Bayer’s $62 billion all-cash offer for Monsanto was publicly disclosed earlier today. My five thoughts on the proposed transaction, in no particular order:
Point #1: Monsanto’s growth has come entirely from buybacks of late.
In 2012, Monsanto made profits of just a hair under $2 billion. In 2016, Monsanto is on pace to make a little bit over $2 billion. Specifically, the change is from $1.997 billion to $2.0250 billion, for a cumulative growth rate of 1.40%. And yet, Monsanto has covered up some of this core business stagnation by taking on enormous sums of debt in recent years to retire shares and boost the earnings per share.
Back in 2012, Monsanto had a nearly pristine balance sheet. It was carrying $2 billion in long-term debt, and was making $2 billion in annual profits. That’s exceptional financial strength for a company that requires moderate ongoing capital expenditures. And now? Monsanto tacked on $7 billion in debt to retire nearly 100 million shares of stock. Monsanto reduced its share count by almost one-fifth, removing 18.53% of the shareholding base so that each dollar of profit would only have to be split 435 million ways instead of 534 million.
As a result, you have a business that is earning $4.65 per share in 2016 compared to $3.70 per share in 2012 despite the business itself continuing to generate $2 billion in profits. However, the debt load attached to that cash flow is now $9 billion instead of $2 billion, putting Monsanto on the high side of a moderate debt burden. The debt was cheap around 3%, but most of the stock was repurchased at a valuation of over 20x earnings, and I don’t you can clearly state whether or not this enhanced shareholder value. The cash position, meanwhile, has declined from $3.7 billion to $1 billion in just the last year.
Personally, I wouldn’t have wanted to take on over $6 billion in debt compared to $2 billion in cash flows unless the contemplated use of funds was exceptional (which this was not), as I would want to prioritize financial flexibility to face the next recession from a position of strength.
Point #2. Buyback reliance has made it easier for Monsanto to become a takeover target.
Starting in the 1980s, and accelerating rapidly in the past 10+ years, companies have begun repurchasing stock with retained earnings and lowering the focus on expansions and new product launches to create value. There’s a safety in repurchasing stock in that the only execution risk is overpaying for shares, and for whatever reason, the Wall Street analyst community isn’t too hard on management teams that pay too much for their own stock. On the other hand, if you launch a new product that fails, the failure becomes part of your reputation/life story.
That said, there is a risk to the incumbent management team that habitually repurchases its own stock rather than organically expands the business. Net profits, rather than earnings per share, are determinative of a company’s market cap. And the larger the market cap, the fewer the buyers that remain eligible to takeover the company you run. If you’re buying back stock, while your peers are growing their companies by increasing their net profits, they are gaining the financial flexibility to take you ever.
When you study Berkshire Hathaway in the 1970s and 1980s, there were a few periods in which Berkshire traded at less than book value and yet Buffett didn’t repurchase any of Berkshire’s stock. His professed reason is that he was investing in things that were compounding faster than Berkshire under book value. That is likely the case, but he was also aware that Berkshire was cash-rich, conservatively financed, and an ownership of extremely valuable assets: a mid-cap that faced a takeover risk from a suitor that wanted to offer a hefty premium and leverage Berkshire’s cash flows.
Point #3. The $122 price tag benefits Bayer shareholders to the detriment of Monsanto shareholders.
The $122 per share offer, despite being a 37% premium compared to Monsanto’s May 9th closing price, still represents an attractive takeover point for Bayer. Some of Bayer’s largest shareholders have expressed skepticism about the deal–calling it empire-building and the assumption of reputational risk by acquiring a GMO company that is not politically popular in Western Europe–but I suspect this is gamesmanship aimed at minimizing regulatory risk and the need for a higher premium (after all, if the shareholders of the acquirer brag about getting a steal, are the board and shareholders of the target company going to approve the transaction?)
With most acquisitions of a company during a bull market, you tend to see a price in the neighborhood of 30x forward earnings. Monsanto is expected to make $5.30 per share next year. If that accurately describes the near-term trajectory, the $122 per share valuation is about 23x earnings.
If I were a member of the Monsanto Board, I would insist on a price in the $135 to $150 range. That still brings you into the neighborhood of 25x earnings to 28x earnings, and more accurately reflects the control premium that recognizes the advantages Bayer will have over Monsanto. I don’t think you could criticize Bayer for overpaying until the price crosses the $160 threshold.
Point #4. Bayer’s debt load has little wiggle room for an increased offer.
