Actavis and a fairy-tale pharma merger

There are few truly transformational corporate mergers on Wall Street that instantly redefine an industry and are a licence to print money for shareholders in the post-merger firm. I am convinced generic Irish pharma Actavis’ $25 billion takeover bid for Forest Laboratories has created such a rare beast, the world’s latest high-growth Big Pharma will have a unique product pipeline with long patent lives in respiratory, cystic fibrosis, hypertension, gastroenteritis and OB/GYN diseases and access to the vast North American primary health care infrastructure/supply chain. It is all too possible for Actavis shareholders to benefit from annual 20 per cent EPS growth in the next five years.

However, Actavis trades at a mere 14 times forward earnings despite stellar tax/cost synergies that could even mean a 22 per cent EPS CAGR. In contrast, Bristol Myers Squibb, admittedly an immuno-oncology concept share, trades at 32 times earnings even though its EPS growth rate is in a similar 18 to 20 per cent annual rate. Actavis shares have more than doubled but it is a company known to very few of the cognoscenti in Irish equities but I believe the Forest Labs deal could make Actavis on the precipice of a stellar valuation rerating. Actavis could be the sweetest, bonny thing to emerge from the Emerald Isle since Riverdance, Sinead, Bono and James Joyce.

I was thrilled by the Forest Labs deal because this company was reinvented by activist shareholder/corporate raider Carl Icahn, who has earned a $600 million profit on the deal. Icahn is the second largest shareholder in Forest Labs and recruited CEO Brent Saunders, who will remain with the merged firm.

Actavis has paid a premium price for Forest Labs, though the targets earnings were depressed by new product launches whose EPS growth impact will only be felt in 2014-17. In any case, cost/tax synergies make this an accretive deal for Actavis (unlike Mark Zuckerberg’s latest $19 billion deal for a Valley real-time messaging startup!). Of course, any Forest Labs investor laughed all the way to the bank with a 30 per cent overnight return! I find it reassuring that Actavis shares rose in Dublin and New York even though debt, dilution and integration risk might argue for a hit. The key variable here is that management expects $4 billion in free cash flow next year, a codeword for share buybacks. Moreover, Forest Labs redefines Actavis and gooses its EPS growth rate to 20 per cent for the next five years. If ever there was a game changer deal on Wall Street, this is it, even though Actavis was built on a succession of generic drug deal-making.

I knew Actavis as Watson Pharma a decade ago and saw it buy a number high margin branded drug makers, notably its $9 billion stock deal to buy Warner Chilcott. Its Irish domicile means a $100 million upfront tax gift on the Forest Labs deal. I will not be surprised if Actavis earns $17 a share next year. If I am right and the post-merger firm’s strategic scale/products/long life patents cause Wall Street to rerate the shares to 20 times 2016 earnings. This means Actavis could rise from its current $205 to as high as $340 a share. Two years from now, Actavis could earn $20 a share and Wall Street could well price its shares at $400. Investment fairy tales? Not at all. Just Google Finance the charts of Regeneron and Gilead, both ideas from this column in 2012.

Could a bidding war emerge to snatch Forest Labs from the embrace of Actavis? I doubt it, since Forest Labs shares have tripled since November (who is the next Forest Labs in the specialty pharma? In my admittedly biased view, Valeant!) and another bidder will not be able to replicate the tax/cost synergies that enabled Actavis to offer its premium takeover bid price. I believe the ideal strategy to accumulate Actavis is the sale of six month at the money 200 strike price put options. I would not be surprised to see Actavis trade in a 180-260 range in 2014 and vastly prefer it as a strategic holding either Teva or Mylan, though not Valeant.