Wednesday, November 18, 2015

Value and Taxes: Breaking down the Pfizer- Allergan Deal

A week ago, I began my series of posts on the drug business, starting with my perspective on how the business is changing and then moving on to posts on Valeant's business model and the runaway story of Theranos. I am finishing this series with a post on Pfizer's plan to merge with Allergan and the economics of the merger. This deal, which will make one of the largest pharmaceutical companies in the world even larger has drawn attention not just because of its magnitude, but also for its motives. While there is some desultory chatter about synergy (as is the case with every merger), this deal seems focused on two specific motivations: the first is that this is a bid by Pfizer to buy Allergan's higher growth and the second is that this is a deal designed to save taxes. Not surprisingly, the latter is attracting attention not just from investors and financial journalists, but also from politicians. 

Growth but at what cost?

One of the most dangerous maxims in both corporate finance and investing is that it is better to grow than to not grow, and that a company that faces stagnant or declining revenues (and income) should seek out higher growth (at any price). In a post from a long time ago, I looked at the value of growth and noted that the net effect of growth depends on how much you pay to get it, and that overpaying for growth will give you higher growth and a lower value. In the graph below, you can see the effect of growth on value for three companies, all of which grow, the first by making investments that generate returns that exceed the cost of capital, the second by making investments that earn the cost of capital and the third by making investments that earn less than the cost of capital.

It is this perspective on growth that makes me skeptical about companies that grow through acquisitions, especially when those acquisitions are big and are of public companies. Since you have to pay market price plus (a premium of 20-30%) to acquire a public company, for a growth-motivated acquisition to create value, you have to be able to find a growth company that is under valued by more than 20% or 30%, given its growth rate, at the time that you initiate the deal to be able to walk away with value added. Note that, much as I am tempted to do a riff about the wondrous benefits of bringing both Botox and Viagra under one corporate entity,  I am deliberately keeping synergy out of the equation since it can justify a premium.

Let's consider then the proposition that the Pfizer deal for Allergan is driven by the motivation of buying growth. The basis for the story is visible in this comparison of Pfizer and Allergan's operating numbers over the last five years:

Over these five years, Pfizer's revenues shrank about 6% a year whereas Allergan's revenues grew at 40.62% a year. That makes the case for the acquisition, right? Not quite, because it depends on whether the market is already pricing in Allergan's growth. If it is, buying Allergan will allow Pfizer to grow faster, but not create value and may in fact destroy value if the premium paid is large enough.  To examine whether Allergan offers growth at a bargain, I considered valuing Allergan, but very quickly abandoned the idea, because it reminded me of Valeant, insofar as it has grown rapidly through acquisitions, funded with significant amounts of debt and its financial statements are a mess. Thus, while it clear that Allergan has grown fast, the question of whether it has grown sensibly is a question that remains to be answered. Looking at the multiples at which Allergan was trading, prior to the Pfizer bid, there is almost no multiple on which it looks like a bargain.

PharmaceuticalsAllerganAllergan Premium
PE Ratio31.24NANA
Price/Book Equity4.114.376.33%
EV/EBIT20.1253.15164.17%
EV/EBITDA13.9719.3238.30%
EV/EBITDAR9.7116.5870.75%
EV/Sales4.717.8566.67%

What is the bottom line? If I were a Pfizer stockholder, I would be concerned if buying growth were the primary reason for this acquisition, since the growth at Allergan is not only at a premium price but also untested (insofar as it is acquired growth rather than organic growth). I would be terrified, especially after recent scares, that the acquisition accounting at the company may be hiding bad surprises.

The Insanity of the US Tax Code

One of the most surprising aspects of this deal is how open the Pfizer management has been about the tax motivations for the deal, with Ian Read, the CEO of Pfizer, saying that "the company is at a tremendous disadvantage under the U.S. corporate tax code and that Pfizer is competing against foreign companies with one hand tied behind our back.” This planned "inversion", of course, has triggered a heated response, understandable (at least politically), though some of the critics don't quite understand the US tax law and what exactly Pfizer will gain by leaving behind its US incorporation. 

