Pfizer and Allergan: Viagra Meets Boxtox

I can't wait to hear the late night talk show hosts talk about a merger between the makers of Viagra and Botox!  But we'll confine ourselves here to the more technical aspects of this deal.  There are many interesting aspects to this one including the size of the deal, the continuation of industry trends, the creation of a giant in Pharmaceuticals, the current price movements of the bidder, target and competitors, the possibility of an inversion, and the social terms of the deal.

First, this deal could be the largest deal of the year as Allergan has a market cap of $112.5 Billion and Pfizer has a market cap of $219 Billion - this year is on pace to be the biggest year yet in M&A.  Second, it continues the consolidation trends we have seen in the pharmaceuticals industry.  Third, it creates the world's largest drugmaker.  The combination would surpass Johnson and Johnson (currently valued at $278 Billion).

The deal would be an inversion, as Allergan is headquartered in Ireland with a far lower tax rate than Pfizer faces in the US.  Expect the US government to seek to impose restrictions on the move putting the tax benefits of an inversion in question.  See our posts about inversions (here, here and here) and the folly of governmental attempts to restrict inversions rather than addressing the root issue and making domicile in the US more attractive.

The price movements at the announcement were typical for the bidder and somewhat abnormal for the target.  The bidder lost a few percent while the target shares rose only 8%. Typical price jumps for the target would be in the 20% - 40% range.   

We've noted many times in these pages about the impact of mergers on rivals.  In particular, our research has shown how the rivals of bidders and targets react to deals involving a competitor.  In today's case, the Guardian reports that the prices of two competitors (GlaxoSmithKline and Shire) declined in value as there was some anticipation that they would be Pfizer's target instead of Allergan.  This illustrates both the anticipation effects embedded in a firm's stock price and the reaction when those anticipated effects are put into question.  Many social terms of the deal remain to be determined, including what happens to Allergan's CEO and how many layoffs might occur as part of the deal.  

One senses that in this market, there is more to come.  There will be a lot to talk about during our December course in Amsterdam.

All the best,

Ralph 

Valeant, Allergan and the Market Pricing of Proposed Acquisitions

We've written  before about the information implicit in the speculation spread, the percentage difference between an offered bid price and the post announcement stock price.  As we have said, if a stock is trading for $20, a bidder offers $30 and the post announcement price moves to $25, that represents a 16.7% speculation spread.  If you bought the stock at $25 and the deal closed at the bid price of $30, you'd earn 16.7%.  We've also noted that the market's perception of deal completion and revision are implicit in the speculation spread and in the post announcement move of the target's stock price.  In the example above (ignoring a few simplifying assumptions), the market is predicting that there is a 50% chance the deal will go through.  (The $25 post announcement price represents a weighted average of a 50% chance the price would return to $20 and a 50% chance it would rise to $30.)  If the deal was certain to be completed, the post-announcement market price would rise to approximate $30.

In our research, we found that the average speculation spread in deals is about 2%, but that the variation in this spread is large and significantly predicts deal outcomes and time till the deal closes.  Time till deal closes is important as it impacts the rate of return earned by arbitrageurs.  The fact that speculation spreads are significantly related to time to closing is testimony to the importance of this time period and to the wisdom of the market.

In our research, 23% of the speculation spreads were negative meaning that the post acquisition price exceeded the offered bid price.  (In our opening example, this would mean the price rose to more than $30.)  What is implied by a negative spread?  You guessed it - a revision in the bid price by the initial bidder or another bidder.

The Allergan saga continues to provide an interesting example of speculation spreads.  Notice the rapid increase in stock price in the chart below.  The price rises before the deal is announced, probably on speculation and dramatically when a bid is announced and Allergan adopts a defensive measure (the poison pill).

The speculation spread, shown in the chart below, is also informative.  Notice the negative spread, implying bid revision.  It continues to be negative until - the bid is revised.

Of course, the Allergan saga is not over.  Allergan management has implemented many of the ideas espoused by Valeant, yet the stock price remains below the highest offer by Valeant and the speculation spread remains positive indicating the uncertainty that a deal would close.  Meanwhile, news has surfaced that Allergan also thought about merging with Salix Pharmaceuticals in a defensive move.

It will be interesting to follow this one going forward.

