A big pill to swallow

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FAT PROPHETS: In a big year for merger and acquisition activity, this week’s headlines are being dominated by the largest announced deal year to date by a long shot. It is of course the Pfizer / Allergan combination which if seen through will see jumbo Pfizer plc become the largest pharmaceutical company on the planet.

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The price tag for the deal? Approximately US$160 billion of total enterprise value, so this isn’t chump change. Even for a company of Pfizer’s (NYSE: PFE, initial buy $27.65) size that is a big pill to swallow and consequently, the deal is all scrip.

Under the proposal, unanimously approved by both company’s boards, Allergan shareholders will receive 11.3 shares of the combined company for each Allergan share and Pfizer shareholders will receive one share for each of their Pfizer shares. When the dust settles, it is expected Pfizer shareholders will own about 56% of the entity.

It is far from a done deal however, already having stirred up a hornet’s nest among the politicians over the financial manoeuvre – the dastardly (according to some trying politico’s trying to grab airtime) tax inversion! The deal is structured as a reverse merger and by shifting its headquarters to the Green Isle (Ireland) Pfizer expects to end up with a tax rate of 17-18% by 2017, compared to the approximately 25% run rate so far in 2015.

Another perk of the deal will be that it will improve access to likely more than ten billion dollars (estimated) that Pfizer has left parked offshore (rather than repatriate it to the US to be taxed) that can be used for share buybacks, fatter dividends and business development. This is a broader issue and collectively US companies are estimated to have some US$2 trillion “trapped” offshore, with other companies in the portfolio such as Cisco (NYSE; CSCO, initial buy $20.15) also having a nice nest egg overseas.

If the deal ends up going ahead, Pfizer will be the biggest company to head abroad in large part in search of a lower tax rate and US politicians are in a tizzy. Naturally, the proposed deal is an opportunity for the presidential candidates to get some airtime as well.

The reality is though that America’s tax system is labyrinthine, out of date and not competitive, particularly for corporate tax. Although decades ago the US nominal corporate tax rate was in broadly line with the global median rate, it now effectively ranks as the highest corporate tax rate in the developed world, and that’s before you add in state and local taxes as well!

Although a lower tax bill is a big part of the attraction for Pfizer CEO Ian Read in our view, Pfizer is also looking to buy Allergan for growth, with the latter company having grown at a rapid pace over the past decade, albeit mostly via acquisition itself.

Allergan’s top selling drug is Botox, which is likely to generate over $2 billion of sales this year. But Allergan also has a strong portfolio across aesthetics & dermatology as well as eye care (see right hand side of below graphic). It also has drugs for CNS, cardiovascular disease and women’s health. The overlap is actually quite limited though, so there should be little risk of being blocked on the regulatory side from that perspective. The whole tax thing is another ball game.

Just briefly, Pfizer anticipates the transaction will deliver more than $2 billion in operational synergies over the first three years after closing, with this targeted for 1H16. Even with limited overlap, we believe this is a lowball figure. The transaction is expected to be neutral to adjusted diluted EPS in 2017, be “modestly accretive” in the 2018 calendar year, more than 10% accretive in 2019 and “high-teens percentage” accretive in 2020.

We believe this EPS growth assumes plenty of share buyback activity as the company flex’s it’s more than $25 billion of expected annual operating cash flow post transaction.

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