Allergan plc Ordinary Shares (AGN) collapsed on the Treasury ruling as we reported late Monday. Shares of Allergan are down about 19 percent in pre-market trading as investors question whether the Pfizer deal will go through. There are many unanswered questions and analysts are taking them on today. Below is the latest from the sell-side. But first RBC Capital trading desk has some important points to make:
RBC Capital (Charlie McElligott) Big Picture: ALLERGAN DISASTER PUTTING A TOP ON EQUITY RALLY?
Hard not to think the seven week equity rally is at significant drawdown risk today, off of a random cluster of idiosyncratic risks spilling-over into potential forced unwinds within the equities merger-arb community, tweaking risk-sentiment of a market now very much ‘tactically long’ (just how re-built has equity positioning become over the past 7 weeks? Barclays is out showing that equity positioning is 1.5SDs above long term average, with US mutual fund beta to stock markets is at post-crisis highs, in addition to l/s HF betas well above average as well).
the ‘why’ is three random reasons: 1) the blunt-force fund (NEGATIVE) performance implications via the AGN / PFE inversion trade essentially ‘blowing-up’ overnight (some arb desks quoting the spread reaction as implying ‘95% dead deal’), 2) yesterday’s absolutely brutal Orange – Bouygues deal implosion (with all the EU telco ‘takeout’ names like NUM FP/ ATC NA / ILD FP smashed down ~15 to 20%—another very popular trade gone completely ‘wrong way’)…all this on top of 3) the macro risk sentiment ugliness occurring in Japan (Nikkei -8.0% over past five sessions, while Yen has strengthened a brutal 2.1% against the Dollar) and European share ‘sogginess’ (Estoxx -6.5% over past 2+ weeks) now starting to weigh as well….with implications as noted in ‘Big Picture’ last week: does the fragile ‘currency devaluation truce’ get tossed with the BoJ’s / ECB’s stock market reaction functions again under fire?
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COMMENTARY: So just when you thought the pain-trades were largely ‘cleaned-up,’ the U.S. Treasury Department’s “shock” anti-inversion proposals announced Monday night dropped an ENORMOUS shoe on the equity (and concurrent fund performance) rally.
With AGN currently -19.0% against PFE +2.5% pre-open, the epicenter of the destruction will be felt within the arb community, where they have this trade on in size (ISI estimates +25mm AGN against -300mm PFE, with only 10% of that trading after-hours last night—i.e. “more to come” today) and lever it up 3 to 6 x’s. One then turns to other deals which might see forced spread-unwinding (e.g. AET / HUM, TWC/CHTR etc) as merger-arb books are scaled-back across Street (you don’t have to be an event-fund to have a side-pocket). Reminder, Merger Arb has been the only equity strategy posting a POSITIVE YTD return (HFR Merger Arb Index +1.6% YTD)…so you know a lot of funds were increasing the sizes of those books because it was working, against a much thornier long / short or market-neutral environment.
Speaking directly to this observation that this has implications far-beyond ‘just’ the risk-arb world: per the most recent GS HF Monitor (thru Q4 filings), AGN is ‘THE’ most consensually held stock across the broad hedge fund community (sampling of 860 funds): there are 80 hedge funds holding the stock as a top 10 largest position (tops of the VIP list), 107 HFs own it overall, it has an average 7% portfolio weight, and 16% of its equity cap is owned by hedge funds.
It’s highly likely that HC dedicateds won’t defend the stock for two reasons: 1) the broad question of ‘are the tax benefits still there to see the deal go through’ with these ex post facto changes to essentially what the acquirer is buying and 2) in light of the spec pharma pain YTD, low delta on managers sticking around to see how it plays out. Clearly last night’s “shoot first / ask questions later” response shows that arbs feel same way.
From an equity quant factor perspective, I see this rippling-out as well: the factor(s) that is screaming—‘low risk’ / ‘anti beta’ (long low beta against short high beta)–is approximately +8% on the year (note: ‘quality’ factor is also +0.5% YTD as well, for similar reasons). This plays out with an investor base that is ‘hold nose and buy’ because they don’t like the fundamental ‘growth’ backdrop, but know they need equity exposure in a yield-less world. Thus, of the S&P sectors, defensives Telcos +15.7% YTD, Utes +14.5% and Staples +6.0%, numbers 1-2-3 at the top of the sector performance tables. On account of this ‘richness,’ some folks have been increasingly looking to short ‘rich’ staples (the only sector of the bunch with liquidity)…but in light of another performance ‘dagger’ like the above, it likely only increases the flows into the ‘low vol’ products and strategies…META PAIN TRADES.
On earnings stripping, we believe regulations were widely expected to happen and were likely already priced in to PFE/AGN (i.e. partially reflected in 17-18% guidance for the tax rate for the combined company vs. current 15% AGN standalone in Ireland). Further, the limitation on earnings stripping will affect many multinational companies as it is a widely used method for smart tax planning.
Here is what we DON’T know:
Is this new inversion regulation enforceable?