All the best,

Ralph

European Private Equity Deal Activity 2014 update; Darden's Takeover Defenses

A key focus of our acquisition finance course is understanding the nature of changing deal markets and incorporating that knowledge into deal structure.  Pitchbook is out with their latest PE report on European Activity and it provides useful updates.  Just a few of the highlights:

For the 6th quarter in a row PE investment in Europe has exceeded 50 billion euros.  Also, the popularity of bolt on investments is increasing, now representing 44% or European buyout activity.  A bolt-on investment is one made through an existing portfolio company rather than a direct investment of funds in a new industry.  Whereas direct investments generally involve new areas of investment, bolt-ons are typically in the same or related industries as the portfolio company.   Further details on these and other highlights can be accessed here.
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Also, in last week's post regarding Allergan and Valeant we noted:

"The Best Takeover Defense: Don't leave Money on the Table.  Anticipate value creating activities and implement them, however painful.  Continuously evaluate your firm's strategy, particularly in light of a changing environment.  Consider Are You a Takeover Target? Take the corresponding action before external markets force change upon you. Don't wait for a hostile bidder to force you into action.  Indeed, Do Unto Thyself."

Allergan was taking a page from their suitors book and slashing R&D.  Another great example is in Bloomberg today.  Darden Restaurants, long facing hostile activist investors, has retired its chairman and CEO and opened the board for activist representation, all actions desired by the activists.  According the story, however, the actions may have been too little, too late.  

As we said, 'Don't wait to implement value increasing actions.'

All the best,

Ralph

Allergan and Valeant - Lessons from the Market for Corporate Control

The current Allergan Inc. case illustrates many points we have made in these posts.  As we start to think about our upcoming Amsterdam class on Structuring the Deal, it is useful to review.  The Allergan situation is an important illustration of the importance of corporate governance and the fact that when internal governance mechanisms (e.g., management and the board) overlook value creating strategies, external governance mechanisms (e.g., hostile bidders, arbitrageurs and the stock market itself) will force that change upon the firm.  It is better to be proactive.

On April 22, 2014 Valeant announced a hostile bid for Allergan, explicitly noting its value creating strategy, with an estimated $80 billion in synergies to be achieved in the first six months.   Allergan rejected the acquisition offer by Valeant but is now implementing many of the same strategies Valeant has proposed.  Specifically, Allergan has focused heavily on research and development while Valeant has focused more on sales.  Valeant said it would cut up to 20% of Allergan employees, primarily in R&D.  Allergan rejected these initiatives but is now following a similar strategy in an attempt to pacify its shareholders.  It has announced that it will lay off about 13% of its workers.  Here are just a few of the lessons from past posts.

The Best Takeover Defense: Don't leave Money on the Table.  Anticipate value creating activities and implement them, however painful.  Continuously evaluate your firm's strategy, particularly in light of a changing environment.  Consider Are You a Takeover Target? Take the corresponding action before external markets force change upon you. Don't wait for a hostile bidder to force you into action.  Indeed, Do Unto Thyself.

Once your firm is in play, the ownership quickly shifts to arbitrageurs.  The Speculation Spread between the offered bid price and the post announcement market price reveals the market's anticipated outcome for the deal (e.g., successful or unsuccessful acquisition and whether the bid will be revised).  Once arbitrageurs are the major owners, a deal is much more likely to happen as their interest coincide with deal completion.  As we noted in April, "The market is predicting a higher, successful bid as the Allergan's stock price on Monday closed well above the $153. value offered by Valeant." Allergan's shares closed at $171.14 on Monday.

This deal is reminiscent of the numerous oil takeovers in the 1980s.  During the late 1970s, many companies began an extensive drilling program searching for more oil.  By the 1980's two factors made that strategy hugely unprofitable.  First, the price of oil fell from $40. a barrel to around $10. a barrel. Second interest rates rose from single to double digits.  Thus, in terms of the present value equation, the numerator declined while the denominator rose.  Not a good combination.  Firms that failed to adjust were subsequently taken over.  

To repeat, it is necessary to always consider if your current strategic course is the best one for maximizing value.  If you get this wrong, you are likely to find out the hard way.

All the best,

Ralph

Rhyming or Repeating?

M&A volume is up substantially in 1H14. Some are worried the market may be overheating just as it did prior to financial crisis in 2006 and 2007. My view is this market is in a different stage than the 2006-2007 period. M&A has been depressed following the crisis. Current activity appears more like a return to normal than overheating. Keep in mind, the stock market increased over 30% last year while M&A was flat. The two are usually correlated.

