Is This Large Pharma Acquisition Worth Its Price?

Sherrie is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you are an Actavis (NYSE: ACT) investor, then maybe you’ve enjoyed the 16% gain since the pharmaceutical company's announced acquisition of Warner Chilcott (NASDAQ: WCRX). Therefore, you might be a little frightened by reports that the FTC is requesting more information regarding the acquisition. Clearly, the FTC could block the deal -- but would this be good or bad for Actavis?

Does The FTC News Have Meaning?

Like many, I had thought the acquisition of Warner Chilcott would be a slam dunk for Actavis. This acquisition would make the world’s third-largest generic company significantly bigger, with the addition of $2.5 billion in annual revenue -- but only if the FTC does not block the deal.

While we do not know what information the FTC is seeking, Actavis has already stated that it still expects the deal to complete in the second half of 2013. However, we’ve seen this play out before. The FTC requested more information from AT&T’s proposed acquisition of T-Mobile; AT&T downplayed its meaning; and the proposed acquisition was blocked for creating an “unfair advantage” and “leading to lost jobs.” 

What Is The Warner Chilcott Benefit?

The so-called "big" benefit to this $8.5 billion acquisition is that it will lower Actavis’ corporate tax rate from 29% to 17%, due to Warner Chilcott being based in Ireland. If you followed the court proceedings with Apple on Capitol Hill, then you know that Ireland was a big topic, as companies often hide revenue due to Ireland's tax leniency. 

Once the acquisition is complete, it could create annual sales of $10 billion. Actavis currently has an operating margin of 12.95%, and Warner Chilcott’s operating margin is 33.44%. If we assume that these operating margins stay the same, then the combined operating income would be near $1.8 billion, with almost $1 billion being produced from Actavis alone. 

Therefore, with a 12% differential in tax benefit, this acquisition would create an additional $120 million in net income for Actavis. If Warner Chilcott can then produce the same net income as it has over the last 12 months, it would add $400 million to Actavis’ bottom line.

Actavis could thus benefit from $520 million in profit over the next year from the acquisition of Warner Chilcott. Since profits are ultimately the only metric that matters, it would take over a decade for this payoff to materialize.

Is It Better For The Acquisition To Be Blocked?

At this point, there is not enough information to know with any level of certainty whether or not the FTC “request” suggests that the acquisition could be blocked. Therefore, I am not going to speculate on whether or not it will happen. However, as an Actavis investor, I hope it is blocked.

Now, investors who are pro-Actavis/Warner will automatically object to my case against this acquisition. However, I think Actavis paid too much to acquire Warner. Yes, Actavis is growing, and is expected to continue growing. Therefore, it will benefit from the new tax structure for many years, assuming that tax structure stays the same.

However, there is the looming issue that Warner is losing exclusivity on many of its dermatology and women’s health drugs, and saw a 13.4% loss in revenue year over year during its last quarter alone. Therefore, Actavis has paid $8.5 billion for a company with $2.45 billion in revenue -- one that is losing revenue by the quarter, and one that has been trying to sell itself for the last year. Hence, as an investor, I would be just fine if the FTC found something wrong, and blocked this acquisition attempt.

Conclusion

My view on acquisitions in biotechnology has always been quite simple: If the market views a company as valuable, then it will probably add value to an acquiring company. In regards to Warner Chilcott, its shares were trading lower by 41% in the two years prior to the initial Actavis acquisition rumors, and rightfully so.

Looking at Actavis, I think the company will be better off without the acquisition. It would take them too long to return a profit from the purchase, and they simply don’t need Warner Chilcott to create shareholder value.

Actavis is growing revenue at 20%-25% per year, and it's trading at just 2.5 times sales and 13 times next year’s earnings. Therefore, it is cheap without the acquisition. But by acquiring Warner Chilcott, Actavis would need aggressive financing; Actavis would need to add more shares (diluting the stock); and Actavis would lose future leverage with its balance sheet (increasing its debt to assets ratio); all to acquire Warner Chilcott. Therefore, I am crossing my fingers that some force of nature (hopefully the FTC) keeps this acquisition from materializing.

At that point, Actavis would be even more attractive than it is with Warner Chilcot as an acquisition.


Sherrie Stone owns Actavis. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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