A Valeant Effort: How Allergan Used Acquisition Accounting To Inflate Sales Growth, Boost NOLs, And Reinvent The Operating Profitability Of Actavis Generics

| About: Allergan plc (AGN)

Summary

Allergan used revenue withholding to inflate the revenue growth of acquirees, notably Legacy Allergan, and their corresponding product lines.

The company appears to be migrating non-IPR&D intangibles between tax jurisdictions to maximize NOLs.

Management apparently decided it was OK to offload assets and amortization charges from Actavis Generics, thereby vastly overstating the operating performance of the business.

Teva's CEO Vigodman has a 4.5M+ bonus riding on successful completion of the merger - making it unlikely he will act in his shareholders' interests without significant pressure.

Allergan's most dramatic price increases have focused on niche disease states for 2nd- and 3rd-tier products, like Valeant - a risk for forward margins in AG.

1 Recommendation

Short Allergan (NYSE:AGN) to PT of $155/sh.

2 The life-cycle of a serial acquirer

2.1 Overall timeline

There are of course acquisitive companies like Pfizer (NYSE:PFE) that have done quite well for long periods of time. However, the acquisition pace of "growth pharma" is quite different from what Pfizer has done. Therefore, it is instructive to study the history of another serial acquirer, WorldCom. This may seem aggressive as I have yet to illustrate any other parallels between the businesses, but I think it is essential to note the milestones in a serial acquirer's lifecycle in order to recognize those signs as we proceed with our work. I call this "hypothesis-driven investing." I have divided the lifecycle into stages per Soros.

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2.2 1983-1995 A prevailing bias and a prevailing trend

1983: Businessmen Murray Waldron and William Rector sketch out a plan to create a discount long distance provider called LDDS (Long-Distance Discount Service).

1985: Early investor Bernard Ebbers becomes chief executive officer of LDDS.

1989: LDDS becomes public through the acquisition of Advantage Companies Inc.

1992: LDDS merges in an all-stock deal with discount long distance service provider Advanced Telecommunications Corp.

1993: LDDS acquires long distance providers Resurgens Communications Group Inc. and Metromedia Communications Corp. in a three-way stock and cash transaction that creates the fourth-largest long-distance network in the United States.

1994: LDDS acquires domestic and international communications network IDB Communications Group Inc. in an all-stock deal.

1995: LDDS acquires voice and data transmission company Williams Telecommunications Group Inc. for $2.5 billion and changes its name to WorldCom Inc.

2.3 1995-1996 Acceleration of the trend

1996: WorldCom merges with MFS Communications Company Inc. and UUNet Technologies Inc.

2.4 1996-1998 A period of testing and price setbacks

Little merger activity.

2.5 1998-1999 If the bias and price survive the testing, then a point is reached where participants no longer believe the usual rules apply. Market values become unhinged from reality. A twilight period occurs where participants continue to play the game although they no longer believe in it

1998: WorldCom completes three mergers: with MCI Communications Corp. ($40 billion) - the largest in history at that time - Brooks Fiber Properties Inc. ($1.2 billion) and CompuServe Corp. ($1.3 billion).

2.6 1999-2000 A tipping point is reached where the bias is reversed

1999: WorldCom and Sprint Corp. (NYSE:S) agree to merge.

2000: U.S. and European regulators block proposed merger with Sprint; WorldCom and Sprint terminate agreement.

2.7 2000-2002 The crash ensues

2001: WorldCom merges with Intermedia Communications Inc., a provider of data and Internet services to businesses.

2.8 2002-2005 The facts come out and regulators respond

2002:

* March 11: WorldCom receives a request for information from the U.S. Securities and Exchange Commission relating to accounting procedures and loans to officers.

* April 3: WorldCom says it is cutting 3,700 jobs in the U.S. or 6 percent of WorldCom group's staff, 4 percent of WorldCom's overall work force.

* April 22: Standard & Poor's cuts WorldCom's long-term and short-term corporate credit ratings.

* April 23: Moody's Investors Service cuts WorldCom's long-term ratings. Fitch cuts the company's ratings, saying it expects WorldCom's revenue to deteriorate during 2002, with prospects for recovery in 2003 uncertain.

* April 30: WorldCom Chief Executive Officer Bernard Ebbers resigns amid slumping share prices and a SEC probe of the company's support of his personal loans. Vice Chairman John Sidgmore takes reins of the company.

* May 9: Moody's cuts WorldCom's long-term debt ratings to junk status, citing the company's deteriorating operating performance, debt and expectations for further weakness.

* May 10: Standard & Poor's cuts WorldCom's credit rating to junk status.

* May 13: Standard & Poor's removes WorldCom from its S&P 500 Index.

* May 15: WorldCom says it would draw down a $2.65 billion bank credit line as it negotiates for a new $5 billion funding pact with its lenders.

* May 21: WorldCom says it will scrap dividend payments and eliminate its two tracking stocks, one that reflects its main Internet and data business and a second that reflects its residential long-distance telephone business.

* May 23: WorldCom secures $1.5 billion in new funding to replace a larger, $2 billion credit line.

* June 5: WorldCom says it will exit the wireless resale business and will cut jobs to reduce expenses and pare massive debts.

* June 25: WorldCom fires its chief financial officer after uncovering improper accounting of $3.8 billion in expenses that covered up a net loss for 2001 and the first quarter of 2002. The company also says it will cut 17,000 jobs, more than 20 percent of its workforce.

* June 26: Nasdaq market halts trading in WorldCom's two tracking stocks, WorldCom Group and MCI Group. Shares of WorldCom touched as low as 9 cents before the halt. President George W. Bush calls for full investigation of the matter.

* June 28: WorldCom lays off 17,000 workers - including about 2,000 in the Washington area.

* July 1: WorldCom reveals that an internal investigation has uncovered questionable accounting practices stretching back as far as 1999.

* July 2: WorldCom chief executive John Sidgmore appeared at a Washington press conference to apologize for the company's accounting scandal. He also said the company hopes to avoid a bankruptcy filing.

* July 8: Former top WorldCom executives Bernard Ebbers and Scott D. Sullivan refuse to answer questions posed by a congressional committee.

* July 9: WorldCom CEO John W. Sidgmore says the company has only enough cash to keep operating for two more months and that it is growing more likely the telecommunications giant will file for bankruptcy protection.

* July 11: In a live Web discussion on washingtonpost.com, Sidgmore says Worldcom will not sell off core Internet operations.

* July 11: A congressman tells the news media that former WorldCom Inc. chief financial officer Scott D. Sullivan told company lawyers that he informed ex-chief executive Bernard J. Ebbers about bookkeeping maneuvers that made the company look more healthy than it really was.

* July 17: A source tells The Washington Post that WorldCom has secured a $2 billion financing package that it would use to operate under bankruptcy protection.

* July 21: WorldCom files for bankruptcy protection, listing some $107 billion in assets and $41 billion in debt, on a consolidated basis as of March 31, the largest such filing in U.S. history. CEO Sidgmore says the company plans to emerge from protection within 9 to 12 months. The company will have access to up to $2 billion in funding but does not plan to tap all of it.

* July 29: WorldCom names two specialists from AlixPartners LLC to oversee its reorganization and straighten its finances. Gregory Rayburn was appointed chief restructuring officer and John Dubel was hired as chief financial officer.

* August 1: WorldCom's former Chief Financial Officer Scott Sullivan and former Controller David Myers are arrested for their role in the scandal. The two were charged in a seven-count complaint accusing them of securities fraud and filing false statements with the Securities and Exchange Commission.

* August 9: WorldCom's internal auditors have uncovered an additional $3.8 billion in improper accounting, doubling the amount of its known accounting errors to more than $7.6 billion over the past two years.

* August 17: The Washington Post reports that members of WorldCom's board support removing CEO John Sidgmore.

* August 22: News report state that a complex deal with WorldCom accounts for some of the revenue America Online previously announced it may have improperly booked.

* August 26: Salomon Smith Barney, the investment banking firm, discloses that it rewarded some WorldCom executives with IPO stock. Critics said the practice raises concerns because it could amount to an improper reward for WorldCom officials for bringing lucrative banking business to Salomon. The WorldCom executives were able to reap financial gain from selling the IPO stock. WorldCom founder Bernard Ebbers and former CFO Scott Sullivan received shares, according to subsequent news reports.

* September 11: WorldCom chief executive John W. Sidgmore agrees to step aside from his top post.

* September 27: WorldCom Inc.'s former controller, David F. Myers, pleaded guilty to three counts of conspiracy, securities fraud and making false statements to the Securities and Exchange Commission. Myers is the first WorldCom executive to fall in the largest accounting scandal in U.S. history.

* October 7: Buford Yates Jr., WorldCom Inc.'s former accounting director, pleads guilty to two counts of securities fraud and conspiracy.

* October 10: Prosecutors charge two former finance officials, Betty L. Vinson and M. Normand, with two counts of conspiracy and securities fraud in separate proceedings.

* Nov. 6: SEC expands fraud case against WorldCom Inc., with claims that the company's improper bookkeeping dates back to at least 1999, totaling over $9 billion in fraudulent activity.

* Nov. 21: WorldCom plans to lay off 3,000 workers in coming month in effort to trim company costs and emerge from bankruptcy.

* Nov 27: WorldCom reaches initial settlement with SEC, in which the company must continue to submit to federal oversight. The question still remains whether the company will be subject to a fine.

* Dec. 16: Judges approve employment contract that entitles new CEO, Michael D. Capellas, $20 million over three years.

* Dec. 18: Six WorldCom directors resign.

* Dec. 20: Despite financial woes, WorldCom is awarded contract to provide global communications service to State Department.

2003:

* Feb. 3: WorldCom announces that it will lay off 5,000 more employees.

* March 12: Federal prosecutors ask WorldCom to delay release of the company's accounting investigations while they examine new evidence that could incriminate former CEO, Bernard J. Ebbers.

* March 14: WorldCom announces that it will take one-time $79.8 billion write-off.

* April 15: WorldCom unveils reorganization plan that would erase most of its debt, rename the company after its long-distance unit, MCI, and move its headquarters from Clinton, Miss., to Ashburn, Va.

* April 22: Former CFO, Scott D. Sullivan, pleads not guilty today to securities and bank fraud.

* May 19: WorldCom agrees to pay investors $500 million to settle civil fraud charges.

* July 7: A federal judge approves a $750 million settlement between WorldCom and federal regulators.

* July 22: Verizon Communications agrees not to oppose WorldCom's reorganization plan.

* July 26: Sources say the Justice Department is investigating allegations that WorldCom improperly rerouted long-distance calls.

* July 31: The General Services Administration notifies WorldCom that it is ineligible to win new federal contracts until it improves accounting controls.

* August 4: WorldCom tells a federal bankruptcy court that preliminary results from an internal investigation found no evidence that the long-distance telephone company tried to disguise the origin of calls or route them improperly to avoid paying fees to local phone companies.

* August 6: A bankruptcy judge approves a $750 million settlement of civil fraud charges made by the Securities and Exchange Commission on WorldCom investors' behalf.

* August 12: WorldCom appoints former AT&T Corp. (NYSE:T) executive Richard R. Roscitt as its new president and chief operating officer.

* August 27: Oklahoma Attorney General W.A. Drew Edmondson files criminal charges against WorldCom Inc. and six former executives, including founder Bernard J. Ebbers.

* Sept. 3: Former WorldCom Inc. chief executive Bernard J. Ebbers pleads not guilty to charges that he violated Oklahoma fraud and securities laws.

* Sept. 9: Two groups of dissident creditors abandon their legal challenge to the company's reorganization plan in return for a combined payout of more than $400 million.

* Sept. 12: A federal bankruptcy judge signs off on WorldCom's revised bankruptcy plan today and allowed the company to send it out to creditors for their approval.

* Sept. 15: WorldCom Inc.'s internal and external auditors testify in U.S. Bankruptcy Court that the company's books remain a tangled mess.

* Oct. 13: AT&T Corp. agrees to drop objections in federal bankruptcy court to portions of WorldCom Inc.'s reorganization plan.

* Oct. 14: WorldCom Inc. announces the appointment of a chief ethics officer who will report directly to the chief executive.

* Oct. 15: A federal bankruptcy judge in New York hears the last remaining objections to WorldCom Inc.'s plan for reorganization.

* Oct. 21: The federal judge overseeing WorldCom's bankruptcy case has ordered the company to respond to the concerns of a small group of creditors who object to the plan.

* Oct. 31: U.S. Bankruptcy Judge Arthur J. Gonzalez approved WorldCom Inc.'s reorganization plan.

* Dec. 22: Federal prosecutors say they intend to show that former WorldCom Inc. chief financial officer Scott D. Sullivan was involved in 13 kinds of accounting fraud in addition to the financial wrongdoing with which he is charged.

2004:

* Jan. 7: The government lifts a five-month suspension that had kept WorldCom from receiving new federal contracts.

* Jan. 12: Company officials say WorldCom is putting the finishing touches on three years of financial restatements but should emerge from bankruptcy protection by a court-imposed deadline of Feb. 28, 2003.

* Jan. 15: Sources confirm that WorldCom is planning to lay off an additional 1,700 employees, about 3 percent of its workforce.

* March 15: WorldCom becomes the latest in a string of companies to split the jobs of chairman and chief executive.

* April 20: MCI officially emerges from bankruptcy, 21 months after filing the largest Chapter 11 case in history.

* May 10: MCI says it will eliminate 7,500 jobs, or 15 percent of its workforce.

* Aug. 12: The Justice Department gives a New York investment firm permission to acquire a controlling stake in MCI Inc.

* Sept. 28: A private buyout firm that had said it was seeking to take control of MCI Inc. sells its 5 percent stake in the long-distance giant.

2005:

* Jan. 8: The lead plaintiff in the WorldCom class-action suit formally announces a $54 million settlement covering 10 former WorldCom directors.

* Jan. 19: Jury selection begins in the trial of WorldCom's former chief executive, Bernard J. Ebbers.

* Jan. 25: Opening statements are heard in the trial of Bernard J. Ebbers.

* Feb. 2: A federal judge rejects part of a groundbreaking settlement in which 10 former WorldCom directors agreed to pay $54 million to settle a shareholder lawsuit.

* Feb. 14: Verizon Communications Inc. announces a $6.75 billion deal to buy MCI Inc.

* March 15: Former WorldCom Inc. chief executive Bernard J. Ebbers is found guilty of conspiracy, securities fraud and making false filings with regulators.

3 The making of a deal-maker

The following is a full reprint of an article published in Forbes in early in 2015. If you do not understand the genesis of growth pharma or the close historical ties between the management at Valeant (NYSE:VRX) and Allergan, it will be difficult for you to understand how the companies "coincidentally" embarked on similar paths. I have annotated the article later in this writeup, but included it undoctored here (link).

The son of a urologist and social worker, Saunders grew up in Pennsylvania and paid his own way through that state's college system as a furniture mover (he still has a bad back) and a clerk, earning a JD and an MBA. By 29 he had made partner at PricewaterhouseCoopers, focusing on regulatory compliance in health care.

He might have stayed a consultant for life had he not caught the attention of Fred Hassan, the legendary pharmaceutical turnaround artist. Hassan had made Pharmacia, a Swedish company, into a market darling through a huge acquisition, a spinout and a 64B sale to Pfizer. By 2003, when he met Saunders, Hassan was chief executive of Schering-Plough, and many thought the company was unfixable. Schering was accused of kickbacks, dangerously bad manufacturing and illegal marketing. Hassan needed an outsider to come in and help him clean up.

Hassan heard about Saunders from Schering's CFO, and though there were two other candidates more qualified on paper, Hassan became impressed by the younger man's drive and focus. "I just became convinced that this guy was going to be all-in," says Hassan. "In the end I think all of us have the IQ. The people who look to doing a job as something they really enjoy doing, they are always going to do better than those who look upon it as a job. I said, "'This guy's really going to get into it.'"

Hassan sold him to the BOD as Schering's new chief compliance officer, and once on board Saunders stamped out bad practices, negotiated hundreds of millions of dollars in settlements with the feds and personally entered the company's guilty plea. He rose fast: In 2007 Hassan tasked his apprentice with leading the integration of Dutch biotech Organon, which Hassan had bought for 14B. In the process Saunders began internalizing Hassan's dealmaking playbook: Create your own team; eliminate middle managers and pay attention to the people who actually deal with your customers; find products that can be made to perform better. Also: Wrap your strategy up in a nice slogan employees, journalists, and investors can get behind - maybe something like "Growth Pharma."

End result: Schering was sold to Merck for 41B in 2009. Hassan left to become partner at Warburg Pincus, and Saunders was left to manage the integration with Merck from the Schering side. "It's a tough experience," says Saunders. "You've worked so hard, and you've become passionate for the people and for the way of doing things. All of a sudden there is a new owner, and they want to do things their way."

When Saunders got another job offer, to be COO of a healthcare products company, he called Hassan, his top reference. "Do you have to take it?" Hassan asked. Saunders, taken aback, asked if there was something wrong with his prospective employer. No, Hassan replied, but could he call him back?

Hassan set up a meeting the next day between Saunders and the partners at Warburg. Within a week Hassan's 40-year-old protégé had an offer to be CEO of B&L, which Warburg had bought for 4.5B in 2007 after its contact lens solution caused dangerous infections. Hassan would be chairman.

It was a tough assignment. Bausch was a 160-year-old company that hadn't grown for 30 years. Saunders replaced two-thirds of the company's managers. He made a string of acquisitions and introduced 34 new products, including a new laser for eye procedures. In the two years he ran the firm, sales grew at an annualized 9% and EBITDA at 17%.

B&L prepared for an IPO, with Saunders still at the helm. But then he got a call from Michael Pearson, a former McKinsey consultant who was now chief executive of Valeant Pharmaceuticals. They knew each other well from their consulting days. Pearson got right to the point: He wanted to buy Bausch.

It was clear Pearson was going to cut Bausch to the bone. (Later, on a conference call announcing the deal, he said that Saunders' team "had made very little cuts" and that Bausch had a cost structure comparable "to a Big Pharma company." He promised to cut SG&A from 40% of sales to 20%. Once in charge, he did.)

Saunders returned from an IPO road show, went to meet Pearson on a Friday and signed the deal to sell B&L at 4am on a Saturday. "It was emotional; I poured my heart and soul into B&L," he says with surprising passion, considering he spent just 24 months with the firm. "I love the brand. I love the people. I love the customers. It almost becomes like your second family." But, he says, it was the "absolute right decision," and there was never any doubt about the outcome. "This company was for sale the day Warburg Pincus bought it," he says. "That's the model in private equity. Warburg Pincus saved the company because this company would have gone through a miserable experience as a public company doing this turnaround."

As the deal closed, Saunders went from Warburg to Icahn. In 2011 Icahn bought an 11% stake in Forest Laboratories and put a lieutenant on the BOD, convinced that Forest's 84-year-old CEO, Howard Solomon, had lost his touch. He chafed at Solomon's plan to hand the business to his son David. "FOREST LABS IS NOT A DYNASTY TO BE DESPOTICALLY HANDED DOWN FROM FATHER TO SON IGNORING THE GREAT RISK OF THIS ACTION TO ITS SHAREHOLDERS," Icahn thundered in all caps in a letter to investors.

Right after the Bausch deal closed, Saunders was make CEO of Forest to appear Icahn. He quickly dipped into Hassan's playbook, dubbing the shake-up "a rejuvenation" - and almost immediately looking to make a deal. Three months after joining Forest, he was having steaks with Paul Bisaro, the CEO of Actavis, at the JP Morgan Healthcare Conference in San Francisco. Saunders joked about the idea of them merging. The idea stuck, and they kept talking more about it, more and more seriously.

On Feb 18, 2014 Actavis bought Forest for 28B, a 25% premium to the stock's previous close. Icahn's take approached 2B on the deal. "He came in and he got it done in 5 months," says Icahn. "If you look at that result that's pretty damn good. I just thought he did a great job."

Successfully jobless once again, Saunders had dinner with Icahn and suggested starting a company by buying some aging drugs from a large pharmaceutical company. Icahn offered to give him 2B, subject to due diligence. "There are very few people I would do that with," Icahn says.

But Bisaro, who'd built Actavis into a 6B powerhouse in the generic drugs business through his own string of blockbuster deals, also recognized Saunders' talent. If he leaves, if we lose him, then the company is going to be worse off," Bisaro said. Over lunch from Actavis' cafeteria, he offered Saunders the CEO job of the combined Actavis-Forest, and Saunders accepted. "I know I would probably be able to make more money doing something on my own," says Saunders, "but I really believe Actavis is something special."

Of course, one of Saunders' first moves was, true to his nature, a blockbuster acquisition. On July 11, 2014, just ten days after he officially became Actavis' CEO, Saunders asked his board for permission to talk to Allergan's CEO, David Pyott, who was embroiled in one of the nastiest takeover battles ever in an industry known for nasty takeover battles.