Especially interesting is the increased activity of activist and hostile bids. In fact we are seeing a potentially new development of a combined activist-hostile bid with the Pershing Square-Valeant-Allergan Drama. Shareholders are putting increased pressure on management to do something. You survived the crisis-now do something beyond share repurchases with our excess cash. Thus,they are positively reacting to many announced deals. This factor plus an improving economy, cheap debt and a rising stock market are contributing factors.

Additional observations include:

1)   Deal Quality: deal quality is high. It is primarily larger consolidating and synergistic industrial transactions like 1990s versus the 2006-2007 private equity going private transactions. The deals are concentrated in the telecom and healthcare industries which are undergoing structural changes.

2)   Financial Structure: although debt remains plentiful and cheap strategic acquirers are primarily funding transactions with equity. The percentage of debt financed cash deals has fallen from over 65% in 2006-2007 to around 45%. This helps lower deal risk as sellers are participating in the future prospects of the new entity, and leverage levels remain modest. Sellers are willing to accept buyer stock given increased confidence in markets. They see the potential for a double dip price increase for an appreciating buyer stock post close.

3)   Private Equity (PE): LBO activity remains far below its 25% pre crisis percentage of total M&A. This reflects current high M&A prices and stiff competition from strategic buyers who have better synergy prospects than PE. PE has responded by using increased leverage to help offset higher purchase prices.

Of course, things can change quickly. The impact of the unwinding of the Fed’s quantitative easing program remains an issue. PE, with its large level of dry powder, could become more aggressive and drive up prices and debt levels. Thus, caution is warranted and disciplined bidding is needed by both strategic and PE acquirers. Nevertheless, the current market feels like it is in the early growth phase-not the later overheated stage. History appears to be rhyming - not repeating the overheated 2006-2007 period at this time.

j

Build or Buy: Deconstructing the Big Pharma Value Chain Thru M&A

Industry changes drive M&A. Currently, we are seeing a plethora of deals in the big pharma industry. Traditionally, the industry utilized a Vertically Integrated business model. The model combines the various links in the Value Chain within each firm including early stage R&D, sales and marketing, manufacturing, and distribution. Early stage R&D is high risk and expensive (more than 15% of annual revenues in some firms). The search for blockbuster drugs to justify such investment has become difficult given many former winners going off patent and weak development pipelines. Consequently, big pharma margins have suffered.

Early stage R&D relied on a big firm’s ability to fund the needed large expenditures. This has become more problematic given the weak governance and incentive structures in large bureaucratic firms. Consequently, firms have been considering alternative funding arrangements. Instead of developing drugs internally, they buy the new drugs from better suited smaller entities thru licensing, joint ventures or acquisitions. These early stage Incubator type firms would be funded by Venture Capital, Private Equity or Hedge Funds. This would allow big pharma to focus on its core competencies. Thus, the question or bet is what is the most efficient structure to undertake early R&D- in house or buy?

This question is at the heart of the recently announced $40B+ Valeant-Pershing Square  hostile joint venture buy-in for Allergan. Valeant's business model is based on buying versus developing new drugs-primarily thru acquisitions with Allergan being the largest by far. Valeant’s R&D expenses to revenues ratio is only 3%. Their stock price has increased 9 fold since the current CEO arrived in 2008 and embarked upon a serial acquisition program. The current bid despite being over 20X EBITDA promises to be minimally dilutive based on the large amount of R&D and SG&A cost savings planned.

Allergan uses the traditional integrated model. Its R&D to revenues ratio is 17% (almost $1B LTM). It also has a top heavy $2B+ SG&A cost structure characteristic of vertically integrated firms. Its stock had stagnated over the past years. The Valeant bid equals a price Allergan has not seen since 2008. It reflects the large strategic value gap inherent in Allergan based on its current strategy and asset combinations.

Allergan is expected to resist the offer. It has a Poison Pill, and is expected to seek possible white knights like Johnson and Johnson. If those fail, then it may embark an acquisition campaign of its own to make itself too big and ugly to buy like Jos A Bank tried. Valeant and Pershing established a significant 9.7% Toehold to cover the downside of losing he bid. How they accomplished this is an interesting application of good Lawyering.

Industry disruptors like Valeant are employing new business models to rapidly reconfigure industries undergoing structural change. They accept the change while targets resist change. Ultimately, history is on the side of change not resistance. Early stage drug R&D will continue. The questions is how and who will perform it.

 J