At high noon, a majestic and lone antelope on the wide-open plains of the Serengeti is peacefully grazing on the wispy wind blown grass.
A bullet pierces the heart of the young antelope not knowing a big game hunter looking for his next trophy has shot it. The poor dying animal not only struggles physically but also is mentally confused thinking its well being was protected by its multi-billion dollar market capitalization and substantial premium market valuation.
The panicked antelope gets a glimpse of two men approaching from behind scrub bushes. The hunter, the one with the rifle, being one J. Michael Pearson of Valeant Pharmaceuticals and his partner, one Mr. Bill Ackman, to me better known as Bill “The Butcher” Cutting from the movie “The Gangs of New York”.
Mr. Bill “The Butcher” Cutting
The young antelope is, you guessed it, Allergan Inc.
Financial Engineering versus R&D and Innovation
Financial engineering – making barrels full of money – can and will trump everything, even reason. When one has the financial math, or the golden keys if you will, why not use them?
J. Michael Pearson seemingly knows the financial math and is building an empire. Mr. Pearson has acquired through Valeant over 100 acquisitions since becoming CEO back in 2008. I have borrowed Mr. Ackman’s ‘PowerPoint’ slide depicting the concurrent history of Valeant’s CEO, Mr. Pearson and the company’s stock price with a few noted acquisitions annotated for your convenience.
I copied this chart from Mr. Bill Ackman’s ‘PowerPoint’ presentation to investors.
Valeant, the company, and its activities are known as a ‘Rollup’. What is a ‘Rollup’ you ask? A ’Rollup’ is where multiple small companies in the same market are acquired and merged together by a consolidator. In this case the consolidator is Valeant and its mastermind is one Mr. Pearson. See my original blog about Valeant and its activities here and a reblog (with new financial data) here.
Financial history is filled with ‘Rollups’. Usually the consolidating company and its mastermind – the protagonist behind the company – is very successful in the beginning and during the numerous acquisitions the consolidator completes. Valeant, the company, and Mr. Pearson maybe new to business history stage but their corporate acquisition activities are NOT new to the annals of business history.
The difficulty behind ‘Rollups’ and ultimately its undoing – failure – is the complex financial math behind the consolidator’s acquisition activities. In my original blog I identified the protagonist, J. Michael Pearson, as an individual who potentially may have figured out the financial math behind doing hundreds of acquisitions with a steadily climbing stock price rewarding him and common shareholders. Readers have to admit I wasn’t wrong in my assessment. See once a protagonist – Pearson – and the consolidator – Valeant – gets on a roll (no pun intended), why stop? The financial math works proportionately irrespective of the magnitude. Hundreds of thousands of dollars can turn into multi-billions and the math still works except for the inconvenience of dealing with the zeros and commas.
With this in mind, Mr. Pearson is reaching all the way for the $50 billion acquisition instead of playing around with an acquisition in the small mid double digit billion. And why not? Mr. Pearson has a solid track record from previous acquisitions and has earned market credibility proving he knows the financial math to make his ‘rollup’ vehicle, Valeant, successful by making shareholders money.
Allergan, Inc. is a company that has a corporate culture prized and steeped in science. A full 17% of Allergan’s revenue is spent on research and development, higher than many of its rivals. Valeant claims to have spent 3% of its revenue on R&D last year but with revenues growing as quickly as the acquisitions were completed and costs slashed as fast as possible one has to give a ‘Spockian’ eyebrow to this percentage. Pearson reassured investors that $2.7 billion in cost savings could be realized from the acquisition of Allergan, Inc.
So much for Allergan’s R&D!
As Bud Fox asked Gordon Gekko in the movie Wall Street, “Why do you need to wreck this company?”
“Because it’s WRECKABLE, all right?” yells Gekko!
Enter Bill “The Butcher” Cutting – Bill Ackman
Looking at his acquisition strategy chessboard Mr. Pearson probably thought about my metaphor of the antelope (just kidding) in that Allergan in the flickering of life between the bullet in the heart and death itself still maybe saved. First, the numbers are getting too big to hide and an acquisition as big as this will attract a lot of financial press. And secondly, Allergan could play the sympathetic ‘Little Red Ridinghood’ card and wrap them selves in scientific innovation helping humankind type of company that will be destroyed by the big bad wolf (Valeant’s greedy ‘Rollup’ financial machine).
Mr. Pearson is smart enough to know this acquisition fight will be fought at the “Five Points” district in lower Manhattan. (OK, yes this fight will occur in the canyons of Wall Street…but Five Points is relatively close and it follows the story line of my analogy so I’m going with it!) And with any fight, especially a knife fight, you need an antagonist. An antagonist that is totally crazy with greasy hair and blood on his apron. An antagonist who will sharpen his knives, axes and isn’t afraid to die especially in front of the countless lawyers and investment bankers Pearson and company will have to deal with to get this deal done.
