John Paulson Talks Up Valeant and Allergan, and Merger Arb

Hedge fund manager John Paulson spoke at the CNBC Institutional Investor Delivering Alpha conference on Wednesday, offering keen insight in the current merger environment. Paulson signaled that Valeant Pharmaceuticals International Inc. (NYSE: VRX) is a very serious acquirer and he has predicted that Allergan Inc. (NYSE: AGN) will ultimately not be likely to win in its effort to block a merger.

The Paulson & Co. hedge fund holds roughly 6 million shares of Allergan, making his stake roughly $1 billion. He has backed Valeant’s offer to buy Allergan. Where the situation got interesting was when Paulson predicted that Allergan’s share price could rise up as high as $222 — versus $165 or so now — based on the savings that Valeant’s CEO might make.

With shares close to $165 now, the all-time high is $174.49 and the consensus price target is up at $187.43.

Paulson gave an interview with CNBC’s Melissa Lee as well at the Institutional Investor Delivering Alpha conference. We have included a link to the CNBC video for those who prefer videos, and we also have a delivered a very long transcript of the Paulson interview on CNBC.

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The full transcript is here. We would point out that this is still the unofficial transcript, so it is unedited for final draft purposes.

MELISSA LEE: Thank you, John, for joining us here. This is your second TV interview you’ve done. The first one being at last year’s Delivering Alpha. We’re thrilled to hear your perspective. And specifically on M&A. And of course there’s so much new news today to talk about.

I first want to congratulate you on your 20th anniversary. Paulson & Company this month celebrating its 20th anniversary in the business. You started off as an art shop basically, so this right up your wheelhouse.

JOHN PAULSON: That’s right. Thank you, Melissa, and CNBC for having me again this year. That’s right. This is a very exciting time to be involved in merger arbitrage. Last quarter we had $1.1 trillion of announced transactions, and that’s the highest it’s been in the last five years, and near the record achieved in 2007.

What’s driving the activity today is several factions, one is very low level of interest rate. Two, record stock market valuation, so companies can use either cash or stock to do transactions. And three, the transactions are accreted. So in a slow-growth environment, by doing a strategic, secretive transaction, corporations can grow faster than they can organically. Because of that many of the acquired stocks are being rewarded and therefore the executives now are in position, in order to grow faster, acquisitions are part of the mix. And if they don’t grow, they themselves — if they don’t grow the acquisitions, they’ve — they may themselves be a takeover target. So that’s propelling activity. And I think that’s going to continue for the foreseeable future.

MELISSA LEE: And we’re also seeing it in terms of how investors are playing some of these deals. Including yourself. You’re not only the holder of the targets, but also the acquirer. How has that changed since you first got into the business? Because that’s sort of an unusual dynamic we have.

JOHN PAULSON: That’s correct, Melissa. We’ve been involved in merger arbitrage for the last 20 years. We’ve built up core expertise in this area, and we have people that are dedicated to the space. Generally they worked for an investment bank in M&A before joining us. And as part of our research, we monitor just about every announced deal globally that is in excess of a billion dollars.

So our approach is there’s, I would say, five key ways that we would seek to profit in this area. One is by traditional merger arbitrage, which is capturing spreads. Earlier this year they were rather tight, but they’ve opened up quite a bit. So in deals like Time Warner-Comcast, they are trading around 9 — 8 to 10 percent. Covidien-Medtronic on the order of 14 percent. DTV-AT&T around 10 to 12 percent. So that’s attractive.

The second area where you can do well is hostile takeovers. Hostile is a different category is when an offer is made, but the outcome isn’t certain, and the target will try and fight the offer. And those situations you can lose money. They’re risky. So such as when Pfizer bid for AstraZeneca. Then they dropped the bid. If you bought AstraZeneca, you would have lost. But they also could be very profitable. Like what happened in Hillshire, when Pinnacle initially bid 45 and it turned into a bidding war with Tyson bidding 50 and Pinnacle coming back at 55 and Tyson winning the bid at 63. So in a matter of three weeks, the stock was up over 40 percent.