Pyott had been CEO of Allergan for 17 years. He'd taken a product Allergan licensed for lazy eye and turned it into Botox (you know what it does), a 2B blockbuster. He'd delivered annualized sales growth of 12% over ten years, along with a 267% shareholder return. Yet to Valeant's Pearson, he was an inefficient CEO who allowed bloated spending to drag down shares. Pearson offered 45.6B for the company, a 31% premium for investors over current share prices, and got Pershing Square's activist hedge fund manager, William Ackman, to take a 9.7% stake in Allergan to push the deal through.

Pearson's parsimony was on full display. He opened up an investor presentation by stating that they were in such a nice room only because Ackman covered the cost. "This'll never happen again, unless someone else wants to pay," he said. That extended to his plans for Allergan. He promised to cut Allergan's 1B+ R&D budget by 69% to 300M and cut another 1.8B, or 40%, from the combined company's operating budget.

Pyott was repulsed. "Valeant is vile, and there is nothing I have learned since then that has changed my mind," he says. "They're an asset stripper." He did everything he could to fight off the attack. He publically disparaged Valeant, cut R&D and operational spending himself, and even filed a lawsuit in California alleging that Ackman's purchase was insider trading.

On July 30 Saunders called Pyott and offered to be a white knight. Over months of phone calls, he portrayed himself as the anti-Pearson, despite the fact that agreed with much of Pearson's thesis on the drug business. No, Saunders told Pyott, he would not strip the company like Pearson. Allergan would continue to do crucial research on things like dry-eye drugs and successors to Botox. Yes, the business could stay largely intact. They kept talking - six times in October alone. All the while Pearson's and Saunders' bids for the company kept climbing, topping 60B. Pyott finally agreed to Saunders' terms when his suit against Ackman went against him. The final offer was 67B - far too expensive for Pearson's blood. Saunders had won.

On the eve of the takeover [about the time this article was published] Saunders is saying all the right things to keep the peace. For starters, he's promising to keep Allergan's R&D budget intact. The new Actavis will spend 1.7B, or 7% of sales, on R&D, compared with 250M, or just 3%, for Valeant. Saunders even says he plans to keep research in drug discovery, because Allergan's research in bacterial toxins (like Botox) and dry-eye disease is some of the best in the world. He points out that when you exclude its generics business, Actavis will spend 13% of sales on R&D, about as much as a big pharma. Even when it comes to sales and other operating expenses, he plans to cut only 1.8B, or about 20%. Ripping deeper, as Valeant would have, has its own costs. Pissing off all your new employees can be expensive and counterproductive. "We're not the Borg; we don't go in and assimilate companies," says Saunders. "We try to learn from their culture. We learn from their processes, and we certainly try to learn from their talent. We want to get better."

Timing plays a part, too. Pearson's slash-for-cash strategy for Valeant shined for investors at a moment when pharma R&D was at its absolute worst. But last year 41 new drugs got approved, 130% more than in 2007 - partly because new science is delivering more successful research programs and partly because of luck.

Still, Saunders being Saunders, there's another possibility: a fast sale. The likeliest buyer: Pfizer. Last year Pfizer attempted a 100B hostile takeover of AstraZeneca, in part to avoid paying US taxes by redomiciling in London. It failed. Buying Actavis, analyst have pointed out, would also allow Pfizer to do the same thing.

Moreover, Pfizer has entertained spinning out its generics business, which is composed almost entirely of old Pfizer drugs. Combining it with Actavis would give it a real generics business for that division, while bulking up the drug business, too. In an interview with analysts at Bernstein Research this summer, Pfizer seems to embrace the idea of potentially buying a generics company. Pfizer declined to comment, and Saunders things the prospects of such a deal are "negligible."

But of course, the door is open. "Our stock's for sale every day on the New York Stock Exchange," he says. "We're a shareholder-friendly management and board."

4 Acquisition history

Allergan has grown at a pace unprecendented in the drug industry, even relative to Valeant. The parent has also changed its name 3 times in the past 3 years (Watson -> Actavis -> Allergan). The difficulties this presents to the security analyst became evident to me when I started digging through the filings to create 5-year graphs for various metrics. One needs to dig through 3 separate filing trails (Allergan/Actavis, Watson, and Actavis Group) plus multiple subsidiaries (Legacy Allergan, Forest, Warner Chilcott) to find the data. One also struggles with limited disclosure of operations of new subsidiaries in the parent's financials, although the parent company is more than happy to provide acquisition accounting data (asset values, capitalization policies, etc).

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5 Numbers

5.1 Basic ratios

The following summary data are pulled from YCharts and do not account for continuing/discontinued operations or other accounting problems. I present them here as a broad overview, but will refer directly to the filings for valuations and manually constructed charts. I will also present YCharts graphs here and there but you should realize their database does not account for all the variables in such a complicated company as this one.

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5.2 Price

The price sensitivities of the two companies have been similar, although Brent Saunder's clever "bifid sale" of the Actavis Generics and Other components of the businesses to Teva (NASDAQ:TEVA) and Pfizer respectively was viewed as something of a put option on the stock. Correspondingly, the stock started to lose its downside when Pfizer fell through.

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5.3 Death triad

This is my favorite roll-up screen, the screen I initially used to identify both VRX and AGN early last year. It also notes such rollup companies as Endo International (NASDAQ:ENDP), the MLPs, and Tailored Brands (NYSE:TLRD).

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5.4 Operating Metrics

Note the large disparity between EBITDA and net income:

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5.5 Balance Sheet

Note that Allergan has a vastly larger asset base than Valeant. Allergan got further in its life cycle than Valeant, permitting this. This should portend to investors correspondingly larger amortization and write-down charges to catch up down the road.

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Endo follows this pattern as well.

5.6 LT Debt vs. FCF

The conventional FCF here omits some very material charges we'll review later. Nonetheless, debt service is clearly a problem. Given that only 10B of the proceeds from Teva are bookmarked for debt repayment - it will remain a problem. If the Teva deal does not complete, it will be an immediate and major problem since the company will (1) no longer be able to benefit from acquisition accounting sans a replacement deal, few of which will be found at the same exorbitant valuation (2) have to go into austerity mode to service debt, cutting into its supposed discretionary cash flows.

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Again, this is FCF BEFORE acquisitions.

5.7 Cash Flow

Note that serial acquirers conventionally boast excellent CFO. This is a fluke arising from the nature of acquisition accounting. The proper metric to use is FCF after acquisitions.

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5.8 Net Income vs. Operating Cash Flow

The discrepancy between net income and CFO hints at poor earnings quality.

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5.9 Earnings Quality

Accruals suggest the same.

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5.10 DSRI

Receivables to revenue hints at early revenue recognition but is difficult to interpret when a company makes large acquisitions each year. We can, however, see that AGN and VRX exhibit a similar trend since 2010.

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5.11 SGAI

If revenue is rising faster than SG&A this can be an indicator of early revenue recognition or inflated revenues. This pattern is not evident.

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5.12 Debt to Equity

At first it might seem Allergan is the more conservatively financed of the two:

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This is an illusion created by Allergan's inflated asset values, while the debt of the two is on the same order of magnitude (40B vs. 30B).

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5.13 Rev/Assets

Allergan's asset base is even less productive than Valeant's. This was an important indicator leading up to the collapse of WorldCom.

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5.14 Assets/PP&E

Assets/PP&E is another classic indicator of inflated asset values that would have tipped investors off to the frauds at Enron and Worldcom. AGN's current Assets/PP&E is over 2x Valeant's - a fact not helped by the fraudulent transfer of intangible assets from Actavis Generics to continuing operations in order to lower amortization at Actavis Generics and boost the unit's apparent operating performance.

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5.15 Debt to EBITDA

Although the YCharts' EBITDA figures are not really accurate, we'll see that AGN has been out of compliance with its consolidated debt ratio covenant for some time - a fact unwisely ignored by creditors in apparent anticipation of the sale of Actavis Generics.

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5.16 Interest Coverage

Allergan's GAAP interest coverage ratio remains low or negative.

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5.17 EV/Rev

Investors assign AGN a significantly higher multiple than VRX - apparently considering (1) the pending sale of the bulk of Allergan's business to Teva and Pfizer, and (2) the moat value of Legacy Allergan's brands.

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5.18 EV/EBITDA

Same comment as above.

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6 Asset productivity

In my Valeant paper I looked at what an appropriate set of comparables would be based on the productivity of the company's assets. The question can be phrased: "how much revenue can the company generate using a given quantity of assets?" This analysis of course ignores margins, but has the advantage of ignoring accounting variations that may emerge farther down the operating statement and balance sheet. Revenue and assets are among the most objective quantities (a company can overstate its assets but will not often understate them). Screening for EV > 50B and Assets/Rev > 5 and excluding banks/financial services companies, we get the following list:

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To address the margin question, let's repeat the analyst using Assets/EBITDA > 25 instead of Assets/Rev > 5:

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Again, we find AGN in strange company indeed. It should be noted that although AGN is typically classified as a specialty-generic pharmaceutical company with high margins and favorable business economics, the productivity of its capital base is more akin to that of a bank or capital-intensive energy producer. Banks and speculative producers tend to accumulate assets during good times and sell off assets/restructure during bad times. It should also be noted that many of these companies have experienced precipitous price declines since summer 2015 due to deterioration in the credit markets generally, the credit crisis instigated by Valeant in the specialty-pharmaceutical industry, and the broad decline in oil prices.

To really drive this point home, let me you show you a few more mind-blowing charts:

7 Organic growth rate

7.1 Method 1: Sum of Top Selling Products

This will repeat for completeness an analysis I conducted in a previous paper. The key to properly valuing Allergan and Actavis Generics is to deduce the real organic growth rate for these businesses. To do this we need to somehow bypass AGN's truncated and confusing accounting. The easiest way to do this is by taking the sum of sales for the top 15 products by 2015 sales (excluding products where individual sales data cannot be extracted). This gives:

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The "total less launches" figure is provided to show what would happen if reinvestment in new product launches was below historical levels. Not surprisingly, sales peak and then start to decline precipitously in such a scenario. While Allergan is more nominally committed to reinvestment than Valeant, it will nonetheless have difficulty giving the businesses the same attention they got when they were independent. This is reflected in the ratio of the number of new product launches at legacy businesses under Allergan's care vs. prior, admittedly using a somewhat limited dataset given the pace of acquisitions. Hence, the true forward growth rate probably lies somewhere in between the two curves. To ensure a healthy margin of safety in our short thesis, we'll take the upper curve. But just keep in mind that if for whatever reason AGN's pace of new launches proportionate to its size should fall below historical levels for the component businesses, sales will level off and start to decline - an uncomfortable fact already noted by the markets at ENDP and VRX.

From the upper curve, we deduce a best-case CAGR of 6.5%.

The above analysis is all fine and good, but doesn't provide us much granularity on what is driving sales - unit volume or unit price. Since the company is cagey about this information, let's see what we can pull from publically available sources in the next section.

First though, let's briefly explore an alternative method for deriving the organic growth rate - one I used in my Valeant article.

7.2 Method 2: Sum of Acquisitions

This method works less well than you might think due to the somewhat nonsensical "organic growth" figures it generates for Warner Chilcott and Actavis Group. The problem is these two companies were themselves acquisitive, making them hardly a good measure of organic growth for the component product lines. Hence we won't pursue this method further.

8 Unit Volume vs. Price Increase effect on sales growth

8.1 Botox (Allergan, acq 2015)

The old Allergan did not provide unit vs. pricing detail for botox. However, they do provide the following guidance in the 2014 10-K for 2014:

Total sales of Botox® increased in 2014 compared to 2013 due to growth in sales for both therapeutic and cosmetic uses. Sales of Botox® for therapeutic use increased in the United States, Canada, Europe, and Asia Pacific, primarily due to strong growth in sales for the prophylactic treatment of chronic migraine and for the treatment of urinary incontinence, partially offset by a decline in sales in Latin America. Sales of Botox® for cosmetic use increased in the United States and Europe, partially offset by a decline in sales in Canada and Latin America. The decline in net sales of Botox® for both therapeutic and cosmetic use in Latin America was primarily due to decreases in sales in Venezuela related to the economic turmoil in that country and lack of foreign exchange. The decline in net sales in Canada resulted from the launches of two competitive products. The increase in sales of Botox® for cosmetic use in the United States and Europe was primarily attributable to higher unit volume. Additionally, sales of Botox® for both therapeutic and cosmetic uses in the United States were positively impacted by an increase in the U.S. list price for Botox® of three percent that was effective January 1, 2014. Based on internal information and assumptions, we estimate in 2014 that Botox® therapeutic sales accounted for approximately 55% of total consolidated Botox® sales and increased by approximately 15% compared to 2013. In 2014, Botox® Cosmetic sales accounted for approximately 45% of total consolidated Botox® sales and increased by approximately 10% compared to 2013. We believe our worldwide market share for neuromodulators, including Botox®, was approximately 75% in the third quarter of 2014, the last quarter for which market data is available.

And 2013 with less detail:

Total sales of Botox® increased in 2013 compared to 2012 due to strong growth in sales for both therapeutic and cosmetic uses. Sales of Botox® for therapeutic use increased in all of our principal geographic markets, primarily due to strong growth in sales for the prophylactic treatment of chronic migraine and an increase in sales for the treatment of urinary incontinence. Sales of Botox® for cosmetic use increased in the United States, Latin America, Europe and Asia, partially offset by a decline in sales in Canada due primarily to the introduction of competitive products in that market. Based on internal information and assumptions, we estimate in 2013 that Botox® therapeutic sales accounted for approximately 54% of total consolidated Botox® sales and increased by approximately 17% compared to 2012. In 2013, Botox® Cosmetic sales accounted for approximately 46% of total consolidated Botox® sales and increased by approximately 8% compared to 2012.

Based on the above, it appears reasonable to assume that Botox has enjoyed strong organic (unit volume) growth plus modest price increases in recent years. These are trends that could reasonably be expected to continue if the brand performs as well under new management as old. It does seem that price increases are more acutely felt in the private-pay setting, perhaps limiting the upside pricing potential of the product (link).

8.2 Restasis (Allergan, acq 2015)

Unit/sales data on this one can be pulled from drugs.com. We can see that prior to 2013 a big part of the sales gains came from unit increases, while price increases drove the gains during 2013. Unfortunately this resource does not provide 2014 data.

From the 2014 old Allergan 10-K:

We increased prices on certain eye care pharmaceutical products in the United States in 2014. Effective January 1, 2014, we increased the published U.S. list price for Restasis®, Lumigan® 0.01%, Lastacaft®, Combigan®, Alphagan® P 0.1%, Alphagan® P 0.15%, Acular®, Acuvail® and Zymaxid®by seven percent. Effective July 8, 2014, we increased the published U.S. list price for Alphagan® P 0.1%, Combigan®, Lumigan® 0.01% and Restasis® by an additional three percent. These price increases had a positive net effect on our U.S. sales in 2014 compared to 2013, but the actual net effect is difficult to determine due to the various managed care sales rebate and other incentive programs in which we participate. Wholesaler buying patterns and the change in dollar value of the prescription product mix also affected our reported net sales dollars, although we are unable to determine the impact of these effects.

From the 2013 old Allergan 10K:

We increased prices on certain eye care pharmaceutical products in the United States in 2013. Effective January 5, 2013, we increased the published U.S. list price for Restasis®, Lastacaft® and Zymaxid® by five percent, Combigan® and Alphagan® P 0.1% by seven percent, Lumigan® 0.1% and Alphagan® P 0.15% by eight percent, and Acular®, Acular LS® and Acuvail® by eighteen percent. Effective May 18, 2013, we increased the published U.S. list price for Restasis®, Alphagan® P 0.1%, Alphagan® P 0.15% and Lastacaft® by an additional five percent and Zymaxid®, Acular®, Acular LS® and Acuvail® by an additional six percent. Effective November 23, 2013, we increased the published U.S. list price for Acular LS® by an additional ten percent. These price increases had a positive net effect on our U.S. sales in 2013 compared to 2012, but the actual net effect is difficult to determine due to the various managed care sales rebate and other incentive programs in which we participate. Wholesaler buying patterns and the change in dollar value of the prescription product mix also affected our reported net sales dollars, although we are unable to determine the impact of these effects.

The unit volume graph corroborates well with Legacy Allergan's declared aggressive pricing increases on the product in 2013, presumably owing the upcoming patent expiration. The above implies Restasis revenue growth on a forward basis will be driven by price increases, if those are an option.

8.3 Namenda XR (Actavis, launched in-house)

Namenda was one of the few products in the most recent list of "Top 15" products that Watson/Actavis/Allergan actually launched itself (and not without excitement in the patient community). Allergan has not provided volume-vs-price data on the product since launch.

8.4 Bystolic (Forest, acq 2014)

While Forest did not provide detailed volume-vs-price data, the disclosures for the past few years indicated a transition from volume- to price-driven growth, as one might expect for a product entering plateau:

2014:

Bystolic (nebivolol HCl), our beta-blocker indicated for the treatment of hypertension, had an increase in sales of 16.4% to $529.6 million in fiscal 2014 as compared to $455.1 million in fiscal 2013. This increase was driven by price increases and modest volume growth.

2013:

Bystolic sales increased $107.3 million to $455.1 million in fiscal 2013 as compared to $347.8 million in fiscal 2012 due to increased sales volume and pricing.

2012:

Bystolic grew 31.6%, an increase of $83.5 million to $347.8 million in fiscal 2012 over the $264.3 million in fiscal year 2011 primarily due to increased sales volume.

It appears that Bystolic has moved from the unit growth to price hike phase.

8.5 Asacol/Delzicol (Warner, acq 2013)

From the Warner 10-K:

Net sales of ASACOL were $793 million in the year ended December 31, 2012, an increase of 7%, compared with $743 million in the prior year. ASACOL net sales in the United States in the year ended December 31, 2012 totaled $719 million, an increase of $46 million, or 7%, compared to $673 million in the year ended December 31, 2011. The increase in ASACOL net sales in the United States relative to the prior year was primarily due to higher average selling prices and a decrease in sales-related deductions, offset in part by a decrease in filled prescriptions of 3% based on IMS estimates. In the United States, our ASACOL 400 mg product accounted for approximately 72% and 78% of our total ASACOL net sales in the United States in the years ended December 31, 2012 and 2011, respectively. In February 2013, the FDA approved DELZICOL (mesalamine) 400 mg delayed-release capsules, our new 400 mg mesalamine product for the treatment of ulcerative colitis. We anticipate that we will commercially launch DELZICOL in March 2013, and that DELZICOL will become the promotional priority for our gastroenterology sales force upon launch.

Per the new Allergan, Delzicol sales did not fully replace Asacol on volume basis:

8.6 Namenda IR (Forest, acq 2014)

Again, we can pull data through 2013 from drugs.com:

From the Forest 2014 10-K:

Sales of Namenda increased $130.3 million or 9.4% to $1.5 billion in fiscal 2013 as compared to $1.4 billion in fiscal 2012. This increase was primarily driven by price increases. During fiscal 2013, Namenda experienced a decline in volume driven by changes in prescribing behavior in the long-term care setting.

Clearly, price increases partially offset declining unit volume for Namenda.

8.7 Lumigan (Allergan, acq 2015)

Legacy Allergan did not provide unit volume/price breakdown for Lumigan, but did note in the 2014 10-K:

We increased prices on certain eye care pharmaceutical products in the United States in 2014. Effective January 1, 2014, we increased the published U.S. list price for Restasis®, Lumigan® 0.01%, Lastacaft®, Combigan®, Alphagan® P 0.1%, Alphagan® P 0.15%, Acular®, Acuvail® and Zymaxid®by seven percent. Effective July 8, 2014, we increased the published U.S. list price for Alphagan® P 0.1%, Combigan®, Lumigan® 0.01% and Restasis® by an additional three percent. These price increases had a positive net effect on our U.S. sales in 2014 compared to 2013, but the actual net effect is difficult to determine due to the various managed care sales rebate and other incentive programs in which we participate. Wholesaler buying patterns and the change in dollar value of the prescription product mix also affected our reported net sales dollars, although we are unable to determine the impact of these effects.

8.8 Linzess (Forest, acq 2014)

Forest 2014 10-K:

Linzess has been granted five years of Hatch-Waxman exclusivity that extends to 2017. Linzess is also protected by U.S. composition-of-matter and method-of-use patents that expire in 2024. A request for PTE has been submitted to extend a composition-of-matter patent to 2026.

Linzess, our guanylate cyclase agonist for the treatment of irritable bowel syndrome with constipation and chronic idiopathic constipation in adults, recorded sales of $175.1 million in fiscal 2014 and $23.7 million in fiscal 2013. The increase was due to increased volume as Linzess was launched in December 2012.