“The Butcher” and his gang doing what they do best. Anybody want to fight?
Pearson (Valeant) and Ackman (Pershing Square) form a Partnership (PS Fund 1)
So Mr. Pearson tells Mr. Ackman of his plans to tender a hostile bid for Allergan after the two were introduced. Together through their respective companies they setup a partnership called PS Fund 1. Valeant chips in $76 million in cash into the Partnership – PS Fund 1. Pershing Square, through the partnership, quickly amassed a 9.7% stake in Allergan, much through the purchase of stock options – very little capital required. On April 22nd Valeant launched their hostile takeover bid for Allergan, Inc. pushing shares of AGN up to $168 – as of Friday’s close April 25th. The true cost of the 9.7% – 10% being the legal limit – stake in Allergan by the partnership has not been disclosed but for the sake of round numbers let’s say the partnership of PS Fund 1 profit is $35 per share. With some 29 million shares controlled by the partnership that’s a cool profit of $1 billion dollars. If a ‘white knight’ appears on the scene and bids a higher price than Valeant and wins Allergan, Valeant gets its money back, $76 million, and 15% of any profit the transaction yields. Of course ‘The Butcher’ and his clients get the rest.
Isn’t this insider trading? How could this be legal you ask? Well, Bill “The Butcher” Cutting’s lawyer – Robert Khuzami – former director of enforcement at the SEC – vetted the Valeant partnership (PS Fund 1) and deemed it legal.
“Folks, it’s smart people like me who make America great.”
Allergan probably could have defended itself against Valeant however with the two of them the heartbeat of my young antelope is growing fainter, indeed.
How do you feel about ‘Financial Engineering’ now! Is this capitalism at its’ finest or something else? I will leave the moral and ethical judgments to you. In no particular order here are my conclusions.
- Call and book the taxidermist. In my opinion Allergan has limited options available to keep themselves independent. The CEO of Allergan could recapitalize the company – pay a huge dividend to shareholders with debt – and perform the necessary self-mutilation in terms of employee layoffs and reduced R&D spending planned by Mr. Pearson and Valeant to remain independent. The other option is, of course, a ‘white knight’, a company of Allergan’s choosing to purchase Allergan at a premium to Valeant’s bid. This ‘white knight’ will have to be careful though. If the CEO’s ‘white knight’ purchase is a vanity purchase and the company’s share price gets crushed because the market doesn’t like the acquisition – the acquisition numbers don’t work – then the ‘white knight’ company maybe the next target for Pearson, Ackman and Company. After one antelope has been shot and two humans are walking around the Serengeti the other animals – pharmaceutical companies – will be visibly nervous.
- I spent all Tuesday afternoon, the day of the formal bid, April 22nd, using Model Price Theory (MPT) and pushing around some of the numbers on Valeant’s pro forma balance sheet if this Allergan deal gets done with the announced numbers. Shockingly the numbers work! Investors and equity market observers might have deduced this because Valeant’s share price appreciated on the announcement of the deal. It amazes me how the market, within seconds of an announced deal can make a snap judgment – and a correct judgment – whether the announced deal is beneficial to the acquiring company’s market value or model price. Mr. Pearson is a financial engineering genius my friends and I have the math to prove it!
- If Valeant’s acquires Allergan, Inc. Bill Ackman and his investors will invest $4 billion in Valeant’s shares with board representation. This is no surprise to me. Bill wants to get closer to the action. Maybe pick up some financial engineering math from his new friend Mr. Pearson. To repeat what I said earlier if the financial math works the magnitude of the numbers are of no consequence. Will the boys, Pearson and Ackman, be happy after this $50 billion dollar Allergan deal gets completed? Of course not! There are still bigger deals to do. How about a $100 billion dollar deal?
- What’s the end game for Valeant, you may ask? Rollups finally get crushed under their own weight. The numbers just get too large. Or maybe in this situation there are no more publicly available pharmaceutical companies to acquire. There is only a hand full of elephants out there after all. Merck has a market capitalization of $167 billion, and Pfizer $196 billion. And both companies are trading below our calculated model price or fair market value. If this Allergan deal gets done, Mr. Pearson and his new best friend, I’m sure, will be getting restless and will be looking for bigger game grazing on the Serengeti. After all a new business history can be written here and isn’t making future history more important then money?
P.S. Friends I would be remiss if I didn’t point out the obvious here. In February 2008 one J. Michael Pearson started out as a lowly CEO of a generic pharmaceutical company with $5 million in Valeant company stock. Today, after short 6 years, Mr. Pearson is now a billionaire financier – yes, he is worth over a billion dollars – and CEO of a public company that will have a market capitalization of $75 billion US dollars if Valeant gets the acquisition of Allergan done. Truly amazing, especially considering that global growth hasn’t been stellar since the Financial Crash of 2008. What have you been doing over the last six years?