Actavis buys Warner Chilcott, Upside Seems Limited

On May 21, 2013,  Actavis (ACT) announced that it would acquire Warner Chilcott (WCRX) for $20.08 per share (found here) and the deal is expected to close by year-end 2013.  This has turned into an incredible string of companies that have been on our New Low Observer Watch Lists and ultimately get acquired.

On April 30, 2012, we gave Warner Chilcott a sell recommendation after the stock gained +57.11% in 3 months(found here).  After that sell recommendation, Warner Chilcott declined –35% by mid-December.  We reiterated our sell recommendation of Warner Chilcott on September 6, 2012 (found here), from that level the stock decline –12.93%, to the December 13, 2013 low.

As regular readers of our work know, we compare investments on an annualized return basis.  In the example above, the annualized gain from December 16, 2011 to April 30, 2012 sell recommendation or the December 31, 2013 completion of the merger, are as follows:

• 12/16/2011 to 4/30/2012:   +276% (excluding special dividend)
• 12/16/2011 to 12/31/2013:   +80% (including special dividend)

There are several concerns regarding the transaction between Actavis (ACT) and Warner Chilcott (WCRX) that should be taken into consideration.  First and foremost, is the current price action of Actavis stock.  Price action determines a majority of relative fundamental value attributes. Below is the Speed Resistance Lines [SRL] based on the stock price for Actavis since June 2006.

Any transaction being carried out by Actavis at the current price is heavily dependent on the stock price remaining at $120 and above.  According to Gould’s SRLs, Actavis has a conservative downside target at $87.01 and an extreme downside target at $43.51.  Our experience indicates that the conservative downside target is a lock, at this point.  This is in spite of the fact that the price could double before getting to such a downside target, as was the case with our April 2012 conservative downside target of $420 for Apple (AAPL) (found here).   While the conservative downside target appears to be a lock, the extreme downside target begs some kind of explanation of how it is possible to decline –50% or more.

The first consideration that comes to our mind is the strategic nature of the purchase.  The Actavis purchase of Warner Chilcott will lower the corporate tax rate from 29% to 17% because WCRX is located in Dublin, Ireland as reported by Bloomberg News (found here).  While the reduction of the tax rate seems to be beneficial, it has done little to contribute to Actavis’ earnings.  Already there has been faux outrage by Congress over the fact that Apple has legally dodged their “fair share” of corporate taxes through entities located in Ireland (found here).  We believe that with Congress spotlighting the issues related to legal tax avoidance, some areas that were once loopholes will be closed.  This will require more time to come up with new legal tax avoidance strategies.  Also, with Warner Chilcott being domiciled in Ireland, the focus of the Apple entities, Ireland may be the first target for changes to the tax loopholes that presently exist.

Another challenge is the dramatic increase in sales and earnings due strictly to the merger (found here).  As reported by Zacks Equity Research, based on the preliminary numbers, sales for Actavis are supposed to jump from 7% to 25% by 2014.  Also, annual earnings are supposed to increase 30% from the current level which stands in the negative for the trailing twelve months.  However, little of the gains for Actavis will be a direct result of internal efficiencies and significant improvement of sales.  This come at a time when Warner Chilcott appeared desperate for a buyer after private equity shareholders cashed in most of their chips after substantial special dividends nearly equal to the IPO price set in 2005.

At the time of Watson Pharmaceutical’s acquisition of Actavis in early 2012, it was announced that, “…Including synergies, Watson anticipates the acquisition will be greater than 30% accretive to 2013 Watson non-GAAP EPS, with accretion accelerating in 2014 through organic growth and further achievement of synergies” (found here).  In the announcement of the merger between Actavis and Warner Chilcott (WCRX), the company press release says that it will be “…immediately Accretive With Opportunities for Substantial Operational Synergies and Tax Savings” and “…The transaction is expected to be more than 30 percent accretive to Actavis non-GAAP earnings per share in 2014, including anticipated synergies.” (found here).  Aside from using nearly the exact same language in the press releases for two different companies, the set up for 2014 could be a big disappointment.

In spite of the accretion that is suggested, Actavis’ 2013 first quarter earnings was –$0.79, down from the $0.43 in the prior year period (found here). In addition, the 2012 fourth quarter earnings were down –10% from the same quarter in the prior year (found here). The 30% immediate accretive non-GAAP gains due to the acquisition of Actavis has not yet been realized.  Also, non-GAAP earnings are not contributing to the bottom line in the form of positive annual net earnings.  It is possible that the merger with Warner Chilcott is simply covering up the failings of Actavis to come through on promises of “immediately accretive” value for the Watson Pharmaceutial/Actavis merger.

Finally, according to Value Line Investment Survey, based on estimated 2013 cash flow, Actavis has a fair value of $120.28.  Since 2006, Actavis has traded below Value Line’s fair value while never trading above such a level.  This trend persisted even after Watson Pharmaceutical acquired Actavis, which was concluded in October/November 2012.  At the current price of $130, Actavis is 3% above Value Line’s estimated 2016-2018 fair value.  We think the persistence of Actavis to trade at or below Value Line’s fair value estimates will continue to dominate the stock price going forward.

It appears that paper gains due to mergers and acquisitions through the use of tax reductions and non-GAAP reporting is not a fundamental shift in Actavis’ ability to increase shareholder value.  Additionally, the +56% parabolic run-up in the price along with Edson Gould’s Speed Resistance Lines and Value Line’s fair value estimates suggest that the downside risks are significant.