By Joel Litman, president and CEO, Valens Research
We call it the “winner’s curse”…
It’s a simple idea. When you’re the highest bidder, you almost always overpay. So winning means you had the most optimistic view of an asset’s value.
That is, unless you know something that everyone else is missing.
It shows up in online auctions on eBay. It happens in bidding wars for paintings and sculptures. And it’s even common with massive merger and acquisition (“M&A”) deals.
We’ve seen thousands of these M&A deals end in disaster. And our “Uniform Accounting” adjustments – where we fix the reported financials of companies to get rid of built-in inconsistencies – show how bad accounting can make the deals even worse.
Right now, most Wall Street analysts expect billions of dollars in value destruction in the second-biggest M&A deal of the year…
The thing is, in this case, they’re completely wrong – relying on faulty numbers. Let me show you what I mean…
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In June, Big Pharma giant AbbVie (ABBV) announced it was acquiring competitor Allergan (AGN) for more than $60 billion.
AbbVie’s management justified the deal by pointing to Allergan’s “aesthetics” offerings – especially its blockbuster wrinkle-fixer Botox.
These products provide a strong and stable franchise, with high profit margins and limited exposure to normal drug business risks. AbbVie’s main business is heavily exposed to those issues, especially the dreaded two words for pharma companies… the “patent cliff.”
A patent cliff is when a drug’s patent expires and generic pharmaceutical companies can offer alternatives. And when generics enter the market, it’s bad news for name-brand drug makers. Prices plunge, and margins collapse.
AbbVie’s biggest breadwinner, arthritis drug Humira, is starting to come under attack. Competing drugs have appeared in Europe. Patents in the U.S. start to expire in 2023. And the clock is ticking.
As a result, Wall Street analysts look at AbbVie’s acquisition and see a company that’s desperate to diversify its business from Humira… and a management team that’s lighting money on fire.
After all, AbbVie was desperate to buy the business. And no one offered to pay more for Allergan. The market appears to think AbbVie has fallen for the winner’s curse. On the day the deal was announced, AbbVie shares dropped from $78 to $66, and they’re still only trading around $71 a share today.
The market has plenty of reasons to hate the deal. Allergan hasn’t generated positive net income, excluding special items, since 2012. And it hasn’t had a double-digit return on assets (“ROA”) since the 1990s.
However, after some digging to figure out the real numbers, we can see what the market has overlooked.
When we apply our Uniform Accounting metrics, the distortions from as-reported accounting statements are removed, including issues around research and development (“R&D”) expensing, special items, and acquisition distortions.
Take a look at the chart below (you can click the image for a larger view). The orange bars show the reported financials, while the dark blue bars show our adjustments. With Uniform Accounting, we can immediately see that Allergan’s ROA is actually more than six times its cost of capital. Those are fantastic profits…
The two panels above outline Allergan’s performance levels in terms of ROA and asset growth versus what sell-side analysts think the company is going to do over the next two years (light blue bars) and what AbbVie is pricing in at its current takeover prices (white bars).
Not only has Allergan had positive ROA since 2013 (something as-reported financials fail to show), it actually has an ROA near all-time highs, at 35%. The firm has also been investing heavily, with adjusted asset growth consistently above 10% prior to 2017… which shows it has been able to maintain its strong profitability even while investing.
That brings us back to AbbVie. Based on the recent stock drop, investors clearly think AbbVie is destroying value…
Maybe AbbVie isn’t a strong enough business to effectively pull off such a massive acquisition. Maybe AbbVie has poor returns and Allergan is actually doomed to see returns compress, too. In other words, if Allergan isn’t the problem, maybe AbbVie is.
Nope. Using the same lens through which we view every company, AbbVie is actually an even better business than Allergan. Take a look…
After seeing adjusted ROA bottom at 24% in 2014, ABBV has improved ROA to 45% since then. As-reported ROA has declined from 12% to 11% over that time frame. Once again, the official financial statements are letting investors down… making them think AbbVie is less profitable than it is.
That leads to wildly inaccurate valuations. Currently, the market (white bars) is expecting AbbVie’s profits to sink near all-time lows, while it continues pouring money into a dying business. As a result, ABBV is trading at only 8.7 times adjusted earnings!
These levels are generally reserved for awful businesses – not one of the largest, most profitable, most innovative firms in health care.
If AbbVie can sustain Allergan’s returns after the acquisition, or even improve them to match AbbVie’s levels, this company is worth a whole lot more than current prices suggest.
This is yet another example of why you can’t rely on so-called standard accounting practices…
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