After hostile, another category is trying to anticipate which company can be acquired next. Over the years of arbitrage, thousands of transactions, so we see this industry going through consolidation, and sometimes it becomes apparent who the next target could be. And if you can anticipate who the target should be prior to the acquisition, that could lead to premiums of 40, 50 percent and higher if that target is subsequently acquired.

Now the last category that’s very important to us now is what you referred to, strategic acquirers. There have been many very successful acquirers where they’ve bought up companies, and they’ve grown their earnings very rapidly and the stock has appreciated tremendously.

Probably the best example of that would be Valeant, which was a small company that Mike Pearson took over as CEO about four or five years ago, and over that period, the last four years, made 35 acquisitions. Strong earnings per share by about 600 percent, and his stock is up 800 percent.

So that’s probably the poster child of a secretive acquirer. So we try and identify those acquirers that can deliver substantial value.

MELISSA LEE: So you identify that acquirer and you’re on the Allergan side of the trade. What is your intent in terms of your holdings of Allergan and how do you work out what the combined company could be worth? Because this calculation is actually very interesting, I would imagine different from the dynamics that we had probably a decade ago where managing the trade meant selling or leaving it once the deal is completed.

JOHN PAULSON: That’s correct. In many situations today you can make far more than the spread by holding onto the acquirer’s stock after the transaction is completed.

Allergan and Valeant is a very interesting and perhaps controversial situation. This is a hostile bid where Valeant has made, I think, three offers now, cash and stock offers to buy Allergan. The stock is trading somewhere around 40 percent higher than a trade before the bid was announced.

Now as I mentioned, Valeant is a very serious acquirer, has been very successful, very well-managed, and they take a different approach to managing pharmaceutical companies than your traditional pharma. So the CEO, Mike Pearson, is very cost-conscious, and so generally when he acquires a company, he’ll eliminate costs that he doesn’t feel are necessary or are duplicative with an existing operation.

So if he is successful in acquiring Allergan, he will reduce costs to a point that it could be 25 percent accretive to Valeant’s earnings per share. And then since this is a stock and cash offer, if Valeant’s stock would arise by as much as the accretion to Valeant’s earnings, then Allergan could be worth as much as 2.20 per share.

So instead of making the $6 spread which is the value of the offer today compared to Allergan’s stock price, if Valeant was successful and was able to achieve these cost synergies, instead of getting 1.72 per share, you can get as much as 2.22 per share.

MELISSA LEE: 2.22, you said?

JOHN PAULSON: Well, that would be the price of Allergan if Valeant’s stock appreciated by as much as the accretion in and Valeant’s earnings per share and you took stock as part of the consideration for Valeant.

MELISSA LEE: So you’re holding it. That’s how you manage the trade, you hold it. So you have confidence in Pearson, and that’s a key part of the decision in terms of holding on, the management of that company.

JOHN PAULSON: Well, he’s a proven success. He’s done this over and over, very successfully, and I don’t think anyone has created more value for shareholders in the recent past than Valeant has, in the pharmaceutical sector.

MELISSA LEE: Do you also have confidence in Bill Ackman? Because you built up your Allergan position after the May 31 filing. So it’s a fairly recent position.

JOHN PAULSON: That’s right. Well, this is another example of a hostile situation. So obviously Allergan had different objectives. They were a successful company in their own right and has their own culture, which would be disrupted by this transaction. So — but it’s really at this point up to the shareholders. And Ackman is the largest shareholder, and he feels a lot of value can be created for Allergan shareholders by merging with Valeant.

MELISSA LEE: Have you talked to Ackman? Do you guys talk and chat about these trades?

JOHN PAULSON: Well, he will have a call, I think, tomorrow. As part of the hostile, he will do a proxy fight to try and unseat the board in order to force the board to negotiate with Valeant. So, you know, we will talk to him about the content.

