Closed AbbVie/Shire: The inversion version

Shire Pharmaceutical is getting ready to recommend an offer from AbbVie to its shareholders – on AbbVie’s fifth attempt. Tax inversion – AbbVie leaving the US to domicile in the UK with Shire – will be a big part of any deal. Lex wonders how big.

This is a live format in which we’ll share our thoughts on a note we’re writing in real-time, and readers will be able to weigh in too on the right. So don’t be shy!

Hello, and welcome to Lex’s first ever open note.

It’s a live format in which we’ll share our thoughts on a note we’re writing in real-time, and readers will be able to weigh in too on the right. So don’t be shy.

Today’s topic is AbbVie/Shire, after the following Emoticon earlier on Monday…

Shire plc (“Shire” or the “Company”) (LSE: SHP, NASDAQ: SHPG) announces that following discussions with AbbVie Inc. (“AbbVie”), Shire requested and has received a further revised proposal from AbbVie on 13 July 2014 (the “Revised Proposal”).

The Revised Proposal comprises £24.44 in cash and 0.8960 shares of new AbbVie per Shire share. Based on the AbbVie share price on 11 July 2014, AbbVie’s Revised Proposal has an indicative value of £53.20 per Shire share(1). Under the Revised Proposal, Shire shareholders would own approximately 25 per cent of the combined new AbbVie.

The Board of Shire has indicated to AbbVie that it would be willing to recommend an offer at the level of the Revised Proposal to Shire shareholders subject to satisfactory resolution of the other terms of the offer. Accordingly, the Board is in detailed discussions with AbbVie in relation to these terms.

Not mentioned above – the tax benefits that AbbVie would get from this deal, should it ‘invert’ and redomicile to a UK holding company. (Shire is listed in London, and based in Dublin.)

That’s what we’re looking at today.

The AbbVie ‘Revised Proposal’ terms, just to reiterate, are £53.20 a share, with roughly a 54 per cent to 46 per cent stock/cash split.

Which is what you need for an inversion to work – shareholders in the acquiree have to own at least 20 per cent of the new company, under the rules, to shift the domicile. Shire holders would own 25 per cent of the New AbbVieShire…

…Which leads us to our first chart. Shire’s market capitalisation, which you can see below (via Bloomberg):

That’s some increase in value: this time last year, Shire was a $20bn company.

And that would be part of why Shire was the perfect inversion-acquisition candidate in pharmaceuticals in the first place. The market cap was fairly manageable: note that Medtronic’s bid for Covidien was around $42bn; AstraZeneca combined with Pfizer would have been $119bn… if it’d worked.

And, not least — Shire had a 100 per cent free float.

@Outlaw – Abbvie’s last full year earnings are here.

AbbVie’s net debt was $5.6bn at the end of the last full year, which was below its annual ebitda ($7.1bn).
But the Shire offer includes £14.4bn of cash.

@abm – That hits the issue here. The £53 offer is a 42 per cent premium, fairly punchy, over the undisturbed price. Medtronic’s offer for Covidien – an inversion deal par excellence – was 29 per cent.

yep @ABM gets right to the point: “I suppose the question is: does the offer price make sense without the tax saving from the inversion?” — the answer is: probably not, but I will chisel away at the math a bit. Remember that there are several discrete sources or value in the inversion. First, the absolute savings on the tax rate (easy-ish to quantify). Then the value of being able to move cash around without paying US taxes on the repatriation (depends on what the combined company plans to do with its cash). Then there are various still harder to quantify issues like tax impact on the US company’s shareholders and the chance that the tax regimes changes after the fact.

@swedes: I’ll work on this math too, but Abbvie has indicated that they are keen to stay investment grades, and this should leave them right on the edge — over 2x net debt/ebitda, under 3x. But let me double check this and I will come back

We should mention Shire’s tax rate, as Rob starts on the maths (and as per Outlaw’s point). From the 2013 Annual Report

So, 16 per cent from 20 per cent. (The statutory Irish corporate tax rate is 25 per cent, of course.)

And just for some history here… a blast from the past (well, early 2008) from FT Alphaville…

Hey, it’s magic. Shire, the pharmaceuticals business best known for its ADHD and genetic therapy work, is re-organising itself as a London and Nasdaq-listed entity through a Jersey incorporated holding company – which will somehow be tax-resident in the Republic of Ireland.

Nothing will change operationally. No job losses are envisaged, with Shire retaining its major sites in Basingstoke and Philadelphia. Shareholders do have to vote through the changes, however.

