By Jake King
Last week, a Reuters article indicated that Endo Health Solutions (ENDP) is exploring options to sell itself, citing Valeant Pharmaceuticals (VRX) and Warner Chilcott (WCRX) as lead suitors and causing ENDP shares to soar 16% to $32.00 on the news (PropThink readers have been following ENDP since $26). Yesterday after the market's close, an article from Bloomberg corroborated the original story, indicating that Fidelity Investments, ENDP's largest shareholder, has been pushing the company to consider a sale after the specialty pharmaceutical company's repeated earnings misses and disappointing financial forecasts. This latest article confirms that talks are happening, and according to sources, Fidelity contacted potential buyers such as Warner Chilcott to gauge interest in acquiring ENDP. While the Bloomberg article focuses on Warner Chilcott, noting that it has retained Goldman Sachs to advise on a potential purchase of ENDP, we continue to believe that Valeant remains a major contender to buy the company considering Valeant's acquisition-driven strategy, potential business synergies, and ENDP's depressed valuation.
Both suitors make sense (see PropThink's prior article), and financial models combining ENDP and either WCRX or VRX reveal that an M&A transaction would be highly accretive to either suitor (details below). Valeant is aggressive and tends to move quickly, but sources have indicated to PropThink that Warner Chilcott wants to do a deal, no surprise as estimates suggest WCRX could increase its EPS by nearly 60% with ENDP as part of the business. In either case, a deal under these conditions makes everyone a winner; Fidelity, as well as other major ENDP shareholders, also own WCRX and VRX. With ENDP's CEO on his way out and major shareholders and the Boards of the three companies aligned in terms of using M&A to create shareholder value, a deal appears likely in the near term. Not only can ENDP shareholders look good on a buyout, but shareholders of either VRX or WCRX are also expected to make money given the boost to EPS that a deal will bring. As a result, if either WCRX or VRX acquires Endo Health, everybody wins.
Endo Buyout is highly accretive for either Warner Chilcott or Valeant. When we combine the businesses of ENDP and either WCRX or VRX, we find significant leverage in the model of the new company, despite the addition of new debt. This is primarily because 1) a significant amount of operating costs at ENDP can be shed in a business combination; and 2) tax rates for each of the foreign acquirers are much lower than ENDP's, creating significant leverage on the bottom line. Below we illustrate these potential business combinations based on 2014 financial estimates. We use 2014 because it represents a conservative base year for each of the companies. In these scenarios, we assume that one-third of ENDP's SG&A expense and half of ENDP's R&D costs can be cut in a merger, which would reduce total operating expenses for an ENDP-WCRX combination or an ENDP-VRX combination by 19% and 16%, respectively. Importantly, our model indicates that a buyout of ENDP at $40 per share would increase EPS for WCRX by 58% and would increase EPS for VRX by 23%.
In the estimates above, we assume that WCRX will have higher borrowing costs vs. VRX despite the same purchase price. While not shown, our models indicate that even if these company's acquire ENDP for $50 a share, deals done at that level would still be nicely accretive to the acquiring entities. Notably, either WCRX or VRX may choose to acquire ENDP and sell off pieces of the business, such as the Medical Devices or Health Services businesses, which are non-core. We believe that conservatively, these businesses could net roughly $2B despite ENDP paying a much higher price when it acquired them. In this instance, the surviving entity would still get a boost to earnings, plus would have the benefit of partially paying for the merger with cash from the divested businesses. Regardless of the way that the transaction is paid for, an acquisition of ENDP makes so much financial sense that we wouldn't be surprised to see a deal announced in the near-term.
Warner may be the frontrunner, with Goldman Sachs advising the drug firm. While Valeant tends to move quickly and aggressively on acquisitions, Warner Chilcott may take the lead in acquiring ENDP. In fact our pro forma M&A estimates above suggest that an ENDP acquisition is actually more earnings accretive for WCRX than it is for VRX. According to the Bloomberg article, WCRX has already hired Goldman Sachs as an advisor on the potential deal, but more importantly, the specialty pharma company needs to raise its earnings prospects, and ENDP could provide an opportunity to revive the story. While ENDP and WCRX have little product overlap, the financial benefits, as noted above, in addition to diversification, could be key drivers of a transaction. WCRX trades at just 3.9x estimated 2013 earnings, and the stock has languished for years. Investors' patience is wearing thin with this stock, and we expect WCRX's Board is likely to try to fold in ENDP to create value. We don't expect VRX to give hard chase if discussions with WCRX get long-winded, but will likely pursue the deal up to a certain price. Our M&A estimates suggest that either WCRX or VRX can easily pay more than $40 a share for ENDP, and the transaction will still be accretive to earnings.
Either way, everybody wins. Both parties are viable suitors for ENDP, and analysts and investors have speculated on these potential business combinations since the ENDP take-out action started. The financials clearly make sense, and all of the major parties involved have incentives to get a deal done, hence our "Everybody Wins" thesis. As mentioned above, numerous institutional investors have a stake in all three companies, Fidelity included, and stand to gain twice (on both the stock of the acquirer and the stock of the target) should either VRX or WCRX step up and buy ENDP. For ENDP, of course, a buyout would come at a handy premium to its current share price, keeping shareholders happy and putting a positive light on management. For VRX or WCRX, the significant cost synergies would enable a portion of the revenue from ENDP's business to drop straight to the bottom line, improving earnings and thus, the share price of the acquirer. But perhaps the biggest winner is ENDP's CEO David Holveck, who upon a sale, could exit the company with dignity, rather than taking the early leave requirement recently served up by the Board. Interestingly, we note that Holveck was picking up shares on the cheap last November shortly before Endo announced his departure, perhaps the best indicator that he would finish on a high note.
Ultimately, we expect a deal to materialize in the near-term. Investors holding shares of all three companies stand to gain considerably, with a shot at selling equity in ENDP at a premium, while still owning its impressive cash flow stream in the form of an acquirer.
Additional disclosure: PropThink is a team of editors, analysts, and writers. This article was written by Jake King. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article. Use of PropThink’s research is at your own risk. You should do your own research and due diligence before making any investment decision with respect to securities covered herein.You should assume that as of the publication date of any report or letter, PropThink, LLC and persons or entities with whom it has relation ships (collectively referred to as "PropThink") has a position in all stocks (and/or options of the stock) covered herein that is consistent with the position set forth in our research report. Following publication of any report or letter, PropThink intends to continue transacting in the securities covered herein, and we may be long, short, or neutral at any time hereafter regardless of our initial recommendation. To the best of our knowledge and belief, all information contained herein is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable, and not from company insiders or persons who have a relationship with company insiders. Our full disclaimer is available at www.propthink.com/disclaimer.