Is This The Biggest Roadblock to a Pfizer-Allergan Merger?

By George

Pfizer and Allergan are reportedly discussing the possibility of a friendly merger between the two pharma giants that could take place before year's end. This proposed deal has drawn broad interest in the media because of the so-called 'tax inversion' component, whereby Pfizer would lower its 26% effective tax rate by relocating to Ireland, after buying the Botox-maker.

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However, I think the media has missed the real story, and perhaps the biggest roadblock to a merger, by blowing the tax inversion angle out of proportion. Here's why.

These merger talks were not spurred by Pfizer's tax problemThe impetus behind a Pfizer-Allergan merger would, point blank, be growth -- not taxes. Because of the loss of exclusivity for several former blockbuster drugs, Pfizer's top-line has been stagnating for several quarters now, despite the launch of multiple new growth products (more on this later).

At last count, Pfizer's total revenues through the first nine months of 2015, for example, declined by 5% compared to the same period a year ago. A quick look under the hood, however, reveals that the main problem is Pfizer's Global Established Pharmaceuticals (GEP) segment, which saw its sales slip by 13%, on an operational basis, in the third quarter, relative to a year ago. By contrast, Pfizer's Innovative Products business saw its sales gap up by 21%, on an operational basis, in the same period.

Source: Pfizer

To solve this problem, Pfizer could chose to pair its Innovative Products with Allergan's branded pharma business (following the latter's divestiture of its generic segment) to form a streamlined, ultra-high growth company that would sport a four-headed monster consisting of Botox, Prevnar 13, Ibrance, and Eliquis. This new company, in theory, should be able to generate 20% plus growth on its top and bottom-lines for several years running. In short, this proposed merger makes sense from a growth perspective and any tax benefits would simply be icing on the cake.

But here's the problem...It's no secret that Pfizer wants to split its Established Products and Innovative Products segments into two separate entities, and it only makes sense to pair the Innovative segment with Allergan for the reasons outlined above.

By carving out the Innovative Products business via a merger with Allergan, though, Pfizer's Established Products business would be left in no man's land. As I mentioned previously, this particular segment is experiencing double-digit sales declines because of falling sales for drugs likeCelebrex and Zyvox. And even the recent acquisition of Hospira isn't enough to reverse this trend. With over $18 billion in sales in the last nine months, the sheer size of this business also implies that it can't be easily repackaged and sold off to a company specializing in generics.

While this unit is still throwing off tons of positive free cash, Allergan's management probably doesn't want to take on this problem. After all, it would turn a large company with a rapidly growing top-line into an absolutely bloated megagiant with a market cap of over $300 billion and a flat top-line. That's not a smart business move, especially after the company struck a deal not long ago to jettison its own generic business in order to focus on branded products. In other words, this merger may ultimately hinge on what Pfizer's management decides to do with its legacy products.

What's next?Although the media has honed in on the tax inversion issue, I don't think it will play much of a role if a deal ultimately goes through. The bigger problem is the fate of Pfizer's Established Products business that's literally sinking under an avalanche of patent problems. Not many investors are going to line up to buy into a company with a plunging top and bottom-line after all.

Pfizer's management therefore has to make an extremely tough call on a business that is still generating boatloads of free cash, but no revenue growth to speak of. And that's a much more pressing issue, at least in my mind, than shaving a few points off of Pfizer's effective tax rate.

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