- Recently the market has been quite optimistic about merger synergy promises.
- History suggests investors should be diligent about analyzing acquirers’ claims around merger benefits and returns.
- While attractive acquisitions may lie ahead, it is critical to continue to carefully evaluate acquirers’ strategies and claims.
Harlan Sonderling, CFA, Senior Healthcare Analyst | March 31, 2014
The “old” healthcare M&A
In the “old days,” pharmaceutical Company A would announce its acquisition of Company B for stock, cash and stock, or cash only. Company A would forecast that the deal is “dilutive to earnings in year one, neutral in year two, and accretive in year three.” Investors recognized that the expected benefits of the acquisition accrued more to the selling shareholders than to the acquirer’s. More often than not, Company A’s stock price would decline on the day of the announcement, and Company B’s would rise as Company A diverted from dividend growth, debt reduction and using its cash to invest in organic growth. Investors assumed, until proven otherwise, that acquisitions were value destructive, at best a means of manufacturing earnings to manage through a period of poor research productivity or patent expiry. Skepticism greeted Company A’s claim that its deals were a meaningful strategic and financial advance, that is, a timely purchase of undervalued innovation (the research pipeline) or an underperforming company ripe for repair. The market viewed merger integration as difficult, risky, and costly, a means of using restructuring charges to boost operating income. Company A did not refer to its return on invested capital forecast or financial metrics other than earnings accretion, and there was little expectation that it would disclose earnings dilution and accretion as the years passed. The consolidated tax rate was assumed to be in proportion to the earnings of each company and dependent almost entirely on the geographic mix of operating income.
The “new” healthcare M&A
Fast forward to the “new era” acquisition playbook. Consider Company A:
- Specialty pharmaceutical company selling a range of products with limited market demand to patients of specialist doctors rather than general practitioners, or
- Generics company selling mostly cheap (less expensive) copies of branded medicines whose patents have expired, or
- Company that manufactures and sells some combination of branded and generic pharmaceuticals.
Company A announces its cash or cash and stock acquisition of Company B, another specialty or generics company, maybe one incorporated in a low-tax jurisdiction. Company A pays a premium, as acquirers almost always do, but eschews a bidding war in favor of a “negotiated transaction.” It announces large and immediately accretive merger synergies from reducing operating costs and uses low interest rate financing. Company A implies that it will “underpromise and overdeliver” on operating cost synergies. Some companies promise “revenue synergies” from their “global marketing reach and operating infrastructure.” All acknowledge that operating efficiency and financial leverage will compensate for the inevitable decline in pharmaceutical research and development (R&D) productivity as firm size grows (money looking for ideas rather than ideas looking for money). Company A announces a lower combined income tax rate resulting from either Company A’s or Company B’s re-incorporation in a low-tax jurisdiction not subject to Uncle Sam’s tax reach, seemingly without concern for the geographic mix of either revenue or operating costs. Concurrently, Company A acknowledges that it will shift as much as it can of its R&D spending and ensuing intellectual property to that jurisdiction. As in the old days, Company A scarcely mentions return on invested capital or financial metrics other than cash earnings accretion.
The market hails the acquisition as a brilliant strategic and financial move, and the shares of both Companies A and B rise, often sharply, to reflect both promised earnings accretion and a higher earnings multiple. The market expects that more accretive acquisitions will be layered on in a rapid “pay it down and do it again” strategy. In fact, some well-liked acquirers’ stock prices have risen simply at the companies’ statements of intent to acquire and restructure another unnamed but inefficient public or private, domestic or international, company or to acquire a company only for the tax benefits.
The term “synergies” seems to be used more often than at any time since the conglomerate craze of the 1960s. The synergies of that era, however, were promised from acquisitions across industry sectors; the deals were supported by the pooling of interests accounting method, which GAAP no longer permits. Today’s acquisition synergies are derived exclusively from within the healthcare industry subsector in which the acquirer operates. We know that the initial 1960s acquisition boom, as well as subsequent acquisition-driven booms, ended when (1) debt costs rose, (2) deal assumptions proved excessively optimistic, and (3) the stock market corrected and the high fliers fell hardest. Today, all of these remain possible, as is the risk that Congress will reduce the corporate tax rate to levels comparable to those of the countries in which many of the new specialty pharmaceutical conglomerates are domiciled, thus ruining the benefits of low foreign tax rates and the promise of future tax inversions.
Specialty pharmaceutical/generics stocks have done remarkably well over the past several years, particularly over the past 12 months, as the companies’ rapid inorganic (acquisition-derived), debt-fueled revenue and earnings growth has been prized. Similar acquisition sprees are ongoing in other healthcare subsectors such as managed care and pharmaceutical distribution, though none with the tax inversion strategies prominent in specialty and generic pharmaceuticals. Nothing above is boasting of our recent investment success in deal-driven specialty and generic pharmaceuticals (or other healthcare subsector) investments, nor to bemoan our lost opportunities in successes others have enjoyed. We do not suggest acquisitive companies and their stocks face imminent disaster if today’s optimal conditions change. Our point is simply to remind investors that nothing goes in one direction, “this time it’s different” promises may not prove correct, today’s stock winners can pause or decline if the “value-creating” acquisition narcotic wears off, and none of the most productive R&D companies have been built by acquisition.