8.9 Alphagan P, Alphagan and Combigan (Allergan, acq 2015)

Legacy Allergan 2014 10-K:

We increased prices on certain eye care pharmaceutical products in the United States in 2014. Effective January 1, 2014, we increased the published U.S. list price for Restasis®, Lumigan® 0.01%, Lastacaft®, Combigan®, Alphagan® P 0.1%, Alphagan® P 0.15%, Acular®, Acuvail® and Zymaxid®by seven percent. Effective July 8, 2014, we increased the published U.S. list price for Alphagan® P 0.1%, Combigan®, Lumigan® 0.01% and Restasis® by an additional three percent. These price increases had a positive net effect on our U.S. sales in 2014 compared to 2013, but the actual net effect is difficult to determine due to the various managed care sales rebate and other incentive programs in which we participate. Wholesaler buying patterns and the change in dollar value of the prescription product mix also affected our reported net sales dollars, although we are unable to determine the impact of these effects.

Legacy Allergan 2013 10K:

We increased prices on certain eye care pharmaceutical products in the United States in 2013. Effective January 5, 2013, we increased the published U.S. list price for Restasis®, Lastacaft® and Zymaxid® by five percent, Combigan® and Alphagan® P 0.1% by seven percent, Lumigan® 0.1% and Alphagan® P 0.15% by eight percent, and Acular®, Acular LS® and Acuvail® by eighteen percent. Effective May 18, 2013, we increased the published U.S. list price for Restasis®, Alphagan® P 0.1%, Alphagan® P 0.15% and Lastacaft® by an additional five percent and Zymaxid®, Acular®, Acular LS® and Acuvail® by an additional six percent. Effective November 23, 2013, we increased the published U.S. list price for Acular LS® by an additional ten percent. These price increases had a positive net effect on our U.S. sales in 2013 compared to 2012, but the actual net effect is difficult to determine due to the various managed care sales rebate and other incentive programs in which we participate. Wholesaler buying patterns and the change in dollar value of the prescription product mix also affected our reported net sales dollars, although we are unable to determine the impact of these effects.

8.10 Lo Loestrin Fe (Warner, acq 2013)

WC 2012 10-K:

Net sales of our oral contraceptive products increased $65 million, or 14%, in the year ended December 31, 2012, compared with the prior year. LOESTRIN 24 FE generated net sales of $389 million in the year ended December 31, 2012, a decrease of 2%, compared with $396 million in the prior year. LOESTRIN 24 FE filled prescriptions were negatively impacted by our shift in promotional focus to LO LOESTRIN FE beginning in early 2011. More specifically, the decrease in LOESTRIN 24 FE net sales was primarily due to a decrease in filled prescriptions of 16%, offset, in part, by an expansion of pipeline inventories, higher average selling prices and a reduction in sales-related deductions relative to the prior year. LO LOESTRIN FE, which was commercially launched in the United States in early 2011 and is currently the primary promotional focus of our women's healthcare sales force efforts, generated net sales of $137 million in the year ended December 31, 2012, an increase of 117%, compared with $63 million in the prior year. The increase in LO LOESTRIN FE net sales primarily relates to an increase in filled prescriptions of 178%, an expansion of pipeline inventories and higher average selling prices, offset, in part, by an increase in sales-related deductions relative to the prior year.

WC 2011 10-K:

Net sales of our oral contraceptive products increased $73 million, or 18%, in the year ended December 31, 2011, compared with the prior year. LOESTRIN 24 FE generated net sales of $396 million in the year ended December 31, 2011, an increase of 16%, compared with $342 million in the prior year. The increase in LOESTRIN 24 FE net sales was primarily due to a reduction in sales-related deductions and higher average selling prices, offset in part by a decrease in filled prescriptions of 4%, and a contraction of pipeline inventories relative to the prior year. LO LOESTRIN FE, which we began to promote in the United States in early 2011, generated net sales of $63 million in the year ended December 31, 2011. Filled prescriptions of LO LOESTRIN FE increased 38% in the quarter ended December 31, 2011 as compared to the quarter ended September 30, 2011. FEMCON FE revenues in the year ended December 31, 2011, which we report in "Other Oral Contraceptives" revenue, were negatively impacted by the introduction of generic competition beginning in March 2011.

8.11 Viibryd (Forest, acq 2014)

Forest 2014 10-K:

We obtained exclusive worldwide rights to Viibryd through our acquisition of Clinical Data, Inc. (Clinical Data) which was completed in April 2011. Viibryd was launched in the U.S. in August 2011. The exclusive worldwide rights to develop and market Viibryd are licensed from Merck KGaA. Viibryd has been granted five years of Hatch-Waxman exclusivity that extends to 2016. Viibryd is also protected by a U.S. composition-of-matter patent that expires in 2014. A request for PTE has been submitted to extend the composition-of-matter patent to 2019. In addition, there are multiple issued U.S. patents directed to polymorphic forms of Viibryd that extend to 2022.

Sales of Viibryd (vilazodone HCl), our selective serotonin reuptake inhibitor (NASDAQ:SSRI) and a 5-HT 1A receptor partial agonist for the treatment of adults with MDD totaled $199.0 million in fiscal 2014 and $162.5 million in fiscal 2013. The increase year over year was driven primarily by increased volume.

Forest 2013 10-K:

Sales of Viibryd (vilazodone HCl), our selective serotonin reuptake inhibitor and a 5-HT 1A receptor partial agonist for the treatment of adults with MDD totaled $162.5 million in fiscal 2013 and $56.5 million in fiscal 2012. The increase year over year was driven primarily by increased volume.

8.12 Estrace Cream (Warner, acq 2013)

Warner 2012 10-K:

Net sales of our hormone therapy products increased $34 million, or 17%, in the year ended December 31, 2012, as compared with the prior year. Net sales of ESTRACE Cream increased $37 million, or 24%, in the year ended December 31, 2012 as compared to the prior year. The increase in ESTRACE Cream net sales was primarily due to a 13% increase in filled prescriptions, higher average selling prices and a decrease in sales-related deductions, offset, in part, by a contraction of pipeline inventories relative to the prior year.

Warner 2011 10-K:

Net sales of our hormone therapy products decreased $11 million, or 6%, in the year ended December 31, 2011, as compared with the prior year. Net sales of ESTRACE Cream increased $21 million, or 15%, in the year ended December 31, 2011 as compared to the prior year. The increase was primarily due to higher average selling prices and an 11% increase in filled prescriptions in the year ended December 31, 2011, offset in part, by an increase in sales-related deductions as compared to the prior year.

8.13 Minastrin 24 Fe (Warner, acq 2013)

No pre-acquisition sales data available, hence no volume/price disclosure available.

8.14 Carafate/Sulcrate (Forest, acq 2014)

2014 Forest 10-K:

Certain of our products or products that we may acquire may have limited or no patent protection. For instance, Carafate has no patent protection. While we believe these products benefit from a variety of intellectual property, regulatory, clinical, sourcing and manufacturing barriers to competitive entry, there can be no assurance that these barriers will be effective in preventing generic versions of our products from being approved. In addition, because Aptalis' strategy has in part been to in-license or acquire pharmaceutical products that typically have been discovered and initially researched by others, future products might have limited or no remaining patent protection due to the time elapsed since their discovery.

No price vs. volume guidance.

2011 Aptalis 10-K:

CARAFATE and SULCRATE

Our CARAFATE and SULCRATE product lines are indicated for the treatment of gastric and duodenal ulcers.

CARAFATE is sold in the U.S. as oral tablets and an oral suspension and SULCRATE as an oral suspension in Canada. Neither formulation is actively promoted. Both product lines compete primarily against generic sucralfate tablets.

We reported combined net sales of $108.6million, $86.5 million and $68.5 million for CARAFATE and SULCRATE in fiscal years 2011, 2010 and 2009, respectively. The increase in sales from fiscal year 2009 to fiscal year 2010 as well as from fiscal year 2010 to fiscal year 2011 mainly resulted from increases in prescription volumes and from price increases.

9 Accounting Practices

9.1 Earnings Manipulation Shenanigans

9.1.1 Recording Revenue Too Soon/Recording revenue before the buyer's final acceptance of the product

9.1.1.1 Channel stuffing: possible, but even if it exists, probably not a significant factor in Allergan's revenue growth

As is well known, Valeant was scrutinized for its booking of revenue to specialty pharmacies such as Philidor, which were actually related parties. The idea is that by owning a distributor you can avoid having to make a distinction between "sell-in" and "sell-through" in your accounting. At the time, Allergan made the following statement:

In a quick response to Valeant's (VRX -27.4%) mess regarding routing business through specialty pharmacies, Allergan (AGN -3.9%) says in a statement that it does not rely on this method for distributing its products. About 3% of the sales of branded products are sold through unaffiliated specialty pharmacies, the majority of which are BOTOX Therapeutic and ZENPEP. Its Anda Distribution business is through a traditional pharmaceutical wholesaler with no specialty pharmacy capabilities or licensing. Trading in AGN has resumed after a brief halt.

This misses the point. The question is that Philidor was primarily a distribution operation, and that its close relationship/ownership by Valeant enabled premature/repeat recognition of revenues. This can be done with any owned distributor so long as it receives product directly from the manufacturer (of course, Philidor was also involved in various aggressive pricing practices that don't relate directly to the question of revenue recognition). Since Allergan owns Anda Distribution outright, a similar opportunity exists for any related-party revenues, which appear to be primarily related to the discontinued Actavis Generics business:

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It is additionally interesting to note that although Anda Distribution's operations relating to Allergan's own products appear to pertain only to Actavis Generics, Allergan intends to retain the business rather than divesting it to Teva and closely co-manage with Teva:

Allergan will retain its global branded pharmaceutical and medical aesthetics businesses, as well as its biosimilars development programs, certain over the counter products, and the Anda Distribution business. The Company will also have continuing involvement with Teva after the close of the transaction. As a result of the Teva Transaction, the Company will hold equity in Teva, continue to distribute Teva products through our Anda Distribution segment as well as purchase product manufactured by Teva for sale in our US Brands segment as part of ongoing transitional service and contract manufacturing agreements.

As we know, the premature revenue recognition at Valeant from Philidor appears to have been limited to <100M, although it would certainly be much greater if Valeant had a "network of phantom pharmacies" as Left originally claimed. So far as I am aware, it was not possible to determine the premature revenue recognition from Valeant's financials alone, but required that one visit the individual websites for the pharmacies and recognize that they were, in fact, Valeant-administered. In the case of Anda distribution this would be impossible since it is a B2B rather than B2C business.

I don't want to overstate the case. Collecting evidence to prove/disprove channel-stuffing through a related-party distributor at Allergan would be impossible without additional disclosure. And given the scale of Anda relative to Allergan's overall business, would it really be important anyway? Anda doesn't seem to have the expertise to distribute most of Allergan's acquired products, and Allergan is more interested in acquiring than reworking its distribution chain at acquires. Further, it would be hard to see this method boosting revenue growth significantly relative to Allergan's method of understating revenues for a newly acquired company to boost YoY growth.

I have often stated that Philidor was more "the straw that broke the camel's back" at Valeant than the real essence of Valeant's accounting transgressions, which have more to do with the methods presented here. If Valeant had actually had an entire network of phantom pharmacies (which is, I guess, still possible), the case might be different.

9.1.1.2 SRA reserves do not appear understated

Although it may perhaps be of less interest, I will comment on a few things I looked for but did not find. One of these is premature revenue recognition by understating SRA reserves (rebates, chargebacks, cash discounts). Since the SEC inquired about Watson's SRA disclosures, I think the company would be aware that it would be unwise to doctor their SRA provisions (link, link, link).

As we can see, SRA reserves and provisions accounted for relatively stable percentages of AP and revenue respectively, implying that significant efforts were not made to accelerate revenue recognition by this device.

9.1.2 Boosting income through misleading classifications

9.1.2.1 Watch for companies that constantly record "restructuring charges"

As you might expect, restructuring charges are a recurring part of Allergan's operating costs in ever-increasing absolute quantities, in keeping with their implied corporate objective to execute one "monster deal" per year:

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These "non-recurring" charges are, naturally, added back to adjusted EBITDA and EPS (see later section).

9.1.2.2 Removing legitimate operating expenses from Actavis Generics' balance sheet, and depositing NOLs on it

Let's compare operating metrics for the discontinued vs. overall operations:

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We notice that Actavis Generics has a much lower asset balance relative to revenue, with correspondingly reduced amortization/asset impairments. Correspondingly, the business has strongly positive operating results and of course, no debt service. We can see the almost comical disparity between Actavis Generics and its parent in the figures below:

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If this seems like magic, it is. Amortization charges are real costs for Allergan - the amortized cost of buying new specialty-generic drugs, which will die off in a few to several years and need to be replaced with others. Thinking you can just "unload" assets from a discontinued business and make those amortization charges go away is like thinking that by writing off the assets of a railroad you'll no longer have to make capital expenditures to replace the rails and engines. Portraying Actavis Generics in this way goes beyond flattering - it's fraudulent, plain and simple. The cessation of depreciation and amortization under discontinued operations accounting does NOT allow Allergan to inflate historical operating performance for the business as well by pulling out assets and amortization charges, which is what has occurred (see above).

But that was just a warm-up for Saunders, who proceeded to pull off one of the greatest tax capers in recent corporate history. He bundled a bunch of Allergan's NOLs into a 5.5B "care package" and dumped it in the nonoperating section of discontinued ops, thereby generating an unprecedented 6.8B windfall year for the segment, and then further claimed discontinued operations on Allergan's consolidated balance sheet, thereby inflating Allergan's own net income by 5.5B! Incredibly, Allergan's only comment for this whopping benefit was the following statements:

(1) For the year ended December 31, 2015, the company recorded a deferred tax benefit of $5,738.8 million related to investments in certain U.S. subsidiaries as this tax benefit will reverse in the foreseeable future. The recognition of this benefit has been reflected in income from discontinued operations, net of tax with the deferred tax asset reflected in non-current deferred tax assets on the balance sheet.

(2) In the third quarter of 2015, the Company reported its global generics business as a discontinued operation and its assets and liabilities as part of assets held for sale. For provision for income taxes, the Company calculated its total provision and its provision for taxes from continuing operations as well as discontinued operations consistent with the accounting standard. As part of recording assets held for sale, the Company also recorded the tax provision or benefit on certain differences between book and tax on its outside basis of both domestic and foreign subsidiaries. The most significant of these is a $5.7 billion deferred tax asset related to investments in certain domestic subsidiaries. This asset was recorded in Q3 since the benefit is expected to be realized in the foreseeable future. Specifically, the deferred tax asset will reverse upon the sale of these subsidiaries to Teva. Refer to "NOTE 7 - Discontinued Operations" for more information.

(3) As discussed in Note 4 to the consolidated financial statements, the Company has changed the manner in which it classifies deferred income taxes in 2015.

Interesting, the FASB modification is noted:

In January 2015, the FASB issued ASU No. 2015-01 "Income Statement - Extraordinary and Unusual Items (Subtopic 225-20)." to eliminate the concept of extraordinary items. As a result, an entity will no longer (NYSE:I) segregate an extraordinary item for the results of ordinary operations; (ii) separately present an extraordinary item on its income statement, net of tax, after income from continuing operations; and (NASDAQ:III) disclose income taxes and earnings-per-share data applicable to an extraordinary item. However, the ASU does not affect the reporting and disclosure requirements for an event that is unusual in nature or that occurs infrequently. The guidance is for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. A reporting entity may apply the amendments prospectively. A reporting entity also may apply the amendments retrospectively to all prior periods presented in the financial statements. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The effective date is the same for both public business entities and all other entities. The adoption of this guidance is not anticipated to have a material impact on the Company's financial position or results of operations.

Anyway, it would seem Allergan has found a way to have its cake (sell Actavis Generics at a premium price) and eat it too (enjoy a humdinger year in the process by excluding all discontinued operations from its consolidated statements except the net income windfall). The only fly in the ointment is that the Pfizer-Allergan merger blew up - the timing would have ensured Allergan's windfall year could never be directly compared with a year to come.

To review how the remarkable 2015 results were achieved, the playbook was:

(1) Move the Actavis Generics business to "discontinued operations."

(2) Inflate operating income for Actavis Generics by vastly understating amortization and impairments, thereby justifying a premium sale price to Teva.

(3) Throw in a monstrous tax benefit for the discontinued business:

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(4) Include the net income for the discontinued operations, no questions asked, on its own operating statement - goosing Allergan's net income by 5.5B in the process! It would seem Allergan has discovered how to have its cake (sell Actavis Generics for premium) and eat it too (inflate its own net income).

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The 5.5B question in all of this is: is it legal to transfer the NOLs (largely generated through amortization charges) from an entire corporation to a single sold division? This is where the beauty of Allergan's tax treatment comes into play, to be discussed shortly. This is a question the IRS will have to figure out. If it says no, as a start, Actavis Generics and Allergan will both take a monumental 5.5B hit to 2015 earnings. Ouch!

9.1.3 Shifting Current Expenses to a Later Period

9.1.3.1 Improperly capitalizing routine operating expenses

We'll dig into capitalization of individual expense categories a bit later, but for now here's a table illustrating how tortuous the cash flows are through the consolidated financial statements:

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9.1.3.2 Amortizing costs too slowly

9.1.3.2.1 Be alert for boosts to income from stretching out the amortization period

9.1.3.2.1.1 Allergan as a whole

If we compare the amortization relative to goodwill and intangibles for AGN vs. a stalwart acquirer like PFE, we see the amortization rates (goodwill and intangibles/amortization) are comparable:

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So everything is hunky-dory, right? Well, we also need to consider the productivity of the asset base. In other words, for a given amount of goodwill and intangibles, how much is associated with currently producing assets and how much with future ones? The distinction is important because we know that there is more uncertainty (and hence higher probability of write downs) associated with the latter. Measured in this way, we can see that PFE's goodwill and intangibles are nearly 4 times as productive as AGN's:

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Here's Allergan's policy for selecting the amortization period:

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Now let's look at some specific examples:

9.1.3.2.1.2 Allergan Acquisition

As a test case let's look at the amortization schedule Allergan provides for the finite-lived intangibles associated with the Allergan acquisition:

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Let's use this to construct an amortization schedule starting on the completion date of the acquisition:

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Notice that this implies that the amortization FROM THE LEGACY ALLERGAN ASSETS ALONE must be around 1875M. Yet, Allergan's 2016 Q1 10Q presented only 1673M (1592M for continuing ops plus estimated 81M for 1 quarter of discontinued ops) for ALL finite-lived assets put together:

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So it seems pretty obvious that Allergan is vastly stretching out their amortization assumptions to inflate their operating income. A few other things to note. After an acquisition, the finite-lived intangibles will produce a level amortization schedule for the first few years (about 7.5B in our example) which will taper thereafter.

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It we look at Assets/Amortization, it will start at around 20-25% (assuming 4-5 years for the average useful life) and rise rapidly thereafter:

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Now, obviously we shouldn't expect aggregate Allergan to show ratios this high since the indefinite-lived intangible write-downs won't contribute to amortization. But the reality is that even many of the "indefinite-lived" intangibles presented above as listed as such simply because their exact lives are uncertain, not because they have indefinite lives. If we assumed a 10-year average life across all assets plus goodwill, the (Amort + Writedowns)/Assets ratio for the whole company would be 10%. Given that the company currently has about 115B in goodwill and intangibles, that would amount to a whopping 11.5B annual amortization expense. This provides a good indication of the future profitability of the business under "steady-state" conditions. And remember that these are just paper charges - most of Allergan's drugs will be off patent or face significant new competitors in 10 years, obviating or significantly impairing both their cash-flow-generating ability and resale value.

9.1.3.2.1.3 Forest Acquisition

The big acquisition before Allergan was Forest. As we saw, the first few years of an acquisition's amortization schedule should be a pretty flat expense, so they're not out of the woods on this yet either. Let's see exactly what they should be paying annually and quarterly:

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Again, we construct an amortization schedule:

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From this we can see that Allergan should currently be amortizing somewhere around 765M quarterly for the Forest definite-lived assets. That brings the total ABSOLUTE MINIMUM that Allergan should be amortizing quarterly at this point to 2640M vs. the paltry 1673M that they actually did. This doesn't even take into account amortization items other than Allergan and Forest. And of course, we have no way to "supervise" management's write-downs of the larger categories of goodwill and IPR&D. We are led to assume the delays to appropriate adjustment of asset values may be vastly greater there based on the asset/revenue ratios for the overall company. When these assets are ultimately written down and charged to expense, the event could be catastrophic for creditors and stockholders alike.

We saw how Allergan's amortization schedule is most often understated even relative to its own weighted average lives for definite-lived assets. The picture gets murkier when we consider the topic of unplanned write-downs of various "soft" asset accounts. As we noted earlier, if the company took a conservative average 10% annual amortization/write-down for its assets, the annual charge to earnings would be a whopping 13.6B - on the same order of magnitude as the company's entire revenue for continuing operations in 2015! Contrast this with the actual ratio of (amortization + impairments)/assets for the last 5 years:

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Given the unpredictability of the competitive landscape in the specialty-generic space, Allergan has done a remarkably good job of keeping its amortization + impairments eerily close to 5% - or an average asset life of around 20 years! Of course, the other possibility is the life will actually be considerably shortened once management changes the opening of many golden parachutes.

