Pfizer and Allergan Agree to $160 Billion Merger
What do you get when you mix Viagra and Botox? We are about to find out, at least with respect to financial impact. With respect to the products, feel free to make your own punchline — we're not going there.
Pfizer, the pharmaceutical giant that manufactures Viagra and many other common medications such as Lipitor, Advil, and Neosporin, recently agreed to a record-breaking $160 billion merger with Allergan, the maker of Botox. Pfizer was already the world's fourth-largest pharmaceutical company, but the combined enterprise will take over first place assuming the deal with Allergan passes collective regulatory scrutiny and shareholder votes.
This merger tops the buyout value list in a year full of mergers and acquisitions (M&As). The total M&A value for 2015 is already well over $4 trillion and is on pace to surpass 2007's record total of $4.61 trillion. Pharmaceutical mergers alone take up nearly 15% of all the 2015 merger values to date.
Why is the pharmaceutical industry so heavily engaged in mergers? Part of the reason involves product strategy, as companies sell off less-productive product lines and maintain growth by using the proceeds to either make similar acquisitions to increase market share or make complementary acquisitions to diversify their offerings. However, one of the primary reasons is to save money on US taxes — whether or not the companies will admit it outright.
Mergers and Tax Inversions
Although Pfizer is the larger company ($200 billion compared to the $122 billion of Allergen) and is also the main driver behind the merger, the deal is structured so that Allergan is technically the buyer of Pfizer. The executive headquarters will be located in Allergan's Dublin, Ireland, location even though the headquarters for Pfizer's global operations is located in New York.
This allows the deal to skate past regulations designed to prevent tax inversions that allow multinational conglomerates to avoid higher US corporate tax rates. Tax inversions take place when a merger between an American company and an overseas company results in the headquarters being relocated in the foreign country.
The US has two tax policies that drive companies toward inversions: we have the highest nominal corporate tax rate of any developed country at 35%, and we are one of the few countries that tax domestic businesses for income earned in foreign countries. The taxes are due when profits are brought back into the US, a process known as repatriation. Multinational companies based in the US avoid these taxes by re-investing the proceeds into the overseas operations, or by executing a tax inversion that no longer makes them a US-based company.
Pfizer will still pay US taxes on income generated within the US, but they save considerable amounts on the remaining tax income. In Pfizer's case, the merger with Allergan drops their effective tax rate from 25.5% to around 17%-18%. That rate puts them in a more competitive tax position compared to foreign competitors GlaxoSmithKline (14.4% effective rate) and Sanofi (17.9% effective rate).
Consider that Pfizer has raked in almost $19 billion in profits over the last two years, and the difference in the tax rates equates to well over $1 billion in straightaway tax savings. What company is not going to take advantage of $1 billion in lower taxes if the opportunity is available?
Instead of debating whether our corporate taxes should be lowered to keep US companies in-country, the US government has put in place regulations to make tax inversions more difficult. The Pfizer Allergan deal bypasses these regulations by being constructed as a foreign purchase of a domestic company. Allergan's parent firm becomes the parent of the combined business, even though it will be named Pfizer and trade under the Pfizer symbol (NYSE:PFE).
Pfizer shareholders get a choice of one share of the new company per Pfizer share or a cash payment. Allergan shareholders get 11.3 shares of the new company per Allergan share. Pfizer investors will hold 56% of the combined company, keeping it below the 60% threshold that would label the deal as a tax inversion.
Investors do not seem impressed with the deal, as both companies finished down on the day of the announcement. Allergan shares fell almost 3.5% to $301.72 per share and Pfizer dropped over 2.5% to $31.33 per share. Reuters reports that the lower-than-expected level of cost savings that the merger would provide disappointed investors.
While investors may not approve, the deal puts Pfizer in an excellent cash position as the majority of Pfizer's payment is in the form of stock. They are now able to access billions that had been held within overseas operations, and they intend to put it to use.
Currently, Pfizer has around $36 billion in cash on the balance sheet and will gain more from the pending sale of the lower-margin generic drugs component of their business for just over $40 billion to Teva Pharmaceutical. Pfizer CEO Ian Read intends to continue with acquisitions of smaller competitors to the extent economics and regulations allow.
Strategic acquisitions may be the key to further growth. Pfizer's revenue has decreased 4% over the past year. Other US pharmaceutical companies are similarly down — Johnson & Johnson suffered a 5.3% drop and Merck is down 8%. Compare this to European rivals Sanofi (up by 11%) and Bayer (up by 15%).
There is clearly more at work here than just taxes. Pfizer maintains a higher gross margin than any other large pharma company according to data compiled from S&P Capital IQ and analyzed by USA Today, but they are faced with an aging line of products. They apparently intend to keep a high margin by jettisoning the generic lines and compiling and maintaining a broad portfolio of newer and higher-margin products.
The entire pharmaceutical field is awash in mergers and takeovers, and the Pfizer-Allergan deal is probably not the last of the lot. If you want to invest in the pharma field, it is very important not only to look at the current condition of your preferred investments but also consider how further buyouts could affect them, whether any rumored merger involves them or a competitor. Would their position be strengthened or weakened?
In Pfizer's specific case, it is largely about tax savings and maintaining a high profit margin. Before investing there, you will have to assess their chances of success and avoiding any regulatory hurdles. The latter seems likely; the former is up for debate.
For those with the insight and acumen to assess the acquisitions correctly that are likely to succeed, there is plenty of money to be made in the pharmaceutical field. However, if you are not willing to do the research and keep up on the activities within the field, you may be better off sticking with safer and more predictable investments.
Pfizer logo by Pfizer [Public domain], via Wikimedia Commons
Allergan logo by Renatoviannajr (Own work) [CC BY-SA 4.0 (http://creativecommons.org/licenses/by-sa/4.0)], via Wikimedia Commons