By Graham Osborn :
This opinion piece, like most opinion pieces, is biased. The big disclaimer here is I bought put options on Allergan's (NYSE: AGN ) stock a few months ago anticipating that the price of the underlying will decline over the next 2 years. It is believed by many that if Teva ( TEVA ) were not to buy Actavis Generics, AGN's stock price would decline substantially. While I am short AGN for a host of reasons, there is no question that if the deal were called off, I would probably earn a profit following the announcement.
I have no incentive to see Teva shares fall at this time. However, I think it likely that Teva shares will fall significantly following completion of the deal (though probably not to the extent Valeant's ( VRX ) shares have fallen). This would probably happen over a period of months rather than immediately. I will explain why I think this.
The reason I think it's OK to write a biased article is because Teva's management is perhaps even more biased due to the 2016 compensation structure. We'll discuss this also. Hopefully, you can find a balanced view somewhere in between.
2 Crisis description
I recently published a fairly detailed analysis of Allergan's accounting (How Allergan Used Acquisition Accounting To Inflate Sales Growth, Boost NOLs, And Reinvent The Operating Profitability Of Actavis Generics), which I believe raises several concerns directly relating to the valuation of Actavis Generics:
(1) AGN's management has engaged in a practice called "revenue withholding" to boost the apparent growth of the aggregate business. The benefits of this practice to revenue growth apply to subsidiaries as well, and will not be unmasked until that subsidiary is no longer subject to acquisition accounting.
(2) AGN's management has been aggressively offloading operating expenses that fall under "amortization" from Actavis Generics. The manner in which Valeant and Allergan treat amortization is complicated and is treated in depth in my article. However, the important point to note here is that it is a legitimate operating expense, which has been dramatically understated on the "discontinued operations" financials in order to boost the division's operating profits. What this means is that the operating profits of the business will be much lower/more negative than expected once Teva actually completes the purchase and integrates the business.
(3) AGN's management appears to have transferred a number of NOLs from its overall business to Actavis Generics. Whether Allergan is actually allowed to do this is potentially an area of IRS/OECD contention (these rules are under "aggressive review"), so I consider these NOLs as "at risk" value for Teva.
(4) Operating cash flow for AGN's businesses (including Actavis Generics) is much higher than it will be in the "steady state" due to the nature of acquisition accounting. Levered free cash flow after acquisitions is a better way to evaluate how the businesses are doing, and this metric is negative - massively so - for all Allergan's business - including Actavis Generics.
(5) AGN's management appears to be aggressively migrating IP ("intangibles") between jurisdictions for the purpose of tax reduction/NOL maximization. Not only is this a benefit Teva will most likely not be able to replicate (since it is an aggressive form of acquisition accounting, and OECD regulations are being updated to block this means of tax evasion), but it imposes a risk of "clawback" taxes not so far down the road.
(6) By acquiring an improperly audited business, Teva incurs its own audit risk with US/international regulators and tax authorities.
2.2 Business economics
2.2.1 Wasting assets
The Actavis Generics portfolio is essentially the garbage NTEs that Allergan did not want. As I illustrated in my article, the portfolio's organic growth is probably no better (and possibly worse) than Teva's generics portfolio, justifying a similar EV/Rev multiple.
2.2.2 Price increases
Teva's management agreed to purchase the business at a time when aggressive price increases on NTEs were both widespread and tolerated by payors, FTC/EC, and the US political establishment. Due in part to the Valeant and Turing collapses, this environment has changed substantially in the last 12 months. Valeant is now being forced by payors to reduce prices on the same drugs it formerly hiked.
Although Allergan has been less heavily scrutinized, it has a similar behavioral tendency to gouge patients in severe-but-niche disease populations. The trick has been to choose less visible patient populations with less well-established patient advocacy networks. This practice is no longer sustainable, and AG's revenue growth/margins will almost certainly be harmed by the trend in the immediate future.
As is well known, Allergan and Teva were involved in a number of competitive ANDAs and patent disputes, which the acquisition would resolve. The hope was that Teva would no longer need to wage price wars against Allergan on these products. The problem is that the price increases Teva would like to implement on these products are likely to face strong payor pushback.