9.1.3.2.1.4 A few more comparisons with Valeant

As one final point, this discrepancy between the way these expenses are usually recorded by pharma companies and how "growth pharma" is capitalizing them was highlighted by Legacy Allergan during their bitter takeover fight with Valeant (how ironic):

With respect to Counterclaimants' allegations that Valeant is "cash-flow positive," Counterclaim Defendants respond that, on information and belief Valeant's financial performance is inferior to Allergan's on the basis of net cash provided by operating activities on the cash flow statement. In addition to having superior cash flows provided by operating activities, Allergan's cash flow from operations/average total liabilities and price to cash flow ratios exceed the comparable measures for Valeant. Further, Valeant's cash flow margin ratio exceeds Allergan's only because Allergan's research and development expenses are included in operating activities, while Valeant's "research and development expenses" (acquired intangible assets) are reflected in cash flows from investing activities. Including amortization of intangible assets as a proxy for research and development expense would result, on information and belief, in Valeant reporting net cash used in operating activities for 2013 and 2012, and would reduce net cash provided by operating activities for 2011 to a nominal amount.

Another point is that while VRX did not disclose its discount rates used to price the intangibles (e.g. current medicinal products, IPR&D), AGN does. AGN is blatantly using discount rates for indefinite-lived intangibles in the 9-11% range, well below industry standard of 16-22%. This again represents a way to mummify asset values on its balance sheet.

9.1.3.2.2 Amortization of inventory step-up hurts COGS, but useful life appears appropriate

One thing we immediately notice is AGN has a much higher average inventory turnover ratio than most other pharmaceutical companies, both specialty-generic and branded:

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This is usually considered a sign of higher inventory turnover, which is a positive sign. However, in Allergan's case this is just a function of their increased cost of goods due to purchase accounting inventory step-ups. The amount of the step-up must then be amortized over the anticipated time for the corresponding product to be sold. As Allergan buys, companies, we can see this amortization adds a growing amortization charge to COGS:

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Note that this charge would quickly fall off if the company were to stop acquiring, thereby bring COGS closer to the industry norm. Importantly, however, I don't see any evidence of unnecessarily slow amortization of step-ups here.

9.1.4 How to make a new friend very happy

9.1.4.1 The story of Valeant and Salix revisited

I want to revisit briefly the tactics Valeant used in the case of Salix (NASDAQ:SLXP) to fraudulently boost the unit's operating performance following the acquisition (link).

Here's SLXP's revenue and NI in the 4 quarters prior to the acquisition, when SLXP apparently hit a rough patch:

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SLXP explained the abysmal performance thus:

Historically, we have not had distribution services agreements with any of our major wholesale distributors and accordingly have had no control over their buying patterns, which have fluctuated in response to, among other things, their inventory levels of our products, discounts we have offered, anticipated future price increases or other factors that did not directly correlate to end-user demand. We announced in November 2014 that we were negotiating with our principal wholesalers to enter into distribution services agreements for each of the products in our portfolio and that we expected these distribution services agreements to be finalized and become effective in the first quarter of 2015, but we have subsequently agreed in our merger agreement with Valeant that we will not enter into any distribution services agreement pending the completion of the merger without Valeant's consent (such consent not to be unreasonably withheld, conditioned or delayed). As a result, if we do not enter into these distribution services agreements, we will be delaying the benefits of the distribution services agreements we had intended to enter into prior to entering into the Valeant merger agreement, which included enabling us to better forecast revenue and expenses. (2014 10K)

Obviously, Salix was being instructed by Valeant to withhold revenues until the acquisition was complete so Valeant could boast better revenue growth for its overall business. This forms a good template for how this gimmick works.

9.1.4.2 Legacy Allergan

Legacy Actavis (by which I mean Actavis before the Allergan acquisition) introduced a most interesting divergence between the pro forma Allergan revenue for Q1 2015 and what it actually booked. It would seem that Legacy Allergan had one of the worst quarters in years immediately following the acquisition:

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There's little disclosure of how Allergan managed to convince its auditors that this misleading treatment was excusable, but one vague hint is contained in the following:

As part of the integration of Legacy Allergan with the Company, management transitioned the legacy Actavis Brand and Corporate U.S. and Canadian operations into the Legacy Allergan SAP Enterprise Resource Planning ("ERP") system during January 2016. In preparation of this change, the Company shipped safety-stock inventory into the trade that approximated $275.0 million of gross sales in the year ended December 31, 2015. Based on the terms and conditions associated with the safety stock, the amount is expected to be recognized as revenue in the quarter ending March 31, 2016.

As we saw in the sum-of-products section, Allergan's organic growth is actually anemic/potentially declining. However, if you look from "time 0" in the graph above to the second quarter of revenue and operating income recognized by Allergan, it looks like revenue grew by 1.5B. This is the secret sauce that enables Allergan to repeatedly boast excellent revenue growth. If Allergan were to fail to acquire a much larger company each year, this benefit would vanish, and the company would post flat or negative growth YoY.

We'll soon see how Allergan used this bogus revenue growth to also post "extraordinary YoY numbers" for its top products acquired from the Allergan acquisition. All that glitters is not gold.

9.1.4.3 Actavis Generics/Teva

It's hard to know for sure, but Allergan may already be delaying some revenue recognition in advance of the Teva transaction to "help out" its new friend:

Cash flows from operations represent net income adjusted for certain non-cash items and changes in assets and liabilities. Cash provided by operating activities increased $2,287.0 million in the year ended December 31, 2015 versus the prior year period, due primarily to an increase in net income, adjusted for non-cash activity of $3,127.3 million ($5,802.2 million and $2,674.9 million of net income, adjusted for non-cash activity in the years ended December 31, 2015 and 2014, respectively), offset, in part, by certain working capital movements including an increase in accounts receivable due to changes in payment terms of select customers within our discontinued operations.

9.1.4.4 Forest

Back in the good old days of 2014, Allergan/Actavis was required to provide less disclosure on the performance of recently acquired subsidiaries. Nonetheless, from what I can piece together Actavis' disclosure of 2014 revenues for the business was considerably lower than Forest's (whereas the inverse is true for the prior year), implying that the third quarter of 2014 may have been a "dip" quarter (like that shown for Legacy Allergan above) with 2013 revenue used to compensate - note that the sum of years 2013 and 2014 remains suspiciously the same between the Actavis and Forest filings.

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9.1.4.5 Warner Chilcott

I was not able to detect any major "revenue hold-back" irregularity for the WC acquisition, although the disclosures are quite limited (see my assumptions in green):

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9.1.5 Creating a larger-than-needed restructuring reserve and inflating future earnings by releasing the reserve

We can see that AGN is one of the most inefficient companies in the industry (both generic and specialty) in terms of revenue per employee: Click to enlarge

AMGN is up there too, but when you consider their actual number of employees and OpEx/Rev is it apparently AGN is vastly less efficient:

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What's going on here? Obviously a big part of the discrepancy is due to the premium AGN is paying for outsourced R&D, which it turns out is far less efficient than doing your own work. However, since another big chunk of OpEx is severance and SBC for acquired employees, it's worth looking at how much AGN is booking for S&R on a per employee basis.

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I think most people would agree that 30-60k is a pretty generous severance package, and certainly a lavish retention package (and remember we haven't even included SBC). The more likely scenario is that they are taking excessive severance charges (as one example) to created reserves that can be released into OpEx at a later date to boost earnings. As Schilit notes:

Any company that is taking a restructuring charge (such as laying off workers) might consider padding the total dollars written off in order to lower future-period operating expenses. Thus, salary expense to employees who are laid off today will decline in future periods, as any future severance payments received will be bundled into today's one-time charge.

When a company takes an appropriately sized restructuring charge (e.g. when it plans to lay off 100 people and takes a charge only for those 100), salary expense will be shifted to the earlier period and classified as below the line. That intraperiod move to below the line works fine for most, but some managements become too greedy and use a second (and unethical) trick. When it is planning to lay off employees, management instead takes an inappropriately large restructuring charge (e.g. it plans to lay off 100 people but announces and takes a charge for 200). By announcing a 200-person layoff when 100 would be sufficient, management doubles the restructuring expense and liability. Let's assume management provides a $25000 severance package for each person laid off. That works out to 2.5M if management acts ethically; alternatively, by doubling the 100 employees to 200, it takes a 5M charge. Of course, another 2.5M still remains in the liability, with no more expected severance obligations. So, management takes the plunge and releases the bogus reserve in the liability account, reducing compensation expense. The sure seems like an enticing trick for an unethical company that needs a few more pennies to beat Wall Street's estimates. We call this "the gift that keeps on giving."

9.2 Cash Flow Shenanigans

9.2.1 Be wary of pro forma CFFO metrics

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As we can see from the earnings releases, AGN likes its investors to focus on revenue growth and non-GAAP net income/non-GAAP diluted EPS growth. Here are the adjustments made to arrive at non-GAAP net income:

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Here we can see the magic of growth pharma in rare form. True, those annoying amortization and restructuring charges still have to appear above the line to calculate GAAP operating income, but it's nice to be able to claim the charges "aren't real cash expense" and add them back to get the non-GAAP figure. The problem is these expenses are indeed a real cash expense - the cost of (1) buying outsourced R&D in the form of businesses, often at inflated valuations, where a "conventional" pharma company would have to use expensable R&D to generate the same results (2) paying employees' base salaries and bonuses.

All this should look quite familiar. As a refresher, here's a summary of VRX's adjustments to CFO to obtain their "adjusted cash flow:"

Perhaps a better term for "growth pharma" would be "non-GAAP pharma."

9.2.2 Using Levered Free Cash Flow after Acquisitions to detect excessive capitalization of operating expenses

One way to determine whether a business is capitalizing a disproportionate amount of expenses is by looking at free cash flow. For acquisitive companies, Schilit recommends FCF after acquisitions. Additionally, if the company has significant debt service requirements and one is considering an equity investment, the levered FCF should be used. The relevant equations are:

Unlevered FCF = Cash Flow from Operations + Interest Expense * (1 - Tax Rate) - Interest Income * (1 - Tax Rate) - CapEx

Levered FCF = Cash Flow from Operations - CapEx - Mandatory Debt Repayments

Levered FCF after acquisitions = Cash Flow from Operations - CapEx - Mandatory Debt Repayments - Acquisitions - Purchase of intangibles

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As Schilit notes, one of the great things about acquiring businesses is it automatically boosts your CFO. In real life (outside acquisition accounting world) it takes money to make money - you have to cover upfront costs in order to make sales. But in an acquisition, you don't pay those upfront costs - at least not out of your operating cash flow. That goes in the investing section. Conversely, when you sell the inventory, finish the research, and collect the receivables for the acquired company, that goes in CFO. Hence AGN's excellent operating cash flow. But the process of acquiring boosts CFO in other ways as we'll see.

9.2.3 Liquidating the working capital of an acquired business helps a serial acquirer further boost its CFO

We can see that in 3 of the past 4 years Allergan/Actavis could have acquired sufficient CFO for the entire year just from that acquisition:

Where did the cash go? To fund the next acquisition of course! It just shows how silly the whole cycle is, and why AGN is now 40B in debt.

9.3 Key Metrics Shenanigans

9.3.1 Showcasing Misleading Metrics That Overstate Performance

9.3.1.1 Look for strange definitions of organic growth

Remember how Legacy Allergan's revenue mysteriously dipped immediately post-acquisition? Let's take a brief coffee break for the Q1 update:

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Wow! Whoever saw such consistent YoY sales growth across product lines for a giant pharma company! That Brent Saunders sure knows how to use synergies to create "sustainable" growth!

Let's now return from our coffee break and fill in the quarterly numbers by product line for the past 2 years:

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Sometimes, a picture is worth a thousand words:

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Suddenly, Brent looks a bit like Lance Armstrong on EPO. And those sales curves just map back onto the funny curve we showed before:

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Like Lance, some executives sure know how to please - and earn their bonuses, as we'll see.

9.3.1.2 Highlighting a misleading metric as a surrogate for earnings

9.3.1.2.1 EBITDA and its variations

As we can see, adjusted EBITDA shares many of the same advantages as adjusted net income (namely an amortization add-back), with the addition of interest expense but the loss of our nice tax benefit:

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Small wonder that management prefers adjusted EBITDA or non-GAAP EPS as its performance metric of choice (aside from the stock price).

9.3.1.2.2 Pro forma earnings/adjusted earnings/non-GAAP earnings

Speak of the devil! Performing the non-GAAP adjustments on net income from continuing operations looks even better - almost like opposite day!

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Non-GAAP earnings has the additional advantage of being a faster-growing metric right now than adjusted EBITDA - which might help explain why management decided to dump adjusted EBITDA in favor of it as their compensation metric on the last proxy. I often wonder who actually reads these proxies apart from John Chevedden - it's like holding an Easter egg hunt, with shareholder/bondholder money as the candy and yourself as the Easter bunny!

9.3.1.3 "cash earnings" and EBITDA are not cash flow metrics

Schilit notes:

Moreover, for capital-intensive businesses, EBITDA is often an illusory measure of performance and profitability because all of the major capital costs run through the Statement of Income as depreciation, and are therefore excluded from EBITDA. Some companies abuse the investment community's acceptance of EBITDA and use the metric even though it is completely unwarranted.

If we compare adjusted unadjusted EBITDA with levered free cash flow after acquisitions, we can see the true cash-flow generating ability of the business:

Notice that this reflects both the increased inefficiency we noted for the business and the "doomsday amortization/writedown" scenario. You can be sure that Brent Saunders sees the reality of the lowermost curve as he struggles daily to find new sources of credit or liquidity - there is very little coming from the core operations. It also shows how laughable consolidated Debt/EBITDA is as a measure of creditworthiness in growth pharma - owing largely to the company's discretion over impairments/amortization rate and the ability to stuff a large portion of normal R&D under amortization.

9.3.2 Maintaining debt covenants

9.3.2.1 Debt Covenants

I could only locate two agreements that concretely stated Allergan's covenants with lenders at the time of their execution. It is possible these agreements were subsequently amended or extended, in writing or verbally, but I take them as a representative case of the ballpark Debt/EBITDA ratios that Allergan's creditors expect it to comply with, relative to what we actually observe:

9.3.2.1.1 Third Amended and Restated Actavis Term Loan Credit and Guaranty Agreement (Link)

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"Consolidated Leverage Ratio" means, as of any date of determination, the ratio of (A) Consolidated Total Debt as of such date to (B) Consolidated EBITDA for the period of the four fiscal quarters of Ultimate Parent then most recently ended.

"Consolidated Total Debt" means, at any time, for Ultimate Parent and its Subsidiaries on a consolidated basis, the aggregate amount of all Indebtedness for borrowed money and all Indebtedness constituting obligations evidenced by bonds, debentures, notes, loan agreements or other similar instruments (other than any Acquisition Indebtedness prior to the consummation of the Acquisition and (ii) any Allergan Acquisition Indebtedness prior to the consummation of the Allergan Acquisition), all Receivables Facility Attributable Indebtedness and (C) all Capital Lease Obligations and Synthetic Lease Obligations.

"Consolidated EBITDA" means, for any period, for Ultimate Parent and its Subsidiaries on a consolidated basis, an amount equal to Consolidated Net Income for such period plus, without duplication and only to the extent such amount represents a charge or expense determined in accordance with GAAP and reflected in the consolidated earnings of Ultimate Parent and regardless of classification within Ultimate Parent's statement of income, the sum of interest expense, (ii) income tax expense, depreciation and amortization expense, (iv) losses attributable to non-controlling interest, (v) stock compensation expense, (vi) asset impairment charges or other charges associated with the revaluation of assets or liabilities, (vii) charges associated with the revaluation of acquisition related contingent liabilities that are based in whole or in part on future estimated cash flows, (viii) business restructuring charges associated with Actavis's Global Supply Chain and Operational Excellence initiatives or other restructurings of a similar nature, (ix) costs and charges associated with the acquisition of businesses and assets, including, but not limited to, Milestone Payments and integration charges (including any of the foregoing associated with the Allergan Acquisition), (x) litigation charges and settlements, (xi) losses and expenses associated with the sale of assets and (xii) other unusual charges or expenses, minus, to the extent included in calculating such Consolidated Net Income, the sum of (1) interest income and (2) gains or income of a nature similar to items through (xii) above. For the purposes of calculating Consolidated EBITDA for any period of four consecutive fiscal quarters (each, a " Reference Period"), if at any time during such Reference Period Ultimate Parent or any Subsidiary shall have made any Material Disposition, the Consolidated EBITDA for such Reference Period shall be reduced by an amount equal to the Consolidated EBITDA (if positive) attributable to the property that is the subject of such Material Disposition for such Reference Period or increased by an amount equal to the Consolidated EBITDA (if negative) attributable thereto for such Reference Period, and (ii) if during such Reference Period Ultimate Parent or any Subsidiary shall have made a Material Acquisition (including the Allergan Acquisition), Consolidated EBITDA for such Reference Period shall be calculated after giving pro forma effect thereto in accordance with Section 1.03 as if such Material Acquisition occurred on the first day of such Reference Period.

9.3.2.1.2 Actavis Term Loan Credit and Guarantee Agreement (Link)

SECTION 7.08 Consolidated Leverage Ratio. Commencing on the last day of the first full fiscal quarter of Ultimate Parent ending after the Closing Date, none of Ultimate Parent, Intermediate Parent, the Borrower or the other Loan Parties will permit the Consolidated Leverage Ratio as of the last day of any fiscal quarter of Ultimate Parent to exceed 5.25:1.00, in the case of the last day of the first full fiscal quarter ending after the Closing Date through and including the last day of the second full fiscal quarter ending after the Closing Date, 5.00:1.00, in the case of the last day of the third full fiscal quarter ending after the Closing Date through and including the last day of the fourth full fiscal quarter ending after the Closing Date, 4.25:1.00, in the case of the last day of the fifth full fiscal quarter ending after the Closing Date through and including the last day of the sixth full fiscal quarter ending after the Closing Date, (NYSE:D) 4.00:1.00, in the case of the last day of the seventh full fiscal quarter ending after the Closing Date through and including the last day of the eighth full fiscal quarter ending after the Closing Date, and (NYSE:E) 3.50:1.00, in the case of the last day of the ninth full fiscal quarter ending after the Closing Date and the last day of any fiscal quarter at any time thereafter.

" Consolidated Leverage Ratio" means, as of any date of determination, the ratio of Consolidated Total Debt as of such date to Consolidated EBITDA for the period of the four fiscal quarters of Ultimate Parent then most recently ended.

" Consolidated Total Debt" means, at any time, for Ultimate Parent and its Subsidiaries on a consolidated basis, the aggregate amount of all Indebtedness for borrowed money and all Indebtedness constituting obligations evidenced by bonds, debentures, notes, loan agreements or other similar instruments, all Receivables Facility Attributable Indebtedness and all Capital Lease Obligations and Synthetic Lease Obligations.

" Consolidated EBITDA" means, for any period, for Ultimate Parent and its Subsidiaries on a consolidated basis, an amount equal to Consolidated Net Income for such period plus, without duplication and only to the extent such amount represents a charge or expense determined in accordance with GAAP and reflected in the consolidated earnings of Ultimate Parent and regardless of classification within Ultimate Parent's statement of income, the sum of interest expense, (ii) income tax expense, depreciation and amortization expense, (iv) losses attributable to non-controlling interest, stock compensation expense, (vi) asset impairment charges or other charges associated with the revaluation of assets or liabilities, charges associated with the revaluation of acquisition related contingent liabilities that are based in whole or in part on future estimated cash flows, (viii) business restructuring charges associated with Actavis's Global Supply Chain and Operational Excellence initiatives or other restructurings of a similar nature, costs and charges associated with the acquisition of businesses and assets, including, but not limited to, Milestone Payments and integration charges (including any of the foregoing associated with the Allergan Acquisition), litigation charges and settlements, losses and expenses associated with the sale of assets and (xii) other unusual charges or expenses, minus, to the extent included in calculating such Consolidated Net Income, the sum of (1) interest income and (2) gains or income of a nature similar to items through (xii) above. For the purposes of calculating Consolidated EBITDA for any period of four consecutive fiscal quarters (each, a " Reference Period"), if at any time during such Reference Period Ultimate Parent or any Subsidiary shall have made any Material Disposition, the Consolidated EBITDA for such Reference Period shall be reduced by an amount equal to the Consolidated EBITDA (if positive) attributable to the property that is the subject of such Material Disposition for such Reference Period or increased by an amount equal to the Consolidated EBITDA (if negative) attributable thereto for such Reference Period, and (ii) if during such Reference Period Ultimate Parent or any Subsidiary shall have made a Material Acquisition (including the Allergan Acquisition), Consolidated EBITDA for such Reference Period shall be calculated after giving pro forma effect thereto in accordance with Section 1.03 as if such Material Acquisition occurred on the first day of such Reference Period.

