Mead Johnson's (NYSE:MJN) shareholders will be getting a great deal if the acquisition by Reckitt Benckiser (OTCPK:RBGLY) goes ahead. After early rumors, both companies have confirmed that they are in advanced talks for an acquisition. The offer is $90 in cash for each outstanding share of Mead Johnson. The stock was trading below $70 on 1, February. If the deal goes ahead, Reckitt Benckiser will be paying a premium of around 28.5%. There had been other rumors of a takeover involving Mead Johnson. However, Reckitt Benckiser seems to be the most eager to get this deal done, which is understandable from its perspective.
Mead Johnson acquisition, while less attractive to the same industry players like Nestle (OTCPK:NSRGY), is an important strategic step for Reckitt Benckiser. Keep in mind that Mead Johnson's revenue and margins have come under pressure in the last three years. Nestle is already a strong player in the nutrition segment, which means that buying Mead Johnson would have made business sense as it would have further strengthened its position. However, Nestle was never going to pay such a premium. For a strong player like Nestle, an offer like Reckitt Benckiser's would have garnered a lot of criticism from the shareholders. Nestle's growth in sales for baby formula and other nutrition products is strong (over 3% organic growth in 2015). There was no immediate need for an acquisition.
For Reckitt Benckiser, however, it makes sense financially as well as on a business level. Reckitt Benckiser will fund this acquisition with its own cash and debt; mainly, it will be debt. However, as the company has an extremely strong investment grade rating of A1 and A+, it can afford to raise cash through debt without incurring too much interest costs. Current outstanding bonds have a coupon rate of between 2% and 3%. Borrowing such large amounts of debt might result in a downgrade or a negative ratings outlook for the company. However, it will be worth the trouble as Reckitt Benckiser will gain substantially in terms of business growth.
Around 37% of Mead Johnson's annual sales come from infant formula and 39% from children's nutrition products. The company has a strong presence in Asia and other emerging markets. The demographics (growing middle class, higher birth rate and an expanding population of working women) are in favor of the business. As a result, demand for nutrition products is expected to rise in the next few years. Currently, Reckitt Benckiser is only generating about 8% of its total annual sales from food products. This acquisition will allow the company to take the segment sales above 27%. It will become the second largest segment for the company after Hygiene, which will account for 32% of the total sales, down from 40% pre-acquisition. These numbers show why Reckitt Benckiser is willing to pay such a high premium. The company has its eye on the growing middle class in some of its key geographic regions. I strongly believe that the premium is mainly for the strategic importance of gaining a substantial share in a business segment. Financially, the deal looks to be a little expensive. Mead Johnson is getting EV/EBITDA multiple of 18x as the deal value puts Mead Johnson EV at $18 billion and the full-year 2016 EBITDA is expected to be just above $1 billion.
Mead Johnson's strong technical profile in the infant formula and children's nutrition segment will give Reckitt Benckiser a platform to aggressively grow its sales in emerging markets. The combined entity will have a wide moat and strong brands. It will be a formidable competitor for Nestle and other players. The fundamentals of the industry are going to improve with the favorable changes in the demographics.
The rationale behind considering the sale when the future growth prospects are bright is that price offered is quite attractive. If the deal goes through, Mead Johnson shareholders will be happy with the premium on offer. Reckitt Benckiser shareholders might be a little restless looking at the premium and valuation. However, the long-term shareholders should not look at it negatively as the deal will be hugely beneficial in the long term. The addition of Mead Johnson products to the Reckitt Benckiser portfolio will allow the company to target an area with a strong growth profile. Wide moat will result in better penetration and strong earnings growth.
The deal has not been finalized yet. However, the language of Reckitt Benckiser's press release sounds quite optimistic. It wants this deal to happen. It gives the company an opportunity to market a quality product to the customers in some of its key geographic regions. It has built a strong understanding of these areas through years of experience. However, a possible risk for Reckitt Benckiser is that its management teams have no experience of managing a nutrition business. Other than this, it is a good deal for Reckitt Benckiser. If the management is able to execute it properly, then the long-term benefits of the transaction will outweigh the premium paid.
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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.