MELISSA LEE: The CEO of Allergan in recent days, the past week or so, has come out in the media talking about how he’s open and looking for a deal actively. There has been speculation that Allergan would buy Shire. Interestingly, this is where your deal activity sort of merges or converges, I should say, because you’re in AbbVie which is obviously making a bid for Shire. How do you see this playing out?

JOHN PAULSON: Well, actually, we are not in AbbVie, but we are in Shire. So we did identify Shire last year as a potential takeover target. They were a midsized, mid cap pharma company growing fairly rapidly with an Irish domicile. So that made them very attractive for several potential U.S. pharmaceutical companies.

So once Valeant made the bid for Allergan, then rumors surfaced that perhaps Allergan could be interested in acquiring Shire. And then last month it was revealed that AbbVie, which was a spinoff from Abbott, so about 90 billion market cap pharma company, had made three bids in June for Shire that were rejected by Shire. But subsequently this month they made a fourth and fifth bid that they’re in negotiations to acquire Shire.

So that ultimate price, believe it or not, is about a 90 percent premium to where Shire traded prior — immediately prior to Valeant made its original recent bid for Allergan.

Now in the Allergan case, it’s an issue that, if possible, they could succeed or defeat the Valeant bid. But standing alone is not the way they can do that. They have to do something else to create comparable or greater value than Valeant is offering.

So one thing they can do is an acquisition of someone else. What is interesting, last year Valeant had made a bid for Actavis.

MELISSA LEE: Which you also hold?

JOHN PAULSON: We hold it now. We didn’t at the time. But they bid $100 a share and then I think bumped it to 110 a share. Actavis didn’t want to sell, and instead of selling, they bought Warner Chilcott. And they achieved so many synergies as part of that transaction that their stock now trades for $210 a share. So they were able to increase the stock market value 100 percent more than Valeant offered last year by going out and doing a strategic accretive transaction itself.

So that sort of creates a path. One way that Allergan could repel the Valeant bid is by creating more shareholder value through a transaction.

MELISSA LEE: So basically in Allergan, the way you look at the trade is — I don’t want to say there’s no downside, but there’s upside in that if they’re bought by Valeant and there was a premium, they’re worth 222 a share, roughly. If they’re not and they enter another deal, they’ll create shareholder value through another acquisition in which they will be the acquirer.

JOHN PAULSON: And thirdly, they can do some of the cost rationalization that Valeant is proposing themselves. So if they can reduce their R&D budget and reduce their SG&A, they can grow earnings faster than what the street anticipates and perhaps deliver comparable value by doing some of the actions that Valeant was going to do, by themselves.

MELISSA LEE: So the three scenarios in which you make money on Allergan, in the last scenario, which is do nothing —

JOHN PAULSON: Now, in a hostile, it’s always risky that the bidder drops the bid and the stock falls. So in the case of Pfizer’s bid for AstraZeneca, they made the bid, AstraZeneca went up, and then they dropped the bid. So Pfizer was not willing to do a proxy fight. And they were not willing to take the offer directly to AstraZeneca shareholders. So it was kind of, from a hostile perspective, a rather weak bid.

Valeant’s bid is different. Number one, they are taking the offer directly to shareholders, so shareholders have a chance to choose, and two, they have a very aggressive shareholder in Bill Ackman who is willing, if the board refuses to negotiate, to start a proxy fight to unseat the board.

So at that point standing still does not seem an option. So I would say the high probability is three ways: One, Allergan — Valeant defeats; two, Allergan buys someone; or, three, they do some internal restructuring that creates additional value.

MELISSA LEE: So in terms of scenario number 2, in which Allergan would be the acquirer, can you see Allergan making a viable bid for Shire considering that AbbVie and Shire have basically until Friday to respond under UK law?

JOHN PAULSON: Well, I know as much as anyone does from the public information. But it seems right now —

MELISSA LEE: You’re just an ordinary member of the public, John.

JOHN PAULSON: It seems right now AbbVie and Shire are getting close to a deal. So If Allergan may have had an opportunity to participate, they don’t seem to be participating this particular transaction.