9.3.2.2 Compliance with Debt Covenants

From the above it seems reasonable to conclude that Allergan's various creditors probably don't want its Consolidated Leverage Ratio above 5.25x, and definitely not above say 10x. It's hard to know how to put this, but AGN is out of compliance with its debt covenants big time. Are the creditors just stupid or have they been taking it on faith since last year that the Teva transaction will close? I'm sorry, but if that is what they are doing it is just not sound lending practice, especially as a fiduciary. And they were out of compliance well before that deal was announced.

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I've include Ycharts graphs for another view, although they should not be given as much weight given they neglect discontinued operations in the most recent quarters and use a different EBITDA calculation from the company:

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See if I can locate the company's calculated total (continuing plus discontinued ops) EBITDA for 2015; if no estimate it as fraction of revenue and calculate the ratio.

10 Price increases

In order to understand Allergan's core markets (apart from a few of its medicines that enjoy long-term patent protection), you need to understand what a New Therapeutic Entity is and how it differs from both newly patented drugs and generic drugs (link).

As the article notes:

It takes three or four years for product development and approval. These products enjoy low risk and high margins compared to newly patented drugs. If a branded company launches "new therapeutic entities" of its own patented drugs, then the practice is called "life-cycle management" or "product line extensions."

The key point is that a product line extension typically only extends a patent by around 3 years (see Healthcare Economics by Paul Feldstein). So what you have a product with a pretty short 2-5 year lifespan but great margins during at least part of that lifespan. So the obvious tack is to hike the price as much as you can and squeeze the product dry, then move on to the next one. This tactic may work even better if different specialty-generic manufacturers work in concert to ensure that the market price remains high, as they did for doxycycline (see links below).

As an example, let's have a closer look at some of the price increases implemented by Valeant:

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The interesting thing is that, of the top 30 Valeant products by Q1 sales, only 3 experienced significant price hikes over the period stated:

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Additionally, notice the tendency for the medications experiencing the largest price increases to be life-threatening/disabling disorders like Wilson's disease, Parkinson's disease, Myasthenia gravis, angina, Hypertension, and clotting disorders. This targeting of severe disorders or niche patient populations (versus larger patient populations with more consumer advocacy) is a key tactic to prevent wider awareness of price increases. By using more modest price increases on your top-selling brands while jacking up prices on a large number of product lines with lower absolute sales, you can raise margins while reducing the probability of resistance from payors or patients.

With these general points in mind, let's look at Allergan's pattern of price increases:

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As with Valeant, we can see that life-threatening/disabling diseases are often the target of price-gouging, particular in niche patient populations (e.g. ulcerative colitis). This presents a problem - as the Valeant investigation widens - it is likely that payors will put major pressure on manufacturers (as they have on Valeant) regarding these price increases - which could put significant margin pressure on many of Actavis Generics' product lines.

Here are the references:

Product

Year of increase

Period of increase

Increase %

Indication

link1

link2

Zenpep ®, Ultrase ® & Viokace ®

2016

unknown

unknown

cystic fibrosis, chronic inflammation of the pancreas, or blockage of the pancreatic ducts

link

Tudorza ®

2015

unknown

unknown

COPD

link

Tetracycline

2013

unknown

6850%

acne and rosacea

link

Doxycycline

2013

6 months

5600%

bacterial infections, including pneumonia and other respiratory tract infections; Lyme disease; acne

link

link

Ursodiol

2014

3 months

1283%

gallstones in patients who do not want surgery or cannot have surgery to remove gallstones

link

Asacol®/Delzicol®

2011

1 month

1200%

ulcerative colitis

link

Digoxin

2013

6 months

884%

congestive heart failure

link

link

Propranolol hydrochloride

2014

unknown

851%

tremors, angina, hypertension

link

link

Canasa ® /Salofalk ®

2014

1 month

326%

colitis

link

Fioricet

2014

1 month

280%

tension (or muscle contraction) headache

link

link

Armour

2015

3 months

50%

hypothyroidism

link

Teflaro®

2014

1 year

50%

pediatric patients with skin infections and community-acquired bacterial pneumonia

link

Restasis®

2015

1 year

10%

chronic dry eye

link

Botox®

2016

1 month

4%

crow's feet, muscle stiffness, overactive bladder, and many others

link

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11 M&A scenarios

11.1 Standalone

11.1.1 Method 1: Aggregate revenue multiple

We now need to select appropriate comps to deduce what multiple is currently ascribed by the market. Of course, if market conditions change for the sector this might no longer be applicable. For our comps we take our 6.5% growth rate +/- 5% and market cap > 25B:

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We'll use the following operating and balance sheet data for AGN:

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TTM Revenue calculation:

Now let's calculate the implied sh price:

EV = (av EV/Rev) * TTM Rev = 4.6 * 22.2B = 102.1B

MC = EV - LT Debt + Cash = 102.1B - 38.6B + 2.3B = 65.8B

Price = MC/Shs = 65.8B/395M =$167/sh

11.1.2 Method 2: Sum-of-parts for "Legacy Allergan," "Actavis Generics," and "Legacy Actavis less Actavis Generics" (LALAG)

11.1.2.1 Multiples for Legacy Actavis and Legacy Allergan based on organic growth comps

If we want to try and separate out the Legacy Actavis and Legacy Allergan components of the business ("rewinding time" to right before the Allergan acquisition), we need to look at the growth rate of the Legacy Allergan portfolio vs. the Legacy Actavis portfolio. Separating these out in our top 15 products:

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We can see the Allergan product growth rate matches up pretty well with Legacy Allergan's historic growth rate in overall sales, so that looks good as a comp for multiples. For the Legacy Actavis component, which was generics-weighted, the best comp on the market qualitatively speaking is probably Teva. Testing this hypothesis, we look at Teva's growth rate vs. the rate derived above for Legacy Actavis and find them comparable. Hence we'll use Teva's multiples to value the Legacy Actavis business in our analysis.

11.1.2.2 Teva current rev multiple (apply to discontinued operations)

Ycharts EV/Rev for Teva: 2.9

Current EV for Teva = MC + LT Debt - Cash = 54.4B + 11.6B - 6.0B = 60.0B

TTM Rev for Teva = Q1 2016 + 2015 - Q1 2015 = 4.8B + 19.7B - 4.9B = 19.6B

EV/Rev for Teva = 60.0B/19.6B = 3.1x

11.1.2.3 Legacy Allergan rev multiple before the company was put in play (apply to continuing operations)

Allergan share price prior to Valeant bid around April 22, 2014: $117/sh, 308M sh outs = 36.0B

Use first set of financials prior to announcement on Nov 17, 2014

EV at the time = MC + LT Debt - Cash = 36.0B +2.1B - 3.9B = 34.2B

Legacy Allergan TTM Rev at the time = 2014 Q1 + 2013 - 2013 Q1 = 1,646.1 +6,300.4 - 1,459.6 = 6.5B

EV/Rev at the time = 34.2B/6.5B = 5.3x

11.1.2.4 SOP 1: "Actavis Generics" EV

AGN Discontinued ops TTM rev = 5.9B

EV for "Actavis Generics" = 5.9B * 3.1 =18.3B

11.1.2.5 SOP 2: "Legacy Allergan" EV

We'll use 2015 pro forma revenue as our approximate TTM revenue. Now we can value this segment as:

EV for "Legacy Allergan" = 8.0B * 5.3 =42.4B

11.1.2.6 SOP 3: "Legacy Actavis less Actavis Generics" (LALAG) EV

This is the business we would be left with if we deducted Actavis Generics ("continuing operations") and then deducted the Legacy Allergan component.

LALAG TTM rev = continuing ops - Legacy Allergan = 16.3B - 8.0B = 8.3B

Since LALAG falls under the "non Legacy Allergan" family of products in the growth rates we deduced above, it deserves the "non Legacy Allergan" multiple just like Actavis Generics does.

EV for LALAG = 8.3B * 3.1 = 25.7B

11.1.2.7 SOP 1+2+3 and PT: $127/sh

The total EV for the business is:

AGN EV = Actavis Generics + Legacy Allergan + LALAG EVs = 18.3B + 42.4B + 25.7B = 86.4B

MC = EV - LT Debt + Cash = 86.4B - 38.6B + 2.3B = 50.1B

Price = MC/Shs = 50.1B/395M = $127/sh

11.1.2.8 What if we had given LALAG the Legacy Allergan multiple?

One of the not-so-subtle implications of Brent's classification of "Actavis Generics" as discontinued operations and everything else as continuing operations is that we should give continuing operations the "Legacy Allergan" multiple since all the "old crappy specialty generic stuff" has been dumped on Teva. This isn't true since the LALAG component consists of products with far less franchise value than the Legacy Allergan portfolio. However, let's suppose we go along with Brent and give LALAG the Legacy Allergan multiple rather than the Teva multiple:

EV for LALAG = 8.3B * 5.3 = 44.0B

Repeating our SOP/PT with this assumption:

AGN EV = Actavis Generics + Legacy Allergan + LALAG EVs = 18.3B + 42.4B + 44.0B = 104.7B

MC = EV - LT Debt + Cash = 104.7B - 38.6B + 2.3B = 68.4B

Price = MC/Shs = 68.4B/395M = $173/sh

We can see this result is much closer to what we deduced using the aggregate revenue multiple method. This reflects the fact that that method fails to take into account the bias introduced by disproportionately weighting Legacy Allergan's blockbusters in the "top 15" products. I guess that's growth pharma at work!

11.1.3 Debt repayment

11.1.3.1 Debt service schedule

Valuation is obviously just one component of price action. A company with finite valuation can still go into default if its cash flow/surplus is insufficient to cover debt servicing costs. Let's review these, first based on notes due dates:

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Then by amortizing the company's own reporting of obligations due by term:

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The thing to note about AGN's debt repayment schedule is it is heavily front-loaded, with multiple tranches coming due over the next few years. This is the main reason AGN is so eager to unload its debt on a prospective buyer.

Let's have a look at some typical debt servicing metrics:

11.1.3.2 Debt-Service Coverage Ratio (DSCR) = Net Operating Income/Total Debt Service; Total Debt Service = Interest + (Principle/(1-Tax Rate))

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Note how AGN's operating income has steadily declined for the past 5 years owing to its serial acquisition strategy.

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A negative DSCR is generally considered a bad thing.

11.1.3.3 Debt Ratio = Total Liabilities/Total Assets

This might be worse if AGN's assets were real.

11.1.3.4 Debt to Equity = LT Debt/Equity

AGN's book value is not that meaningful for the same reason its assets are not. Tangible book at least provides us a flavor:

11.1.3.5 Equity to Assets = Equity/Assets

11.1.3.6 Time Interest Earned = EBITDA/Interest

As we'll see, even this ratio is an artificial measure of creditworthiness due to the real nature of items excluded by EBITDA, particularly amortization and various write-downs. An even larger issue is delayed amortization, which enables the company to artificially satisfy its debt covenants.

11.2 Teva/Actavis Generics

1.2.1 Deal structure

For the deal structure I quote from TEVA's prospectus:

Actavis Generics Acquisition

On July 26, 2015, we entered into a definitive agreement with Allergan plc to acquire its worldwide generic pharmaceuticals business and certain other assets, which we refer to as "Actavis Generics." We will pay total consideration consisting of $33.75 billion in cash and approximately 100 million Teva shares, which represented $6.75 billion in value, based on the previously-agreed price of approximately $67.30 per share. Closing of the transaction is subject to certain conditions, including relevant regulatory approvals. Subject to satisfaction of the closing conditions, we expect the acquisition to close in the first quarter of 2016. Following consummation of the acquisition, our generics segment is expected to make up a much larger percentage of our revenues. Further information about the Actavis Generics acquisition, including a copy of the Master Purchase Agreement, is contained in a Report of Foreign Private Issuer on Form 6-K filed by us with the U.S. Securities and Exchange Commission (the "SEC") on July 28, 2015.

We expect to finance the $33.75 billion cash consideration for the Actavis Generics acquisition, together with related fees and expenses, through a combination of new equity (including the issuance and sale of ADSs in the concurrent ADS offering described below and of Mandatory Convertible Preferred Shares in the offering contemplated hereby) and the proposed debt financings described below.

Actavis Generics

Actavis Generics includes, with certain exceptions, Allergan's U.S. and international generic commercial units, third-party supplier Medis, global generic manufacturing operations, global generic research and development ("R&D") unit, international OTC commercial unit (excluding OTC eye care products) and some mature international brands. Actavis Generics has operations in more than 60 countries, with the United States representing more than half of the revenues of the business in 2014 and for the nine months ended September 30, 2015. Its other major markets include the United Kingdom, Russia and Poland. As of September 30, 2015, Actavis Generics marketed over 275 generic pharmaceutical product families in the U.S.

Actavis Generics' growth strategy has focused on internal development of differentiated and high-demand products, including challenging patents associated with these products, (ii) establishment of strategic alliances and collaborations and acquisitions of complementary products and companies. Actavis Generics also develops and out-licenses generic pharmaceutical products through its Medis third party business.

Actavis Generics sells generic pharmaceutical products primarily to drug wholesalers, retailers and distributors, including national retail drug and food store chains, hospitals, clinics, mail order retailers, government agencies and managed healthcare providers such as health maintenance organizations and other institutions.

Actavis Generics has devoted significant resources to research and development. It conducts its R&D activities through a network of more than 20 global R&D centers, the majority of which are being acquired by Teva. As a result of these activities, Actavis Generics had a pipeline of more than 200 Abbreviated New Drug Applications ("ANDAs") on file in the United States as of December 31, 2014.

The special purpose combined financial statements and other information relating to Actavis Generics are included in a Report of Foreign Private Issuer on Form 6-K filed by us with the SEC on November 30, 2015.

11.2.2 Valuation - PT $183/sh

The adjustment to our previously ascertained valuation is a straightforward addition of the cash consideration and removal of the corresponding business units. We note that whereas Teva paid 40.5B for Actavis Generics, its value is closer to 18.3B (i.e. Teva paid more than double what the business is worth even without taking the operating distortion/NOLs into account). Running the calculation:

AGN EV post-deal = Legacy Allergan + LALAG = 42.4B + 25.7B = 68.1B

MC = EV - LT Debt + Cash = 68.1B - 38.6B + 40.5B + 2.3B = 72.3B

Price = MC/Shs = 72.3B/395M =$183/sh

This obviously also does not take into account the value-adding or value-destroying effect of buybacks, future transactions, or the like.

We'll take the average of the deal and no-deal scenarios as our, PT of$155/sh.

11.2.3 Debt repayment

AGN's ability to repay debt after the transaction is impossible to predict. However, Brent has stated:

The company's stock buybacks will begin immediately after the close of a deal for Teva Pharmaceuticals to Allergan's generic drug business for $40.5 billion. The company will start buying back stock in increments of $4 to $5 billion when the deal wraps up this month, Saunders said, then renew the program until it exhausts the $10 billion.

"My sense is that will take us several months to do the whole thing but we will get it done," he said, adding that the Dublin-based company could not complete an immediate buyback because of Irish law.

The Teva deal will also allow the company to pay down about $8 billion in debt immediately. Another $2 billion in debt will be paid over the next 18 months as bonds mature, Saunders said. The rest of the profits from the Teva deal, Saunders said, are designated for growth.

"That will leave us net round number about $20 billion including cash flow from operations to invest for growth," he said. "We'll be looking to bolster our position in the categories in which we compete through M&A."

This means the intended debt repayment is around 10B, leaving a 30B balance. Most of the issues already highlighted will still pertain (recall this debt balance will approximate VRX's).

11.2.4 Teva management's pay incentives to close the deal

If a deal on Actavis Generics is clearly not in shareholders'/bondholders' best interests (even if you only took into account the overpayment consideration, and ignored the Valeant-related pricing pressure or deeper problems outlined in this article), why does Vigodman continue to promote the deal as the greatest thing since sliced bread? I don't know the answer, but my guess is he and his team are getting paid well for their poor stewardship:

In addition to the above review of market trends and benchmarking, in proposing the below changes to Mr. Vigodman's terms of office and employment, the Compensation Committee and the Board recognized the transformation of the Company achieved under his leadership during 2015, which built on his previous success in fixing the Company's foundation and solidifying its position. Most significantly, under Mr. Vigodman's leadership, the Company entered into a transformational agreement to acquire Actavis Generics, which is expected to strengthen Teva's already world-leading generics business. The Compensation Committee and the Board further recognized Mr. Vigodman's leadership in building a broader and more diversified growth platform, extending the lifecycle of its key specialty medicines and building a promising late-stage specialty pipeline in its core therapeutic areas, while improving the Company's financial results and operations. Except as described below, all terms of office and employment of the President and CEO, as previously approved by our shareholders, will remain unchanged.

APPROVAL OF INCREASES IN THE BASE SALARY OF THE PRESIDENT AND CEO

Pursuant to the President and CEO's employment agreement (as approved by the Company's shareholders), the Compensation Committee and the Board of Directors are required to annually review his base salary for potential increase. To provide certain flexibility for the Compensation Committee and the Board to comply with this requirement, the Compensation Committee and the Board recommend that shareholders approve, without the need for further shareholder approval, increases in the President and CEO's base salary of up to 10% annually of his then current base salary commencing in 2016, as may be determined by the Compensation Committee and the Board. Such base salary shall be adjusted for subsequent quarterly increases in the Israeli CPI. In accordance with the foregoing, the Compensation Committee and the Board of Directors reviewed the President and CEO's base salary and, subject to approval of this proposal 3a by the shareholders, resolved to increase his monthly base salary, effective as of January 1, 2016, to NIS 488,520 (approximately $125,198, or$1.5 million annually, according to the rate of exchange on March 1, 2016), to be adjusted for subsequent quarterly increases in the Israeli CPI.

The Board of Directors recommends that shareholders vote FOR the approval of increases in the base salary of Teva's President and CEO, as may be determined by the Compensation Committee and the Board, subject to the limitations described above.

APPROVAL OF AN AMENDMENT TO ANNUAL CASH BONUS OBJECTIVES AND PAYOUT

TERMS FOR MR. VIGODMAN FOR 2016 AND GOING FORWARD

Subject to the adoption of the amended Compensation Policy set forth in proposal 2 above, the

Compensation Committee and the Board of Directors have approved, and recommend that Teva's shareholders approve, an amendment to the annual cash bonus objectives and payment terms for Mr. Vigodman so that the objectives and payment terms for 2016 and onwards shall be as follows: Up to 85% of the President and CEO's annual cash bonus for each year will be based on overall Company performance measures, similar to those determined for other executive officers, using key performance indicators (the " Company KPIs") as determined by the Compensation Committee and the Board in accordance with the below. These key performance indicators will be comprised as follows:

at least 60% of the Company KPIs will be comprised of financial measures, which will include at least three out of the following financial measures: non-GAAP operating profit, revenues, non-GAAP cash flow from operations, non-GAAP earnings per share and up to two other financial measures chosen by the Compensation Committee and the Board of Directors. In computing the bonus, each financial measure used shall be weighted between 8% and 44% of the Company KPIs; and

(ii) no more than 40% of the Company KPIs will be comprised of at least one operational measure, which may include: quality measures, compliance measures, customer service, milestones for product pipelines and personnel survey score. Each operational measure used shall be weighted between 8% and 32% of the Company KPIs.

Subject to the limitations set in the amended Compensation Policy and applicable law, no more than 30% of the President and CEO's annual cash bonus for each year will be based on an evaluation of his overall

performance based on the discretion of the Compensation Committee and the Board of Directors and/or on quantitative and qualitative performance measures, such as establishing and implementing the Company's strategy and risk management as well as demonstrating internal and external leadership. The Compensation Committee and the Board of Directors may, in special circumstances (e.g., regulatory changes and significant changes in the Company's business environment), following their determination of the objectives and the respective weightings, modify the above measures, consistent with the Compensation Policy. Following the end of each year, the Compensation Committee and the Board of Directors shall determine, whether and to what extent, the objectives have been met. The payout terms for the President and CEO's annual cash bonus will be as described in the below table. As noted above in proposal 2, the threshold for achieving any annual cash bonus payments is being increased from 85% to 90%.

No additional payout would be made for performance in excess of 125% achievement of the performance criteria. The payout formula may result in a partial bonus in the event of employment during part of a calendar year. In addition, the President and CEO's annual cash bonus may be subject to "super-measures" and/or a bonus budget, as determined by the Compensation Committee and the Board of Directors.

The Board of Directors recommends that shareholders vote FOR the approval of the annual cash bonus objectives and payment terms for Mr. Vigodman, Teva's President and CEO, as described above.

