Mergers and Taxes, A Follow Up on "Inversions"

Last week we commented on the increased number of "inversions" where a US firm is merged into a foreign firm to become domiciled in a more tax friendly country.  (See Politics, Taxes and Economic Reality.) Our argument was for recognition of the economic reality of the marketplace and the need for companies and countries to remain competitive.  Countries with unfavorable tax environments will lose business.  An unproductive tendency, we warned, is for countries to try to set up roadblocks inhibiting the laws of economics.  These attempts are generally unproductive and can create unintended consequences that only exacerbate the situation.

Indeed, an interesting blog from the Deal Lawyer, points out that the Treasury department has already implemented steps to prevent or slow down these inversions.  According to the article, current law states that the existing shareholders of the US firm must end up owning no more than 80% of the new company to create an inversion.  The law is being changed, however, to require existing shareholders to own less than 50% after the deal is complete.  Obviously, acquiring companies are not going to be anxious to give up such control.

The end result will be a rush to complete these deals before the new laws take place at the end of this year.  A better long term strategy for the United States or any country is to recognize the economic reality faced by business and understand motivations for the inversions.  Imprisoning business with uncompetitive laws may work in the short run.  It will never work in the long run.

All the best,

Ralph

How Do I Pay: Stock, Cash or Combination?

The selection of the acquisition payment currency has important implications for both the seller and buyer. So far in this century about 55% of deals are cash, 23% combination and 22% stock. The proportion of cash and combination deals has increased since the elimination of Pooling of Interests accounting in 2001. Like all M&A items, the selection is negotiated and depends on the relative points of views of the buyer and seller regarding whether the risks and rewards of the acquisition should be shared. The simplest approach is use cash, but sometimes that is not always possible.

Buyer considerations regarding the use of stock in whole or part include the following:

1)   Valuation: consider not only the seller’s valuation, but also that of the buyer’s post transaction value to gauge the exchange ratio impact. The buyer should never use its shares if it believes them to be undervalued; whereas, it should use its shares if it believes them to be over-valued and the seller will accept them. An extreme example of this is AOL’s purchase of Time Warner.

2)   Synergy Risk: use cash if synergy risk is deemed low to keep the upside and stock if high to share the risk. Facebook’s recent high priced acquisitions are primary stock transactions. This helps cushion the downside should the early stage technology targets fail to work out as planned.

3)   Market Risk: if shares are used then you need to decide who bears the market risk of the shares changing price after the offer is made but pre close. The options include a fixed price deal where the buyer assumes the risk, a fixed share arrangement where the seller takes the risks or using collars and caps to share the risk. (See our post Acquisition Risk, Collars, and the Comast Time Warner Deal.)

4)   Dilution: this includes both ownership and earnings dilution. Whenever new shares are issued the relative ownership positions of existing shareholders declines. This can be an important control issue for middle market firms and argue for a cash deal. Buyer earnings and earnings per share (EPS) always increase in a debt financed cash transaction provided the target’s earning exceed the incremental after tax interest cost on the debt. In stock transactions the new shares issued can cause a decline (dilution) in EPS if the seller’s price-earnings ratio exceeds that of the buyer. Over time, the EPS dilution should decline as earnings grow. Usually, buyers prefer a breakeven dilution of 2-3 years.

5)   Taxes: the buyer prefers a taxable transaction involving all or a substantial portion of the price to be in cash. This allows the write-up of the assets acquired by the buyer and higher future tax deductions. Other considerations include changing tax domicile to lower tax rates as in the Pfizer-AstraZeneca  bid.

6)   Credit Rating: debt financed cash transactions impact the buyer’s target debt rating.

Seller considerations include:

1)   Valuation: the seller needs to value the buyer’s shares on a post acquisition basis to determine what if any premium it actually receives. This means doing due diligence on the buyer. These valuation issues explain why targets in hostile takeovers prefer cash over stock as AstraZeneca is now demanding from Pfizer. Remember the old joke - daddy I sold my bike for $20,000- I traded it for 2 $10,000 marbles. The value of marbles, like the buyer’s shares, is an opinion. Cash, however is a fact.

2)   Taxes: sellers can defer capital gains taxes if the transaction is structured as a tax free share exchange. Unfortunately, this has negative tax implications for the buyer which will probably be reflected in the offer price.