MELISSA LEE: Even though Shire-AbbVie, that’s purely — it looks at least — and I think the CEOs would acknowledge, it’s purely based on inversion because the overlap in their portfolio is virtually nil.

JOHN PAULSON: Well, there’s a couple of strategic reasons for the transaction. So one is the tax inversion issue. Two, there is some overlap in certain key areas. But three, I think the most important issue is that AbbVie is doing extraordinarily well, but a lot of their success is based on one product, which happens to be Humira, which is the most successful or largest pharmaceutical product out there which is growing rapidly. Because of their overreliance on that product, the company trades at I would say a below-market multiple. So by acquiring Shire and broadening the base, it’s likely that the combined company will trade at a higher multiple than AbbVie traded at before because of the benefits of diversification of the broader growth platform that they could add more value than they could achieve by themselves.

So I would say there’s three reasons why AbbVie is so intent on doing this transaction.

MELISSA LEE: That’s the deal you would like to see happen. When you see the four players, Valeant, Allergan, Shire, and AbbVie, you see the combinations that are basically lowering the prices in the market, AbbVie-Shire, and then Valeant-Allergan. That’s the way you see it play out?

JOHN PAULSON: I think in this case AbbVie is likely to succeed with Shire. We will know by Friday because that’s what they call the put up or shut up phase.

MELISSA LEE: How do you manage that trade? Do you hold on through the integration?

JOHN PAULSON: That’s interesting. We will have to see how accretive this transaction is to AbbVie. I think based on the numbers we’ve seen it will be accretive to AbbVie’s earnings per share. So their earnings per share will go up. If they also get multiple expansion, then AbbVie’s stock can rise after the transaction, and if you hold onto your Shire stock you can get an additional premium.

MELISSA LEE: So that’s sort of an unknown as of now in terms of whether or not you hold on. Whereas in Allergan’s case, you are intent on holding because you can see the value post deal?

JOHN PAULSON: That’s right.

MELISSA LEE: I will talk about another area where you see a lot of energy brewing. And that is energy. And there was a headline Monday morning, Whiting Petroleum-Kodiak Oil & Gas. You’re on both sides of those trades on paper. You made roughly $360 million.


MELISSA LEE: Was this a case where you saw two players that were ripe for a deal either as targets or acquirers?

JOHN PAULSON: Yes, that’s correct. What’s going on in the oil sector in the U.S. is just amazing. The U.S. is leading in the oil extraction technology that no other country in the world comes anywhere close. So as a country we have vast reserves in shale, but it’s attached to rock. And until recently they didn’t have the technology to separate and extract the oil from the shale economically. But really in the last five years they’ve perfected that by both horizontal drilling and fracking, that they can now extract this oil very economically.

And one of the most prolific areas where they’re accomplishing this is called the Bakken fields in North Dakota. North Dakota has now grown to be the second-largest producing state in the country after Texas. So within the Bakken you have five majors, including Exxon, Statoil, Hess. And you have three leading independents. And those three leading independents are Whiting, Oasis, and Kodiak.

Then you have the large independent called Continental that’s controlled by a large shareholder.

So each of these three companies were growing very rapidly. The growing production between — last quarter between 25 and 50 percent year-over-year in an environment when the majors have declining production.

MELISSA LEE: I just want to — this is a signal to the audience. You also have a position in Oasis. You get —

JOHN PAULSON: Yes. Now in addition to growing very rapidly, they have huge reserves. Between the reserves and resources they can continue producing oil at current levels for about 50 years. And they’re trading at very modest multiples of EBITDA, in some cases less than the multiples the majors are trading at.

So to us it looked like they were all potential — each of these three potential takeover targets. At the same time that they weren’t taken over, the stocks should appreciate because of their rapid growth. So we became the largest shareholder in each of these three companies. And what happened on Monday was Whiting announced an acquisition of Kodiak that’s very accretive to Whiting, and as a result, both Whiting shares and Kodiak shares have appreciated.

