Inversion Crackdown: Does It Spell The End For Pfizer/AstraZeneca?

The U.S. Treasury’s initiative to reduce M&A motivated by tax avoidance could leave Pfizer in a lurch, without an attractive acquisition target to reenergize the big pharma’s long-term outlook.

The U.S. Treasury released a notice late Sept. 22 announcing tax policy changes intended to reduce the economic advantage of M&A for the purpose of tax inversion, leaving investors in Pfizer Inc. wondering what the changes will mean for Pfizer’s M&A strategy – and particularly if the news means the end to a mega-merger with AstraZeneca PLC.

Other pharma deals hang in the balance, most notably AbbVie Inc.’s $53.3 billion acquisition of Shire PLC, already signed, but not yet closed [See Deal]. The Treasury said the tax changes apply to deals closed on or after Sept. 22.

But a Pfizer mega-merger tax inversion play now appears particularly precarious given that Pfizer is only in the process of evaluating potential takeover targets. Pfizer CEO Ian Read has been vocal recently about his interest in reducing Pfizer’s tax rate by acquiring an international company.

The strategy first came to light as a very real possibility when Pfizer went public with its interest in acquiring AstraZeneca in April, motivated partly by the tax inversion opportunity. [See Deal] But even after Pfizer’s final £69 ($117 billion) bid was rejected by AstraZeneca in May and the deal fell apart, the company continued to say it was evaluating tax inversion M&A opportunities (Also see "AstraZeneca Gets A Reprieve But Will Have To Earn Its Independence" - Pink Sheet, 26 May, 2014.).

Many investors have assumed Pfizer will reopen discussions with AstraZeneca in November when U.K. takeover laws allow it to approach again, or negotiate with another takeover target. Allergan PLC, based in Ireland, has been floated by investors and analysts as a potential backup target if a deal with AstraZeneca fails to materialize. Pfizer has appeared open to evaluating other opportunities in public comments of late. On Sept. 23 media reports surfaced saying that Pfizer had approached Actavis to express interest in the company.

In a recent interview, Pfizer Global Innovative Pharma Business President Geno Germano defended the company’s interest in a tax inversion deal. He said it was management’s responsibility to evaluate ways to create shareholder value including tax inversion deals, even as the public outcry against them and backlash from legislators grew (Also see "Pfizer’s Geno Germano Talks M&A Strategy" - Pink Sheet, 1 Sep, 2014.).

However, U.S. corporations argue that the domestic 35% corporate tax rate, one of the highest in the world, puts them at a competitive disadvantage against international rivals.

The latest announcement from the U.S. Treasury comes after the Obama administration said in August it was evaluating ways to curtail the tax benefits of tax inversion even faster than Congress could act. Nonetheless, the fact that the changes will be immediately effective is a wakeup call to industry and other multinational corporations that the window of opportunity for completing tax inversion deals is closing.

Still, the new changes don’t block tax inversions altogether and some are already questioning how legal they are, given that they come without Congressional approval or a public comment period.

The changes aim to reduce tax inversions by eliminating some of the economic advantages. They eliminate some of the techniques inverted companies use to access overseas earnings of foreign subsidiaries without paying U.S. tax, one of which is known as hopscotch loans. They also aim to strengthen the requirement that the former owners of the U.S. entity own less than 80% of the new combined entity by eliminating certain practices that help companies to inflate the ownership structure.

“For some companies considering mergers, today’s action will mean that inversions no longer make economic sense,” the U.S. Treasury said in a statement.

Plus, the Treasury said it plans to evaluate other ways to reduce the tax benefits of inversions. And Congress has also been looking to stop tax inversions.

Despite Changes, Opportunity Remains

Whether or not an inversion would still make economic sense for Pfizer remains to be seen. One of the reasons Pfizer was able to justify paying so much for AstraZeneca was because it could use offshore cash to fund the transaction and because it could substantially lower its tax rate after completing the deal. Under the new changes, Pfizer may not be able to access ex-U.S. cash to fund the deal without paying U.S. taxes on it.

Pfizer declined to comment on the tax changes or say how it could impact the company’s M&A strategy.

Shares of AstraZeneca on the London stock exchange closed Sept. 23 down 3.57% to £44.14, suggesting investors see a diminishing window for a deal getting done. Pfizer’s stock closed the day about flat at $30.05

Still, analysts said the possibility of a merger remains, especially given the amount of uncertainty around the Treasury’s changes and potential issues with the legality.

Bernstein Research analyst Tim Anderson said in a same-day research note that if a take-out premium were to be entirely eliminated from AstraZeneca the stock would trade at around £40, “implying the market assumes there is still a partial chance that Pfizer and AstraZeneca merge, which is our view as well.”

“Without inversion, the outlook for Pfizer would change for the worse because the company’s prospects as a stand-alone look challenging,” he added.

ISI Group analyst Mark Schoenebaum, in an email, said that if Pfizer can lower its 27% tax rate to a 21% tax rate for the combined business, his estimates fair value for the deal is $92 per share, in line with Pfizer’s most recent £55 ($92.48) per share offer for AstraZeneca.

As for AbbVie/Shire, the Treasury announcement raises the uncertainty around the deal getting finalized, but AbbVie could be on the hook to pay a substantial breakup fee to Shire if it falls through. AbbVie is required to pay a $500 million breakup fee if its shareholders reject the deal, but would have to pay more than $1.5 billion – or 3 percent of the transaction value – if its board of directors recommends in favor of breaking off the deal.

“Moreover, the legality of not grandfathering deals that have already been announced, but not closed (e.g. AbbVie/Shire), will also probably get challenged,” BMO Capital Markets Corp. analyst Alex Arfaei said in a Sept. 23 research note.