APPROVAL OF AN AMENDMENT TO ANNUAL EQUITY AWARDS FOR THE PRESIDENT AND CEO FOR EACH YEAR COMMENCING IN 2016

Subject to the adoption of the amended Compensation Policy as set forth in proposal 2 above, the Compensation Committee and the Board of Directors approved, and recommend that Teva's shareholders approve, that commencing in 2016 and with respect thereto, the President and CEO's annual equity-based award may be in an aggregate value of up to $6 million (instead of $3.5 million, as previously approved by shareholders), as shall be determined by the Compensation Committee and the Board of Directors. In accordance with the foregoing and subject to its approval by the shareholders and the adoption of the amended Compensation Policy (proposal 2), the Compensation Committee and the Board of Directors resolved to grant the President and CEO an additional equity-based award with a value of $1 million, for a total equity-based award for 2016 with an aggregate value of $4.5 million.

The Board of Directors recommends that shareholders vote FOR the approval of the annual equity awards for Teva's President and CEO, as described above.

Make no mistake about it, Mr. Vigodman WANTS this deal. He used it as a ticket to structure an extravagant pay package for himself (aggregate value of 6-7.5M), and if the deal falls through so does his pay. Notice how he was careful to use the same performance metrics Allergan uses (revenue, non-GAAP net income/EPS, non-GAAP CFO) since these metrics are guaranteed to go up post-acquisition. It's almost as if Brent and Erez sat in a room together, constructed this deal, and said "how can we work together to ensure we both get our maximum 2016 bonuses?" And Mr. Vigodman is not going to let anyone - including his own shareholders and bondholders - get in the way of his long-awaited bonanza. He has managed a sleepy generics-weighted company since 2009 with few big paydays, and so he DESERVES this. If Actavis Generics turns out to be a not-so-great business added on to Teva's existing stable/declining operations, and they can't service the debt, he'll just resign 6M-enriched and go somewhere where his services are more appreciated.

Assuming the FTC approves the deal, in all likelihood the only way Teva shareholders/creditors could block the deal would be to force Vigodman to resign. In my humble opinion, ditching the CEO to prevent him from taking on a crippling debt load to overpay for a crumbling business is probably the only way to save Teva now.

11.2.5 Interested parties

11.2.5.1 Myself

Although I am a small player I put this in for balance. I have been studying Valeant and Allergan for the past 2 years. As mentioned elsewhere, I began my Allergan short thesis in summer 2015 but ultimately put the project on hold because the Teva deal introduced much complexity in the analysis relative to Valeant. I published my Valeant thesis in August 2015. I did not short Valeant prior to publishing the article because I was not skilled at the technical aspects of shorting a stock, nor did I feel confident enough in the timing to use put options. I did briefly short a small amount of Valeant sometime after that and lost money on the trade I believe.

Subsequent to Allergan's announcement of the merger of equals I concluded the stock was capped out and bought a small amount of puts in Q4 2015. I did not implement a larger position until the merger of equals failed this year. It is my belief that Allergan faces a multitude of problems, which will play themselves out over the next year or so. I also think that if the Teva deal were to fail to close for any reason, the impact on the stock price of Allergan would be immediate and dramatic. However, I view the probability of the transaction going through as >50% based on the vested interests of the parties as already outlined. My articles are written from a fundamental/analytical point of view, and have not historically produced much impact in the markets. My main goal is to convince others to perform their own analysis, which may hopefully lead to profitable trading decisions over the long term.

11.2.5.2 AGN

11.2.5.2.1 Management

Management clearly wants a deal for the following reasons:

(1) The deal will trigger transformational bonuses for executives

(2) The deal will support the stock price, also increasing executive compensation

(3) The deal will permit AGN to make another large acquisition, thereby perpetuating the accounting irregularities that have sustained the perception of organic growth thus far

For reasons I don't fully understand, management seems to constantly misguide on the probability of deals going through. In the article I showed you in the introduction, Brent Saunders considered a Pfizer deal very low-probability even though a deal was made later that year (as the article predicted). Once the deal was struck, he claimed the probability of the treasury nixing the deal was <10%. It doesn't seem that investors can rely on him for closure probabilities.

11.2.5.2.2 Stockholders

Allergan's stockholders are of a mixed nature, as are the equity markets generally. In the short term case you have traders playing the spread on the Teva deal pre/post valuations. In the medium term you have risk arbitrageurs like Paulson who anticipate more M&A. In the long term you have individual investors who buy into management's strategic vision as well as value or growth funds, which still view the company as undervalued.

Regardless of how shareholders view the company, it is clearly in their best interest for the deal to go through since AGN faces significant mandatory debt repayments over the next few years. Additionally, Actavis Generics is most likely already experiencing flat or declining sales so they are better off without that junk. Additionally, shareholders actually benefit in the short-term from management's deceptive acquisition accounting practices. It is a strange feature of the markets that shareholders sometimes gather around management without asking many questions since "whatever they're doing seems to be working." This situation is fundamentally reflexive/unstable however.

11.2.5.2.3 Bondholders

Bondholders are a different group from the stockholders. They tend to be heavily weighted toward institutions such as pension funds (fiduciary money) and have a longer-term investment horizon. Consequently, the bondholders have a greater interest in basic fiscal health and conservative growth of the company - to support income - and lesser interest in short-term stock price appreciation, particularly if it is accompanied by greater risk-taking on the part of management. This said, bondholders could scarcely reject a 10B+ infusion of capital specifically for debt repayment and the potential of further acquisitions to boost EBITDA and superficially improve the debt metrics.

11.2.5.3 TEVA

11.2.5.3.1 Management

As noted, Vigodman and his team want a deal too for the following reasons:

(1) TEVA has experienced anemic or negative growth in recent years (similarly to Allergan's generic businesses without acquisition accounting), which puts pressure on management to "make something happen"

(2) Management presented significant increases in base salary and bonuses in its last proxy which are based on growth in "adjusted" operating metrics that will be easily satisfied by the act of making the acquisition regardless of how it performs

(3) Management has been deceived by Allergan's portrayal of Allergan's operating results and thinks AG is actually an organically growing business that will help it satisfy its amended debt covenants. Relatedly, management does not understand the growth pharma model and how it understates real operating/maintenance costs of the business through capitalization.

(4) Management still thinks it will be able to raise prices on currently overlapping products in a post-Valeant world with increased price scrutiny.

Based on these motivations, I fully expect Vigodman and his team to fight all opponents including their own shareholders to make sure the deal goes through. I think the only thing that would deter them is a Valeant-like implosion at Allergan, which would harm their own stock if they were to push for the deal at the current price. This leads to one major disincentive management has for a deal at the current price: if they were to stand back and let Allergan fail, they would have the opportunity to swoop in in 6-12 months and buy the same assets at Valeant-style firesale prices. However, they would have a hard time pitching this scenario to stockholders unless Allergan takes a large near-term hit.

11.2.5.3.2 Stockholders

Teva stockholders appear to have done limited due diligence on Actavis Generics (how could they given the level of disclosure?) and by and large believe it will be a positive development for the stock. Many retail investors think the prices of both stocks will increase if the merger is approved by all parties - which certainly would have been true 1-2 years ago. Both Teva and Allergan have constructed attractive pro forma financials showing how the deal will be a win-win for all parties. These things aside, it does appear there are some institutions who have grown unhappy with the deal price. The problem is that Teva has already committed to the deal and these same shareholders may worry that pulling out would hurt their own stock in the short-term (partly on account of the breakup fee) while risking a lawsuit with Allergan. Said shareholders will therefore need an excuse to pressure management to pull out or renegotiate. Two possible leverage points are (1) heavier scrutiny of the deal followed by termination or a significant price concession (2) the FTC (assuming it approves) makes such extensive divestiture demands that the economics of the deal even with the pro forma assumptions change considerably. I maintain however that Teva's shareholders are not a very active bunch, and will probably not do much without strong action from one of the other interested parties.

11.2.5.3.3 Bondholders

Teva's bondholders are the big loser in all of this, but luckily they are also probably the most stupid. Institutions have been buying large baskets of corporate debt relatively indiscriminately over the past 5-10 years based on ratings, and as long as the debt metrics appear satisfied they aren't asking many questions. That said, the smarter bondholders may have realized several things: (1) the deal presents significant "event risk" to Teva's existing issues since an enormous amount of new debt will be piled on top of that (2) the debt service will require a significant EBITDA contribution from Actavis Generics, one which will be far from forthcoming as previously noted. These factors raise a possibility (although I have been told by other posters that it is unlikely) that Teva will not be able to complete the 22B debt financing to complete the purchase at desirable rates. Of course, in order for that to happen one of the following would probably need to happen first: (1) the corporate spreads blow up again as they did earlier this year (2) a generalized increase in awareness of Allergan's accounting. Some catalyst would be needed to make these stakeholders view Teva's postdeal financial structure as similarly vulnerable to Allergan's current one - i.e. on the verge of collapse. I've discussed this more fully in my earlier article.

11.2.5.4 Regulators

11.2.5.4.1 SEC

It would not be surprising to me if the SEC decided to scrutinize Allergan as they have Valeant. The parallels between their financial statements are extensive. This creates potential deal liability.

11.2.5.4.2 IRS/Treasury

Contrary to popular belief, the IRS and Treasury have a much broader say in Allergan's business model than just whether it can conduct future inversions. Specifically, Allergan's ability to

(1) lump taxable income with unspecified intangibles, and migrate the income to lower-tax jurisdictions via transfer pricing

(2) aggregate NOLs from across its operations into a sold subsidiary to increase the selling price of that subsidiary

collectively implicate billions in uncollected IRS revenue. As Valeant's book and tax liabilities are opened to regulators, tax-enforcement agencies will have every incentive to claw back taxes from other companies in the space or effectively nix the sale of certain subsidiaries. As mentioned, Allergan has a number of ongoing SEC audits reportedly due to its acquisitive history.

11.2.5.4.3 FTC

My analysis here will be extremely superficial due to lack of knowledge. What little seems clear to me is that, as the largest generic merger in history, the deal was obviously intended by management on both sides to reduce some of the cutthroat competition between Allergan and Teva for generic market share. Additionally, the process of filing a competitive ANDA (or fending off an ANDA filing by a competitor) is quite expensive and introduces undesirable uncertainty for a company. When the deal was originally proposed (prior to the Valeant and Turing outcry) Vigodman almost certainly believed that Teva could phase in price increases on the overlapping portfolio items. It's unlikely these would have turned around the overall business prospects, but they might have improved the short-term economics of the transaction.

What I think can be stated fairly confidently is that the FTC will at minimum require additional significant divestitures for a deal of this size to move forward. This is based on my reading of past decisions as well as the EU review for the deal, which required fairly extensive ex-US divestitures (link, link).

The wild card here is how the FTC will view this megamerger in the wake of the Valeant scandal and with knowledge of Allergan and other generic pharmaceutical manufacturers' significant pricing abuses over the past decade. By denying the deal, it would effectively close the door to the consolidative wave that has motivated managements to try to show sales growth through price increases. The FTC would be making a public example to the industry. Part of my basis for considering this as an option is Ramirez's hawkish attitude towards industry attempts to stifle competitive ANDA filings (link).

My knowledge in the area of FTC reviews is limited, which makes my views susceptible to bias over facts. I encourage you to do your own precedent-reviews analysis. In my opinion, the FTC is far from the primary arbiter of the future of either company.

11.2.5.4.4 European Commission

The European Commission has already approved the deal with divestitures, so one might view their forward role as minimal. This isn't quite the case. As per the risk factors, the European Commission exercises not only antitrust jurisdiction but also fair taxation jurisdiction as well:

Changes in tax laws or tax rulings may have a significantly adverse impact on our effective tax rate. Proposals by the current U.S. administration for fundamental U.S. international tax reform, including without limitation provisions that would limit the ability of U.S. multinationals to deduct interest on related party debt, if enacted, could have a significant adverse impact on our effective tax rate. Many countries in Europe, as well as a number of other countries and organizations, have recently proposed or recommended changes to existing tax laws which could impact our future tax obligations. The Organization for Economic Cooperation and Development has been working on a Base Erosion and Profit Sharing Project, and is expected to continue to issue, guidelines and proposals that may change various aspects of the existing framework under which our tax obligations are determined in many of the countries in which we do business. The European Commission has conducted investigations in multiple countries focusing on whether local country tax rulings or tax legislation provides preferential tax treatment that violates European Union state aid rules. If the Company's effective tax rates were to increase, or if the ultimate determination of the Company's taxes owed is for an amount in excess of amounts previously accrued, the Company's operating results, cash flows, and financial condition could be adversely affected.

While it is unclear whether broader scrutiny on taxation would affect the EC's decision, it does raise problems for Teva down the road in taking advantage of Actavis Generics' existing NOLs or preserving the ability to maximize NOLs going forward.

11.3 Pfizer/Allergan

11.3.1 Deal structure (link, link)

On November 23, 2015, the Company announced that it entered into a definitive merger agreement (the "Pfizer Agreement") under which Pfizer Inc. ("Pfizer"), a global innovative biopharmaceutical company, and Allergan plc will merge in a stock and cash transaction (the "Pfizer Transaction"), which attributes a $160.0 billion enterprise valuation using the then-current stock price at the time the Pfizer Transaction was announced. Company shareholders will receive 11.3 shares of the combined company ordinary shares for each of their existing Allergan shares and Pfizer stockholders will receive in respect of each share of Pfizer common stock held by them, at their election and subject to certain proration procedures described in the Pfizer Agreement, either one share of the combined company or an amount in cash equal to the volume weighted average price per share of Pfizer common stock on the New York Stock Exchange ("NYSE") on the trading day immediately preceding the date of the consummation of the Pfizer Transaction. The Pfizer Transaction is anticipated to close in the second half of 2016.

11.3.2 Importance of the deal to Allergan

As we saw, the S/WCOM merger announcement marked the transition from a bull to a bear market for WCOM's stock. The reason is that this was the biggest merger imaginable for WCOM - the proverbial "pot of gold" at the end of the rainbow. A rollup can die before it reaches the pot of gold (witness Valeant), but it cannot proceed beyond that point without losing its modus operandi - acquisition accounting. Correspondingly, the "failed merger of equals" is the terminal event for the rollup. Let's review more closely why this is so (merger announcement article, termination announcement article).

Notice a few things:

(1) the S/WCOM merger was announced at the peak of the dot-com bubble. By the time the regulators blocked the deal, liquidity was drying up and there were no suitors to offer a comparable price for the company. The "pot of gold" had vanished. The timing is no coincidence - megadeals like this are what drive a bull market, and so it should come as no surprise that the biggest megadeals are announced near the peak of a speculative market. As we have seen, this proved the case for PFE/AGN in the subsequent collapse of the biotech sector, with various other spectacular failures including Valeant, Endo, and Theranos

(2) Bernard Ebbers, "MSCI WorldCom's deal-making chief executive," was the main driver behind the deal

(3) Both transactions were motivated by a desire to share a "moat" franchise. For S/WCOM it was wireless, whereas for PFE/AGN it was patented drugs

(4) The termination of the merger was not regarded as the bursting of a speculative bubble at the time, but rather as an impetus for more deals. It was imagined that WCOM stock could only go higher, since "someone else would inevitably come along"

(5) Analysts were surprised that the DOJ would move to nix the merger

So, in summary, PFE/AGN was a "failed merger of equals." The collapse of Valeant indicated the sector was starting to turn, but AGN's stock was effectively propped as "sold" between the TEVA and PFE deals. In spite of this, the spreads were huge. AGN's stock has since lost intermittently 30% of its value.

Some personal narrative: In August 2015 I started working full-force on my Valeant short thesis, which was published August 18, 2015 after the ValueAct selling had begun. If you have read it, you will know it was similarly templated to this article. But the interesting thing is I actually started writing that article with Allergan (then Actavis) as the subject rather than Valeant. I'd read the 10-Ks and they were highly symmetric although some of the capitalization terminology varied. Then, literally the day I was about to send my article to the publisher (July 27, 2015), Brent Saunders announced the deal to sell the generics business to Teva. Since this changed many assumptions in the analysis, I decided not to publish. I expect I was not the first of many bearish analysts to be deterred by Brent Saunders' pace of restructuring, which he seems to use not only to maintain growth but also to confound the valuation of the company.

Valeant collapsed sooner than I expected following the publication of my article (along with countless other articles that preceded and followed it) and never had the opportunity to consummate the merger of equals. When the PFE/AGN deal was announced I knew it represented the peak of speculative mania in the pharma sector. Correspondingly, when the tax law was changed to block the deal, I waited to see what the impact would be on the stock price. When I saw that the stock was still propped up (similarly to how WCOM's was after S/WCOM fell through) I started buying 2018 LEAPS.

You might ask why I don't feel more nervous about the Teva deal closing. The answer is that I think about how similar the overall story is to WorldCom, Valeant, Endo Pharma, and various others. I see the need for ever-larger deals, a business model premised on ever-larger amounts of debt and capital, a management motivated by obscene bonuses to manipulate its accounting and consummate deals, an industry facing a reversal of pricing power it has long enjoyed, and a sector which is entering a bear market. I also remember that Valeant's collapse came out of the blue, right as the company was potentially gearing to acquire Zoetis. There was no particularly reason to think Valeant would collapse at the moment it did unless you looked at the stock chart. Even though I couldn't predict to you the specific fundamental pathway that will lead to the expected outcome, the pattern screams that Allergan will collapse, and spectacularly so, within the next few years for one reason or another.

12 Tax reduction

12.1 Debt service

Allergan's interest payments are considerable and no doubt help reduce taxable income. But they are far less important than the operating expenses, which we'll review next.

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12.2 NOLs

Allergan's tax advantages have less to do with its Irish incorporation (although it is a factor) and more to do with the character of its financial statements. Viewing the operating statement, we easily see that amortization, restructuring, and interest provide the largest offsets to operating income, ensuring that operating income is almost always negative. This results in an income tax benefit each year that can be applied towards operating income in future (hopefully) profitable years. This also results in a rising balance of juicy NOLs. Of course, if the business is never profitable it will never get to take advantage of these.

But these NOLs may present an appealing prize to a potential acquirer and, correspondingly, can raise the valuation of the target or subsidiaries of the target. And as we have seen, even though an NOL has a much lower value to an unprofitable business, the sale of the business may actually allow the seller to recognize the accumulated NOL benefit as income under asset sales. For this reason, AGN has a strong incentive to maximize its NOLs. This can be done by migrating the assets underlying the operating expenses (e.g. amortization) to the jurisdictions where they can earn the largest NOLs.

As mentioned, operating expenses are large compared with interest payments right now (overall debt service is a different matter):

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We can also see that the lion's share of the NOLs are coming from US jurisdictions. This would make sense since the US tends to have higher corporate taxes - a bad thing for profitable companies but a good one for unprofitable ones if the NOLs impart sale value:

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12.3 IP migration and transfer pricing

12.3.1 BEPS overview

From the OECD's website:

In an increasingly interconnected world, national tax laws have not always kept pace with global corporations, fluid movement of capital, and the rise of the digital economy, leaving gaps and mismatches that can be exploited to generate double non-taxation. This undermines the fairness and integrity of tax systems.

Base Erosion and Profit Shifting (BEPS) refers to tax planning strategies that exploit these gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate tax being paid. BEPS is of major significance for developing countries due to their heavy reliance on corporate income tax, particularly from multinational enterprises (MNEs).

Research undertaken since 2013 confirms the potential magnitude of the BEPS problem. Estimates conservatively indicate annual losses of anywhere from 4 - 10% of global corporate income tax (NYSE:CIT) revenues, i.e. USD 100 to 240 billion annually.

BEPS is a global problem which requires global solutions. For the first time ever in tax matters, OECD and G20 countries worked together on an equal footing. More than a dozen developing countries have participated directly in the work and more than 80 non-OECD, non-G20 jurisdictions have provided input.

Fifteen actions equip governments with the domestic and international instruments needed to tackle BEPS. The final BEPS package gives countries the tools they need to ensure that profits are taxed where economic activities generating the profits are performed and where value is created, while at the same time give business greater certainty by reducing disputes over the application of international tax rules, and standardising compliance requirements.

12.3.2 AGN's risk factors

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12.3.3 Changes to the risk factors in 2015

Note the expanded mention of BEPS from the 2014 10-K:

(1) [ADDED] For example, in 2013 the Company recognized a goodwill impairment charge of $647.5 million WITHIN DISCONTINUED OPERATIONS

(2) [ADDED] Many countries in Europe, as well as a number of other countries and organizations, have recently proposed or recommended changes to existing tax laws which could impact our future tax obligations. The Organization for Economic Cooperation and Development has been working on a Base Erosion and Profit Sharing Project, and is expected to continue to issue, guidelines and proposals that may change various aspects of the existing framework under which our tax obligations are determined in many of the countries in which we do business. The European Commission has conducted investigations in multiple countries focusing on whether local country tax rulings or tax legislation provides preferential tax treatment that violates European Union state aid rules. If the Company's effective tax rates were to increase, or if the ultimate determination of the Company's taxes owed is for an amount in excess of amounts previously accrued, the Company's operating results, cash flows, and financial condition could be adversely affected.

