is it a bargain deal for sun pharma

Expensive stock acquires (cheap?) stock
Sun Pharma has agreed to acquire 100% of Ranbaxy in a multi-billion dollar deal. The transaction will result in a combined entity which will play a dominant role in the specialty generics segment.

Whenever an acquisition takes place it is justified with a number of arguments in its favor; the most common are: strategic advantage, control, and synergy.

Let's still ask the question: Is this deal good for the shareholders of both Sun Pharma and Ranbaxy? If it is not, obviously the deal is superfluous, waste of resources, at least for one firm.

First, this will be an all-stock transaction; which means there will not be any direct and immediate impact on cash. When an acquisition is done through stock it is important to know whether stocks of both the acquirer and target are expensive or cheap compared to the quoted market prices. Without this understanding we cannot conclude whether the deal is value accretive.

Just before the announcement Ranbaxy was quoting at Rs.459.55.

And Sun Pharma was quoting at Rs.571.80.

In accordance with the deal, Ranbaxy shareholders will receive 0.80 share of Sun Pharma for each share of Ranbaxy. Based on the stock price of each firm the transaction (exchange ratio) appears to be at the current market prices. 

We can see that both stocks have popped up in the subsequent days; Ranbaxy quoting at Rs.468.40 on 11 April, and Sun Pharma at Rs.627.20. Sun Pharma has shown more optimism to this deal though as the stock has rallied about 9.60% in four days. The market must be considering that the deal is a bargain for Sun Pharma. Is it so?

The past performance
Let's start with the market value of the firms before the deal. 

This is how the firms have performed:

Past 6 months:

One year:

Two years:

Five years:

Struggling Ranbaxy
Now let's move to Ranbaxy. I am not sure whether it has actually returned 147% in the last five years; in 2008 and 2009, the market value of its equity was higher. Even in December 2004 Ranbaxy's market value of equity was Rs.236 b; now it is pretty much the same, in fact a bit lower at Rs.196 b.

This is how it has moved over the years.

Let's not do any compounding; we know that it is not so good.

The 2004 annual report had the following forecast:

Its 2012 revenues were a little more than $2 b, and for 2013 a little less than $2 b.

Assumptions drive analysis
Ranbaxy's 2013 annual report is not yet released. That's some problem, but not much. With Rs.108 b of revenues and Rs.4.4 b of operating income in 2013, the pretax operating margin is only 4.10%; it was about 12% in 2012. This compares pretty low with Sun Pharma's operating margin of about 42%. Similarly, return on capital of Ranbaxy is about 8% compared to 45% of Sun Pharma.

It is only fair to consider that the current fundamentals of the firms would drive their growth for the next five years. After that it is expected that Ranbaxy would move towards better margins and return on capital, and both Ranbaxy and Sun Pharma would become stable growth firms.

With these assumptions, the gap between market values of equity of Ranbaxy and Sun Pharma which is currently about 6.52x should come down only slightly but not significantly if these are independently valued. This is simply because in the next five years Ranbaxy should grow at much lower rate and Sun Pharma at much higher, and thus already building a base effect.

Since these firms are going to merge going forward, the benefits of synergy, if any, can add value to the combined firm. Obviously, the value of Synergy will depend upon the assumptions related to the benefits of synergy. Sun Pharma might have made assumptions such that synergy benefits accruing to the combined firm would make the acquisition justifiable.

With a generous dose of synergy benefits translating into better margins and return on capital, the deal appears to be indeed a bargain for Sun Pharma. If synergy benefits were lower or not to be there, obviously the bargain should reduce.

The bargain lies in the future
In the final analysis it all depends upon how Ranbaxy shapes up in the coming years; better operating margins and return on capital, combined with adequate reinvestment, including in research and development, should increase the value of the combined firm. Will this happen? Sun Pharma would expect so.

Can Ranbaxy catch up with Sun Pharma in terms of margins and return performance? Sure it can, and if it does, it is a real bargain deal for Sun Pharma.

The bigger bargain
There is one thing that is clear: Sun Pharma is using its over-priced stock to acquire Ranbaxy which is struggling at the moment. This itself could be the the real bargain.