Allergan Calls Valeant Unsustainable, Doubts Inversion

Updated from 8:53 a.m with CEO comment and afternoon share prices.

NEW YORK (TheStreet) -- Irvine, Calif-based pharmaceutical giant Allergan (AGN) doubts it will be one of a rising number of companies in its industry that would use a merger to move headquarters abroad and cut its overall tax rate. That revelation came on a conference call in which Allergan executive sought to explain why the company rejected a $45 billion unsolicited takeover offer from Valeant Pharmaceuticals  (VRX) and called its rival's business model unsustainable.

Nonetheless, Allergan said it would review a revised proposal from Valeant. declining to comment on whether there was a potentially acceptable financing mix for takeover proposal. That lack of commentary indicates that in spite of a strongly-worded response from Allergan to Valeant's bid, there remains the prospect that a merger might still be negotiated.

In a letter rejecting a late-April unsolicited takeover offer proposed by Valeant and hedge fund Pershing Square Capital Management, Allergan said the $45 billion offer was undervalued and risky given the amount of stock being used in the transaction.

>> Read More: Pershing Square and Valeant's Allergan Deal Is A Watershed

>> Read More: Wachtell Sees a Threat In Allergan's Bid

"[The] Board has determined that Valeant's proposal creates significant risks and uncertainties for Allergan's stockholders and believes that the Valeant business model is not sustainable," Allergan said in a letter addressed to Valeant's CEO Michael Pearson on Monday.

Valeant's offer valued Allergan at $48.30 a share in cash and 0.83 Valeant shares.  The cash component of the offer came to about $15.5 billion.

After consulting with financial advisers Goldman Sachs and Bank of America Merrill Lynch, in addition to legal advisors Latham & Watkins and Wachtell, Lipton, Allergan said it had decided the offer was undervalued and presented too much risk for the company's shareholders given the amount of stock proposed in the transaction.

Allergan's rejection, however, could indicate negotiations of a deal may be more about price.

"[Your] Proposal includes a large stock component, which we believe is a risk for Allergan stockholders due to the uncertainty surrounding Valeant's long term growth prospects and business model. Valeant's strategy runs counter to Allergan's customer focused approach," Allergan said.

"In particular, we question how Valeant would achieve the level of cost cuts it is proposing without harming the long term viability and growth trajectory of our business. For those reasons and others, we do not believe that the Valeant business model is sustainable," the company concluded.

On a conference call Monday, Allergan CEO David Pyott elaborated on the company's views of Valeant's unsustainable business model. He said Valeant, one of the most prolific acquirers in the pharmaceutical industry, is struggling to grow its business organically. Pyott also questioned the results of Valeant's R&D efforts and said it it is all but impossible to slash research budgets while growing organic revenue.

"Our model works, whereas Valeant's model of cutting and slashing really doesn't work for more than a very short period of time and that shows up in the same-store low growth that they produce," Pyott said.

When pressed by analysts over an inversion transaction, whereby Allergan would look to acquire a non-U.S. based company and shift its headquarters abroad, Pyott expressed doubt such a deal would materialize. Pyott, citing recent political backlash against inversion transactions, said such tax loopholes will eventually be closed.

"[P]rojecting current differences into the future, I think personally, and I think that the board's view, Allergan's board's view, is somewhat unlikely," Pyott said of his belief in the sustainability of inversion transactions.

Currently Pfizer (PFE) is seeking to shift its tax headquarters to the U.K. as part of a takeover of AstraZeneca (AZN).

Meanwhile, TheStreet reported Walgreens (WAG) may give investors guidance on whether it will invert its tax headquarters outside the U.S. by late-summer or early fall.

Updated Guidance

To underscore Allergan's prospects without Valeant, Pyott gave investors and analysts an updated guidance for the company in 2014 and beyond. 

Allergan also said on Monday it expects to increase earnings per share by 20%-to-25% generate double digit revenue growth in 2015. The company also provided guidance of double digit sales growth over the next five-years, in addition to a compound annual EPS growth rate of 20%.

Pyott said that for the $7 billion to $10 billion Allergan has invested in R&D, the company has grown culmulative revenue by over $50 billion and expects a further $100 billion in revenue in coming years. 

Allergan shares fall less than 1% to $159.72, recovering some losses in Monday trading. Valeant shares also fell less than 1% to $130.16 in Monday. Shares in both companies have gained sharply since the deal was first announced.

Activists Re-Writing Rules

Pershing Square Capital Management may be re-writing the rules of activist investing after teaming up with Valeant on a takeover proposal for Allergan.

The effort is the first that counts an activist hedge fund investor as a crucial piece and it raises the prospect of similar marriages between activist investors and deal-seeking corporations looking to press an unsolicited merger.

On April 21, Pershing Square disclosed it had acquired over $4 billion worth of Allergan's stock, or approximately 9.7% of the company's outstanding shares, as part of an unsolicited effort to merge the two pharma industry giants.

And then on April 22, Valeant released details of its bid, including estimates of $2.7 billion in annual operating synergies in the event of a merger and the prospect of a 20-cent dividend.

While Allergan is best known for its Botox treatments, Valeant Pharmaceuticals has emerged as one of the fastest growing generic drug manufacturers in the world.

Valeant's initial offer contained a cash component of $15.5 billion with the rest of the transaction financed with stock. Such a merger would be among the largest pharmaceutical deals and values Allergan at over $45 billion.

Barclays and Royal Bank of Canada agreed to financing commitments to cover the cash portion of a deal.

"The combination of Valeant and Allergan represents the most strategic and value-creating transaction I have ever analyzed," Bill Ackman, head of Pershing Square, said in a statement in April. Ackman said Pershing would elect to take all-stock in a transaction as part of a long-term investment.

A New Type of Mega Deal

A possible merger between Valeant and Allergan, on its face, isn't surprising. Valeant has indicated that after a string of acquisitions, the company was again on the prowl for a large deal. The inclusion of Pershing Square and a set of contingencies that tie both parties together, however, may break new ground in activist investing.

A source familiar with the deal said it was Valeant that reached out to Pershing Square about a bid for Allergan in February. Because Valeant reached out to Pershing, that source said there were no insider trading issues in building an Allergan stake because no fiduciary duty was breached.

The structure that Valeant and Pershing agreed on is complicated, but the salient points are that Pershing is taking most of the risk in the $4 billion Allergan stake and the fund could become one of Valeant's top long-term shareholders were a merger with Allergan ever consummated.

Pershing and Valeant created a vehicle, called PS Fund 1, in which Valeant contributed $75.9 million to acquire Allergan stock. Funds managed by Pershing Square are responsible for the remaining investment. Were a transaction to be completed, Pershing will be required to hold Valeant shares worth at least $1.5 billion for at least 12 months.

Valeant said its cash-and-stock bid would lead to a high single-digit tax rate for the combined company, in addition to synergies nearing $3 billion, according to Morgan Stanley estimates.

Overall, Valeant forecast that a merger could generate 25% to 30% earnings per share accretion in the first year after a deal is completed. Additionally, compound EPS growth is forecast in the 15% to 20% range. Valeant also forecast at least $300 million in annual R&D spending for late-stage pharmaceutical projects.

>> Read More:

Pershing Square and Valeant's Allergan Deal Is A Watershed

Wachtell Sees a Threat In Allergan's Bid

-- Written by Antoine Gara in New York.

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