:

"...we firmly believe a shareholder vote will be overwhelmingly in support of the deal."

"...confident in our ultimate success."

"...confident that both Allergan and Valeant shareholders will support this combination"

"...we believe strongly that the support is there."

"...we are going to have a shareholder vote and this deal will be done"

"...we are confident it will go through"

Well, despite all that talk, Valeant is huffing and puffing to gather shareholder support. Ackman revealed that he expects to collect 40% shareholder support by mid-August so that there is sufficient buffer if people trade out of Allergan. That definitely doesn't sound like "overwhelming" support to me. Does it to you? Since Ackman already owns 9.7%, he hasn't yet been able to gather even 30% of the remaining 90%?

Without arbs there won't be a deal and without a deal there won't be any arbs. This must be why at every opportunity Pearson and Ackman call the deal with Allergan "inevitable." If the deal doesn't happen as I expect it won't, there will be a lot of disappointed Valeant investors because of these numerous assurances from Valeant management.

Valeant avoided telling how exactly it will achieve the synergies it claims

In the June 17th call, analysts asked some interesting questions. One of them was regarding R&D cuts and what exactly Valeant will retain in Allergan's R&D programs. Pearson's response was that he would spend $300-400 million on R&D in the combined company. He said he would decide what programs to spend on by gathering Valeant scientists and Allergan scientists and third-party independent scientists in a room and asking them to vote. Allergan says one needs that much money just for FDA mandated maintenance of existing products.

My guess is that no investor out there knows exactly how much it would cost Valeant to have the R&D programs it wants - because Valeant itself doesn't know exactly what R&D programs it will keep until Pearson's "scientists-in-a-room vote."

Most interesting question for me

The most interesting question for me was when an analyst asked how Valeant would realize the SG&A synergies it claims. Pearson's response was:

"We are expecting to maintain most of the customer-facing spending. One thing that we have learnt from the Medicis and B&L acquisition is 'dont touch the salesforce'. In Medicis we did touch the salesforce and that was problematic for a period of time. So that was a lesson we learnt. You can expect very little change in terms of the salesforces."

Then he said he would cut marketing expenses. OK, sounds reasonable to me so far. Then Pearson said this:

"The vast majority of the reductions in SG&A will be sort of backoffice - we don't need two headquarters buildings, we don't need two IT systems, we don't need two financial organizations, we don't need two investor relations, we don't need two heads of manufacturing, you know all those types of things. That is where the vast majority of synergies will be captured."

Then the analyst asks a great follow-up question:

"Can you give us your estimate or guess of how much that spend would be at Allergan? What proportion of their SG&A is their cuttable expense?"

Pearson gives this shocking reply:

"We have an estimate but you know if I gave you one today there would be an article rolled out about how terrible it was, that estimate was."

That's it. That is how Pearson avoided detailing what exactly he would cut. He doesn't have the confidence to tell us because he thinks he could be wrong?

I have worked at companies of different sizes and I know that the items that Pearson claims will deliver him the vast majority of synergies simply can't add up to much. Yes, you can save on investor relations and finance and HR, but you can't save that much on IT and manufacturing - larger companies will need larger IT and manufacturing. How much does a headquarters building cost annually? And how is this any different from any two other companies merging - what is special about Valeant's synergies?

Federal Reserve trying to bust Junk-bond bubble

This Bloomberg article says so. Remember that Valeant is junk-rated and needs the second-largest ever junk-bond offering to acquire Allergan. It seems the Federal Reserve has been trying to bust it for quite a while now, though unsuccessfully. However I believe in "don't fight the Fed" because eventually it will get busted, just not sure when.

Conclusion

Investors should demand exact details from Valeant because Valeant is claiming far more synergies in the Allergan deal than it has obtained in any past acquisition.

Allergan cutting 13% of its workforce is a fact. Valeant's synergy claims are Valeant's opinions. Just look at what Valeant told analysts on the June 17th call.

I believe Allergan is serving at matchpoint. Once it bags an acquisition it will be game, set and match Allergan. Valeant is staring into the abyss right now and Allergan needs to give Valeant that tiny nudge.

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