Investors received some not so shocking news yesterday with regards to the Allergan (NYSE:AGN)/Pfizer (NYSE:PFE) merger yesterday after the bell. The Treasury Department made an announcement regarding corporate tax inversions, which was telegraphed back in November 2015 that will make this Allergan/Pfizer marriage even more difficult to consummate.
The government is going to try limiting the amount of corporate inversions by limiting the amount of stock by disregarding foreign parent stock attributed to the deal for inversions to U.S. based companies. Earnings stripping is also going to be tackled by aiming for large interest deductions and allowing the IRS to parse debt instruments into part debt and part equity, and finally creating more work upfront for any potential partners by making them do the legwork identifying what is debt and what is equity when going through the due-diligence process. Treasury has been trying to enact something twice previously but hasn't been really successful.
Regardless of what laws are passed or not, when corporate lawyers and accountants have a job to do they are going to get it done and they'll find a way to continue spending less on taxes. These new rules are just an additional road block and not a solution. The root of the problem is the American corporate tax is just too high as can be seen by these stats pulled together by KPMG. Our government just keeps putting Band-Aids on the situation rather than tackling the actual problem and none of these Band-Aids are too burdensome to remove. But changing the corporate tax law is going to take an act of God to get done.
Now the question becomes, does this impact the Allergan/Pfizer merger in reality? Sure it does for the time being as Allergan's stock has dropped nearly 20% in after-hours trading yesterday but in reality if it wasn't for these tax implications this deal would get approval because there is very minimal product overlap between the two companies. The value of the inversion itself is roughly $27B from a market cap valuation perspective.
Prior to the merger announcement Allergan was trading roughly at $300/share from an ongoing operations perspective and if the news stands that causes the stock to trade around $220/share then this will be a very steep discount to what it was trading at on a standalone basis prior to even the merger announcement. I don't believe these new rules will put the fire out on the transaction whatsoever because these two companies knew something was coming down the pike eventually. If Pfizer does however decide to walk away there will be a hefty breakup fee associated with it that will be deposited into Allergan's bank accounts.
Investors shouldn't be buying stocks based on risk-arb spreads but should be buying a company based on the underlying fundamentals. Now ask yourself if Allergan deserves to be trading at this supposed $220 level even though ongoing operations have improved from when the deal was announced? Probably not, I'd say it is fair to say that it should be trading near $300 at least because that is what it was trading at prior to the announcement. On valuation alone Allergan is trading at 16x next year's earnings estimates with 11% long-term earnings growth expectations which makes it a great stock to own on a standalone basis.
Yes there is an increased risk of the deal not happening now but Allergan was inexpensive going into the news and it will be even more inexpensive on any weakness. Fortunately Allergan is not a company that can be in the crosshairs of the presidential candidates either for price gouging because the majority of their revenues are derived from the cosmetics space and are cash payments so that bit of revenue will remain unscathed from this biotech fallout we've been experiencing. I don't the stock can go much lower than here based on the company's product revenue streams.
I currently only have a 20% position in the name and will plan on watching the action tomorrow morning to potentially layer in another 20% position, especially if the 20% decline stands. I don't believe that this third time will be a charm for the Treasury department in trying to implement restrictions on tax inversions although these new rules will be effective on deals that have not yet closed. Although on the surface this deal may seem like it is being done for the tax inversion it is also a deal that makes sense from a product offering perspective as there are only six overlapping therapeutic areas with only two products that are overlapping between the two companies. The deal is expected to close later this year but I own Allergan on strictly a standalone basis. With the stock trading at a 52-week low and with ongoing operations improving what is there not to like about this maker of Botox.
Disclaimer: This article is in no way a recommendation to buy or sell any stock mentioned. This article is meant to serve as a journal for myself as to the rationale of why I bought/sold this stock when I look back on it in the future. These are only my personal opinions and you should do your own homework. Only you are responsible for what you trade and happy investing!
Disclosure: I am/we are long AGN.
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.