But how does this work – a British firm which can trace its history back to 1986 simply adopts a new corporate wrapper and, almost overnight, seemingly avoids UK corporation tax? A few Treasury officials might want to know – before the rest of corporate Britain disappears down the same revenue drain.

It says AbbVie/Shire in the box above, but it seems we have another pharma inversion deal being announced today.

Some Emoticon via Richard Blackden at Fast FT:

Mylan To Acquire Abbott’s Non-U.S. Developed Markets Specialty And Branded Generics Business In An All-Stock Transaction

This is Abbott Labs, from which AbbVie was spun off not so long ago. Link to the release here.

But look at the inversion terms specifically:

Abbott will carve out the Assets and transfer them to a new public company (“New Mylan”) organized in the Netherlands. Immediately following the transfer, Mylan will merge with a wholly owned subsidiary of New Mylan, and New Mylan will become the parent company of Mylan. The new public company will be called Mylan N.V. and will be led by the current Mylan leadership team and headquartered in Pittsburgh.

Under the terms of the transaction agreement, Abbott will receive 105 million shares of New Mylan upon closing, resulting in Mylan shareholders owning approximately 79% of New Mylan and Abbott indirectly owning approximately 21% of New Mylan. Mylan shareholders will recognize gain for U.S. federal income tax purposes on the exchange of Mylan common shares for New Mylan ordinary shares.

The bold part is my emphasis. I’ll come back to what it means in just a second.

@swedes: abbvie off 2%, to $53.85, pre-market in the states.

AbbVie is not the only company that may be interested in Shire. Allergan (itself a target for Valeant) has also been talking about making an acquisition, and Shire could fit the bill. Inversions are popular, but there aren’t too many UK or Ireland based companies of the right sort of size. Here are the UK-listed pharma stocks, by market cap:

GSK: £76bn
AstraZeneca: £55bn
Shire: £28bn
Hikma: £3.4bn
BTG: £2.3bn

After that it’s down to Dechra at £0.6bn.

As an aside, Mylan’s tagline perhaps tempts fate here…

Yes, just on that question of Mylan shareholders paying US federal capital gains tax on the inversion. How many shareholders are aware that this can follow their company inverting domicile?

Actually, Dealbook had a great piece on this recently, as the issue has also cropped up in Medtronic/Covidien:

The Internal Revenue Service will treat the acquisition as if Medtronic shareholders had sold their shares. Under I.R.S. rules, when a company moves abroad in a tax inversion, the buyer’s shareholders must pay capital gains if they will hold 50 percent or more of the shares.

That is the case for Medtronic, and so its shareholders will be stuck with that big tax bill — up to 33 percent in California after you include the state tax. (In Minnesota, where the top capital gains tax is 7.9 percent, shareholders may pay up to 29.7 percent of their holdings in tax.)

Let’s pause and reflect that Medtronic is pushing a transaction that from Day 1 may cost some of its shareholders as much as 33 cents on the dollar.

Now – Shire, in preparing to recommend the AbbVie offer, referred to terms still to be ironed out. The nature of AbbVie’s inversion to the UK is probably going to be included in the paperwork there. Well, what about implications for individual shareholders paying tax? Is it easy to spot? Seeing is believing, after all.

So, I may end up making this note about both Mylan and AbbVie… NB – I’ll be posting the full note in this session later on in the afternoon, and will be actively posting here for another hour or so.

But so far…

- It looks like Shire investors get a good deal – note the market cap chart we started with – if AbbVie’s share price holds up, that is.

- What about AbbVie holders? Their company’s tax rate is 22 per cent, with difficulties repatriating offshore cash and so on thanks to the US tax code. Shire’s is 16 per cent. The premium is over 40 per cent. Do future earnings increase enough from here?

- But what if the transaction is taxable for AbbVie shareholders?

- And what if US tax law changes in future? We already noted this interesting little get-out provision in the Medtronic/Covidien agreement, on the blog:

That’s more or less a free walkaway if the law changes. For any other more usual dealbreakers, Medtronic is bound to pay $850m in reverse break fees.

Oh yes, and we haven’t got round to the actual industrial logic of the merger yet! Assuming there’s much driving the deal, compared to the tax advantages.

AbbVie gets almost two-thirds of its sales from an arthritis drug, Humira, which faces patent issues in the near future. Shire specialises in treating ADHD and rare diseases. We’ve been sceptical in the past that AbbVie’s distribution clout (for example) can help Shire much here.

Meanwhile, Shire has grown hugely in the last decade (its sales doubled between 2007 and 2013). But as we also argued recently, eventually the law of large numbers sets in.

