August 20, 2019

Breakingviews: Transatlantic pet care deal will need grooming

by Breakingviews.

Elanco Animal Health’s push to be a bigger noise in animal health will require some hard graft. The Eli Lilly spinoff on Tuesday offered to pay up to $7.6 billion in cash and stock to purchase Bayer’s animal-health division, replete with best-selling flea powder and tick collars. The deal may make more sense for the seller than the buyer.

Elanco is paying Bayer $5.3 billion in cash, and up to $2.3 billion in stock. After Tuesday’s 6% decline in its share price, the latter portion of the offer is actually worth about $2.1 billion. The Bayer unit’s resulting enterprise value of 19.7 times this year’s forecast EBITDA is reasonable compared with nearly 24 times for the market leader, $61 billion Zoetis. After all Zoetis is expected to report 7% revenue growth and an operating margin of 37%, nearly double the comparable figures for both Elanco and its new acquisition.

The cash will come in handy should Bayer decide to reach a settlement with the 18,400 Americans who say its Roundup weed killer gave them cancer. Elanco, by contrast, is taking on more debt to do the deal and will be reliant on ambitious cost-cutting plans to deliver a decent return.

True, the acquisition would make the U.S. company the second biggest player in the pet care market, whose global revenue is rising 5% a year. But Elanco’s top line is forecast to grow just 1% this year. Assume Chief Executive Jeff Simmons delivers $300 million of annual savings and that the animal-health unit he’s buying generates 2019 operating profit of 314 million euros, in line with Refinitiv forecasts. Breakingviews calculations show he will manage a 7.7% return on investment, only marginally better than Bayer’s 6.7% weighted average cost of capital.

The deal’s financing is another reason to pause for thought. Elanco is funding the cash portion of its offer through a bridging loan that it says will be paid for with new equity and more debt. That will push gross debt to a hefty 5 times EBITDA, returning to a more manageable 3 times multiple within two years if all goes to plan. Altogether, the deal appears less of a pedigree pooch and more a rescue dog in need of some care and attention.

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