The profit engine at Bayer is a little over $4 billion per year. At Monsanto, it’s $2 billion. If the deal goes through at $122 per share, it ought to work out well for Bayer shareholders because the company will carry over $40 billion in debt against $6 billion in profits. That 6.5x leverage load is high, but Bayer management signalled an intent to cut $1.5 billion in annual costs for three years and use the existing cash flows to pay down debt. If that means Bayer is making $6.5 billion while paying down a $40 billion debt burden, it’s a worthwhile strategy considering that Monsanto has a ten year earnings growth record of 20% annualized.
However, from the Bayer point of view, I would be hesitant to expand the offer much. If Bayer had to pay $150 per share for Monsanto, and funded the additional purchase price with debt, then Bayer’s debt load would shoot up an additional $12 billion. If you’re carrying a $52 billion debt load compared to a little over $6 billion in profits, you cannot have a cyclical downturn. If another 2009 arrived, and stuck around for a couple of years, you’d be facing bankruptcy or punitive debt/equity issuances, which is absurd considering that both companies have wildly profitable histories and would cause wreckage for shareholders solely on account of excess leverage.
Even if a pessimistic worst-case scenario doesn’t play out, it is unlikely that Bayer would be able to borrow cheaply if the debt burden rose meaningfully above $40 billion. At that point, additional debt would likely need to be issued in the 6% to 8% range which defeats much of the purpose of the Monsanto acquisition.
Why not just issue equity to finance an increased bid for Monsanto? Because Bayer stock, which was trading at 110 euros in April, is now down to the lower 80s on news of the Monsanto bid. An increased offer would probably drive the price of Bayer stock lower. If Bayer cuts its debt load in half, it’s probably a 150 euro per share stock. Equity financing would effectively gift part of Bayer to the current Monsanto base or permit new Bayer investors an attractive entry price if it chooses to finance new shares for cash that it then uses to acquire Monsanto.
Point #5. Monsanto is a jewel worthing fighting over.
There are some companies, with such extremely lucrative cash engines, that you don’t just take a small premium and go away. Instead, you need to take a cue from Dylan Thomas and refuse to go gently into the night.
Monsanto was only making $0.34 per share in profits back in 2000. It is now making $4.65 per share. That’s 17.76% annual growth over a sixteen-year period. Cumulatively, that’s 1,267% profit growth in just under sixteen years. The dividend has grown from $0.20 in 2000 to $2.16 now. That’s 16.03% annual growth, or 980% growth. If you were collecting $1,000 in Monsanto dividends back in 2000, you would be collecting almost $10,000 in annual income from Monsanto today.
That’s why I dismiss the Bayer shareholders who claim this is empire-building. No, it’s not. They’re saying that with a wink in their eye to themselves. The growth at Monsanto has been so extreme that I wouldn’t blame Bayer for considering additional financing to up the offer. However, if they do that, they better hope we are nowhere near a deep global recession, as cyclical agriculture businesses, deep recessions, and high debt loads are a great formula for permanent capital impairment.
But if I were on the Monsanto Board, or a Monsanto shareholder, I would be in no hurry to get this over with. The Monsanto shareholders have one of the Top 50 assets in the world on their hands, and it has been very good at creating rapid wealth built by earnings growth for their long-term shareholders.
If I were an employee of Monsanto, and I held Monsanto stock, I wouldn’t vote for the transaction at any term. Non-controlling shareholders don’t have a fiduciary duty to maximize wealth; they are free to look at the $1.5 billion in synergies and know that is code for the loss of their job and vote accordingly. An extra $30 per share that would come within a year or two anyway is not something you want to put your livelihood at risk over.
Incidentally, this is the reason why I keep coming back to companies like Google, Johnson & Johnson, and most of all, Berkshire Hathaway. Having lots of cash completely changes the long-term consequences of corporate takeovers for shareholders. That Precision Castparts deal at Berkshire is going to be adding $1 billion per year to Berkshire’s bottom line, and I don’t think that additional 6% in immediate earnings power has been factored into Berkshire’s stock price yet.
Bayer knows a good asset when it sees one. I would take statements of hesitancy and apprehension from Bayer with a grain of salt–they are playing coy to see the deal through. And at $122 per share, Bayer has an easy template for delivering double-digit returns for the next five years. If Bayer didn’t leverage itself, it could just up the ante to $135 or so and get the deal done. But the debt necessary to sustain that bid greatly reduces the benefits for Bayer shareholders, and if it comes to this, this is precisely what makes the game of business so interesting to outside observers.