Reckitt Benckiser Group Plc is asking investors to make a big leap of faith with its potential $16.7 billion purchase of Mead Johnson Nutrition Co.
Rakesh Kapoor, Reckitt's chief executive, has made no secret of his desire to do a deal, telling Bloomberg News in late 2015 that he could be interested in Pfizer Inc.'s consumer health business.
The trouble is, none of the consumer arms of the big pharmaceutical companies seem to be available, and even if they were valuations would be high. So, faced with slowing growth in its core business, Reckitt has looked elsewhere. Equity holders will have to rely on Kapoor's ability to deliver his cost-cutting magic in a very competitive market that's a step away from the company's normal business.
The choice of Mead Johnson is a curious one. Reckitt has been focusing on developing over-the-counter medicines, which are faster growing, higher margin and less dependent on economic cycles than cleaning products and food.
One justification for the apparent strategic drift is that going into baby formula helps Reckitt access mothers who might buy its other brands, such as Nurofen for Children. Plus, Mead Johnson bulks up Reckitt in emerging markets. The target generates 30 percent of its sales from China, where infant nutrition is expected to generate strong growth.
Meanwhile, there would be few competition concerns, given the lack of overlap.
But these benefits are offset by some strategic and financial risks. This deal takes Reckitt into a direct fight with the two giants of the market: Nestle SA and Danone SA. Reckitt won't have the natural competitive advantage it has enjoyed in its diversification into consumer health, where it can gain an edge from its knowledge of shopper habits, in a market dominated by pharmaceutical groups.
Moreover, net debt will be an estimated 3.7 times Ebitda based on consensus forecasts for the two companies' performance in 2017. That is high, but the ratio would probably fall quickly given strong cash generation, and Reckitt says it will stay investment grade.
The real snag with taking on more debt is that it would make it harder for Reckitt to do a chunky deal in consumer healthcare if an opportunity arose. Reckitt might need to issue equity to do another big acquisition, complicating the process.
The timing looks opportunistic, following a 25 percent fall in Mead Johnson's share price since July. An offer at the proposed $90 per share would be a 29 percent premium to Wednesday's close, but only a 24 percent premium to the shares' three-month average. A counter-bid can't be ruled out.
At the current terms, the deal needs to generate big cost savings to deliver an acceptable return. The cost including assumed net debt is $18 billion. Yet even in 2020, Mead Johnson is expected to make only about $1 billion of operating profit. Without synergies, the after-tax return on investment would be just 4 percent, against a 7 to 8 percent cost of capital. That suggests Reckitt sees big efficiency gains filling the gap.
Management has a strong track record here, having cut costs and grown brands folded into its portfolio through purchases including Durex condoms and Scholl footcare products. But Mead Johnson already has high margins, potentially limiting the scope for synergies.
Investors are betting that Kapoor will be able repeat the trick nonetheless -- the shares rose as much as 5.3 percent. Now he needs to justify their optimism.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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