Abbott: The Best Laid Plans...Or Not?

| About: Abbott Laboratories (ABT)

Summary

Abbott is a Dividend Aristocrat.

Abbott has raised its dividend 44 years in a row.

Abbott recognized that it needed some well considered acquisitions to continue its path of unparalleled accomplishment.

Abbott surveyed the landscape and selected a worthy candidate to acquire.and then another.

And then the music stopped.

Introduction

"An' lea'e us nought but grief an' pain, For promis'd joy!" Robert Burns (1785)

This article found its gestation in two prior SA articles. One is an article I wrote earlier. The second is an article by Justin Polce, "A Deal Worth A Leer".

The Setup

I tell Abbott's (NYSE:ABT) recent history in the first section of my earlier article. Abbott ably recounts its own story starting earlier in its history on its web site. There are few American companies among our great pantheon of exceptional blue chip companies who have a prouder heritage.

Nonetheless, Abbott's growth projections have disappointed recently. This is not something a premier blue chip company who aspires to maintain that status dares ignore for very long. Abbott is not one of those. It has responded vigorously. As matters unfold it may prove to have done so with excessive vigor.

Abbott's Alere Acquisition Deal

The very article I cite to show concern over Abbott's growth also announced Abbott's initial and most controversial response to it. It reports an acquisition announced February 1, 2016 for which Abbott issued an enthusiastic press release stating:

"Abbott and Alere Inc. (NYSE: ALR) announced today a definitive agreement for Abbott to acquire Alere, significantly advancing Abbott's global diagnostics presence and leadership. Under the terms of the agreement, Abbott will pay $56 per common share at a total expected equity value of $5.8 billion. Once the transaction is completed, Abbott will become the leading diagnostics provider of point of care testing. Abbott's total diagnostics sales will exceed $7 billion after the close."

A local Chicago (Abbott's home town) business publication provides an entertaining, rather disconcerting, take on the deal. This second article's title is framed as a question: "Why on earth is Abbott's White spending $5.8 billion on Alere?"

The first line of the article answers the question as follows: "He can't help himself."

It goes on to provocatively remind readers of White's recent remarks in a January 2016 earnings release relating to the prevailing prices of potential acquisition targets:

"'The price that some of these things would be for sale at would be imprudent. You have to step up and say we're not going to be in that zone, we're not going to be that irrational."'

Concerns over the Alere deal have persisted. At Abbott's next conference call on 4/20/16 the Alere deal was a thorny issue. One conference call questioner requested help in responding to his investors' concerns about the Alere deal:

"Where they seem to be getting hung up is this, the growth opportunity for Alere, right? They see Abbott as large-cap growth company and they're buying a business that has below Abbott growth rates."

Chairman White's answer eschewed particularity. Instead he took very much a "big picture" approach to the point. He said:

"I look more at the Diagnostics business broadly in all phases, all segments, and I look at it globally and I look at it by testing categories, not just point of care, or core lab, or blood screening, or molecular testing and so forth. And I think our Diagnostics business has shown that there is good growth to be had and good growth if you're innovative and your systems and your products are responsive to customer needs."

This was not the last question for that conference call on the Alere deal.

Another Alere question was right on target from a time-line perspective given Abbott's soon to be announced offer to pay a termination fee to void the Alere deal:

"Miles, just to clarify, on Alere, are you reaffirming your commitment to the transaction?"

This one earned a cautious response, as follows:

"I am going to be careful how I answer any questions about Alere, Mike, because as you know they've had delays filing their 10-K. We don't know when they'll file their proxy. We don't know when they're going to have a shareholder vote. So right now I'd say it's not appropriate for me to comment on Alere."

This was an answer to make Abbott's lawyers smile. Such an answer is unlikely to come back to bite the speaker at some subsequent deposition.

Of course there is no way to know right now if the Abbott-Alere deal is headed to litigation. On the other hand, it is certainly not beyond the realm of reasonable speculation.

