Allergan’s (AGN) odd patent transfer to the St. Regis Mohawk Tribe is gaining a lot of scrutiny. It sued rivals from offering generic Restasis, its blockbuster dry eye treatment. Now the judge in he case, Judge William Bryson, has asked for details of the patent transfer meant as an IPR defense. According to Allergan it sold the Restasis patents in exchange for a promise of immunity from the Mohawks:

The Saint Regis Mohawk Tribe agreed to assert immunity during patent challenges and extend that immunity to Allergan Inc. in exchange for Allergan giving it ownership of patents protecting the dry eye treatment Restasis, the drugmaker said Tuesday after a federal judge in Texas told it to prove the deal wasn’t a “sham.”

The tribe agreed not to waive its sovereign immunity when facing challenges at the U.S. Patent and Trademark Office, including inter partes reviews, or during other administrative proceedings trying to invalidate the drug’s patents, Allergan said. Additionally, the tribe agreed to give Allergan a limited field of use exclusive license, and then continue to assert its immunity in any related PTO proceeding.

By my calculation the Restasis patents are worth over $14 billion. Restasis had Q2 revenue of $354 million at an estimated EBITDA margin of 68% or $241 million. That equates to annualized revenue and EBITDA of $1.4 billion and $963 million, respectively. With an enterprise value of $96 billion AGN currently trades at 15x EBITDA, so that would make Restasis worth about $14 billion. Allergan is paying the Mohawks [i] $13.75 million up front and [ii] $15 million in annual royalties for the benefit of their immunity. In effect, the Mohawks received $14 billion in value and annual royalties payments to take Restasis off Allergan’s hands.

Judge Bryson has to make his own determination of the true value of the Restasis patents. He then has to determine if the Mohawks' sovereign immunity is a fair exchange for Restasis patents which currently generate over $1.4 billion in annual revenue.

Why Parsing The Patent Transfer Is Important

The judge wants to know if the sale was a “sham.” Allergan alerted Judge Bryson that the Mohawks would be co-plaintiffs in the federal patent case, yet never filed a motion. Allergan needs to show the judge and the defendants – Teva (TEVA) and Mylan (MYL) – why the Mohawks should be added as co-plaintiffs. It will not impact the federal case but it could impact the IPR brought on by Mylan. If the judge determines the transfer was a sham then the IPR – where the Mohawks are claiming sovereign immunity – could potentially deem the same thing. AGN could sell off if investors believe the IPR will have a slim chance of winning without sovereign immunity.

The federal case will be decided by the end of the month. Allergan is now claiming the Mohawks own the Restasis patents, so a loss in federal court and/or an impaired claim of immunity could both hurt Allergan. Restasis is of the utmost importance to the company. It represents 9% of revenue and 15% of income. The company reported 8% Y/Y revenue growth in Q2, yet its organic growth was around 1%. Generic competition could drive down the price of Restasis; a loss of market share could amplify the loss of pricing power. Stagnant organic growth and the presence of generic rivals could also make it difficult for Allergan to service its $30 billion debt load, which is now at over 4x run-rate EBITDA.

AGN is down about 13% since the Mohawk deal was announced early last month. If the company loses its attempt to beat back generic competition or if investors believe its case is weakened, the stock could fall further. Over the next handful of days all eyes could be on the state of Texas where the federal patent trial is taking place. The fate of Restasis and AGN could hang in the balance.