The Q&A – Why Pfizer's $160-billion merger with Allergan may not happen

What has the US Treasury Department done?

It is formalising suggested guidance from 2014 and 2015 into temporary regulations, which are designed to target "serial inverters," and which could have significant implications for a number of pending inversions – including Pfizer and Allergan – and even some that have already closed.

The new proposals focus on companies that have "acquired multiple US firms in stock-based transactions over a short period of time," and are designed to eliminate "a significant amount of the tax benefits of serial inversions."

Controversially, the Treasury Department is proposing a 'look back' provision, which in the case of the Pfizer-Allergan merger would mean that Allergan's deals in the prior 36-month period would not be counted when calculating ownership of the combined Pfizer/Allergan entity. Removal of the stock component of key deals could push Allergan's equity in pro-forma Pfizer/Allergan below 20 percent, noted ISI Evercore analyst Umer Raffat; thereby falling short of the necessary inversion criteria (the 40 percent ownership which confers tax benefit).

While Allergan could argue that it was not proactively "bulking up" to facilitate an inversion deal with Pfizer, the real question is not one of Allergan's intent or whether the Treasury Department is overstepping its authority, but whether the proposals prompt Pfizer to walk away from the deal, adds Raffat.

What could happen next if Pfizer walks away from Allergan?

From a financial perspective, breakup of the deal would have "minimal adverse consequences" for Pfizer, suggests ISI Evercore analyst Mark Schoenebaum; the break-up fee – triggered by "adverse changes in tax law" - is $400 million.

While the financial implications of the Allergan deal collapsing would have limited consequence, Pfizer management would face the ignominy of failing in two high-profile acquisition pursuits; albeit for very different reasons (AstraZeneca – supported by the UK government – successfully thwarted Pfizer's unsolicited approach in 2014).

Schoenebaum argues that Pfizer would likely move to acquire one or more biotechnology companies if the deal with Allergan does fall through, while the decision on whether to separate Pfizer's innovative pharmaceutical and established pharmaceutical businesses could be accelerated to the second half of this year (the suggested timeline prior to Pfizer announcing its intention to acquire Allergan).

If Pfizer does have a 'plan B' (should that be 'plan C'?) it has "not been well articulated," wrote Bernstein analyst Tim Anderson in a note to investors.

Shareholders appear to have been less than enthusiastic about Pfizer's approaches for both Allergan and AstraZeneca, but have been sold by management on the rationale that an inversion deal is necessary to facilitate a subsequent split of the company. Some have been troubled by the fact that Pfizer has been willing to put itself in the firing line of regulators and others by a deal-type that appears primarily to be about financial engineering, adds Anderson. If Pfizer does walk away from Allergan there will also be scrutiny of the 'established products' business and whether it can be divested in its current guise as a standalone entity. This could test the patience of investors who were first exposed to the notion of a split by Read five years ago.

Separation of the established products business may not be Pfizer's "fall-back position," note analysts at Jefferies, adding "we believe that the value proposition of a separated unit would be largely tied to its potential cash flow/dividend stream, which relies on an inverted structure to maximise the amount of cash that can be returned to investors."

As Schoenebaum notes, if Pfizer considers inversion an avenue it cannot proceed down, it could rely on targeting larger companies, but the tax rate issue that Pfizer has described as its motivation for an inversion deal would not disappear.

Pfizer is also faced with the issue of large-scale M&A being out of favour within the Big Pharma peer set, but is forced to consider this against the previous series of large-scale acquisitions it has completed over the past 16 years (Warner Lambert, Pharmacia and Wyeth). Pfizer's post-acquisition growth performance – and perceived disruption on R&D productivity – following each of these acquisitions has aided the industry's broader focus on smaller, bolt-on deals, but in aggregation, these acquisitions likely require Pfizer to undertake something more radical (hence talk of a split and the desire to invert).

One alternative strategy for Pfizer could be to extend its current $22 billion, three-year share buyback programme to $50 billion over the same time period, remarks Anderson. By his calculation this would lift the company's stand-alone earnings per share CAGR from 7.1 percent to 10.7 percent; by contrast he forecasts a CAGR of 12.5 percent for a combined Pfizer/Allergan over the same period.

And what of Allergan? – as a recent Bloomberg column noted, Allergan and Valeant Pharmaceuticals were in a similar position five years ago and have pursued not-dissimilar M&A-led strategies since; look how that has ended up for the latter. "Allergan is compelling even as a standalone company," wrote analysts at Nomura, who suggest that focus on the Pfizer deal has caused Allergan's strong underlying fundamentals to be ignored; "it has some of the best, most durable assets in the sector, it is run by a shareholder focused management team with strong operational abilities and has a solid mid-to-late stage pipeline that could deliver significant upside to our estimates."

What is likely to happen?

Analysts at Citi were suggesting that the deal now looks unlikely to go through and speaking on a webinar for investors on Tuesday, ISI Evercore's Raffat suggested the merger is likely "dead," based on usable Allergan equity under the newly proposed provisions. Wells Fargo analyst David Maris noted that having spoken to both Ian Read and Allergan CEO Brent Saunders in recent weeks, while both companies are eager for the deal to complete, the prospect of a potentially distracting and long legal battle may make them reconsider the merits of a transaction. Analyst at Jefferies wrote "the treasury action looks like more than just a wrinkle for Allergan merger. Other inversion targets such as GlaxoSmithKline and AstraZeneca could still potentially be considered, though we sense this may be the end of Pfizer's inversion attempts."

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