2.3 Debt burden
As I referenced in an earlier article ( link ), Teva will be taking on an unprecedented amount of debt to fund this acquisition. The actual service of this debt is a very different question from whether the price paid was appropriate. It doesn't take a genius to figure out that a business with around 20B in stable-or-declining revenue and not-so-great margins is not going to gain much debt servicing ability by adding another 6B of operations with basically the same margins and growth profile (once corrected for acquisition accounting).
Meanwhile, the debt load will increase by around 4-fold to the tune of about 45B. Not even Valeant or Allergan have ever had that much debt, and these were companies that were at least able to give the impression of growth to investors for a while. As a company that will not be able to digest another big acquisition in the near future, Teva has no such advantage.
VRX/ AGN were also taking on debt during a rising bull market in equity and investment-grade debt, whereas TEVA is taking on this debt at peak cycle (at best) and the start of a recession (middle case scenario). 45B, stable or declining revenues, and a wasting asset base is not a pretty picture - like waving a red cape in front of the ratings agencies. It is my personal belief that AGN is handing TEVA a ticking time bomb that has a decent chance of going off later this year.
Imagine what would have happened if you had paid 40B for a piece of WorldCom (an analogy I further explore in my article) - you would have shared in the woes of the serial acquirer you bought the business from.
I did an updated value calculation for Actavis Generics in my last Allergan paper, and the result wasn't pretty for Teva. Namely, I concluded that AG doesn't deserve a multiple any higher than Teva's existing operations, leading to an EV of 18.3B in current market value for the business. That's right - Teva shareholders are about to pay more than double what the market currently values Actavis Generics at (outside the acquisition accounting umbrella) - not including future market devaluations. I wouldn't be surprised if fair market value is down to 15B or so within 6 months. And under a forced asset sale scenario, Allergan might sell it off for less than that, say 10B. It's a lot of money to pay for the pleasure of owning a business for a few extra months.
In conclusion, it is my belief that the decision on whether to consummate this deal represents the defining moment in Teva's history - where the company makes a decision between (1) preserving its cash and looking for ways to purchase strategic "moat" assets, or waiting for the specialty-pharma implosion to mature to pick up some assets from Allergan/Valeant/others at firesale prices or (2) buying a business that has been dressed up to appear well-performing, taking on a mountain of debt in early recession to do it, losing most financial flexibility going forward, and ultimately landing in the bankruptcy heap as the specialty-generic sector repeats the implosion we saw in the energy sector with leveraged shale producers.
Note the symmetry here - whoever holds that 40B+ in debt is in big trouble, and whoever doesn't has cash to buy fire-sale assets. Allergan has a much more extensive list of problems, which is why I've shorted them. But Teva shareholders should think of the transaction as a zero-sum game in which they are the "greater fool."
3 Crisis management
3.1 Management needs new incentives
3.1.1 Compensation Package
Teva shareholders might ask "But how could this happen? Our management is supposed to be looking out for our interests." In a perfect world that would be true. Unfortunately, Brent Saunders appears to have shared some of his expertise on the art of executive compensation with Vigodman. This art is called "non-GAAP incentive compensation," and is designed to reward management for doing deals whether or not they create shareholder value.