MELISSA LEE: Do you hold on to this — and I ask this because does this acquisition take a Whiting-Kodiak combination out of the game in terms of further acquisitions whether it’s the combined company becomes the target or the acquirer?

JOHN PAULSON: That’s a very exciting situation. One thing about the oil sector, it’s a very large sector. Before Whiting bought Kodiak, the company with the second-largest acreage in the Bakken in North Dakota was Exxon. So Exxon’s there. Statoil is there. There’s other majors around. The combined company now will have a market value of about 17 billion. But when you look around the world, Exxon has a market value of 440 billion.

So while Whiting is bigger, in a sense it becomes more attractive to other large oil companies that don’t have a presence in the U.S. And the remarkable thing about the U.S. is that there’s no restriction on private companies buying oil assets.

Along with Canada, it’s I think the only country in the world where the oil sector is private. And if you’re a major oil company and you don’t have a presence in the remarkable revolution that’s occurring here, you’re sort of left out.

So ultimately I think the combined company as well as the other independents, you know, are still attractive to other larger acquirers.

MELISSA LEE: The stock reactions were interesting to watch on Tuesday. Because Oasis fell, and what that told me, just as a market observer, was that because there was some overlap between Kodiak and Oasis in terms of the presence in the Williston Basin, that perhaps it was thought that Oasis was no longer a potential takeout target by Whiting and so was left on the side, it was down 5 percent. What happens in your view to Oasis at this point?

JOHN PAULSON: Again, these companies are outstanding companies. They’re run by entrepreneurs. They’re innovators in the energy sector. Oasis is growing rapidly. It’s very attractive acreage. So I think the upside either as an independent or a target are very good for now the combined Whiting and Kodiak as well as Oasis.

MELISSA LEE: Could they all combine? I mean Whiting, Kodiak, and Oasis?

JOHN PAULSON: Many possibilities.

MELISSA LEE: Let’s say in a year, do you think the combined company, Whiting, Kodiak, and Oasis, do you think they remain the same in a year or do they have different —

JOHN PAULSON: They’re too attractive. They are too attractive to sit there at the current valuation. They are independent, they are in the U.S., they are growing very rapidly, they have enormous reserves, and the cost of harvesting the reserves continues to decline every year. So it should — it’s not likely they will remain — they may remain as independents for a long period of time.

MELISSA LEE: They may remain.

JOHN PAULSON: It’s not likely they will remain independent for a long period of time.

MELISSA LEE: Okay. Let’s switch gears and talk about a deal we saw this morning. Because you’re also very interested in media. We all open our papers, including yourself, this morning to a 20th Century Fox bid for Time Warner, massive bid, $80 billion, which has already been rebuffed.

So how do you take a look at that deal, what is your thought process in determining whether or not that is a deal you should be participating in?

JOHN PAULSON: Good question. That’s exactly what we had to focus on this morning. So the key issue in a hostile is what are the probabilities that the transaction will be completed either with the bidder or another acquirer? And then how high could the bidding ultimately go for this particular asset.

In this case, you know, one way to estimate that is to look at the size of the acquirer relative to the target. So generally the bigger the target relative to — the bigger the acquirer to the target, the greater the ability for the acquirer to pay a high price.

In this case, they are about the same size. So there’s a limit to how much Fox could ultimately pay for Time Warner. So we’re not going to see a very rapid type of bidding we saw in Shire, where the premium ultimately was 90 percent above the unaffected price, or in Hillshire we had two very large bidders bidding for small asset that was both very strategic to them, where the ultimate price was also around 80 to 90 percent higher than where Hillshire traded initially.

When you’re the same size, there’s a limit to how much cash you can pay, and there’s also a limit to how much stock you can provide before it becomes diluted to the acquirer’s stock and the stock goes down.

The second thing we look at are there other bidders that can potentially surface. At this size range, there’s not a lot of other potential acquirers.

