As of November 1, Medtronic (NYSE:MDT) completed the acquisition of China Kanghui Holdings for the princely sum of $816 million. Kanghui is a Chinese manufacturer of medical devices which supposedly fits particularly well with Medtronic's business, both in terms of products and due to its distribution network.
China Kanghui Holdings produces and sells orthopedic implants and associated instruments for spine, cranial maxillofacial, and craniocerebral trauma. Kanghui sells its orthopedic implants through 335 third-party distributors, who then sell those products to hospitals directly or through sub-distributors. Kanghui's business is a decent fit for Medtronic since 21% of Medtronic's FY2001 revenues came from the spine and biologics segment. Also obviously, Medtronic might be eyeing the use of Kanghui's distribution network to move its own products, making for an easier penetration of the Chinese market.
Although the pricing of this acquisition seems somewhat aggressive at around 42 times earnings, the strategic fit seemed good enough that Medtronic was willing to take the deal.
However, there might be reasons to believe not all will go well with this deal.
In a very interesting post, Bronte Capital explains several reasons why Medtronic might have been misled about this deal. It's always a challenge to know what's real when buying Chinese stocks, and seemingly the same might be true when buying entire companies - this, in spite of Medtronic supposedly having done proper due diligence on the deal.
The main reasons why the deal might be problematic are:
- A too-large 36.9% net profit margin (that's after tax) on a company that supposedly dedicates just 3.7% of sales to R&D, thus highly unlikely to be selling high margin, unique, medical devices;
- Too-large inventories when compared to cost of goods sold, meaning the company would have to be holding 437 days of inventory. This is exceedingly large when compared to any normal company out there, meaning either the company is mismanaged or - most likely - this asset is the result of artificially inflating profits (because when artificial profits are created, assets are created in the balance sheet. Often in Chinese companies this has included fake cash or fake inventories);
- Too-large and too-fast growing fixed assets. Again, when a company makes up earnings it has to create assets in the balance sheet, and Bronte Capital feels that inventories and fixed assets is where such might be occurring here;
- Additionally, Bronte Capital describes efforts by others, in the ground in China, coming up with Kanghui having reported different fixed assets to the SAIC (Chinese accounts). This is something which is harder to confirm right now as SAIC accounts are no longer easy to access, and was also a quite common occurrence in other alleged Chinese stock frauds;
- Finally, others also raised doubts regarding Kanghui owning Libeier, due to the chain not carrying Kanghui products.
Taken together these doubts present a credible chance that Medtronic might have been misled in the deal. If such were to be confirmed, given the size of the deal and the implied carelessness, it might be enough to sow some negativity on Medtronic stock even if not enough to threaten Medtronic's viability.
Presently Medtronic is trading at a sensible valuation - just 11.5 times forward 2013 earnings. Still, the large ($816 million) acquisition of Kanghui might yet turn out to be a dud, given the doubts surrounding it.
Those wanting to be long Medtronic would probably be better served to wait and see how it plays out. Taking into account Medtronic's valuation and its relative size, I wouldn't short Medtronic on this insight, but it might clearly pay to wait and see how things go.