I have vented extensively about the absurdity of US tax law and how it encourages perverse behavior from businesses (and individuals). Rather than repeat myself, let me focus in on the three aspects of the law that makes it so damaging: 
  1. The level of rates: There was a time four decades ago when the US federal corporate tax rate, at 40%, was in the middle of the global tax rate distribution, with many countries adopting a policy of punitive corporate taxation. The corporate tax rate in the US was last lowered in 1986 to 34%, then raised to 35% in 1993 and has remained unchanged since. With state and local taxes, it amounts to close to 40% in 2015. The rest of the world has moved away from the US and lowered corporate tax rates, leaving it with one of the highest marginal tax rates in the world in 2015. (See this KPMG site for tax rates around the world
    Source: KPMG
  2. Global versus Territorial taxation: Adding to the US tax code's woes is the requirement that US companies pay the US tax rate not just on US income but on income generated elsewhere in the world. In 2015, it remains one of six countries that follow this practice, whereas the rest of the world has moved to a territorial tax model, where companies get taxed based on where they generate income (and are done). The Global tax model, which was born in an age when the US economy was the driver of the global economy and US companies were domestically focused, results in US multinationals facing much higher tax rates on world income than multinationals incorporated elsewhere.  (Interestingly, Ireland is one of the six countries with a global tax model but with its low tax rate, the effect is muted.)
  3. The Repatriation Trigger: To cap off this trifecta, US tax law adds a clause that specifies that the “additional US tax” due on foreign income has to be paid only when that income is repatriated to the United States. In response, US companies have had the logical reaction and not repatriated foreign income, leaving that income “trapped” in foreign locales. In 2015, it was estimated that the trapped cash amounted to more than $2 trillion, money that cannot be used to pay dividends, buy back stock or make investments in the US, but can be used to make investments anywhere else in the world
The benefit to a company of removing itself from US tax incorporation, i.e., inversion, is therefore two fold:
  1. No US taxes on foreign income: While the company will continue to pay the US tax rate on its US income, its foreign income will be taxed only at the foreign domicile's tax rate. 
  2. Untrap cash: To the extent that the company has built up trapped earnings (in foreign locales) that it is restricted from using, it can release the cash without any tax penalties.
Given US tax law, the question is not why some companies seek to leave its tax jurisdiction, but why more of them do not, and the answer lies in an uneasy middle ground, a wait-it-out scenario that many US companies have adopted, where they let income accumulate in foreign markets and wait for one of two developments. One is a change in US tax law, which people on both sides of the aisle seem to agree is needed, but don't seem to want to bring to fruition. The other is that Congress will blink yet again and pass another one of its "tax holidays", a "once in a lifetime" chance (that shows up once every decade)  that will be given to companies to bring their cash home with no penalties. The net effect is that the US ends up with the worst of all worlds: a tax code that is ineffective at collecting taxes (as evidenced by the drop in corporate tax collections over the last three decades) while encouraging companies to borrow more and more money (and save on taxes at the marginal rate).

Pfizer: The Numbers 
To understand how exposed Pfizer is to the vagaries of US tax law, I started by looking at the geographical distribution of Pfizer revenues over time:
Note that Pfizer generated only 43.08% of its revenues in the first nine months of 2015. If Pfizer were to be taxed, at the marginal rate in each region, based on where it generated its revenues (regional tax), its tax rate in those nine months would have been 30.68%. As a US company, though, Pfizer would have to pay almost 40% of this income as taxes, translating into significantly higher taxes each period.  Pfizer, of course, chose not to take this course, as manifested in two numbers. The effective tax rate that Pfizer has paid over the last five years has averaged to 23.45%, well below 40%, and a significant portion (my rough estimate is $12 billion) of Pfizer’s cash balance of $20.66 billion is trapped. Binging it back will result in a tax bill of $1.99 billion (using a differential tax rate of 16.55%, the difference between the US marginal tax rate of 40% and the effective tax rate of 23.45%). 