Of course, it was at Vigodman's own initiative that the following compensation scheme was brought to the board of directors and recommended to shareholders, who - unfortunately - approved it. Let's review Vigodman's 2016 IC:
In addition to the above review of market trends and benchmarking, in proposing the below changes to Mr. Vigodman's terms of office and employment, the Compensation Committee and the Board recognized the transformation of the Company achieved under his leadership during 2015, which built on his previous success in fixing the Company's foundation and solidifying its position.Most significantly, under Mr. Vigodman's leadership, the Company entered into a transformational agreement to acquire Actavis Generics, which is expected to strengthen Teva's already world-leading generics business. The Compensation Committee and the Board further recognized Mr. Vigodman's leadership in building a broader and more diversified growth platform, extending the lifecycle of its key specialty medicines and building a promising late-stage specialty pipeline in its core therapeutic areas, while improving the Company's financial results and operations. Except as described below, all terms of office and employment of the President and CEO, as previously approved by our shareholders, will remain unchanged.(( A )) APPROVAL OFINCREASES IN THE BASE SALARY OF THE PRESIDENT AND CEOPursuant to the President and CEO's employment agreement (as approved by the Company's shareholders), the Compensation Committee and the Board of Directors are required to annually review his base salary for potential increase. To provide certain flexibility for the Compensation Committee and the Board to comply with this requirement, the Compensation Committee and the Board recommend that shareholders approve, without the need for further shareholder approval, increases in the President and CEO's base salary of up to 10% annually of his then current base salary commencing in 2016, as may be determined by the Compensation Committee and the Board. Such base salary shall be adjusted for subsequent quarterly increases in the Israeli CPI. In accordance with the foregoing, the Compensation Committee and the Board of Directors reviewed the President and CEO's base salary and, subject to approval of this proposal 3a by the shareholders, resolved to increase his monthly base salary, effective as of January 1, 2016, to NIS 488,520 (approximately $125,198, or$1.5 million annually, according to the rate of exchange on March 1, 2016), to be adjusted for subsequent quarterly increases in the Israeli CPI.The Board of Directors recommends that shareholders vote FOR the approval of increases in the base salary of Teva's President and CEO, as may be determined by the Compensation Committee and the Board, subject to the limitations described above.(( B )) APPROVAL OF AN AMENDMENT TOANNUAL CASH BONUS OBJECTIVES AND PAYOUT TERMS FOR MR. VIGODMAN FOR 2016AND GOING FORWARDSubject to the adoption of the amended Compensation Policy set forth in proposal 2 above, the Compensation Committee and the Board of Directors have approved, and recommend that Teva's shareholders approve, an amendment to the annual cash bonus objectives and payment terms for Mr. Vigodman so that the objectives and payment terms for 2016 and onwards shall be as follows: Up to 85% of the President and CEO's annual cash bonus for each year will be based on overall Company performance measures, similar to those determined for other executive officers, using key performance indicators (the
Now don't get me wrong - I don't have any problem with rewarding an executive in proportion to the company's shareholders, or even a bit above them. What I do have a problem with is executive compensation that puts management at odds with its shareholders.
Vigodman is getting rewarded basically for making Actavis Generics go through regardless of whether he's doing his own shareholders in in the process. Non-GAAP metrics ALWAYS look good post-acquisition, as I show for Allergan in my article. Vigodman is guaranteed to get his payouts - but only if the deal goes through.
This means that Teva shareholders cannot rely on their CEO to act in their best interest to resolve the crisis. If they wish to retain their CEO, his IC needs to be realigned with their interests prior to any decision on a deal. I would recommend TEVA share performance through at least mid-2017, since fundamentals-based metrics can be difficult to interpret immediately post-acquisition.
I'm not a huge fan of TSR- ("total stock return," a corporate pneumonic for share price) based comp packages, but I think in this case it's better than the alternative. If TEVA shareholders suffer as a result of Vigodman's decisions, well, Vigodman should suffer as well - and vice versa. By all means pay Vigodman his 6M+ IC for making his shareholders money - but only if. If Vigodman wants to do well by his shareholders the path is clear - sit on the cash and wait for valuations to come down, then buy.
3.1.2 Continued employment
Unfortunately, Vigodman may adamantly oppose changes to his compensation package. He also has "reputation risk" on the line for the Actavis Generics deal - he's defended the deal for long enough that he's likely to continue doing so just to save face (even if his bonus is disconnected from the outcome). Therefore, shareholders may have to apply a "my way or the highway" mentality - tell him to pull out of the deal or find a new employer. In general when you have to micromanage your CEO it's easier to just replace him. So finding a good interim CEO is another option.
This isn't as extreme as it sounds. Unless he has a major change of heart/incentives, Vigodman is going to lose his job in one of two ways (1) shareholders get rid of him before the deal closes or (2) shareholders get rid of him after Actavis Generics is consolidated and the company runs into debt service problems and the stock starts tanking.
3.2 Actavis Generics needs an in-depth independent audit
3.2.1 Get Actavis Generics independently audited to determine and address the concerns outlined and properly value the business
Teva's "independent" audit was conducted by PwC, Allergan's auditor. This is like asking the insured to do his own insurance inspection. Worse yet, PwC was the same auditor that turned a blind eye on Valeant's problems before the stock imploded - and appears to be doing the same at Allergan. When I tried to pull basic historical data about Actavis Generics' performance from either the independent audit report ( link ) or the preferred offering documents ( link ) I found them nearly worthless. This was the point where I realized Teva's management appeared to have done limited due diligence.
