Since Life confirmed that it has hired Deutsche Bank and Moelis & Co., several potential suitors have emerged, including a few private equity firms, as well as Thermo Fisher Scientific (TMO). It's this potential bid from Thermo that I'll explore first.
Thermo Fisher: Cementing Its Market Lead?
In late January, Reuters reported that Thermo Fisher, the largest life science company in the world, is considering a bid for Life, which would be the company’s biggest deal since the $12.8 billion merger of Thermo Electron and Fisher Scientific in 2006. And given that Life already has a market capitalization approaching $11 billion, the premium needed to take control of the company may push the total cost to over $12.8 billion. On the surface, such a deal makes sense. Thermo Fisher and Life Technologies sell their products to many of the same customers, which creates opportunities for cost and revenue synergies. For example, Credit Suisse believes that Thermo Fisher could see a 10-11% increase in EPS, even before accounting for what the firm believes will be $400 million in cost savings. However, such a deal will come with several complications. The biggest obstacles are financial.
The life sciences sector is one that naturally lends itself to M&A, give that many companies in the sector sell to the same customers, which leads to a high level of potential synergies in a merger and/or takeover. However, years of deal making have weakened balance sheets across the sector, with goodwill and debt accumulating in many cases. Thermo Fisher has $12.4745 billion in goodwill on its balance sheet, which represents 45.59% of the company’s total assets. In addition, Thermo Fisher ended Q4 2012 with $6.269 billion in net debt. The company’s aggressive capital deployment strategies have served investors well, with shares of Thermo Fisher up over 34% over the past year. But constant M&A, buybacks, and dividends have weakened Thermo Fisher’s credit ratings. In July 2012, all 3 ratings agencies downgraded Thermo Fisher on the back of its $925 million takeover of One Lambda, which was announced alongside a new buyback program. S&P rates the company as A-, 4 steps above junk; Moody’s rates it as Baa1, 3 steps above junk; and Fitch rates the company BBB+, 3 steps above junk. With only $855.3 million in cash, Thermo Fisher will need to either issue stock or debt to fund a deal for Life Technologies, something that may not sit well with the company’s investors or bondholders.
Sources close to Thermo Fisher have indicated that the company is uninterested in Life’s sequencing business, which is the source of much of Life’s future expected growth. Given that Life’s board of directors and investors may hold out for over $70 per share, Thermo Fisher’s investors may not approve of a deal over $10 billion for a company with a lower growth profile than that of Thermo Fisher when the sequencing business is excluded (that being said, a divestiture of the sequencing business could help defray some of the cost needed to take control of Life). Bondholders of Thermo Fisher may also voice objections. In addition to the increased leverage that Thermo Fisher will likely need to acquire Life, there is also Life’s own balance sheet to contend with. The company currently holds $276.369 million in cash & investments, versus debt of $2.414069 billion. In addition, based on the company’s Q3 2012 10Q (a full balance sheet for Q4 2012 has not yet been released), 51.93% of Life Technologies’ assets are in the form of goodwill. Should Thermo Fisher take control of Life, goodwill will be piled on top of goodwill, and the company will likely add billions of debt to its balance sheet, further weakening its credit profile. And while Thermo Fisher would also gain control of Life Technologies’ solid cash flows, it's likely that any incremental increase in cash flow will be used to pay down debt as opposed to increasing the dividend or buying back stock. Thermo Fisher’s management team may have to work hard to convince their investors of the rationale behind a deal for Life Technologies, something that could very well cause the company to walk away from the negotiating table. While other potential suitors have been named, such as GE (GE) and Danaher (DHR), Thermo Fisher has emerged as the most likely acquirer, and analysts are skeptical that either GE or Danaher will be tempted to make a bid for Life.
Private Equity: Can A Deal be Done?
