The U.S. Treasury Department announced earlier this week that it seeks to regulate proposed inversion mergers where one of the merging companies seeks to adopt the other's legal domicile. Inversions have become a hotly contested 2016 U.S. presidential election campaign issue as many companies look to invert, citing high U.S. corporate tax rates and various compliance measures (e.g., Dodd-Frank, Affordable Care Act, Sarbanes-Oxley) that stimulate the idea of moving their headquarters abroad and maintaining American subsidiaries. Notably, the new proposed regulations would target a practice known as earnings stripping, which involves inverted companies lending money back to their U.S. subsidiaries, which in effect lowers their taxes by counting these interest payments as tax deductible.
The $160 billion Pfizer-Allergan merger is the most prominent of recent inversion mergers involving a mega-cap U.S. pharmaceutical company seeking to stake its operations in the more tax-friendly Ireland, with its 12.5% corporate tax rate versus the 35% rate by remaining U.S.-headquartered. Allergan had been expected to benefit from its integration with PFE due to complementarity of the two companies' product portfolios along with PFE's world-class outreach and commercialization capabilities.
The deal, which was previously slated to presumptively close sometime in the second half of 2016, is now of course officially dead. Pfizer management filed an 8-K report to the SEC on April 6, 2016 declaring that an "adverse tax law change" had rendered its eventual close unlikely enough to the point where it was no longer worth waiting on. The merger had reached the point where the combination of several months' worth of additional waiting and its relatively low probability of closing were simply circumstances not worth being tied to due to the strategic immobilization it thrust on the company. Upon the news, AGN fell 19% in Monday's (April 4's) after-hours trading, though it has rebounded slightly since.
How might this news affect Pfizer's share price going forward?
For PFE shareholders, it's the ever-important question.
In a previous article we argued that the AGN merger would ultimately prove beneficial for PFE long-term through tax benefits, a business segment reorganization and consolidation, and access to AGN's pipeline to help drive top-line growth. Even as the more stringent regulation caused PFE to back out of the deal, it shouldn't threaten PFE's long-term viability as a strong income play. By the very nature of merger announcements themselves, acquiring firms (i.e., PFE's role in the deal) will normally suffer a dip in their price due to investors' skepticism over synergies actually being realized in practice. Naturally, when the probability of the merger took a dip upon Monday evenings news, PFE received a ~3% pop to reflect the greater uncertainty over a deal that looked very likely to close under the current legal environment. It has risen approximately 10% since.
We argued in the previous article that PFE's intrinsic valuation was difficult to justify at its languishing sub-$30 price observed last month. Even with the back-out of the AGN deal, M&A directed toward the benefit of its Global Innovative Products segment (i.e., new drug development) will still be on PFE's radar going forward. Other targets may include a smaller target such as Shire (enterprise value of $36.4B), or another larger player in the pharmaceutical space such as GlaxoSmithKline (EV of $114.6) or another charge at AstraZeneca (EV of $80.4B), the target of PFE's hostile takeover attempt in 2014.
From a strategy perspective, the collapse of the AGN deal could put a spin-off of PFE's Global Established Products division (i.e., generics business) back on the table, an action that many analysts viewed as a potential boon for shareholders last year. A GEP spin-off has been speculated for the same reasons PFE has sold off its non-core business components in the past - recent examples include Zoetis (animal health division), infant nutrition sale to Nestle in 2012, and its capsugel pill segment sale to KKR in 2011. The Hospira merger was expected to groom the segment for a spin-off by capturing its market share in the generics market. Divestitures of ancillary units have highlighted PFE's strategic goal of deriving capital to invest in its core growth units (i.e., GIP), one of the main reasons why AGN was targeted in the first place.
On the same token, although PFE has never prioritized its generics/biosimilars business - the big revenue in the modern pharmaceutical industry has always primarily been from developing blockbuster products - PFE may decide against a spin-off. Within the past couple years, the U.S. FDA began an approval process for biosimilars, which will help drive demand for these drugs going forward as more patents on popular brand-name drugs expire. Accordingly, PFE may find that retaining a strong (and perhaps growing) presence will help the business long-term.
The AGN merger sought to consolidate the business into two divisions from its current three. Its Vaccine, Oncology, and Consumer segment would have combined with its GIP division to form a new Global Specialty and Consumer Brands segment, while keeping its GEP segment as is. Even in its current three-segment organization, the sum-of-the-parts valuation for PFE is fairly straightforward.
We valued the GIP segment at approximately ~$60 billion, Vaccines at ~$30 billion, Oncology at ~$20 billion, and Consumer at ~$20 billion. The drug pipeline in 2016 revenue looks to be worth approximately $45 billion. The GEP/biosimilars segment is worth approximately $80 billion. Adding these figures up gives an estimated intrinsic market cap value of $255 billion. With roughly six billion shares outstanding, we still expect an intrinsic value slightly north of $40/share, or roughly on par with what peer median EBITDA multiples might suggest.
The market is current valuing these divisions at an approximate collective value of $195 billion, or about a 23%-24% discount to our believed intrinsic value. Even independent of what value Allergan could have provided to PFE by lowering its tax rate, initiating a reorganization of the business, and driving further revenue growth through the integration of AGN's unique pipeline, the long-term robustness of PFE's business model and standing in the market should realistically change very little even with the Treasury Department's success in engendering a PFE's back-out.
Even in light of recent developments, PFE has the benefit of its own pipeline, alternative M&A to consider, a reliable 3.5%-4% dividend yield, and a potential spin-off of GEP (if it wishes to go that route) for PFE to remain a long-term hold with remaining 20%+ upside.
Disclosure: I am/we are long PFE.
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.