Allergan's 2015 10-K provided more detail on "discontinued operations." However, I found that the operating performance was distorted by significantly understated amortization relative to the assets, resulting in inflated operated income. The assets on the balance sheet are not well characterized, like those for Allergan itself.
Teva's shareholders owe it to themselves to get the business fairly audited by a 3rd party to check whether Allergan has fairly represented the operating performance and financials of the business. I believe that the results may differ from those presented.
Additionally, shareholders have the right to receive price-vs.-volume data for all acquired product lines. As I showed in my earlier article, Allergan has the bad habit of holding back revenue for new acquirees to boost YoY product sales - but it also provides limited visibility on whether price increases or volume are driving sales. Detailed product line data could paint a very different picture of how the business will actually perform once it leaves Allergan. It may even reveal the 18B figure to be significantly higher than fair value.
3.2.2 Convene the board to determine the most attractive termination strategy
I will review the options below. I believe there are a number of scenarios under which a breakup fee could be avoided. I might add that a 1B breakup fee, although painful, would be far better than the alternative. A 2.5B breakup fee would more painful, but still far better than the alternative (overpaying by 20B+ plus for a business, etc., etc.).
3.3 The board needs to identify the cheapest possible deal exit
3.3.1 Termination conditions
The termination conditions per the Master Purchase Agreement are outlined below:
11.1 Termination.This Agreement may be terminated at any time prior to the Closing:by the mutual written Consent of Seller Parent and Buyer Parent;by Seller Parent or Buyer Parent if the Closing has not occurred bymidnight, Eastern Time, at the end of the day on July 26, 2016(as it may be extended pursuant to the first or third proviso of this Section 11.1, the
3.3.2 Let the merger agreement expire
If the closing does not occur by July 26, shareholders would have the option to pull out without a breakup fee. If the FTC review extended beyond that date, that would provide a pretext. However, since the FTC review might finish earlier, Teva would then have to depend on internal delays to reach the deadline. Allergan could conceivably claim that internal delays resulting in MPA expiry should incur a breakup fee, so this option may not be ideal.
3.3.3 Decide not to complete required divestitures
The MPA does not require that Teva submit an approvable package to the FTC. For example, if the FTC required that Teva divest a certain asset to secure approval that Teva did not want to get rid of, this refusal would trigger FTC to reject the merger. So Teva actually has considerable leverage to influence the FTC's decision in this respect, nor is such leverage inappropriate.
3.3.4 Terminate the merger agreement for breach of adequate representation and warranty
Given that Actavis Generics' operating performance has been materially misrepresented by Allergan, the MPA terms of "adequate representation and warranty" have already been violated. However, Teva might have to go to court to avoid the breakup fee. My guess, however, is that Allergan would not be particularly eager to go to court on accounting issues.
3.4 Post-termination options for M&A
Once the deal is terminated, Teva will have a good bit of cash on hand. My recommendation is to hold on for a bit. The specialty-generic sector is currently undergoing a washout, which should present some attractive values. For example, Valeant is currently shedding assets. Without the liquidity provided by the inflated Teva deal valuation, Allergan will (I expect) collapse in Valeant-like fashion within the next 12 months (I explain the reasons for this in my article).
This has a good chance of happening anyway, but Teva will have too much debt under the current scenario to profit from it. On the other hand, if Teva pulls out and lets circumstances run their course, they'll probably be able to pick up the very same assets from Allergan (if they still want them) at bargain-basement prices sometime in early 2017. The fact that Allergan will find itself in this situation is not Teva's fault but Allergan's - it isn't Teva shareholders' responsibility to bail Allergan's management/shareholders out of the Gordian debt knot they have constructed for themselves.
By holding onto their cash now, Teva shareholders with the opportunity to buy assets with much less debt and still have the financial flexibility to weather a sector downturn and tightening payor environment. In the long run, conservatism separates the survivors from the wipeouts. And between Allergan and Teva, there is almost guaranteed to be one pretty spectacular wipeout.
As you can see, the actual termination of the Teva deal is relatively easy to do. The more difficult task for Teva shareholders will be repressing their CEO, whom they have unwittingly incentivized to do a big deal in 2016 even if he runs the company into the ground in the process. They do, however, still have a chance to correct that mistake and preserve their company.
See also Value For The Next Decade: Part 1: Biotech on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.