Valuing Pfizer 
To illustrate the impact that changing the tax code that governs Pfizer has on its value, I considered three scenarios. 
  1. Patriot Games: In this scenario, I assume that Pfizer does its patriotic duty (as some critics would label it) and not only decide to bring all of its trapped cash home today (and pay the differential taxes) but repatriate all of its foreign income each year back to the US and pay a 40% marginal tax rate on that income. 
  2. Wait-it-out (Tax Limbo): In this scenario, Pfizer will leave its trapped cash overseas, continue to pay taxes to foreign governments on foreign income but not repatriate the cash. That will leave their effective tax rate well below the US marginal tax rate and Pfizer will have to hope that US tax law gets fixed or that Congress does another one of its “once in a lifetime” tax holidays. 
  3. Go Irish: In this scenario, Pfizer buys Allergan and meets the requirements for shifting its incorporation to Ireland. Note that doing so does not affect their taxes on US income but it will not only un-trap their cash but also remove the constraint they face today on foreign income. 
The different assumptions that I make about taxes under the three scenarios are summarized:

Tax ModelMarginal tax rate (for cost of debt)Effective tax rate (next 10 years)Effective tax rate (in stable growth)Trapped Cash
Patriot Games40%40%40%Return immediately & pay taxes now.
Wait-it-out (Tax Limbo)40%23.45%, with taxes on deferred taxes paid in year 10.40%Return in ten years & pay taxes then.
Go Irish (Invert)40%23.45%30.68%No taxes due

In the table below, I value Pfizer under each scenario (see spreadsheet), first using the conventional accounting numbers (which treat R&D as an operating expenses) and next using adjusted numbers (where I capitalize R&D):
Patriot GamesWait-it-outGo IrishEffect of Inversion
R&D ExpensedEquity Value$154,806.00$176,047.00$209,637.00$33,590.00
Per share$25.09$28.53$34.39$5.86
R&D capitalizedEquity Value$121,074.00$135,156.00$162,309.00$27,153.00
Per share$19.62$21.91$26.60$4.69

The rationale for an inversion is that it will increase Pfizer’s equity value by $27.2 billion and its share price by $4.69 per share. This calculation, though, is based on the assumption that US tax law will never change, and that its dysfunctional components will continue in perpetuity. If you assume that the current bipartisan talk of fixing the law will result in changes (in either the corporate tax rate or in the global tax feature), the value increase will drop off substantially.

Deal or No Deal?
I applaud Ian Read's focus on shareholder value but will this deal create that value? I am skeptical and here is why. Even if you accept the upper limit of the value of inversion ($27.2 billion), that increase in value does not incorporate two potential costs associated with inversion.
  1. The new rules covering inversions will require that Pfizer go through contortions to qualify and some of these contortions will add to the cost of the deal.
  2. There is the possibility of a backlash, not so much from customers, but from politicians. There are senators who are already threatening the company with consequences, though I am not sure that any of them would actually go as far as to ban or restrict Pfizer product sales in the US (since that would hurt those who need the drugs the most). Even if they do, given that the US Senate is disproportionately composed of older men, I am confident that they will carve out a "Viagra exception" for themselves.
There is a second and even bigger concern that I would have as a Pfizer stockholder. If the rumors that Pfizer is planning to pay a 30% premium are right, that would translate into a premium of more than $30 billion over Allergan's market capitalization to buy the company. Since the growth is already priced in (at least in my view), the only way you can create value is to draw on synergy and nothing that either company has said suggests any concrete benefits from the combination.

The bottom line is that this looks like a bad deal for the wrong company, at the wrong time and at the wrong price, the wrong company because Allergan's accounting statements are a mine field due to acquisition accounting, the wrong time because we may actually be on the verge of a major change in US corporate tax code and at the wrong price because of the premium on an already large market capitalization.

The Morality Play? 
As I was writing this post last week, I had a conversation with a friend about Pfizer. After I explained why I thought the Pfizer plan to acquire Allergan made sense, given the tax code and Pfizer's global exposure, her response was that Pfizer should not do this because “it is immoral". While I was floored initially by her assertion, it would be have been both futile and hubristic for me to try to prove her wrong. She is entitled to her moral judgments, just as I am entitled to mine, but it is moral, rather than economic, differences that usually lie at the heart of tax debates and that is perhaps why it is so difficult to get a consensus.

