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M&A deals that add value are rare – expensive deals that do so rarer still

03/03/2017

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

Reckitt Benckiser’s household-name brands may be very reassuring but, in the eyes of The Value Perspective, the numbers involved in its proposed purchase of a US baby milk manufacturer are not …

 

The news Reckitt Benckiser, the UK-based maker of Durex condoms, is close to buying US baby milk group Mead Johnson in a deal worth some $16.7bn (£13.6bn) inspired a few jokey remarks when it was announced last month. “Now that’s a hedge” was one of the better lines we saw although, here on The Value Perspective, we rarely find mergers and acquisitions (M&A) much cause for merriment.

No – our thoughts on the subject are more accurately illustrated by the headline that accompanied a piece we wrote towards the end of last year about an even bigger corporate marriage – M&A deals the size of BAT and Reynolds can often see value go up in smoke. Clearly those two cigarette manufacturers did not share our misgivings, however, as the $49bn deal was finally signed off in January.

Ultimately, of course, you can only judge M&A success in hindsight but, as we did with BAT and Reynolds, we are nevertheless prepared to stick our neck out and say Reckitt buying Mead looks a pretty poor idea from a valuation perspective. For one thing, people have drawn comfort from the fact so many well-known brand names are involved – Reckitt being the group behind Dettol, Harpic, Nurofen and Vanish, to name just four.

In which case, what harm can adding another in the shape of Enfamil baby formula do? But just think about that for a moment – baby milk has nothing in common with cleaning products and headache tablets beyond the fact consumers consume them. That is hardly a compelling strategic rationale for shelling out almost $17bn.

Still, it would seem Reckitt has cash burning a hole in its pocket while CEO Rakesh Kapoor has been under pressure to do a deal for some time now. Having recently missed out on a couple of potentials targets, he and his company have now concluded Mead is worth about 20 times its annual profits – which is expensive even in the traditionally gung-ho world of M&A.

A rare beast

History suggests an M&A deal that adds value is a rare beast – but an expensive M&A deal that adds value is a whole lot rarer still. So why, you might well ask, would any company pay such a high price for a business with which it has so little in common? It is a good question and one possible answer is it would allow Reckitt to borrow a lot of money in the hope of eventually generating a lot of profit.

Mind you, the sort of profit commentators suggest Reckitt could be making on a five-year view – always assuming everything goes exactly to plan, which is hardly a given in finance – really would not appear to be worth the risk of taking on so much debt. And, again, especially after shelling out so much in the first place. Taking on bad risk for bad reward after paying a bad price is, well, a bad combination.

As it happens, taking on a lot of debt could also help grow Reckitt’s earnings – at least in the short term. And, as it happens, earnings growth is one of the measures on which the Reckitt management team’s bonus system is based. To be clear, we are not casting aspersions on anyone’s motives here but we would question to what degree such a remuneration structure aligns management’s interest with those of long-term investors.

None of this is to state buying Mead Johnson will categorically be a bad deal for Reckitt – all could turn out fine. But, over the years, value investors have learned the importance of playing the averages and, on average, a deal with metrics this poor ends poorly over time. Regardless of the personalities, the track records and all the reassuring brands involved, we remain highly sceptical of this kind of acquisition.

Author

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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