Winning Warner-Lambert

A fascinating game is unfolding as arbitragers try to assess just how determined Pfizer will be.
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I generally hate deals between large drug companies. The nature of these gargantuan transactions is always the same: They're done at no premium, they're couched as mergers of equals and they're more about management succession and perquisites than they are about shareholder value. Furthermore, there is seldom an arbitrage spread worth playing, since the at-the-market valuation means there is very little downside if the deal breaks, and you don't get rewarded for bearing minimal risk.

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So I rolled my eyes when the press leaks started on the

American Home Products

(AHP)

merger with

Warner-Lambert

(WLA)

. I thought the sheer enormity of the deal would act as a poison pill because the $1 spread was way too narrow to justify putting on -- unless an interloper emerged with a competing bid.

That train of thought quickly turned into a $11 mistake as

Pfizer

(PFE) - Get Report

unveiled its bearhug letter hours after the merger was officially announced, creating a bonanza for arbs astute enough to have bought Warner-Lambert and gone short American Home.

There certainly will be more opportunities as this transaction progresses. The issue now is how to handicap the future sequence of events.

How secure is the deal with American Home? Well, Warner-Lambert is the nominal target in this merger of equals. It is incorporated in Delaware. There is an important legal precedent on the books there from the

Time

-

Warner

-

Paramount

free-for-all earlier this decade which protects deals in which corporate control is not transferred. This is why so many companies go out of their way to describe their deals as mergers of equals or strategic mergers and the like. If control has not been transferred,

Revlon

duties, or the obligation to seek the highest price for shareholders, have not been invoked.

Warner-Lambert will no doubt take this position. Warner-Lambert is not selling the company, so it need not conduct an auction. The dilemma Warner-Lambert will face is how to convince its shareholders to vote in favor of an inferior deal.

Pfizer has done the bare minimum at this point. It has sent a bearhug letter and filed a lawsuit in Delaware complaining about the size of the $2 billion breakup fee that will be paid to American Home if Pfizer prevails. The proposed 2.5 share-exchange ratio is even conditioned on the breakup fee being disallowed by a judge.

Pfizer has many more bullets in its gun, and the sooner the company starts firing them, the higher the likelihood of Pfizer prevailing. Pfizer should immediately commence an exchange offer -- a tender offer where you pay with your own shares instead of cash. In addition to demonstrating a higher level of commitment to the deal, this move would also force a formal public response from Warner-Lambert.

Next, Pfizer should take advantage of Warner-Lambert's absurdly weak takeover defenses and launch a consent solicitation. This tactic involves removing Warner-Lambert's entire board of directors by soliciting proxies from 50.1% of the shares. You don't even need to wait until the next shareholder meeting -- just show up with the ballots and claim control of the board. It is a very potent tactic, and one that most companies have eliminated from their charters and bylaws over the years.

So far, Pfizer has not committed to taking these steps. Unless it does, I doubt the company can bring sufficient pressure to bear on Warner-Lambert's board to negotiate with it. As an arb, I want to make sure Pfizer will stay committed no matter how nasty the fight gets. I have been burned too many times over the years by bidders who have gotten cold feet when the mudslinging starts.

The maneuvers Warner-Lambert has left to consider are much more difficult. The company could recast the deal as a cash tender offer by Warner-Lambert for American Home, but I doubt either company has the stomach for that level of resulting debt. Warner-Lambert could induce American Home to increase the 1.4919 share-exchange ratio to compete with the Pfizer bid, but then it crosses the point of no return from a Revlon perspective.

I always like to see the board members owning a meaningful amount of stock. Nothing focuses attention better than self-interest. So I am pleased to see the outside directors of Warner-Lambert all own more than $1 million of stock each. On the margin, they have a personal financial incentive to do best by shareholders rather than perusing the deal which is best for management's personal career paths.

The developments here should be fascinating to observe. Right now, I think Pfizer will slowly increase the pressure until Warner-Lambert capitulates and formally puts the company up for sale. After that, the highest bidder wins. And Pfizer looks now to be the more determined bidder with the better currency.

And American Home? Once again, it seems destined to be left at the altar.

At the time of publication, neither Brail nor Palestra held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brail appreciates your feedback at

commentarymail@thestreet.com.