bayer-monsanto

Bayer has agreed to acquire Monsanto at $128 per share valuing its equity at $57 b in an all-cash transaction. To finance the deal Bayer intends to raise both debt and equity. If the $19 b mandatory convertible bonds are the only debt to be raised, it appears like the entire acquisition being financed by equity. Then by implication it is not an all-cash deal, but an all-equity acquisition. For that to happen, Bayer must consider that its stock is overpriced. That is the first explanation that Bayer needs to give to its shareholders, although the major equity increase is through a rights issue.

Bayer must also consider that value of Monsanto's operating business is higher than $66 b. But is it? 

Monsanto is a mature business. Its revenues have not moved much in the past three years. And it has been generating steady cash flows. How much its revenues could grow in the next 5-10 years? Perhaps they would grow at a modest rate which would also be its perpetual growth rate; Monsanto is not a high-growth business. As of May 2016, Monsanto had $10.56 b of debt and $1.37 b in cash. 

If we consider operating margin of 25% and return on capital of 20% as sustainable for a foreseeable period, we can make value of Monsanto's business a function of perpetual growth rate and expected rate of return. 

For the analysis, I have not adjusted research and development expenses that Monsanto charges to its income statement. It would be much better if that is accounted for as an asset and amortized. 

The perpetual growth rate should be sustainable and reflect its mature business profile. Expected rate of return, which becomes the cost of capital, should be based upon the opportunity costs available at the time of acquisition. Of course, it should reflect the riskiness of cash flows; but how risky these cash flows are is a matter of perception. Rather than relying on CAPM, to supply a cost of capital, I would rather use a rate that I see is suitable for the acquisition. After all, if Bayer has opportunities to invest in a business that has an expectation of 10% rate of return, why should it invest in a business that can give 7%? As of now, the 10-year treasury has a yield of 1.69%. Obviously, Bayer would like to beat it, but by how much? 

If revenues grow at 3%, Monsanto will generate free cash flows of $2,134 m. Value of the business now depends upon the expected rate of return on cash flows. 

It looks like at 7% rate of return, Bayer is expecting value increase from control and synergies of 22.39%. This is to say that Bayer expects to increase growth rate in revenues, increase operating margins and increase return on capital after the acquisition is complete. How feasible is that? I am not too sure of growth rate, but if Bayer achieves an operating margin of 30% on a sustainable basis, it appears to have nailed the deal at 7% rate of return.

If the expected rate of return is higher, obviously Bayer has a tough job ahead.

To justify the acquisition price without benefits from control and synergies, Monsanto needs to grow at a much higher rate on a perpetual basis. 

At 3.73% growth rate, Bayer should expect a rate of return of 7% on the acquisition. Any higher expectation would put Monsanto under immense pressure to grow. It looks like a rate of return of 10% is not feasible.

If Monsanto grows at a much lower growth rate of 2% (operating margin of 25%), Bayer will have a lot explain to its shareholders. 

That is even when Bayer manages to increase operating margin to 30%. 

Such is life even for the corporates. It is both uncertain and filled with probabilities. By the way, Monsanto is still trading at a 20% discount to the acquisition price. Investors, who have faith in this acquisition and Bayer, still have the opportunity.