Investors in Zimmer (ZMH) have reacted with great enthusiasm to the news that the company acquired Biomet in a huge deal.
This deal is one of the latest major deals being announced in the wider medical and healthcare industry this year. While the expected accretion, driven by expected synergies sounds very appealing, I don't believe that the pro-forma combination's valuation is appealing enough for me to initiate a position at current levels.
Acquisition Of Biomet
Zimmer announced that it has signed a definitive agreement under which it will acquire Biomet in a $13.35 billion deal. With the intended acquisition of the privately held company the new combination will become a leader in the $45 billion musculoskeletal industry.
Following the deal Zimmer will become the second-largest company in the market which treats muscle and orthopedic injuries. Zimmer will see greater diversification in the faster growing sub-industries like sports medicine, extremities and trauma products.
Zimmer stresses that the deal as well as Biomet itself fits its strategic framework which focuses on growth, operational excellence and prudent capital allocation. The latter seems a bit ironic as the company will incur huge amounts of debt to finance the deal.
Zimmer will pay an incredible $10.35 billion in cash while the remainder of the deal will be paid by issuing $3 billion in stock. The cash comes from existing cash balances, a $3.0 billion term loan and bridge loan facilities. As a result of the new equity being issued to pay Biomet's shareholders, the latter group will own a combined 16% of Zimmer.
The deal is of course subject to regulatory approval and is expected to close in the first quarter of 2015.
Implications Of The Deal
Following the deal, Zimmer expects to generate $7.8 billion in revenues while reporting $2.8 billion in adjusted EBITDA. Adjusted earnings per share are seen to increase by double-digit percentages. Estimated synergies are expected to come in around $135 million in the first year after closing, steadily increasing towards $270 million by year three.
We know that Zimmer reported 3% growth in revenues to $4.62 billion last year. Net earnings came in at $761 million while Zimmer reported EBITDA of $1.4 billion. Based on the outlook for the combined entity, Biomet generates $3.2 billion in revenues while reported adjusted EBITDA of roughly $1.4 billion.
The $13.35 billion price tag values Biomet at roughly 4.2 times annual revenues and 9-10 times EBITDA. During the conference call, Zimmer disclosed that it anticipates earnings accretion of $1.15 to $1.25 per share in the first year after closing. This guidance is based on expected synergies of $135 million which is seen to double by 2017. Given the expected dilution in order to finance the deal, earnings accretion is expected to increase towards $2.00 per share by 2017.
Synergies And Shareholder Enthusiasm
Investors are thrilled about the deal which can partially be explained by rather sizable cost synergy estimates. Estimated synergies will top at $270 million in year three following the deal. Combined with the hefty price-earnings ratios being paid in the sector, this could boost the valuation significantly.
Besides cost cutting, Zimmer anticipates to offer more comprehensive and scalable solutions to its clients which allows the combination to grow faster together. Cross-selling opportunities are available as well with both companies running their own team of sales representatives. Once the deal is completed, Zimmer will become the second largest operator in the market surpassing Stryker (NYSE:SYK) while still trailing Johnson & Johnson (NYSE:JNJ).
On the back of the news shares of Zimmer jumped from $91 to a high of $107 per share, boosting the market valuation by $2.7 billion. A retreat of the shares towards $101 has lowered the jump in the valuation to $1.7 billion, or little over 6 times expected synergies.
Implications For Investors
The equity in the new combination will be valued at roughly $20 billion, while the company will operate with a net debt position of around $10-$11 billion. Equity in the new company is valued at 2.6 times annual revenues and roughly 7.1 times adjusted EBITDA. This excludes of course the debt incurred by the company following the deal.
As a result of the significant debt incurred, Zimmer will focus on reducing leverage. Its dividend will be maintained at 15-20% of earnings while share repurchases are suspended for the moment.
While direct payments in the form of higher dividends or share repurchases will be scaled back in the near future, Zimmer has the potential to create more value for its shareholders by accelerating growth and cutting costs. This transformation from short term gains to a long term growth story should drive the valuation of the company in the long run.
While the deal looks great on paper, I believe that the current valuation is already quite high. On a pro-forma adjusted earnings basis Zimmer is expected to earn roughly $1.2 billion at the moment. A $20 billion valuation therefore values the business at 17 times earnings. Note that the debt incurred will constrain Zimmer's future dealmaking possibilities without the use of stock financing for years to come.
Investors are rightfully enthusiastic about the deal, yet I don't believe that the current valuation is appealing enough for me to jump the bandwagon at current levels.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.