3)   Liquidity: the focus is on the float of the shares to be received, lock-ups and registration rights.

Bottom line for me is the KISS principle (keep it simple stupid). It is usually cheaper for the buyer to pay in cash. This may reflect Warren Buffett’s apparent preference for cash purchases. Sellers will have an easier task of evaluating the offer and less risk in cash deals. Thus, being a simple guy, I recommend cash transactions whenever possible. If not using cash, be sure you are at least as smart as the other side.

J

Politics, Taxes and Economic Reality

I don't know anyone who enjoys paying more in taxes than is required but taxes are important and vital to our country.  So is the necessity of creating an environment where business can compete and win.  The Wall Street Journal noted that Pfizer is changing its headquarters from the US to enjoy a considerably lower tax rate abroad.  The article goes on to note that these inversions, as they are called, are created by merging into a company in a different country and are becoming more plentiful.

Many things remain the same for Pfizer.  It will still use New York as its operational headquarters, for example, and still widely market its products in the US.  One thing that will change is the lower tax revenue the United States will receive.

The article notes that Pfizer is fully complying with all laws and will continue to pay taxes as required in the United States.  Nevertheless, I fully expect we will hear more from politicians about Pfizer and other companies initiating these moves.  In other circumstances, politicians have created laws forbidding actions 'undesirable to the state' or heavily taxing 'undesirable' actions.  Indeed, such laws are one of the motivations for Pfizer's shift: the move will permit more tax favorable flexibility in utilizing off-shore funds rather than face hefty US taxes under current law.  It has long been argued that more reasonable and creative laws for the use of off shore funds would aid companies and increase tax revenue for the US, but changes have not been forthcoming.  

Many politicians seem to believe that the laws of economics can be ignored or worse, that their own laws are superior in creating  a more desirable world.  In the worst cases, laws are created by politicians without full analysis of the details or even recognition of possible unintended consequences.

In the end, the laws of economics prevail and the countries of those who ignore these laws suffer the consequences.  Instead of creating barriers or lamenting loss of business, energy would be better spent in working to make the business environment of our country more competitive.   That includes a hard look at the tax codes and the economic reality of the world.

All the best,

Ralph 

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

Costs, Benefits, Taxes and Culture

Mergers are once again filling the headlines of our financial papers and as one who writes a merger blog, there are plenty of things we could discuss.  The Omnicom Publicis merger appears in danger, reportedly due to the resulting tax structure of the deal (although one can suspect other issues as well).  

Taxes also figure in the the $46 billion dollar offer of Valeant for Allergan.  According to an article in the Wall Street Journal, Valeant changed its domicile to Canada after its 2010 merger with Biovail.  As a result, it's tax rate is below 5%, offering a huge competitive advantage over companies in the United States.  Allergan is headquartered in California, so one strategy would be to move the business to Canada.  

But the Valeant Allergan deal is also newsworthy because of the differing cultures of the two companies.  Allergan is more focused on research and development, while Valeant is focused on sales.  Indeed, the planned strategy of Valeant is to reap savings by slashing the R & D spending of Allergan.  Certainly there can be value in R & D and that brings us to the nexus of the items we've talked about.

Consider three aspects of the Valeant, Allergan deal: taxes, culture and strategy.  There are three major claimants on EBITA - bondholders, debt holders and the government.  Reducing taxes increases funds available to the other claimants and can result in significant gains for equity.  

Merging companies with clashing cultures, however, is fraught with problems and can dramatically increase integration costs.  In this case, however, it is clear that Valeant is well aware of the culture/strategy issues and not afraid to confront them.  

So lets consider the pieces: taxes, culture, costs, benefits and strategy.  The value of a company and the value of any deal always come down to the basics - cash flows and risks.  We estimate value by discounting expected cash flows at a rate commensurate with the risks.

And cash flows can be increased in two major ways - growing the revenue or reducing the costs.  Both can be viable strategies and the success of any deal will hinge on the correct estimation of the costs and benefits and implementation of the specific tactics to bring them to fruition.  Both companies have been successful following different paths.  The question here is whether it makes sense for the paths to converge.

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.  Valeant's stock price rose dramatically as well.  It will be interesting to follow this deal.  

