Without question, one of the more shocking events of the year has been the Treasury's decision to insert itself into the world of pharma inversions, going as far as to create a bizarre regulation aimed squarely at preventing Allergan (NYSE:AGN) and Pfizer (NYSE:PFE) from becoming one. The market punished Allergan shares on the news while rewarding Pfizer shareholders-though I think this is ultimately the reaction of merger arbs covering Pfizer shorts and dumping Allergan stock more than a rerating of shares on a fundamental basis.
Ultimately, the Treasury's move may cause some near-term harm to shares of Allergan, but I think the company is now more likely to see its deal to sell its generics business to Teva (NASDAQ:TEVA) succeed. Two factors, in my view, will help the Teva deal close. For one, the government no longer needs an excuse to block the Pfizer/Allergan merger, and secondly, the lack of a merger should create a new generics player, reducing "concentration risk" and able to scoop up overlapping assets from the Teva/Allergan deal.
The government no longer needs to block the Pfizer/Allergan merger
Based on the dramatic actions of the Treasury, I believe the government planned to use every tool at its disposal to prevent Pfizer from leaving the United States. Little more evidence is needed that a regulation designed with language that essentially only impacts one current inversion.
Thus, I do not think it is a stretch to say that if the Treasury couldn't justify blocking the deal, another government agency would. I think the likely opponent here would have been the FTC. The FTC could have recommended the Depart of Justice (DOJ) block the Teva/Allergan deal on anti-trust grounds. The respective companies have significant portfolio overlap, and in contrast to allowing the companies to divest overlapping products, the merger could have been blocked.
Were the merger blocked, I am near certain that the FTC would find some overlap between Allergan's and Pfizer's respective generic portfolios, allowing regulators to block that deal on anti-trust grounds. The generic lap is the most conceivable way for this to have occurred, as Pfizer and Allergan do not have much branded pharmaceutical portfolio overlap.
Pfizer's generic business will likely be spun-off against a wave of generic consolidation
Now that the deal for Allergan is dead, I believe Ian Read and team are likely to break Pfizer into 2 businesses-proprietary pharma and generic pharma. The smaller proprietary pharma company may actually be able to invert, creating tremendous tax savings for shareholders. What's relevant to Allergan, however, is that the new Pfizer generic business could be interested in acquiring divested products from the Teva/Allergan deal as it creates its own portfolio. I am not privy to the exact details of the portfolio overlap, but I suspect there are several high value generics that will attract interest from Pfizer as it looks to create a standalone generics platform.
Having a new player in the generics space also could assuage some concerns about industry consolidation, creating a less critical look from the FTC. As you may recall, Allergan is set to own ~10% of Teva, which meant that Pfizer, owner of significant generics business, was set to own 10% of Pfizer. With regulators less concerned about industry concentration, the divestiture process should go more smoothly.
Completion of the deal with Teva substantially derisks Allergan's equity
Given the panic inherent recently in the specialty pharma market, I believe many investors are worried that Allergan is another Valeant (NYSE:VRX) waiting to happen. The company has amassed a tremendous $41B mountain of debt due to acquisition heavy growth. Allergan undoubtedly owns several high quality assets, but its business model alone is enough to shake confidence in the common equity.
However, I think closing the deal with Teva substantially derisks the equity both in practice and in confidence. While it's difficult to peg an after-tax value, Allergan will receive $40B+ or so on a pretax basis. This provides Allergan with ample liquidity, and importantly, the ability to aggressively de-leverage if the market losses confidence in its business model.
That said, I think shares are worth about $350 based on my discounted cash flow analysis. Because of the confidence I have in CEO Brent Saunders' ability to identify and commercialize valuable assets, I think Allergan's stock in the next 3-5 years is likely to outperform the price Pfizer placed on the assets. I expect Allergan to acquire valuable proprietary pharmaceutical products that it can commercialize better than its competitors, driving a quick recovery in Allergan's share price.
Disclosure: I am/we are long AGN, VRX.
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.