Reuters has reported that multiple private equity firms, including KKR, Blackstone, Bain Capital, and TPG are weighing bids for Life Technologies. A private equity of Life Technologies would represent the largest healthcare leveraged buyout since the end of the financial crisis, with Credit Suisse estimating that at least $7 billion of equity would be needed to take control of the company. A leveraged buyout of Life Technologies is further complicated by price. Rumors of a deal have sent shares of Life to their highest levels since the creation of the company. However, given the leverage that will be added to Life’s balance sheet, as well as the leverage already on it, it's likely that private equity firms cannot afford to pay as much as a strategic buyer. Jefferies, for example, has said that a leveraged buyout can occur at a price of between $50-$60 per share, which is already below the company’s current share price. JPMorgan has said that a buyout could occur at between $65-$75 per share; the midpoint of this range implies a premium of 11.34% to current prices. However, it's unclear if $70 per share would be enough to sway Life’s investors. Since the beginning of 2010, and until buyout rumors surfaced, shares of Life had been mostly range-bound, and its investors may want to see a more substantial premium, one that a private equity firm (or consortium of firms) is unable to provide. However, a divestiture of the company’s sequencing business could make a transaction more likely. Private equity buyers are primarily interested in the high degree of recurring revenue at Life, and the cash flows that it provides, not the company’s future growth potential. Given the interest in genetic sequencing, it may be easier to find a buyer for this business if it is offered without the rest of Life.
Almost $44 Million Reasons for a Deal
Investors often forget that merger and deal negotiations fall apart not because of price, leverage, or other financial factors, but because of the people involved. Perhaps there are conflicts over who will run the combined company, or the executive teams simply don't get along. Conversely, mergers often happen because there are incentives for executives to strike a deal. Perhaps they need to find a successor for themselves, wish to move on to a new venture, or are facing pressure from activist investors. A third possibility? the prospect of millions in payments for completing a deal.
Life’s most current proxy statement discloses that CEO Greg Lucier stands to earn $43,794,422 in severance payments if he is terminated following a change of control. And even if he is terminated with cause following a change of control, he still stands to earn over $12 million in severance, which gives him incentive not to oppose a deal. While the company’s board of directors will make the final decision on any sale, they'll seek input from Greg Lucier, who is also the board’s chairman. And given the millions he stands to earn from termination following a change of control, it's likely that he will, at a minimum, not oppose a deal. It should be noted that this provision favors a strategic acquirer. Private equity firms are likely to leave Lucier in the corner office. However, a strategic buyer, such as Thermo Fisher, is far less likely to leave Lucier in charge. And given that Mark Casper, Thermo Fisher’s own CEO, is 43, there's no reason for him to do this deal to bring in a successor, especially given the fact that Greg Lucier is 47. Lucier will likely be terminated if Thermo Fisher takes control of Life (at most, Lucier could move to a new division at Thermo Fisher that would house Life). Lucier’s compensation package isn't going to be the key factor that leads to a takeover, but it's a facet worth noting, as it gives the CEO a solid reason to support a deal.
Life’s Standalone Prospects
The question that investors need to ponder at this point in time is whether or not it is wise to buy shares of Life Technologies at these levels. I believe that Life’s standalone prospects are good in the long-term, not because of its sequencing business, but rather because of its valuation.
There is a reason that Illumina has been able to not only retain, but expand its lead in sequencing. It is focused solely on sequencing (and ancillary genetics businesses), whereas Life focuses on a far wider variety of markets. Combined with a lack of meaningful research & development spending, it's unsurprising to see that Illumina leads the sequencing market. In 2012, Illumina spent 20.12% of its revenues on research & development, while Life spent just 9%. And that 9% was split amongst many more divisions and product lines. Life’s saving grace lies in its valuation. At current prices, Life trades at 15.94x trailing 12-month earnings, versus 31.3x for Illumina (not to say that Illumina is overpriced; its growth prospects and industry-leading margins and balance sheet warrant a premium valuation). The table below breaks down Life’s consensus forecasts and its forward valuation (P/E multiples are based on Life’s closing price of $63.44 as of February 13).
Life Technologies Earnings Forecasts
% Change from Prior Year
While Life may not be growing at the same rate as Illumina, its multiples are less than half of those of its primary competitor, and the company has been steadily buying back stock, with its diluted share count falling by 3.36% over the course of 2012. Life’s strategic review may result in something to boost shareholder value, even if it does not result in a sale. CEO Greg Lucier has stated that all options are on the table. It's possible that Life will initiate a dividend or buy back stock in a more aggressive fashion. That, combined with the inherent stability of Life’s recurring revenues (a key reason private equity firms may be considering the company) and cash flows, as well as its forecasted growth as a standalone company, are not a bad combination for investors to be exposed to.