If you own a business that would benefit from shifting away from the US for tax reasons, and you have patriotic or moral reasons for not doing so, you are well within your rights in staying US-bound and I support you in your choice. If you are the manager of a publicly traded company and you face the same choice, I am afraid that you cannot impose your patriotic or moral judgments on your stockholders. Not only are many of them foreign investors (with a very different sense of what comprises patriotism), but quite a few of them will part ways with you on your judgment that maximizing taxes paid  to the government is a moral calling.

YouTube Video


Blog Posts in this series
  1. Divergence in the Drug Business: Pharmaceuticals and Biotechnology
  2. Checkmate or Stalemate? Valeant's Fall from Grace
  3. Runaway Stories and Fairy Tale Endings: The Theranos Lesson
  4. Value and Taxes: Breaking down the Pfizer- Allergan Deal
Datasets

  1. Tax Rates by Country
Spreadsheets



12 comments:

Anonymous said...

there are two things your DCF model is not taking in to account which make it very tough to arrive at an intrinsic value at this point in time other than what you have done:
1. Many do see cost savings via this merger that could be as high as $3 billion
2. There are many product overlaps between the two companies and divestitures of some Pfizer product lines will have to happen to address anti-trust issues. Pfizer has some product categories that are growing much slower than many of Allergans which will be divested.

The above two points and perhaps social issues are partially contributing to why this is taking so long for any resolution in addition to getting comfortable with any political backlash and what a next move would be in light of one.

Without an understanding of the above two points I find it hard to value Pfizer other than as a going concern operating under a dysfunctional tax system.
Congress knows the corporate tax system needs to be reformed. The hold up is who gets their hands on the cash; is it Congress for its social programs, or corporations to do as they see fit.
When i hear someone like your friend raise the issue of morality, I would ask them which is not moral; acting rationally in the face of perverse incentives, or the parties that impose the incentives.

Anonymous said...

Professor,

Intuitively, why is Pfizer's value lower under capitalizing R&D vs expensing R&D?

Michael F. said...

Dear Professor,

Many news stories have paid lip-service to this deal from the perspective of Pfizer (understandably, as if the acquisition proceeds, Allergan will be integrated into Pfizer rather than vice versa) however what effect does the deal have on Allergan's business? Presumably, a 30% premium to the share price is a nice touch and undoubtedly shareholders (to whose best interests Allergan management purportedly owe their duty) will be pleased, but does such an acquisition handicap future growth for the 'Allergan division'?

I appreciate that growth is further down the list of reasons for the deal versus the tax benefits that will accrue to an Ireland-domiciled Pfizier however does becoming part of Pfizer make it more or less difficult for Allergan to execute its 'growth' strategy and is there any precedent that might illustrate that it is also a bad deal in the long term for Allergan? (notwithstanding the fact that were this deal 20 years ago, Allergan might have its own case study in Terry Smith's "Accounting for Growth").

Aswath Damodaran said...

1. You may very well be right about the cost savings and if they do amount to as much as $3 billion, it would justify the deal. I just guess we will have to wait and see.
2. When you capitalize R&D, you treat it like any other capital investment. If it is value creating and productive, capitalization will increase value. Pfizer has spent $82 billion in R&D over the last decade and has little to show for it. The capitalization reflects this reality and looking forward suggests that the more Pfizer spends on R&D, the less it will be worth.
3. You are right. I have not looked at the consequences of this merger for Allergan. If tax benefits become the primary rationale for this merger, I am concerned about the effects on both businesses, post-merger.

Anonymous said...

Why can't they simply move the incorporation location to Ireland, without an acquisition? Like for example Transocean, which was originally incorporated in the US but is now incorporated in Switzerland for tax reasons (https://en.wikipedia.org/wiki/Transocean#Transition_to_a_Swiss_holding_co._and_expansion_:_2008_-_till_date)

Anonymous said...

Hi, there migth an error on the lease converter.The present values are equal to the commitment.

Aswath Damodaran said...

I don't see how Pfizer can move incorporation without an acquisition. And the lease converted was misbehaving. Its been fixed now.

Atul Sharma said...

