Abbott Laboratories (NYSE:ABT) is on an acquisition spree, but the most recently announced deal to buy St. Jude Medical (NYSE:STJ) didn't seem to be too popular with the market. Shares have shed over 10% of their value since the deal was announced on Thursday. There seems to be some uncertainty over the Alere (NYSE:ALR) deal as well, which I personally think could be a positive if it falls through. The sharp drop in Abbott's share price was sudden, but it may have created a long-term opportunity as well.
The Alere deal - I don't like it
Fellow contributor Paul Nouri wrote a solid article detailing why the Alere deal may be destructive to Abbott shareholders' wealth. I'd like to also opine that I'm no fan of the deal either.
Looking at Alere, I can see why Abbott might want it superficially, especially for its point-of-care diagnostic testing. Looking at the numbers, though, I don't like the deal. Alere is loaded with debt, and taking a glance on Morningstar, its return on invested capital hit a high peak of only 2.35% in fiscal 2014. This compares to Abbott's ROIC of around 15% for fiscal 2015. However, Abbott achieved ROIC of only 6.74% in 2013 and 7.64% in 2014, but we can see that the trend has been towards improvement post the AbbVie (NYSE:ABBV) split.
Abbott also generates better cash flow in my opinion, with free cash flow as a percentage of sales ranging between 9% to a little over 12% post AbbVie. Alere only converts about $0.05 of every $1 into free cash flow.
Now, to make the deal even foggier, there appears to be turbulence between the two companies. Abbott apparently has some concerns about the deal, attempting to terminate it, but Alere's board rejected Abbott's request, indicating that there was no basis for it.
Alere is also currently being investigated by the U.S. government over its sales practices in some emerging and frontier markets. Abbott also thinks there may be some inaccuracies with some of Alere's representations, warranties and covenants in its merger agreement, according to CNBC. Abbott's offer to terminate the deal was also apparently related to Alere's delay in filing its 2015 Form 10‑K, as well as the other issues mentioned above.
St. Jude looks like a much better deal
Abbott announced its acquisition of Alere in February, and then just recently announced it will be buying St. Jude as well. I personally like this deal better, and if completed, it should make Abbott a stronger competitor in the medical devices market.
St. Jude also looks like a solid business on its own, boasting ROIC ranging between 10% to north of 16% consistently over the last decade. It's also a cash cow, with free cash flow to sales ratios usually falling in the 15-20% range over the last ten years.
I'm not sure I like the dilution that will occur to existing Abbott shareholders because of the new equity (roughly $3 billion in new shares) that will be issued to rebalance the company's capital structure, but at least it's relatively clear that Abbott is getting an excellent business at a decent price, unlike the Alere acquisition.
Less dividend growth? One thing is for certain, Abbott will have much more leverage
Abbott is a dividend aristocrat. It has raised its dividend every year for over four decades, and has been increasing it at a rapid clip. This may change after the recent spending spree, however. The company will be taking on a lot more leverage (assuming both deals are approved and/or don't fall through).
It will likely have to be a lot more financially disciplined going forward as a result, especially to maintain its investment grade credit rating. Abbott's leverage sat at about 2 times before its recent purchases. After the closing of both deals, however, that number will be more around 5 times. The Alere purchase was financed in part with a $9 billion bridge loan, and another $17.2 billion loan has been introduced to help with the St. Jude purchase.
Issuing additional equity and raising cash is likely in part needed to preserve the company's credit rating. S&P Ratings Services recently kept Abbott's credit rating at A+, but with negative implications.
Going forward, I think the company will be more focused on deleveraging than dividend growth, assuming both pending transactions are completed. The St. Jude acquisition will bring Abbott another $5.7 billion in net debt.
In a perfect world, I would personally like to see the Alere deal go away and see Abbott only acquire St. Jude. I personally like the latter deal much more and think it's a solid long-term move. I can live without high single-digit dividend growth if the business will be stronger in the long term. A starting yield of around 2.7% isn't too shabby, either.
I think shares will become especially compelling if they drop just a little more, placing Abbott's dividend yield closer to the 3% mark. That would also mean new 52-week lows, however.
Will Abbott get there? No one has a crystal ball, but I could see this scenario playing out if arbitrageurs short the company and go long St. Jude to make money off the spread.
After the sizeable haircut that's left shares at around 17.6 times projected 2016 earnings, I'm seriously contemplating jumping back into Abbott Labs. I would probably jump right in if the Alere deal fell through.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ABT over 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.
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