All the best,

Ralph

Responding to Low T

The T in question is the Competitive Advantage Period and not testosterone. It is time in which a firm can invest at returns exceeding its cost of capital. T, or moat as used by Warren Buffett, is the driving factor underlying tech firm high valuation multiples. It is based on strategic barriers including technology, First Mover Advantages and regulation. (Also, see our previous post: Find your sustainable competitive advantage.)

It has a dramatic valuation impact as it declines when firms or industries mature. T eventually fades for most industries as they experience Regression to the Mean due to competitive forces such as new entrants and substitutes. Firms like Apple can have several years of remaining T; whereas, firms like Hewlett Packard’s T is largely gone. This fact is reflected in their widely differing valuation multiples. In fact, you can view T as the number of years a firm has before it undergoes a fundamental corporate change like a LBO, recapitalization or sale.

The current flurry of tech related deals presents insights into how firms are handling the rapid changes in T. These firms are based upon rapidly changing technology life cycles, which can be measured in terms of dog years. Firms can respond this development in two distinct manners. The first is to accept and mature gracefully and increase shareholder distributions as IBM has done. 

Alternatively, you could try to adapt by either developing new products like Apple or acquiring new products and technologies as is Facebook –see Crisis. The acquisition approach is to be distinguished from weak acquirers such as Hewlett Packard seeking to hide declining performance.

Tech firms like Google are investing in strategies which just happen to be executed thru acquisitions. Unlike Cisco which pioneered this strategy, these new transactions are much larger. 

The transactions have two objectives. The first is to acquire skills and technologies faster and cheaper than could be internally developed. The second to pick technology winners early and help them develop early as Facebook is doing with its Oculus Acquisition. In these efforts Real Option Valuation is used to supplement traditional Discounted Cash Flow analysis.

There are many risks involved with the acquisition approach. For example can you the right targets? Can you properly execute the transactions? Can you grow the acquired technology fast enough and large enough? How will your competitors respond?

The jury is still out on how this plays out. It is fascinating to watch.

J

Agency Theory,Corporate Governance and Acquisitions

We’ve mentioned that one of the ways going private creates value is through improved governance.  In fact, governance is strongly linked to mergers and acquisitions.  Consider the following:

Governance involves aligning the interests of owners and managers.  A merger changes the ownership of target and possibly bidding firms.  Thus, it creates possibilities for altering the alignments that previously existed.

Governance issues are called agency problems in the academic literature because they involve agents (the CEO, the board and management) working on behalf of the owners (shareholders).  Agency problems occur naturally because the best interests of owners may not coincide with those of the agents they hire.  Good governance seeks to align these interests. 

In future posts, we’ll spend more time on some of the potential agency conflicts that arise naturally in corporations and in particular in mergers and acquisitions.  They include, but are certainly not limited to:

CEO compensation.  It is natural for an executive to desire more and for owners to want to pay what is justified.

Consumption of perquisites by the executive team.  A sole proprietor may have a Spartan office and fly coach.  If he/she does not, they bear 100% of the costs of any perquisites.  This is not true for the CEO of the typical large corporation who probably owns less than 1% of the equity and hence bears that proportion of the costs of perquisites.  Suddenly the private jet looks more appealing.

Resistance to mergers.  A merger in the best interests of shareholders may nevertheless cost a target CEO his or her job.  Enough said.

Acquiring for the sake of building the empire.  An executive may desire to expand the empire for personal reasons.  After all, the size of a company is linked to measures of ‘prestige’ like being part of the ‘Fortune 500.’  And, of course, there is a strong link between size of the firm and size of the CEO’s pay.

Getting caught up in deal fever and overpaying.  We’ve noted a good deal becomes a bad deal at some price.  Most of us have encountered a bidding situation, on eBay or elsewhere, where we’ve gotten caught up in the momentum of bidding and gone beyond our preset upper limits.  Ego can also becomes a factor in heated bidding wars.  Neither of these situations is best for us as individuals and they certainly aren't best when playing with shareholder's money.

Conflicts between classes of capital.  Less obvious are the conflicts that can exist between equity holders and debt holders.  In a share repurchase, for example, equity holders may gain at debtholders expense.  This can occur when the collateral protecting the debt holders (including cash) is reduced for share repurchase.

These are but a few of the potential conflicts that must be handled carefully in mergers and related transactions.  In a subsequent post, we'll talk about the incentives created when an owner (say an institution) holds both debt and equity in a deal.    

Ralph