Alere-Abbott Deal Challenges

So exactly what has dampened Abbott's swashbuckling ardor for the Alere deal? No one outside Abbott's inner circle of decision makers will ever know for sure. Likely they are not all of one mind on the point.

Some will say that the St. Jude deal has played a part. In his April 20, 2016 earnings call Chairman White was able to pre-announce his demurrer to any possible such claim in response to a question which asked:

"…Miles, you've said in the past that you're not constrained on doing more deals even after the Alere acquisition. So how should we think about Abbott's ability to do another medium size transaction while the Alere deal is pending and there's some uncertainty? And second, is the sweet spot for Abbott still that $5 billion to $7 billion range that you've talked about in the past?"

Knowing that he would shortly be announcing a $25 billion acquisition, Chairman White would be forgiven if he had a smirk on his face when he responded:

"…I'd tell you, again, I don't feel unreasonably constrained at all. I think that we're always conscious of capital allocation; we're always conscious of return; we're always conscious of where our debt is and what our debt rating is and so forth. We want to be all in the right balance here. But for the things that I think would be on my radar screen, I think we're in good shape here."

Of course the question asked about "another medium size transaction" while the St. Jude deal is more of an extra jumbo size transaction. Nonetheless the answer expresses no constraints along this line other than debt rating.

This sets a low bar. Although the St. Jude deal is posing debt rating challenges, they are likely manageable over time. For now Moody's and S&P both see the combined deals as having negative impacts on Abbott's current stellar credit rating. Nonetheless, both express confidence in Abbott's ongoing stability after defined credit downgrades. I explore these further towards the end of this article.

A more acceptable and likely more accurate reason why Abbott would gladly pay several tens of millions to get out of the deal is the one mentioned by Alere in its release announcing rejection of the offer.

According to an April 29, 2016 Reuters report:

"Abbott had raised concerns about the accuracy of various representations, warranties and covenants made by Alere in the merger agreement, and offered to pay $30 million to $50 million to terminate the deal, Alere said on Thursday."

Can Abbott Get Out of the Alere Deal?

Fifty million is chump change. If Alere had let Abbott off the hook for this amount its shareholders would be justifiably outraged. The Abbott-Alere deal reportedly involved a 50% premium to Alere compared to its pre-deal price. If Alere released Abbott without an alternative purchaser in place and charged Abbott less than a ten figure fee it would cause itself no end of problems.

How about Abbott freeing itself from the contract in accordance with the terms of the contract. First, let me make it clear that this contract is gnarly as only might be imagined by a major Chicago law firm working out a multibillion dollar merger for its client with a major New York law firm on the other side. My interpretation is anything but authoritative. Nonetheless, I have read portions of the contract and will give my take.

Can Abbott scoot away from the deal by paying its termination fee of …of…? Check it out. Section 7.03 calls for a plump termination fee of $177 million. This is of no apparent use to Abbott in its current situation. The fee is labeled as a "Company Termination Fee". Alere is the "Company" and this fee appears to be a charge imposed on it and payable to Abbott if Alere should opt for a better offer.

Abbott is defined as the "Parent". There is no "Parent Termination Fee". The contract does give Abbott the right to terminate in case of a breach by Alere but only in specific situations. These are not clear cut.

The contract contains a representation at section 3.08 that since January 1, 2014, Alere has been in compliance with the Foreign Corrupt Practices Act. Alere is being investigated for possible failures in this regard. However, at the current time, there is no public proof that Alere has violated this Act. The only thing that is known is that Alere is being targeted for possible violation. The contract representation is not simple. It would not apply to violations that would not have a material adverse affect on Alere in accordance with that term as defined in the definition section 8.12 of the contract.

Abbott's home town business journal has reviewed the situation at length. It sets out a well considered analysis.

This article looks to other deals to assess the possible outcomes. It notes:

"While the Jan. 30 purchase agreement between the two companies outlines several ways in which there could be a breach of contract, it isn't clear whether any has occurred. Past examples show that when an acquisition and an FCPA probe are concurrent, there's no standard way to come to a resolution. Some deals went through-like General Electric Co.'s purchase of Alstom SA's energy assets for about $15 billion and Zimmer Holdings Inc.'s $14 billion acquisition of orthopedic manufacturer Biomet Inc. In a few cases, they were dropped, like Lockheed Martin Corp.'s effort to buy Titan Corp. in 2004."

