Will Bayer's Takeover of Monsanto Be a Bust?
A successful corporate acquisition should increase cost savings, boost profits,
and expand markets. Unfortunately, too many do just the opposite.
By Ben Levisohn
Sept. 17, 2016 2:27 a.m. ET
Like an Olympian attempting a perfect dive, a corporate acquisition should make as little splash as possible. Too often, though, companies act like a bunch of kids playing cannonball at the pool.
Deal making has slowed this year--some $2.4 trillion worth of mergers has been announced globally, off last year's $3.1 trillion at the same time in 2015--but it has hardly disappeared. Last week, Bayer (ticker: BAYN.Germany) announced it would purchase Monsanto (MON), and Allergan (AGN) agreed to buy Vitae Pharmaceuticals (VTAE).
While the deals all come with promises of faster growth and "synergies"--Wall Street-speak for the lower costs and bigger profits that should emerge following a deal--history shows that most acquisitions fail to live up to the hype.
Look, we get it. The sluggish global economy has made mergers and acquisitions an attractive way to boost profits. Unfortunately, most deals do no such thing. In a recent study, S&P Global Market Intelligence's Richard Tortoriello found that companies that made large acquisitions--defined as 5% or more of enterprise value--have seen their profit margins, earnings growth, and returns on capital suffer relative to competitors. "If synergies are the main justification of M&A, the data throw into question whether synergies are actually realized," Tortoriello says. Indeed, companies in the Russell 3000 index that have made large acquisitions from January 2001 through April 2016 returned less than half of that benchmark's returns during that period.
Not all deals go bad, but there are several warning signs to be wary of. Tortoriello found that companies making particularly large deals have underperformed their competitors by 9.3% over a three-year period, while companies using stock, as opposed to cash, to fund their acquisitions have also trailed. Fast-growing companies , as measured by asset growth, have also underperformed after making a purchase, as have companies that increased their share count. Strangely, companies with large cash hoards also have underperformed by 10%. "If you're awash in cash, you might not be as disciplined on price or selection as you might be otherwise," Tortoriello says.
Those signs should make Bayer investors wary. Yes, the German chemical giant is paying cash for Monsanto, but it will be issuing stock and convertible bonds to help cover the cost. The deal is enormous: The $66 billion takeover price is more than 60% of Bayer's $105.3 billion enterprise value. And what of the promised financial gains? Bernstein analyst Jeremy Redenius notes that the potential deal (it's still unclear whether regulators will let it happen) should add 7% to Bayer's earnings through 2021. But the return on invested capital generated by the deal is likely to be lower than Bayer's cost of capital--the cost of financing its assets--despite its claims to the contrary. "Given the low cost of debt, this is not a value-destroying deal," says Redenius. "But it's not a value-maximizing deal, either." He would have preferred that Bayer make smaller acquisitions to boost its pharmaceutical business.
Allergan's purchase of Vitae might have a better chance of success. Allergan is paying just $639 million in the all-cash deal for the small biotech company, and it has the potential to add two skin-care treatments--one for psoriasis, the other for eczema--to its portfolio of such products if continuing drug trials go well. Citigroup analyst Liav Abraham called Allergan's acquisition "a solid strategic fit."
But sometimes it's the deals that aren't done that should get the attention. Gilead Sciences (GILD) has been under pressure to do something, anything, ever since sales of its blockbuster hepatitis C drugs started slowing, thanks in part to competition from the likes of Merck (MRK) and AbbVie (ABBV). Gilead has oodles of cash on its balance sheet--some $24.6 billion as of June 30--and investors are all but begging it to engage in "transformative" M&A.
So far, at least, Gilead has pushed back against those calling for a big deal. The biotech giant was said to be in the running for Medivation (MDVN) before Pfizer (PFE) won the bidding with a $14 billion bid. And speaking at industry conferences the past two weeks, management emphasized that it's looking to make small acquisitions, with the company particularly willing to take a risk on a poly ADP ribose polymerase, or PARP, inhibitor, a potentially effective treatment for certain kinds of cancer.
That's exactly what Gilead should be doing, says Hilarey Bhatt, chief investment officer at Bhatt Innovation Capital, a Mill Valley, Calif.-based hedge fund. She notes that Gilead has been successful in the past making small deals that turned into big successes, and sees no reason to believe that this time will be different. "It's smart for them to spend time looking for the right acquisition," Bhatt says. "People should be patient."
Just don't expect a big splash.