Maybe Rob can weigh in more here. However, when it comes to the brands versus generics issue (and Shire’s specialism, ADHD) – some charts from Credit Suisse last week:

On that point, Shire shareholders (as well as getting the cash) will own 25 per cent of the combined company despite only contributing 21 per cent of its revenues.

From the department of very rough approximations, here is a thought on the value of the tax savings. Wall street thinks that AbbVie, as an independent company, will have $7.75bn in pre-tax income in 2015. The difference in the tax rates last year was 6.2% — 22.6% vs 16.4%. Multily that difference by the pretax earnings and about half a billion dollars or after-tax income is born. Capitalize that at 10 times and you have $5bn of value — or about a third of the premium paid. But that may exaggerate some, if Shire’s 2013 rate was anomalously low. You could also have a quibble about the cap rate.

Also, @Swedes: you bet it has governance implications. If I am sitting there getting a fat tax bill on my AbbVie position and I find out that the exec’s or board are getting made whole by the company on their tax bills, I am going to throw my toys out of the pram. Big time.

The issue with getting old fashioned cost savings out of the deal is that Shire is not company that has a fat infrastructure, or one that overlaps very much with AbbVie’s. As the CEO of Shire recently pointed out, their specialty products have small salesforces — they are not canvassing across legions of general practitioners. In the case of their rare disease portfolio, they might have one salesperson per country. AbbVie isn’t going to fire that guy.

The lack of therapeutic overlap, incidentally, makes it interesting to see if anyone (ahem, Allergan) tries to interlope here at the last minute, no?

If few pharma companies will compete with Shire on its specialties, then there aren’t many potential tie-ups here that could upset the FTC and prevent a deal, surely – or that would disrupt existing operations/R&D.

But it is crucial to remember here that there is a very important source of value in this deal that is not cost or tax savings. It is diversification. Part of the reason that AbbVie is not a very richly values stock — it trades at 11 times next year’s ebitda – is because half of its earnings come from the arthritis drug Humira. That makes the company risky, should something go wrong there. Humira’s patent expires at the end of 2016 (though because it is a biologic, its sales may not be decimated by expiration). The idea is that one Shire’s products are in the mix, diluting the Humira dependence, the shares of the combined company will rerate (eventually). Think of it this way: every time that ev/ebitda multiple increases by one notch, $7bn in value appears.
Will this work? I have no idea.

A quick look at who will be making the decisions here. The shareholder lists of both are dominated by the usual suspects. According to data from S&P Capital IQ, Blackrock, Fidelity and State Street between them own almost 18 per cent of Shire and 15 per cent of AbbVie. Capital is the biggest shareholder in AbbVie but has only a small stake in Shire.

Hedge fund manager Paulson & Co is the most interesting name on the list, with a 3.2 per cent stake in Shire.

A look at the Shire share price at pixel time (via Bloomberg)…

It’s £49.35 – or 7 per cent below AbbVie’s ‘revised’ proposal. Hmm.

A quick note on the combined company’s pro forma balance sheet. AbbVie had net debt of $5.3bn at the end of Q1. Shire brings net debt of $1.4bn. The cash outlay to Shire’s shareholders is $24.5bn. So combined net debt will be about $31bn. Using the street estimates from Bloomberg, the combined Ebitda for the two companies next year will be $11.6bn, giving a net debt/ebitda ratio of 2.7. Give a little credit for a cost synergy or two, and I see investment grade for new Abbvie.

Swedes – That depends on whether Fidelity (or any other fund) includes tax in reported returns, or whether the tax bill gets thrown into the year-end within the costs of trading.

In short institutional investors might not have an incentive to complain about capital gains and inversion, if retail holders would be the ones paying. I see a potential principal-agent problem here…

Do we like this deal at this price, for Abbvie Shareholders? At this point, I do, on the assumption that the tax savings comes through and the valuation of the combined, in time, rises a bit because of diversification. Together, those could more than cover the premium paid, if we assume a bit of cost efficiency, too. Neither of those things is guaranteed, though — and I want to get the details on the capital gains hit I’m going to take as a Shire. I hope shareholders, especially the big institutional ones, press AbbVie hard on that issue.

@Stefanoc – in the past, big pharma deals have not triggered antitrust fights and this one – it hard for any two companies to dominate any therapeutic area. And as we said, there is not tons of product overlap in the AbbVie/Shire case. I think the surgical equipment field might be a little different, though.

On that note we are going to bring this first Lex Live session to a close.

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This was fun. Let’s do it again soon.