The Bottom Line

The Polce SA article I referenced at the outset estimates a successful Corrupt Practices probe as creating a potential $65 million fine for Alere. The author and I trade comments as to whether or not this would create an out for Abbott. At the time I thought it would. Now, having spent more time reading the actual contract language, I am less sure. In any case it will take a good long time before anyone knows if the current situation rises to that magnitude of risk.

By my evaluation time and distraction of this issue create the far greatest dilemmas for Abbott.

Bringing successful mergers to their full potential is a significant independent management challenge. It requires ongoing management of personnel to maximize their effectiveness for the newly merged entity.

How daunting of a challenge is it for Abbott as it decides how to best deploy its new assets, to realize that there could be one or more key personnel, contractors, or representatives who later turn out to be toxic as the criminal probe crawls forward.

Abbott's Upcoming >40 days Wanderings in the Desert

Abbott's near term future will challenge the company.

Moodys and S&P view the proposed transactions similarly in this respect. Once Abbott closes on its two deals the die is cast. We will look at the Moody's version here. First comes the credit rating downgrade. While acknowledging that Abbott intends to partly fund its acquisition spree with new stock issuance, Moody's still has specific rating downgrades in mind. It has stated:

"Moody's expects that Abbott's senior unsecured ratings will be downgraded to Baa3 and its short-term rating downgraded to Prime-3 with a stable outlook."

Moody's discussion of the situation is direct and to the point. It seems perceptive and noteworthy to this author. Moody's later commentary states:

"'Abbott is taking on significant leverage for two of the largest deals in its history,' said Diana Lee, a Moody's Senior Credit Officer. 'The anticipated Baa3 rating outcome reflects relatively high initial leverage as well as our belief that Abbott will face constraints as it deleverages,' continued Lee."

It goes on to make predictions and note possible alternative courses, pointing out possible risks and opportunities:

"Moody's believes that these constraints are partial offsets to Abbott's large scale and diversification. The company is targeting debt/EBITDA of 3.5 times by the end of 2018. However, in order to achieve this leverage, Moody's believes that the company will be highly reliant on earnings improvement because of relatively weak free cash flow, resulting from higher interest expense, large dividends and capital expenditures. In addition, Abbott generates high levels of non-US profits and cash flow. Unless the company would be willing to repatriate non-US cash, Abbott would need to borrow to fund its shareholder initiatives and capital expenditures. Finally, Moody's anticipates that in order to finance this deal and other US cash needs, Abbott will substantially draw down on its cash balances, reducing its financial flexibility."

Similar cautions and commentary are available from S&P (it will lower Abbott's corporate credit rating to "BBB-".

In SA commentary following SA's news announcement of the acquisition, several commentators note that the deals will serve as a constraint on Abbott's dividends going forward. Of particular note is the following excerpt which Wambaugh takes from Abbott's Investor's Relation site:

"As part of this plan, Abbott will reduce its share repurchase activity, moderate the pace of growth of its dividend, and M&A activity will be minimal until it achieves its leverage targets."

No mention is made of this but synergies are part of Abbott's inducement to do the deals. One possible source of synergistic savings is layoffs.

Summary

Make no mistake if all goes well, "well" won't be quite as well as it would have been if Abbott could have managed these deals at more palatable prices. If the Alere deal turns into the stinker which could occur, "well" may be quite "unwell"…at least until Abbott gets back on track.

Abbott's chairman White knows better than to "sweat the small stuff". He is able to breeze ahead with a deal that appears to be of the very type he recently ridiculed. He sees the growth potential in merger with a company growing more slowly than his own.

As the next few years unfold his mettle is destined for repeated testing. He has ratings' agencies to appease, investors spoiled by a stellar string of past regular dividend raises, companies and businesses to integrate.

Disclosure: I am/we are long ABT.

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.