However this interpretation may be too aggressive as Treasury likely overstepping its authority, and will be challenged in courts.
While a deal would bring additional upside, we continue to like PFE as a standalone. Our target price for PFE as a standalone entity remains $38, suggesting significant potential upside from current levels. This is driven by our excitement on what we see as an underappreciated product story, especially in oncology and vaccines. Several important upcoming catalysts include PALOMA-2 data and additional Phase 3 data readouts for Ibrance, CD137+PD-1 data at ASCO and Phase 3 study readouts for their PCSK9 inhibitor bococizumab (Exhibit 3). We would also expect PFE to resume activity on the business development front as it looks to further boost its innovative business ahead of a potential split of the company. While a large transformative deal may not happen following the failed efforts around AZN and now potentially AGN, there are several small-mid size biopharma companies that PFE could potentially target in the coming months. All of this is dependent on the company’s final decision on Allergan plc Ordinary Shares and the stock may be range bound until we get further clarity from PFE on their plan with AGN and, if not AGN, what they will do next.
We are disappointed with what we see as arbitrary action by Treasury. One can’t argue the acquisition actions by Allergan were intended to eventually lead to the Pfizer transaction.
That said, (i) we believe the fundamental value of AGN as standalone is greater than the stock current price; (ii) we are yet to understand the courses of action available to Allergan/Pfizer.
It is unclear if the new notice will hold absent formal action from Congress. While today’s notice may clarify the rights of the IRS under statute 7874, it is unclear if the Treasury has any legal standing to attempt to enforce the statue. Past conversations with consultants have suggestedaction would be needed from Congress, and that this is unlikely in an election year. We would therefore expect significant push back from various stakeholders to this somewhat arbitrary change in the ‘7874 inversion rule.
There are several unanswered questions – PFE and Allergan plc Ordinary Shares are “conducting a review” of the announced actions. First, in after-market with AGN -22% to ~$217, the implied spread is ~$140 per share. In other words, the stock is reflecting deal break. Two questions we are looking for better clarity on: (i) Assuming AGN is below the 20% inversion threshold, can anything be done to get it back up from a deal structure perspective and would that still make sense for PFE? (ii) Is there legal recourse against Treasury’s action and are PFE/AGN willing to pursue it?
We see two scenarios: (1) PFE/ Allergan plc Ordinary Shares deal fails: If PFE’s stake in the newco is >80% after excluding the inversions of US companies (ie, Actavis, Forest and Allergan) into Warner Chilcott that fall within the 3 year look back, then Pfizer may not be able to invert into Allergan plc Ordinary Shares under the current deal structure, and may choose to break the deal. If this happens, we would expect PFE to respond positively as the deal overhang is removed. Regarding Allergan, investors have believed that the stock should trade at a discount to the large cap sector which currently trades at ~14.5x, in which case, we would expect AGN to trade in the 12-13x range. Consensus for 2017 is at $17.24, and 12-13x yields a range of $206-224 in the short term, but over the course of the year, we would expect the Allergan management team to cut costs, repurchase stock, and paydown debt to drive earnings and thus the stock higher by year end. (2) If the deal succeeds: We expect AGN to trade to the $347 range (deal value based on current PFE price) and PFE to trade up slightly.
After the close, the Treasury released its third set of measures to discourage tax inversions. The most controversial proposal, in our view, would consider deals over a 3-year period to apply more stringent limitations or eliminate the inversion altogether. We interpret the calculation as still satisfying the 20% threshold, but if clarity on an acceptable tax outcome can’t be obtained, shareholders may reject the deal.
Implications for Pfizer: An increase of the U.S. owned portion from the proposed 56%/44% ownership split between Pfizer/Allergan to 60%-75% or greater would essentially negate the benefits of an inversion. This could potentially raise the projected 17%-18% tax rate back toward standalone Pfizer’s mid-20% rate. Additionally, Pfizer’s cash, of which 80%-90% is located overseas, would still be taxed at the U.S. tax rate of 35% upon repatriation. The impact of earnings stripping on the deal is more challenging to assess as Pfizer would have greater access to its ex-U.S. cash and would potentially be less dependent on debt on a go forward basis. While we do not have an opinion on whether the Treasury’s actions rises to the level of a material event, both companies have the right to terminate the deal under specific circumstances with termination fees of up to $3.5B.
Share price spread continues to widen: Based on the proposed 11.3 share exchange ratio, the spread between Pfizer’s and Allergan’s share prices has increased from 16.4% based on closing prices on Nov. 20, 2015 (the last trading session before the deal was announced) to 26.6% based on April 4, 2016 closing prices. However, given that Allergan plc Ordinary Shares shares declined 20% in the aftermarket, we have conducted a sensitivity analysis of the spread under two differing pricing assumptions relative to Pfizer’s last closing price. Under scenario 1, which assumes a $250/share price for Allergan, the spread is calculated at 35.8%. Under scenario 2, which assumes a $225/share price for Allergan plc Ordinary Shares, the spreads widens further to 50.9%.