Understanding The Mylan-Upjohn Merger

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Mylan is probably one of the most hated companies out there with one of the most hated CEOs. 

Saying that it has underperformed the market in recent years is an understatement: The stock has lost roughly 80% of its value from its peak to this month's trough, without any change in management, which protected itself against takeovers by adopting a complex poison pill arrangement.

So Pfizer is clearly adopting a contrarian strategy here and Mylan seems to be surprisingly open to its attempt.

The two businesses

Upjohn is an extremely cash generative business for Pfizer: It delivered $2,274 of pre-tax earnings on $3,075m of sales in Q1/19 for a stunning 74% EBT margin, and grew a bit YoY.

That said, it won't stay as profitable. According to the merger presentation, annual revenues in 2020 should reach only $7.5-8B, with an EBITDA margin of ~50%. This is due to the loss of exclusivity on Lyrica and expected volume-driven discounts in China.

Mylan's EBT margin has been very lumpy in recent years, while its FCF margin was usually around the 10% mark. The merger presentation guides to $12-12.5B of sales in 2020 and an EBITDA margin of about 30%. Overall, Mylan is expected to contribute ~48% of the combined entity's EBITDA.

Finally, debt. Mylan carries $12B of net debt - and here the story has an interesting twist. In fact:

"Upjohn will issue $12 billion of debt at or prior to separation, with gross debt proceeds retained by Pfizer. Upon closing, the new company is expected to have a solid investment grade credit rating. The new company will have approximately $24.5 billion of total debt outstanding at closing."

So Pfizer will actually take $12B out of the business before spinning it off to its shareholders. Despite contributing roughly the same EBITDA and the same debt load, in the end, Pfizer shareholders will own more of the new company.

However, Mylan faces the same wave of opioid lawsuits as Teva , while Pfizer managed just in time to offload its risks to Allergan  (which has sued Pfizer as a consequence). Apparently, Pfizer factored these risks into its calculation.

So, while Pfizer seems to be the one that profits the most, it actually could have simply kept its cash generative, high-margin business without risking any trouble with Mylan's lawsuits. Moreover, excluding the one-off inflow of $12B, the near-term consequence will be earnings dilution for its shareholders. Evidently, Pfizer sees long-term potential in Mylan's assets or, at the very least, in a combination of its own assets with Mylan's. This can be due to greater scale, the removal of a competitor, and simple synergies. The press release also hints to bringing Mylan's assets to markets where Upjohn has a strong presence.

The combined entity will be the world's largest generic drugmaker, with annual sales a bit higher than Teva's expected ~$17B for 2019.

The new entity's geographic focus would likely be the emerging markets. Upjohn already makes ~20% of its sales in China and has its global headquarters in Shanghai. Mylan's CEO also recently commented about the growth potential in the emerging markets and has struck a deal with Theravance to expand their previously U.S.-focused Yupelri partnership to include China as well.

Market consequences There are two ways to look at this transaction: 

• The first one sees the deal as a business combination and a vote of confidence by Pfizer. 
• The second one sees it as a creative transaction which allows Pfizer to actually get rid of its generics unit while making a nice one-off profit.

If the market adopts the first interpretation, I guess Mylan shareholders will enjoy this news. The new entity will be far more robust, with a better reputation and no strange poison-pill arrangements anymore (although the executive chairman and the controversial figure of Rajiv Malik will remain). 
Finally, it represents a vote of confidence, especially related to the opioid lawsuits - which Pfizer wasn't part of, but evidently is not afraid of getting entangled in.

Under this scenario, for Teva shareholders, the merger is also good news. There will be only one strong competitor instead of two. The vote of confidence on the lawsuits is important for Teva as well, since its shares have tumbled mainly because of totally hypothetical extrapolations of past settlements - and Pfizer doesn't seem to believe these lawsuits are that dangerous. 
Finally, further mergers might be in the cards as well. For example, if Pfizer had merged its generics unit with Teva and refinanced its debt, interest costs would have come down immediately and the excellent FCF generation in the Upjohn segment would have put to rest any bankruptcy speculation, with evident benefits for the equity valuation. So the market might start to speculate on a similar deal involving Teva. Consolidation usually comes in waves and the chronically underperforming generic drug industry could certainly need some consolidation. Other players might fear the market power of this newly formed entity and rush to form a larger business with better chances to compete.

In contrast, if the market looks at the deal as a sale from Pfizer to Mylan, it won't be good for the sector. Yet, I believe this is unlikely, given how cash generative Upjohn has been for Pfizer. The $12B windfall isn't enough to compensate for that. So Pfizer probably really sees value in the combination with Mylan.
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