Third, you have to look at are there any antitrust issues. So we already did a preliminary analysis of that, and surprisingly, given the size, there doesn’t appear to be any major antitrust issues. I think Murdoch identified the asset that would be most troubling, which would be CNN, which he agreed to sell up front.

So the question is does Murdoch come back with another bid and could he ultimately persuade the Time Warner board to sell? And how high can he ultimately go? So these are all the issues that we have to look at.

MELISSA LEE: It sounds like you’re still looking at it.

JOHN PAULSON: We’re looking at it. We still have interest.

MELISSA LEE: Why would it be of interest? And what side of the deal would be most interesting?

JOHN PAULSON: The issue is if you buy Time Warner stock today at 83, is Murdoch coming back and how high could he pay for Time Warner and still make sense for shareholders? And then if he doesn’t come back, the stock is up $12, could it into potentially fall?

So I would say it’s a large deal, it’s exciting, but because of the dynamics, it’s not a slam dunk as to what the outcome could be.

I should stress any hostile deal is going to be risky. So in the case of, again, going back to the AstraZeneca-Pfizer. If you bought the AstraZeneca stuff after Pfizer made the bid, it would have been a losing transaction. They ultimately did not make a hostile tender and did not make a proxy, and the board was able to just say no, and Pfizer went away.

So you have to always approach it from a portfolio perspective, with the understanding that you could be right, but you could also be wrong.

MELISSA LEE: Well, at this point, John, do you think you would be more right or more wrong? What is the bottom line here? You’re still looking at this, and so this could potentially be of interest to you? Or does it look so unlikely or the risk/reward —

JOHN PAULSON: Let me say, the shareholder perspective, it looks like it could continue, but it’s not all that exciting. It’s not going to be like a Hillshire, where the ultimate bidding could be 40 percent higher than where the first bidder came in and 80 percent above the transaction price.

You have got an evenly priced, evenly matched acquiring target, limited flexibility how high the acquirer can go, and a very recalcitrant board in Time Warner, that they don’t appear to want to sell. And the difficulty in Fox in ultimately making a hostile offer directly to Time Warner shareholders.

So from a share shoulder perspective, getting involved at this point, it could work out take, but it’s not all that exciting.

MELISSA LEE: In our chat last week you indicated that for media deals specifically it’s not as attractive, the accretion isn’t necessarily there after the deal, so these are more opportunistic participations on your part.

JOHN PAULSON: There is some accretion. I think they identified about a billion in accretion as a result of the merger. But the higher the value goes, the less the accretion for Fox earnings per share. So it won’t have the same type of impact as Valeant’s did or Allergan has or that AbbVie’s for Shire has, or some of the other deals that we’re involved in.

MELISSA LEE: We’re just about out of time, unfortunately. But I did want to circle back to some advice that you gave last year here at Delivering Alpha. That was to the average retail investor. You essentially said the best investment one could make is to buy a primary residence. Do you still stand by that? And how about all those institutions that bought single-family homes and are renting them?

JOHN PAULSON: I still think, from an individual perspective, the best deal investment you can make is to buy a primary residence that you’re the owner-occupier of. Today financing costs are extraordinarily low. You can get a 30-year mortgage somewhere around 4 and a half percent. And if you put down, let’s say, 10 percent and the house is up 5 percent, which is the latest data, then you would be up 50 percent on your investment. And you’ve locked in the cost over the next 30 years. And today the cost of owning is somewhat less than the cost of renting. And if you rent, the rent goes up every year. But if you buy a 30-year mortgage, the cost is fixed.

So I think it, you know, is still a very attractive investment.

MELISSA LEE: If you are the owner-occupier.

JOHN PAULSON: An owner-occupier.

MELISSA LEE: As a secondary, to rent, that’s not a good idea.

JOHN PAULSON: Yes, to buy it as an investment and rent it out, I’m not so enamored with that concept.

MELISSA LEE: John, thank you so much for joining us. We really appreciate it. Ladies and gentlemen, John Paulson.

This transcript was published with permission from CNBC.

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