On the 23rd of May, the German drugs and chemicals group Bayer (OTCPK:BAYRY) (OTCPK:BAYZF) said it had made an offer to buy U.S. seeds company Monsanto (NYSE:MON) for $122 per share in cash or a total value of $62 billion including debt, to create the world's biggest agricultural supplier. At the time of the offer, the exchange rate for EUR/USD was 1.12.
Thursday last week, the British people voted in favor of leaving the EU. This decision is having a strong impact on the forex market, as well as the debt markets. I believe that this event could have a significant negative impact on the chances of a deal between Bayer and Monsanto to happen.
First, if the EUR keeps falling against the USD (due to political and economic problems that Europe could face because of Brexit), Bayer will have to raise more debt (in EUR). Currently Bayer has a healthy balance sheet, despite completing the acquisition of the consumer care unit of Merck (NYSE:MRK) for $14.2B just two years ago. As of today the debt/equity of Bayer is 86% and its EBIT/interest is 7.1. These figures are not fantastic but reasonable. However, the situation would change dramatically should the acquisition of Monsanto go through. In fact, Moody's has put Bayer rating under review declaring that:
…despite Bayer's intention to finance approximately 25% of the transaction's enterprise value with equity primarily via a rights offering, Moody's believes that the offer signals a step change in Bayer's financial policy. Financial leverage will increase sharply post-closing, with total debt to EBITDA likely to rise close to 4.5x (on a Moody's adjusted and pro forma basis (i.e. including a full year contribution from Monsanto)).
…the transaction will give rise to significant execution, reputational and integration risks given its size both in terms of its monetary value and the scale of the operations acquired by Bayer. While material synergies should arise from the combination of the two companies' crop science businesses, Moody's notes that Bayer is paying a multiple close to 16 times Monsanto's LTM EBITDA at a time when Monsanto's profitability has come under some pressure owing to more challenging market conditions following a period of strong growth driven by the continuing market penetration of its GMO seeds and commercialisation of new products.
A rising debt and a lower rating are a dangerous combination in a turbulent market. Bayer will need to raise more debt and will have to pay more interests due to financiers' risk aversion and consequent higher corporate interest rates that will be associated with its lower rating. Further complicating the situation, the European banks are under stress at the moment. Markets are skeptical about their liquidity, especially in a turbulent market. For example, Credit Suisse (NYSE:CS), one of the financing banks, has lost 15% on Friday and 10% on Monday. In this situation, banks might be more careful in their lending and might be wary of an overleveraged deal.
Second, Bayer plans to raise approximately 25% of the cash from equity financing. However, this option also seems to be getting more complicated. The equity markets are plummeting (in the last two trading sessions the Dax hast lost approximately 10% and Bayer about 5%), and therefore it will be more difficult and certainly less convenient to raise large amounts of cash. Since the rumors about the merger surfaced, Bayer has already lost 20/25% of its market capitalization or $25B of value. In this scenario, raising equity capital is not an ideal option.
Considering the negative shareholders' response to this deal, I believe that Brexit reduces the likelihood of a merger going through (aside from regulatory concerns that make it even less likely at this stage). In this light, Bayer is a compelling buy while Monsanto is a strong sell. The shares of Bayer could rebound to €95/100, especially considering its defensive proposition that might appeal to investors in a turbulent market. On the other hand, Monsanto shares will probably fall to the levels pre-offer ($90).
Disclosure: I am/we are long BAYZF.
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.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.