(3) [ADDED] Risks Related to the Pending Sale of our Generics Business to Teva Pharmaceutical Industries Ltd:

There are a number of risks and uncertainties associated with the pending sale of our generics business and certain other assets to Teva, including, among other things, the potential failure of a condition to closing, including the condition related to obtaining required regulatory approvals, which gives rise to the termination of the master purchase agreement executed between us and Teva.

Either party has the right to terminate the master purchase agreement if the closing has not occurred by July 26, 2016, subject to extension in certain circumstances. To the extent that the current market price of our ordinary shares reflects an assumption that the transaction with Teva will be consummated in the timeframe and manner currently anticipated, and that a portion of the sale proceeds will be used to pay down debt, any delay in closing or failure to close, or in a mix of debt paydown different than assumed by investors, could result in a decline in the market price of our ordinary shares. Similarly, any delay in closing or failure to close could result in damage to our relationships with customers, suppliers and employees and have an adverse effect on our business. Pending the completion of the transaction with Teva, the attention of our management may be directed toward the transaction and related matters, and their focus may be diverted from the day‑ to‑ day business operations of our company, including from other opportunities that might otherwise be beneficial to us. We have agreed to indemnify Teva and its affiliates against certain losses suffered as a result of our breach of representations and warranties and our other obligations in the master purchase agreement. Any event that results in a right for Teva to seek indemnity from us could result in a substantial payment from us to Teva and could adversely affect our results of operations. If we successfully complete the sale of our generics business, our revenues will decrease accordingly and our business will be subject to concentration of risks that affect our retained businesses, including our branded business. Refer to "Pfizer and Allergan may fail to realize all of the anticipated benefits of the Pfizer Transaction or those benefits may take longer to realize than expected. The combined company may also encounter significant difficulties in integrating the two businesses.

(4) [ADDED] New wording on the Pfizer deal, where the word "Allergan" is regularly replaced with the term "Pfizer." This suggests Allergan has made the IMPLICIT accounting assumption that it will have a transformative deal once per year.

(5) [REMOVED] Language on debt taken on to buy Allergan and potential obstacles to refinancing this debt

(6) [ADDED] The tax rate that will apply to the combined company is uncertain and may vary from expectations.

There can be no assurance that the Pfizer Transaction will improve the combined company's ability to maintain any particular worldwide effective corporate tax rate. Pfizer and Allergan cannot give any assurance as to what the combined company's effective tax rate will be after the Pfizer Transaction because of, among other things, uncertainty regarding the tax laws (including future changes to such tax laws and interpretations thereof) of the jurisdictions in which the combined company and its affiliates will operate. The combined company's actual effective tax rate may vary from Pfizer's and Allergan's expectations, and such variance may be material. Additionally, tax laws or their implementation and applicable tax authority practices in any particular jurisdiction could change in the future, possibly on a retroactive basis, and any such change could have an adverse impact on the combined company and its affiliates."

12.3.4 BEPS at Valeant (link)

I quote at length from a good article on Valeant's taxing practices:

Perhaps most important, however, the company moves its intellectual property offshore and uses transfer pricing to reduce taxable profit in higher rate jurisdictions, according to Dimitry Khmelnitsky, an investment analyst with Veritas Investment Research in Toronto who specializes in special situations and accounting issues. That's the key factor driving the 3% tax rate, he said. Transfer pricing refers to the price one company division charges another division for goods and services transferred across borders.

"Valeant has not demonstrated nor disclosed sufficient details to assess why its off-shore tax structure and the related transfer pricing is sustainable," Mr. Khmelnitsky said in a recent research note, adding that one major risk is that Valeant appears to have little in the way of business presence in its key offshore entities. "Instead, the company simply noted that its actions are similar to other IT companies, and that it is in compliance with all applicable laws."

[ article on transfer pricing]

[Transfer pricing is the setting of the price for goods and services sold between controlled (or related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a parent company, the cost of those goods paid by the parent to the subsidiary is the transfer price. Legal entities considered under the control of a single corporation include branches and companies that are wholly or majority owned ultimately by the parent corporation. Certain jurisdictions consider entities to be under common control if they share family members on their boards of directors. Transfer pricing can be used as a profit allocation method to attribute a multinational corporation's net profit (or loss) before tax to countries where it does business. Transfer pricing results in the setting of prices among divisions within an enterprise.

In principle, a transfer price should match either what the seller would charge an independent, arm's length customer, or what the buyer would pay an independent, arm's length supplier. While unrealistic transfer prices do not affect the overall enterprise directly, they become a concern for government taxing authorities when transfer pricing is used to lower profits in a division of an enterprise located in a country that levies high income taxes and raise profits in a country that is a tax haven that levies no (or low) income taxes.

Transfer pricing is a major tool for corporate tax avoidance[1] also referred to as base erosion and profit shifting (BEPS). The OECD has adopted (subject to specific country reservations) fairly comprehensive guidelines.[2] These guidelines have been adopted with little modification by many countries.[3] Notably, the United States and Canada have adopted rules which depart in some material respects from OECD guidelines, generally by providing more detailed rules.

Because countries impose different corporate tax rates, a corporation that has a goal of minimizing the overall taxes to be paid will set transfer prices to allocate more of the worldwide profit to lower tax countries. Many countries attempt to impose penalties on corporations if the countries consider that they are being deprived of taxes on otherwise taxable profit. However, since the participating countries are sovereign entities, obtaining data and initiating meaningful actions to limit tax avoidance is hard.[4] A publication of the Organisation for Economic Co-operation and Development (OECD) states, "Transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions."[citation needed]

In general, transfer prices don't differ much from the market price. This is because one of the units would always lose out if a different price were to be set. In the long term, this could affect the unit's performance and therefore the overall financial health of the multi-entity company.

The reason transfer prices shouldn't differ too much from market price is down to the principle of arm's length pricing. This is a system, which means the transfer price shouldn't be too different to the current market price, i.e. it should be within reach.

[/end article on transfer pricing]

But even technology companies are subject to higher tax rates, Mr. Khmelnitsky said. Apple, branded a poster child of tax avoidance by U.S. lawmakers, pays a roughly 21% cash rate on its worldwide income and 87% of its taxes are paid in the United States, he noted. Meanwhile, Valeant pays "very little U.S. taxes," he said, even though the country is its largest commercial market.]

There's another matter, tax specialists say: The shifting of intellectual property out of the U.S. itself and how Valeant has accounted for that.

"The bigger ticket issue which is going to pop right out [for the IRS] is how are they moving this offshore at little or no tax?" said Mr. Abraham, who has studied Valeant's two most recent Form 10-K annual filings. "There's only two ways out of it. If all [their] profits are in these low-tax jurisdictions, that means that they're pushing most of the profits to the intellectual property itself as opposed to any other activity. And if it was pushed to the IP, how did you get the IP out without paying [significant tax]?"

Mr. Abraham cautioned he can't be certain what the company is doing because it provides no meaningful disclosures on its offshore subsidiaries.

But he takes as an example Valeant's purchase of U.S. speciality oral health company OraPharma Topco Holdings Inc. in 2012, as detailed in Valeant's annual filing that year. According to the filing, OraPharma's lead product is Arestin, an antibiotic for the treatment of periodontitis.

In its accounting of the acquisition, Valeant recognizes US$15.5-million as the fair value for the acquired IP and research and development for Arestin but US$466-million in "identifiable intangible assets," which it specifies only as OraPharma's "product brand" and "corporate brand."

Mr. Abraham said Valeant is attributing little or no value to Arestin and to the intrinsic value of other patents. That suggests that it is the asset the company is transferring offshore, with little or no gain recognized on the transfer.

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"You can't have it both ways," Mr. Abraham said. If the company states the value was in the other intangibles, namely the product and corporate brands of OraPharma, then the resulting profit should have followed the value and remained in the United States, he said. Alternatively, if the company says the value was in whatever assets were transferred offshore, then there should have been a rather significant tax assessed on the offshore transfer.

"Barring an abusive loophole, Valeant would have to pick its poison," he said.

There is the possibility the assets Valeant transferred offshore are sheltered significantly by net operating losses or tax credits that might be carried forward. But Mr. Abraham said this is unlikely.

The IRS issued a notice in 2012 saying it recognized there are loopholes in the laws governing the transfer of intangible property by U.S. companies to foreign entities. The U.S. agency is expected to close the loopholes and issue new regulations retroactive to July 2012.

Valeant has added specific wording in the tax risks section of its annual filing to address possible reassessments by tax authorities. It states: "The final outcome of any audits by taxation authorities may differ from the estimates and assumptions that we may use in determining our consolidated tax provision and accruals. This could result in a material adverse effect in our consolidated income tax provision, financial condition and the net income for the period in which such determinations are made."

Mr. Pearson has said that Valeant treats taxes like an operating expense, adding the company has world-class advisors in the area, including New York law firm Skadden, Arps, Slate, Meagher & Flom LLP as well as professional services firms Deloitte and PricewaterhouseCoopers.

But Mr. Abraham and Mr. Khmelnitsky as well as other accountants note that just because a company is advised by a well-known accounting firm doesn't mean tax authorities won't challenge the methodologies used to arrive at the transfer pricing and valuation practices or the assumptions used.

In that sense, the rules are more like a framework that's subject to interpretation.

Merck & Co., Forest Laboratories Inc., Pfizer Inc,. and Eli Lilly & Co. have all been reassessed by the IRS in the past decade. British pharmaceutical giant GlaxoSmithKline plc, which also used PricewaterhouseCoopers as its auditor, settled with the IRS for US$3.3-billion in 2006 after the tax agency contested the transfer priced being charged to the drug maker's U.S. subsidiary.

Asked about Valeant's tax structure, company spokesperson Laurie Little offered no new details beyond previous answers and disclosures, repeating: "We book revenue where inventory and products are sold through inter-company agreements and distribution networks and record profit where earned and where each party earned an arm's-length remuneration."

Observers note that it's impossible to say with certainty when Valeant's tax probes will be resolved. Mr. Abraham said the IRS may want to have a longer 20/20 hindsight to see what cash flows result from Valeant's offshore property transfers. That could take years.

This article gives us a way to identify opportunities for IP migration - look at the intangible asset/IPR&D intangible asset ratio.

12.3.5 Legacy Allergan

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12.3.6 Forest

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12.3.7 Warner Chilcott

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12.3.8 Kythera

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12.3.9 Auden Mckenzie

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12.3.10 Summary

From the above comparisons we can induce:

(1) AGN's presentation of acquisition accounting for intangibles/IPR&D intangibles is remarkably similar to Valeant's, implying the intent is similar

(2) AGN's intangible/intangible IPR&D ratios are high, like Valeant's

(3) AGN provides far less disclosure than Valeant (at least in this Valeant example) on the composition of these asset categories

It seems reasonable to conclude that AGN and VRX have adopted this manner of acquisition accounting for the same reason. As the investigations at Valeant widen perhaps additional light will be shed on the mechanisms used to redistribute the intangible assets and the tax implications of doing so.

12.4 Other tax-policy comparisons with VRX (link)

This article relates to a Valeant whistleblower who touches tangentially on the issue. It is less relevant but I include it for completeness:

The crux of Mr. Melnyk's allegation against Valeant is that the company's income is not being taxed in the United States even though its corporate leadership resides in that country. In that sense, he believes the company is infringing U.S. tax law. He says Valeant will eventually spin into a "death spiral" when authorities force the company to pay back the taxes owed, which will trigger debt covenants with lenders.

By taking advantage of Canadian tax treaties with Barbados and, more recently, other countries in Europe and elsewhere, Valeant is further reducing its tax bill while its main decision-making happens in the United States, Mr. Melnyk alleges. Unlike the United States, Canada allows companies to shift their intellectual property centres to lower-tax jurisdictions while repatriating the profits without incurring more tax.

The situation has allowed Valeant to pay a tax rate under 5% and save tons of money, contributing to an aggressive growth-by-acquisitions strategy that gives it, in theory, more firepower than U.S.-based rivals in takeover situations. Many U.S.-based companies are subject to a tax rate north of 30%. Allergan, the Irvine, Calif.-based company currently fighting off a takeover bid from Valeant, paid a tax rate of about 26% in 2013.

"We book revenue where inventory and products are sold through inter-company agreements and distribution networks and record profit where earned and where each party earned an arm's-length remuneration," he said. "Each entity is resident in their country of their incorporation and we're compliant with all local laws as well as the laws of the relevant treaties between each party."

In a quarterly filing with the U.S. Securities and Exchange Commission on August 1, Valeant disclosed that during this year's second quarter, the U.S. Internal Revenue Service started an audit of the company for the years 2011 and 2012.

Note that like Valeant Allergan has multiple ongoing audits of subsidiaries underway. It might be said that this is typical given Allergan's pace of acquisitions, but Allergan's pace of acquisitions is by no means typical - nor are its IP accounting policies.

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13 Corporate Governance

13.1 Auditors

PricewaterhouseCoopers is well on its way to achieving the reputation that Arthur Andersen enjoyed in the aftermath of Worldcom/Enron. Despite its complete failure to recognize Valeant's overseas tax-evasion entities and premature revenue recognition etc, PwC continues to steward the shareholder's interest over at Actavis/Allergan/Watson. In fact, this relationship goes back to the early 2000s per Watson's filings. Hopefully PwC has managed to stay on top of things as the company's growth has exploded. Or maybe they've outsourced some of the work - after all, Saunders used to work in PwC's healthcare compliance practice and would be more than happy to help them out. Perhaps he picked up some compliance tips from Mike Pearson, whom he appears to have met back in their consulting days. Clearly Saunders' healthcare compliance experience helped keep Valeant out of trouble - he was an advisor to the company starting in August 2013 until recently.

Interestingly, PwC netted 51M in fees last year for their hard work vs. the 52M Arthur Anderson made in 2000 for their Enron audit - the year before Enron collapsed:

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As Schilit notes:

As the investigation into the auditor's role in the Enron collapse proceeded, Arthur Andersen fired its lead audit partner for Enron, David Duncan, after learning that he had destroyed documents from the audit file. Subsequently, a federal jury convicted Arthur Andersen of destroying Enron-related materials to impede an investigation by securities regulators. It vowed to appeal, but before the appeal and its subsequent exoneration, Arthur Andersen ceased auditing public companies and disbanded.

Who knew being an auditor could be so much fun?

13.2 Management Team

13.2.1 Brent Saunders, CEO

13.2.1.1 Dr. Jekyll

[WEBSITE] He previously served as Chief Executive Officer and President of Forest Laboratories and had served as a Director of Forest since 2011. Mr. Saunders has significant healthcare industry expertise and a proven track-record leading business transformations and integrations. Prior to Forest, he was chief executive officer of Bausch + Lomb, a leading global eye health company, serving in this capacity from March 2010 until August 2013. Mr. Saunders also held a number of leadership positions at Schering-Plough, including the position of president of Global Consumer Health Care and was named head of integration for the company's merger with Merck & Co. and for Schering-Plough's acquisition of Organon BioSciences. Before joining Schering-Plough, Mr. Saunders was a partner and head of Compliance Business Advisory at PricewaterhouseCoopers LLP. Prior to that, he was chief risk officer at Coventry Health Care and senior vice president, Compliance, Legal and Regulatory at Home Care Corporation of America. Mr. Saunders began his career as chief compliance officer for the Thomas Jefferson University Health System. Mr. Saunders serves on the Board of Trustees of the University of Pittsburgh. He is also the former Chairman of the New York chapter of the American Heart Association. He is a member of the Business Council and PhRMA. Mr. Saunders, 45, earned his MBA from Temple University School of Business, his J.D. from Temple University School of Law and his bachelor's degree from the University of Pittsburgh.

13.2.1.2 Mr. Hyde

Who knew that running a capital-munching rollup and eternally bickering with bankers to loosen your debt covenants could give you all that grey hair? I think the article I included at the beginning gives you a pretty full picture, but I just want to highlight a few things:

The son of a urologist and social worker, Saunders grew up in Pennsylvania and paid his own way through that state's college system as a furniture mover (he still has a bad back) and a clerk, earning a JD and an MBA. By 29 he had made partner at PricewaterhouseCoopers, focusing on regulatory compliance in health care.[PwC is Allergan and Valeant's longtime auditor]

He might have stayed a consultant for life had he not caught the attention of Fred Hassan, the legendary pharmaceutical turnaround artist.[Hassan has subsequently been accused of channel-stuffing and concealing clinical trial results - link] Hassan had made Pharmacia, a Swedish company, into a market darling through a huge acquisition, a spinout and a 64B sale to Pfizer. By 2003, when he met Saunders, Hassan was chief executive of Schering-Plough, and many thought the company was unfixable. Schering was accused of kickbacks, dangerously bad manufacturing and illegal marketing. Hassan needed an outsider to come in and help him clean up.

Hassan heard about Saunders from Schering's CFO, and though there were two other candidates more qualified on paper, Hassan became impressed by the younger man's drive and focus. "I just became convinced that this guy was going to be all-in," says Hassan. "In the end I think all of us have the IQ. The people who look to doing a job as something they really enjoy doing, they are always going to do better than those who look upon it as a job. I said, "'This guy's really going to get into it.'"

Hassan sold him to the BOD as Schering's new chief compliance officer, and once on board Saunders stamped out bad practices, negotiated hundreds of millions of dollars in settlements with the feds and personally entered the company's guilty plea. He rose fast: In 2007 Hassan tasked his apprentice with leading the integration of Dutch biotech Organon, which Hassan had bought for 14B. In the process Saunders began internalizing Hassan's dealmaking playbook: Create your own team; eliminate middle managers and pay attention to the people who actually deal with your customers; find products that can be made to perform better. Also: Wrap your strategy up in a nice slogan employees, journalists, and investors can get behind - maybe something like "Growth Pharma."[Saunders was Hassan's protégé and likely internalized his accounting principles at this time.]

End result: Schering was sold to Merck for 41B in 2009. Hassan left to become partner at Warburg Pincus, and Saunders was left to manage the integration with Merck from the Schering side. "It's a tough experience," says Saunders. "You've worked so hard, and you've become passionate for the people and for the way of doing things. All of a sudden there is a new owner, and they want to do things their way."

When Saunders got another job offer, to be COO of a healthcare products company, he called Hassan, his top reference. "Do you have to take it?" Hassan asked. Saunders, taken aback, asked if there was something wrong with his prospective employer. No, Hassan replied, but could he call him back?

Hassan set up a meeting the next day between Saunders and the partners at Warburg. Within a week Hassan's 40-year-old protégé had an offer to be CEO of B&L, which Warburg had bought for 4.5B in 2007 after its contact lens solution caused dangerous infections. Hassan would be chairman.[Note how similar the genesis of "new" B&L was the to the genesis of "new" Valeant. In both cases an activist fund came in and installed a key board member as well as a former-consultant CEO. This was a common flip-and-sell maneuver in the mid-2000s].

It was a tough assignment. Bausch was a 160-year-old company that hadn't grown for 30 years. Saunders replaced two-thirds of the company's managers. He made a string of acquisitions and introduced 34 new products, including a new laser for eye procedures. In the two years he ran the firm, sales grew at an annualized 9% and EBITDA at 17%.[Saunders' methodology obviously has not changed much over the years. The key to this period is it was done under Hassan's tutelage.]

B&L prepared for an IPO, with Saunders still at the helm. But then he got a call from Michael Pearson, a former McKinsey consultant who was now chief executive of Valeant Pharmaceuticals. They knew each other well from their consulting days.[Saunders and Pearson go way back.] Pearson got right to the point: He wanted to buy Bausch.

It was clear Pearson was going to cut Bausch to the bone. (Later, on a conference call announcing the deal, he said that Saunders' team "had made very little cuts" and that Bausch had a cost structure comparable "to a Big Pharma company." He promised to cut SG&A from 40% of sales to 20%. Once in charge, he did.)[Saunders, while clearly already well educated in the art of serial acquisition, would not have overlooked how quickly Michael Pearson was making money as CEO at Valeant. He has grown more and more eager to distance himself from Pearson's acquisition philosophy, partly as a political means to poach deals like Allergan. Indeed, more than anything he seems to have been eager to emulate the Pearson prototype.]

Saunders returned from an IPO road show, went to meet Pearson on a Friday and signed the deal to sell B&L at 4am on a Saturday. "It was emotional; I poured my heart and soul into B&L," he says with surprising passion, considering he spent just 24 months with the firm. "I love the brand. I love the people. I love the customers. It almost becomes like your second family." But, he says, it was the "absolute right decision," and there was never any doubt about the outcome. "This company was for sale the day Warburg Pincus bought it," he says. "That's the model in private equity. Warburg Pincus saved the company because this company would have gone through a miserable experience as a public company doing this turnaround."[If Saunders felt any ambivalence about Valeant's policies, those feelings evaporated quickly at the prospect of a quick exit.]