Dear Prof Thanks for interesting perspective to merger scenario of Pfizer with Allergan; there are few things which I wished your views upon - 1) the levered beta is high 0.85; is it due to high risk R&D 2) the important aspect will be post merger scenario - assuming that Pfizer moves ahead with merger given inversion & medium term growth prospects - Will Allergan's sale $13 bn at ~50% translate to sustained growth for combined entity; also Allergan current portfolio & for future growth drivers are best designed for base at which Allergan is right now; there is a huge difference of Revenues of 2 entities & so are customers hence further reducing value of synergies upon integration; the growth driver in Pharma at high base of $49bn are way different for the 1s at $13 bn.

Although these are subjective aspects but makes lot of impact on decision making; the combined entity will be earnings accretive for short to mid term (thanx to inversion); but in long run; if the Business units are carved out depending on the strategic portfolios growth drivers; & there on take up productive R&D (as planned by Pfizer) post Split in 3 entities, it will be a matter of strategic structuring, The anticipated revenues of newly carved out entities since will have lower base, more agile/lean structure & will be able re-chisel their growth drivers more finely;

There are good number of examples like J&J Roche Novartis GSK (did strategic restructuring of portfolio) who in recent past have reviewed their investments in R&D and now progressing aggressively in re-defined area of future growth; some of them are even investing now anticipating fall in revenues of next 10 yrs (latest Cancer R&D).

Pharma in recent past has been very demanding in terms of orchestrating the growth & hope you will agree that in past 10 yrs Pharma market due to the inherent nature of medium term PLC (off patent fall in revenues/increasing generics usage) & high investment in R&D with staggered/uncertain productivity has been in stochastic phase; but with advent of Biotech products & Immuno Onco (new biotechs), foresee that future will be more deterministic & will have archetypes for consistent growth drivers

Anonymous said...

Thanks for the analysis. Perhaps the proposed sale of Allergan's generic business to Teva for 40.5 billion (35 billion of that in cash) and Allergan's ongoing rights to 50 pct of Teva's Revilimid generic revenues should be considered. With this transaction (expected to close in Q1 2016), most of the complexity of Allergan goes (Actavis, Warner Chilcot etc) and what remains is the legacy Forest Labs and legacy Alllergan - more or less traditional pharma companies which presumably can be more easily evaluated by Pfizer. Ability of Ian Read and Frank D Amelio to extract synergies from the merger should also not be underestimated. Still the premium is sizeable and something could easily go wrong for sure.

albert jaramllo said...

Regarding the morality issue: Pfizer has benefited greatly from research based initiated and funded by US government health agencies (NIH, NSF, etc.); by NOT paying such a significant amount of taxes that could benefit further research into Orphan Drugs, Cancer Research, Pediatric Diseases and other ailments that cannot support a market based R&D function. Pfizer is basically dumping a future responsibility simply to build up its spreadsheet. Also, Pfizer also has partnerships and alliances with many university US-based research institutes, Also, PFE received tax benefits for doing so. As a US based company, Pfizer has had entree to these Institutes as a function of being a US corporation. Once the Plc issue goes through, the University or non-profits that are aligned with Pfizer now have a whole host of new regulatory issues to deal with. Who will have jurisdiction over new product development: the FDA or the EU based Health authorities? So the morality argument is basically whether it is okay or not to dump an investment partner (US govt) simply because it is not as favorable and accommodating as it used to be. You can see why there is so much animosity towards pharmaceuticals as they all want the benefits of Government investment, but refuse to share the financial benefits with the US government or the medical benefits with the populace.

Incidentally, also missing from the analysis are the tax credits and favorable tax status PFE gets from US state and local governments as a function of the location of manufacturing sites, research sites, etc. As a Plc, there is no longer a need to provide these credits based on local/state employment or deductible contributions to US universities, research non-profits, etc. supported by the PFE foundation.

Carter Venkat said...

Would Pfizer have to pay state and local taxes on income it repatriates? Asked another way, will the tax they owe if they repatriated the trapped cash be the tax differential between 16.55% and 40% or the difference between 16.55% and 35%?

Aswath Damodaran said...

Since many states build off federal income tax law, my guess is that it would be the 40%, not the 35%.