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Pharma investors should focus on innovation, not tax, says analyst

Future of pharma is innovation, not Pfizer’s mega-deal

24-11-2015 | Insight | Stijn Vanacker Investors in pharmaceutical companies should focus on value creation from innovative drug development rather than mega-deals that lower tax rates, says equities analyst Stijn Vanacker.

Speed read:
  • Pfizer buys Allergan for USD 160 billion in world’s largest pharma deal
  • Takeover is structured to take advantage of lower taxes in Ireland
  • R&D is much more important than ‘tax inversion’ in the long run
  • Investors should remain focused on cash flow and product pipelines

US drug giant Pfizer on 23 November agreed to pay USD 160 billion for Irish company Allergan in the largest deal ever seen in the healthcare sector. Pfizer is reversing into Allergan – a technique where the target effectively buys the bidder – to allow it to be domiciled in Ireland and take advantage of much lower tax rates there than in its native US.

However, the real focus should be on exciting new products that come out of R&D programs rather than ‘tax inversion’ schemes that the US government could block, says Vanacker, a healthcare analyst with the Robeco Global Equities team. Both companies have blockbuster products that were developed through such R&D initiatives: Pfizer is best known for Viagra while Allergan makes Botox.

The deal will lower Pfizer’s tax rate from 25% to 17%. This financial engineering strategy has become more important to them because they fear legislation may change with a new US President next year.

What matters is R&D engines
“We have seen quite a few tax inversions in the sector in the past five years in healthcare. While generally that’s good for investors because managements are thinking about returns and the profitability of the business, the thing that gets drug companies is never financial engineering: what really matters is the output of their R&D engine.”

“So we’ve now seen M&A for tax reasons, and M&A for drug reasons. The drug reasons over time are much more important and value creative than tax reasons. Generally healthcare investors will not reward drug companies for improving their growth profiles solely through tax actions.”

He says the jury is out on whether the deal will make much difference to investing in pharma, unless the US government takes action. “For the sector it doesn’t have a real impact,” he says. “Half of the investor community is happy with what they see, because the earnings profile of Pfizer will improve, but the other half is scared that there might be a political backlash. The US government might retroactively cancel it, which would make it catastrophic for Pfizer.”

“There have already been some changes to tax laws because the US doesn’t like to see its crown jewels leave. So Pfizer had to do a transaction as soon as possible; they tried it last year with a USD 100 billion bid for AstraZeneca, who refused to accept it because they didn’t believe in the tax benefits amongst other things. There is doubt in the industry as to how sustainable this is.”

Will other sectors follow suit?
Vanacker says it is too early to say whether other sectors with large American players such as the internet, aerospace or food and drinks industries will go down this potentially profitable but controversial tax inversion road. “A lot of pharma companies have done it because it opens up cash that can be repatriated back to the US, but it’s hard to tell if it will spread to other sectors,” he says.

“But it’s true that the US has one of the highest corporate tax rates in the world, so the theme we’ve been discussing in our team is whether the US will do something about its tax code. It is losing a number of companies, so if the US wants to retain its crown jewels, it had better become more competitive with its tax rates.”

“If that happens you can expect companies with currently high US taxes to become tremendous investment opportunities if they move from say a 35% tax rate to 20% or so. But that’s a political decision and so we have no insight as nobody knows what the priorities for the next US President will be, though the tax code is definitely higher on the agenda than it has been before.”

Product pipelines are key
Vanacker says product pipelines remain key to values going forward, as has been seen with a recent spate of biotech companies coming onto the stock market. “There’s been a big push to improve productivity – that’s the biggest thing that’s happened to healthcare over the past five years, with a lot of new innovative medicines being developed,” he says.

“There has been a big wave of new products and that has re-rated the whole sector. That has triggered M&A and is why current valuations for small-cap biotech names are really high now.

“So there’s a tremendous amount of investor money flowing into new ideas in healthcare, mainly led by new R&D projects coming to market. For me, it is R&D productivity that matters most.”





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