As the deal closed, Saunders went from Warburg to Icahn. In 2011 Icahn bought an 11% stake in Forest Laboratories and put a lieutenant on the BOD, convinced that Forest's 84-year-old CEO, Howard Solomon, had lost his touch. He chafed at Solomon's plan to hand the business to his son David. "FOREST LABS IS NOT A DYNASTY TO BE DESPOTICALLY HANDED DOWN FROM FATHER TO SON IGNORING THE GREAT RISK OF THIS ACTION TO ITS SHAREHOLDERS," Icahn thundered in all caps in a letter to investors.

Right after the Bausch deal closed, Saunders was make CEO of Forest to appease Icahn. He quickly dipped into Hassan's playbook, dubbing the shake-up "a rejuvenation" - and almost immediately looking to make a deal. Three months after joining Forest, he was having steaks with Paul Bisaro, the CEO of Actavis, at the JP Morgan Healthcare Conference in San Francisco. Saunders joked about the idea of them merging.[Note that Saunders is always the driver behind a deal.] The idea stuck, and they kept talking more about it, more and more seriously.

On Feb 18, 2014 Actavis bought Forest for 28B, a 25% premium to the stock's previous close. Icahn's take approached 2B on the deal. "He came in and he got it done in 5 months," says Icahn. "If you look at that result that's pretty damn good. I just thought he did a great job."[Saunders and Icahn share their "take the money and run" mentality.]

Successfully jobless once again, Saunders had dinner with Icahn and suggested starting a company by buying some aging drugs from a large pharmaceutical company. Icahn offered to give him 2B, subject to due diligence. "There are very few people I would do that with," Icahn says.

But Bisaro, who'd built Actavis into a 6B powerhouse in the generic drugs business through his own string of blockbuster deals, also recognized Saunders' talent. If he leaves, if we lose him, then the company is going to be worse off," Bisaro said. Over lunch from Actavis' cafeteria, he offered Saunders the CEO job of the combined Actavis-Forest, and Saunders accepted."I know I would probably be able to make more money doing something on my own," says Saunders, "but I really believe Actavis is something special."[This may help explain why Saunders feels chronically underpaid].

Of course, one of Saunders' first moves was, true to his nature, a blockbuster acquisition. On July 11, 2014, just ten days after he officially became Actavis' CEO, Saunders asked his board for permission to talk to Allergan's CEO, David Pyott, who was embroiled in one of the nastiest takeover battles ever in an industry known for nasty takeover battles.

Pyott had been CEO of Allergan for 17 years. He'd taken a product Allergan licensed for lazy eye and turned it into Botox (you know what it does), a 2B blockbuster. He'd delivered annualized sales growth of 12% over ten years, along with a 267% shareholder return. Yet to Valeant's Pearson, he was an inefficient CEO who allowed bloated spending to drag down shares. Pearson offered 45.6B for the company, a 31% premium for investors over current share prices, and got Pershing Square's activist hedge fund manager, William Ackman, to take a 9.7% stake in Allergan to push the deal through.

Pearson's parsimony was on full display. He opened up an investor presentation by stating that they were in such a nice room only because Ackman covered the cost. "This'll never happen again, unless someone else wants to pay," he said. That extended to his plans for Allergan. He promised to cut Allergan's 1B+ R&D budget by 69% to 300M and cut another 1.8B, or 40%, from the combined company's operating budget.

Pyott was repulsed. "Valeant is vile, and there is nothing I have learned since then that has changed my mind," he says. "They're an asset stripper." He did everything he could to fight off the attack. He publically disparaged Valeant, cut R&D and operational spending himself, and even filed a lawsuit in California alleging that Ackman's purchase was insider trading.

On July 30 Saunders called Pyott and offered to be a white knight. Over months of phone calls, he portrayed himself as the anti-Pearson, despite the fact that agreed with much of Pearson's thesis on the drug business. No, Saunders told Pyott, he would not strip the company like Pearson. Allergan would continue to do crucial research on things like dry-eye drugs and successors to Botox. Yes, the business could stay largely intact. They kept talking - six times in October alone. All the while Pearson's and Saunders' bids for the company kept climbing, topping 60B. Pyott finally agreed to Saunders' terms when his suit against Ackman went against him. The final offer was 67B - far too expensive for Pearson's blood. Saunders had won.[Notice that the key differences between the Valeant and Actavis offers were the price tag and the R&D spend. It was because their rollup strategies were so similar that both wanted the same prize.]

On the eve of the takeover [about the time this article was published] Saunders is saying all the right things to keep the peace. For starters, he's promising to keep Allergan's R&D budget intact. The new Actavis will spend 1.7B, or 7% of sales, on R&D, compared with 250M, or just 3%, for Valeant.[Note that R&D spend is no longer broken out in Allergan's filings, nor is amortization, so once Legacy Allergan was absorbed Saunders was free to do as he pleased. And no, 3% is not so far from 7% where there is no clear barrier between R&D spend and amortization]. Saunders even says he plans to keep research in drug discovery, because Allergan's research in bacterial toxins (like Botox) and dry-eye disease is some of the best in the world. He points out that when you exclude its generics business, Actavis will spend 13% of sales on R&D, about as much as a big pharma. Even when it comes to sales and other operating expenses, he plans to cut only 1.8B, or about 20%. Ripping deeper, as Valeant would have, has its own costs. Pissing off all your new employees can be expensive and counterproductive. "We're not the Borg; we don't go in and assimilate companies," says Saunders. "We try to learn from their culture. We learn from their processes, and we certainly try to learn from their talent. We want to get better."

Timing plays a part, too. Pearson's slash-for-cash strategy for Valeant shined for investors at a moment when pharma R&D was at its absolute worst. But last year 41 new drugs got approved, 130% more than in 2007 - partly because new science is delivering more successful research programs and partly because of luck.

Still, Saunders being Saunders, there's another possibility: a fast sale. The likeliest buyer: Pfizer. Last year Pfizer attempted a 100B hostile takeover of AstraZeneca, in part to avoid paying US taxes by redomiciling in London. It failed. Buying Actavis, analyst have pointed out, would also allow Pfizer to do the same thing.

Moreover, Pfizer has entertained spinning out its generics business, which is composed almost entirely of old Pfizer drugs. Combining it with Actavis would give it a real generics business for that division, while bulking up the drug business, too. In an interview with analysts at Bernstein Research this summer, Pfizer seems to embrace the idea of potentially buying a generics company. Pfizer declined to comment, and Saunders things the prospects of such a deal are "negligible."[What Saunders says about deals and what actually happens are two different things. Notice how he also said a breakup of the Pfizer deal had a <10% probability - months before the deal collapsed].

But of course, the door is open. "Our stock's for sale every day on the New York Stock Exchange," he says. "We're a shareholder-friendly management and board."

13.2.2 Paul Bisaro, Executive Chairman

He served as the Chief Executive Officer of Actavis from September 2007 to July 2014. Prior to joining Actavis (then Watson), he was President and Chief Operating Officer of Barr Pharmaceuticals, Inc. ("Barr") from 1999 to 2007. Between 1992 and 1999, Mr. Bisaro served as General Counsel and from 1997 to 1999 served in various additional capacities including Senior Vice President - Strategic Business Development at Barr. Prior to joining Barr, he was associated with the law firm Winston & Strawn and a predecessor firm, Bishop, Cook, Purcell and Reynolds from 1989 to 1992. He also served as a Senior Consultant with Arthur Andersen & Co. Mr. Bisaro received his undergraduate degree in General Studies from the University of Michigan in 1983 and a Juris Doctor from Catholic University of America in Washington, D.C. in 1989.

The coziness of Allergan's boardroom has not gone unnoticed. John Chevedden, a self-annointed "shoestring activist" (www.reuters.com/article/us-activist-chev...), purchased his requisite $2000 of stock for the purpose of submitting the following proposal:

Proposal No. 8: Independent Board Chairman

Shareholders request our Board of Directors to adopt as policy, and amend our governing documents as necessary, to require the Chair of the Board of Directors, whenever possible, to be an independent member of the Board. The Board would have the discretion to phase in this policy for the next CEO transition, implemented so it does not violate any existing agreement. If the Board determines that a Chair who was independent when selected is no longer independent, the Board shall select a new Chair who satisfies the requirements of the policy within a reasonable amount of time. Compliance with this policy is waived if no independent director is available and willing to serve as Chair. This proposal requests that all the necessary steps be taken to accomplish the above.

It is the responsibility of the Board of Directors to protect shareholders' long-term interests by providing independent oversight of management. By setting agendas, priorities and procedures, the Chairman is critical in shaping the work of the Board.

A board of directors is less likely to provide rigorous independent oversight of management if the Chairman is an insider, as is the case with our Company. Transitioning to a board chairman who is independent of our Company and its management is a practice that will promote greater management accountability to shareholders and lead to a more objective evaluation of management.

According to the Millstein Center for Corporate Governance and Performance (Yale School of Management), "The independent chair curbs conflicts of interest, promotes oversight of risk, manages the relationship between the board and CEO, serves as a conduit for regular communication with shareowners, and is a logical next step in the development of an independent board." (Chairing the Board: The Case for Independent Leadership in Corporate North America, 2009.)

An NACD Blue Ribbon Commission on Directors' Professionalism recommended that an independent director should be charged with "organizing the board's evaluation of the CEO and provide ongoing feedback; chairing executive sessions of the board; setting the agenda and leading the board in anticipating and responding to crises." A blue-ribbon report from The Conference Board echoed that position.

A number of institutional investors said that a strong, objective board leader can best provide the necessary oversight of management. Thus, the California Public Employees' Retirement System's Global Principles of Accountable Corporate Governance recommends that a company's board should be chaired by an independent director, as does the Council of Institutional Investors.

An independent director serving as chairman can help ensure the functioning of a more effective board of directors. Please vote to enhance shareholder value.

Not surprising, Allergan was not super-thrilled to include the proposal in its proxy statement (link):

13.2.3 Maria Teresa Hilado, CFO

Ms. Hilado was appointed Actavis' CFO on December 8, 2014. Prior to joining Actavis, Ms. Hilado served as Senior Vice President, Finance and Treasurer for PepsiCo, Inc. since 2009. Before joining PepsiCo, she previously served as Vice President and Treasurer for Schering-Plough Corporation from 2008 to 2009. Before joining Schering-Plough, Ms. Hilado spent more than 17 years with General Motors Corporation in leadership roles of increasing responsibility, most notably Assistant Treasurer from 2006 to 2008 and CFO, GMAC Commercial Finance LLC from 2001 to 2005. She began her career with Far East Bank and Trust Company, Manila, Philippines. Ms. Hilado received a B.S. in Management Engineering from Ateneo de Manila University in the Philippines, and an MBA from the University of Virginia's Darden School of Business Administration.

13.2.4 William Meury, EVP Branded Pharma

Mr. Meury joined Actavis in July 2014 as Executive Vice President, Commercial, North American Brands. Prior to joining Actavis, he served as Executive Vice President, Sales and Marketing, Forest Laboratories, Inc. He joined Forest in 1993 and held positions in Marketing, New Products, Business Development, and Sales. Most recently, as Executive Vice President, Sales and Marketing, Mr. Meury oversaw the activities of several departments including Product Management, Market Research, and Commercial Assessments, as well as Forest's Global Marketing and Early Commercialization groups. Mr. Meury directed 10 product launches during his tenure at Forest. Before joining Forest, Mr. Meury worked in public accounting for Reznick Fedder & Silverman and in financial reporting for MCI Communications. He has a B.S. in Economics from the University of Maryland.

13.2.5 C. David Nicholson, EVP Branded R&D

Dr. Nicholson joined Actavis as Senior Vice President, Global Brands R&D in August 2014. Previously, he served as Chief Technology Officer and EVP, R&D for BayerCropScience from March 2012 to August 2014; Vice President of Licensing and Knowledge Management at Merck from 2009 to December 2011; and Senior Vice President, responsible for Global Project Management and Drug Safety at Schering-Plough from 2007 to 2009. From 1988 to 2007, Dr. Nicholson held various leadership positions at Organon, where he most recently served as Executive Vice President, Research & Development and was a member of the company's Executive Management Committee. He received a B.Sc. from the University of Manchester and his Ph.D. from the University of Wales.

13.2.6 Jonathon Kellerman, Global Chief Compliance Officer

Prior to joining Actavis, Mr. Kellerman spent 20 years with PricewaterhouseCoopers LLP (PwC) in leadership roles of increasing responsibility, most recently 10 years as Partner in the company's Pharmaceutical & Life Sciences Advisory practice. Mr. Kellerman was responsible for helping lead the firm's Governance, Risk & Compliance practice. He has extensive experience in compliance strategy and commercial performance improvement, including global anti-bribery/anti-corruption program assessment, design and implementation work; building and implementing effective global compliance programs; managing fraud investigations and remediation activities; re-engineering processes supporting key commercial and R&D business activities and compliance controls; and re-designing how companies engage health care professionals. Mr. Kellerman received a B.A. in Sociology from Franklin & Marshall College.

13.3 Recent Turnover

13.3.1 Management Team

The highlighted execs started or left their positions within the last 3 years:

Of course, Bisaro has been with the company for a long time and was the one who hired Pearson. But many of the others (including the CEO/CFO) have had very brief tenures and might be expected to have little loyalty to the company or its long-term investors. The phrase that comes to mind is "in it for the money," and as we'll see there is plenty of money involved.

13.3.2 Board of Directors

Turnover at the board has also been significant, although this can obviously be a good or bad thing:

13.4 Compensation Package

13.4.1 Structure

Executives get paid essentially for 3 things: raising the stock price, raising adjusted EPS, and doing "transformational" deals.

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13.4.2 Share Ownership by Management and Board Members

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I went ahead and calculated the value of the underlying at today's stock price. This will be somewhat inflated since we don't have the detailed stock option data available and are referencing the underlying. We'll deal with that problem in a later table.

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13.4.3 Historical Compensation of Executives

13.4.3.1 Annualized Comp

What I've done in this table is sum up the compensation by position title. So for example, if the old CEO left and a new CEO joined (as happened in 2014), I totaled the compensation for both individuals as "CEO compensation." Since shareholders are paying the CEO (for example) to do a job, this approach makes operating sense.

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13.4.3.2 Outstanding Equity Awards

Now let's look at equity compensation awards for the execs:

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For this data, I valued the options as if they expired in 2018 - although most in fact have much longer durations. The longer duration of course needs to be offset for options that cannot be sold ("Europeanness"). Notwithstanding the illiquidity, I expect the Black-Scholes value of most of these options is higher than presented here - much higher in some cases.

13.4.4 2016 Board Compensation

For perspective, per WSJ, "median pay of an S&P 500 board member is $255,000 a year, according to a Wall Street Journal analysis of data as of Oct. 30 from MyLogIQ and regulatory filings." Among the Forbes 500, a select few fell in higher pay brackets:

The winners were:

Here's what the directors are being paid this year:

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In case you can't see the last column, the average director pay was $570,270. That falls right between Oracle and Autodesk on the list of companies with highest paid directors. And the equalization payments were bad either, bringing the average payments per officer up to $792,136, which would fall right behind Celgene (excluding whatever they offer for equalization). It would seem the directors have adequate incentives to behave, and perhaps not rock the boat too much.

It's also mildly interesting (though perhaps a red herring) that the highest paid non-NEO board member appears to be a scientific, rather than financial, advisor.

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Tax gross-ups on business expense reimbursements and tax equalization payments were as follows:

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13.4.5 Incentives for "Transformational Deals"

13.4.5.1 Termination with Change of Control

When the treasury nixed the Pfizer deal, Brent Saunders was mad. Very mad. Here's why:

It's not every day that you see a pay chart bracketed in units of 20M, but there you have it. And this pay package was constructed at a time when Brent Saunders already knew about the Pfizer deal and considered its probability >90%. He considered that 140M practically in the bag as he transitioned on to his next great life adventure. And make no mistake - the sting of that loss will not be easily forgotten as he charts the company's course going forward.

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And don't forgot the 55M tax reimbursement!

13.4.5.2 2015 Awards

As it stands, Brent will have to accept a measly 15M for the TIA portion of his 2015 pay. Will he be satisfied? Time will tell..

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13.4.5.3 Future Awards

And life only gets better in 2016 and beyond!

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Don't pay too much attention to these numbers though - the TIA (transformational incentive awards) make these incentives look like chump change.

13.4.6 Performance metrics

13.4.6.1 2015 Non-GAAP EPS (do more deals and inflate revenue growth for new businesses)

As we recall, there is a significant difference between the performance suggested by net income and "adjusted" net income:

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Let's see how our executives decided to compensate themselves for their hard work:

Corporate Financial Performance. For the 2015 performance year, non-GAAP Earning Per Share (EPS) replaced Adjusted EBITDA as the corporate financial performance metric. The Compensation Committee made this change because they believe non-GAAP EPS: better aligns to investor expectations; (ii) maintains a strong focus on profitability; is durable as we continue to grow in size and complexity; (iv) is easy to understand and communicate; and aligns with the market practice amongst our peers.

For the purpose of measuring corporate financial performance, " Non-GAAP EPS" means the Company's diluted earnings per share adjusted to exclude charges or items from the measurement of performance relating to: amortization expenses; (ii) asset impairment charges and losses /(gains) and expenses associated with the sale of assets; business restructuring charges associated with the Company's Global Supply Chain and Operational Excellence Initiatives or other restructurings of a similar nature; (iv) costs and charges associated with the acquisition of businesses and assets including, but not limited to, milestone payments, integration charges, other charges associated with the revaluation of assets or liabilities and charges associated with the revaluation of acquisition related contingent liabilities that are based in whole or in part on future estimated cash flows; litigation charges and settlements; and (vi) other unusual charges or expenses.

Given the timing of the closing of the Allergan Acquisition, which occurred near the end of the first quarter of 2015, non-GAAP EPS goals were established by the Committee for two time periods as shown below. Full year performance was determined by taking the weighted average of the two periods. Additionally, non-GAAP EPS performance for purposes of the AIP includes the performance of our global generics business, which is being divested to Teva Pharmaceuticals Industries Ltd. during 2016.

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As we've seen, non-GAAP EPS creates a magical world in which R&D expense (amortization, write-downs) and SG&A expense (amortization, write-downs, restructuring) don't exist, not to mention it excludes those unfortunate upfront costs for making an acquisition and the attendant debt service. The message of this incentive plan is clear - keep doing what you're doing, make another "transformative" acquisition, and you shall be well compensated.

13.4.6.2 TSR CAGR (raise the stock price)

Of course, life as a high-flying corporate executive wouldn't be complete with options - lots and lots of options. And if you can't backdate your options, there's always the next best thing: front-load them. This is one reason why Brent Saunders' outstanding equity awards alone are worth around 90M. And do make sure your option awards are themselves contingent on the stock price rising ("TRS CAGR" is a nicer term). I call this options on options: not only are your options worth more when the stock goes up, but you get MORE of them. What more could you want?

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Funny how good a job this program has done at retention, huh? Some myths in corporate America pay too well to be dispelled.

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14 Insiders

Insider activity does not give us much guidance on this one - after all, the insiders are getting their stock "for free."

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15 Institutions

15.1 Q1 2016

By and large, the top holders reduced their positions from the last reporting period. The notable "smart money" in Allergan includes Paulson & Co, Third Point, and now Icahn. Paulson (a risk arbitrageur) has been reducing his position. Loeb, who previously enlarged his position aggressively, is now cutting back as well. As we've seen, Icahn has been a longtime Saunders supporter and based his investment "on Brent" rather than on analysis, much as Ackman investment in Pearson as "the next Buffett." Unlike Ackman, Icahn tends to respond less warmly when erstwhile friends lose his money.

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15.2 Q4 2015

The previous reporting period:

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16 Catalysts

Potential catalysts to the downside:

Blowup of Pfizer deal represents "failed merger of equals," the inflection point in Soros' model

Blowup of the Teva deal due to scrutiny by securities holders of the acquirer (or a "come to Jesus" moment by Teva management); this may produce an immediate credit crisis for Allergan since they cannot sell Actavis Generics now for nearly what Teva offered last year, both because of market valuations and because of the massively overstated operating results

Completion of the Teva deal, which the market already largely assumes - eliminating its perceived value as an upside catalyst

Stock buybacks or future deals

Decompensation of the investment grade markets

Downgrades by the ratings agencies given the company's debt-reduction program

Scrutiny of accounting practices by SEC Scrutiny of tax reduction practices by IRS and US Treasury

17 Background Resources

Other articles I wrote that you may find useful for background include:

(1) Valuing Valeant

(2) A Prescription for Valeant

Disclosure: I am/we are short AGN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.