Novartis (NVS) has announced Phase II of its planned acquisition of eye-care leader Alcon (ACL), purchasing the remaining tranche of Nestle’s majority stake. Valued at $28 billion, the deal advances the combination of two of the more attractive higher-growth participants in the beleaguered Pharma sector. Alcon has a market cap of $46 billion and estimated 2009 revenues of $6.4 billion. It manufactures a range of ophthalmic products, including surgical devices, medicines and eye-care products. Novartis, in turn, has a respective market cap and revenue of $137.6 billion and $43.6 billion. It continues to execute well with a better pipeline than many peers, even as it too faces significant revenue exposure to patent expiration. Indeed, Alcon and Novartis shares have been sector favorites for this investor over the years.
As attractive as the deal seems, however, it has its rough edges. It is thus of interest both to investors and students of M&A.
First, a look at the details. On the first day it could, Novartis commenced the exercise of its call option to purchase Nestle’s (OTCPK:NSRGY) remaining 52% stake for $180 per share, or $28 billion dollars. We recall that Novartis had acquired an initial 25% stake from Nestle for $143 per share in April 2008 (or $10.7 billion). At the time, it also established the $180-per-share call option for Nestle’s remaining stake, one that could be exercised by either party between January 2010 and July 2011. This rich price seems early, in our view.
At a mere 10% premium over the year-end close of $164 per share, the deal was surely anticipated by investors eager to capture Nestle’s guaranteed gain. And why should they not? Common shareholders have a common claim on corporate assets and can expect to enjoy a common valuation. Yet Novartis management apparently has other views. With the same announcement, it has proposed to merge the remaining 23% minority stake (publicly held) into Novartis with a 2.80:1 share-exchange, valuing their Alcon shares at a mere $151 per share Indeed, this is below where it traded on the prior close, which surely adds insult to injury.
Why should the executive management of Novartis ravage these investors?
Because they believe they can, apparently. Since Alcon is incorporated in Switzerland, Swiss corporate law obtains. Thus, Novartis management expects that they can vote the combined 77% stake to approve the buyout of remaining shares, despite the 16% disparity in price for minority shareholders. Management additionally believes the $151 per share price is “fair” in that it represents a premium over the share price that preceded its initial offer in April 2008. We note it is even “fairer” than the trough pricing of November 2008 ($68 per share).
In short, Nestle deserves the high share price because it can deliver the controlling interest. This seems defensible, in our view. More striking, however, is the notion that other holders of the common shares deserve a lower price. That a majority of common shareholders could vote to lower the value of others’ common shares will seem brazenly unfair. And why not?
Fortunately, Alcon’s Board of Directors seems to agree. Not only do minority Alcon shareholders enjoy protection from a “coercive takeover bid”, Swiss Corporate Law requires the Board to approve any such proposal with “interested” (i.e., Novartis-related) directors abstaining. In other words, Novartis may not be able to stack the board and ram through the disadvantageous proposal. It is no surprise then that the Alcon Board is “disappointed that Novartis is attempting to circumvent [shareholder] protections and corporate governance best practices.” We are surprised they should try, even if they are burdened by the high call price they chose.
So, given this situation, what are investors to do with Novartis and Alcon shares? At $54 per share, Novartis stock is brushing against the sell-side mean target price, having ridden well with the market. If you are well in the money on Novartis shares, it will be a good time to capture your gain. The company’s reputation for clean execution will falter if the dispute with Alcon holders persists. A significant amount of revenue goes off patent in 2012. Moreover, financing the purchase of Nestle’s remaining stake will substantially reduce cash and significantly increase debt, limiting its financial flexibility while it pays down this leverage (to be roughly a modest 2x combined EBITDA). Finally, any common shareholder should be wary of a management so willing to undermine the rights and economic position of other common shareholders. In short, for now at least, the stock thesis for Novartis shares has weakened.
Alcon shares are somewhat more attractive, however. It is hard to know how, when, or if the merger will proceed, assuming Novartis persists with its proposals. The stated Novartis position seems ethically suspect and contrary to the common notions of fair play that underlie most advanced jurisprudence. If we assume the Alcon Board is able to uphold minority shareholder rights, Novartis will have to either increase or abandon its bid for their shares. If you are in the stock, the 16% upside may well be worth the wait. If you are an investor with new money, however, we recommend you look for richer targets at this speculative juncture.
Disclosure: The writer owns no shares in NVS or ACL