Key Takeaway
We have suspected that ZTS may become a bid target going into 2015 and that
the Investor Day on November 18 is geared towards bid defense. Bayer is the
most logical and motivated potential acquirer of the business should activists
trigger an M&A process, in our view. Whilst ZTS shares have appreciated
recently, we see room for Bayer to offer at least a 25% premium and drive high
single digit earnings accretion from what we see as a strategic asset for them.
Bears caught sleeping by activists: We have long held the view that Zoetis was likely to
become the subject of bid speculation going into 2015, as a potential consolidation target
for the Animal Health industry. On November 11, Pershing Square Capital Management
disclosed that it and Sachem Head Capital Management together have taken approximately
8.5% and 1.6% stakes in Zoetis, respectively. Whilst this specific event was unexpected, it
has fueled the market's interest in Zoetis as a potential target for M&A activity.
We are cautious on a take-out near term; Think mid-2015 is more likely: First
we look to remind investors that although activist investors have taken a significant stake,
there is no actual bidder yet. Whilst Valeant (VRX, $131.09, Buy) is often cited as a potential
suitor, we believe that an all debt/ cash bid from Bayer (BAYN GR, €109.50, Buy) is the most
likely outcome as it is best placed to get real revenue synergies and take out cost without
damaging the future of the business. There could also be some tax benefits as Bayer may
neutralize repatriation taxes as a non-US buyer. Timing is another issue on our minds as it is
unclear as to exactly when Zoetis can be bought without triggering a capital gain liability,
given the tax-free spin status awarded to it during the separation from Pfizer (PFE, $30.42,
Buy). We caution that sometime during H1'15 might be the earliest that a transaction can
happen in that regard.
We believe ZTS is a key transaction for Bayer: Our investment thesis on Bayer
has for some time assumed that it would bolster up Consumer Health (which it did in
2014 through Merck & Co. [MRK, $59.31, Hold]), separate Bayer MaterialScience (which
management have announced may happen as early as mid-2015), and scale up Animal
Health, which management have recently indicated that they are strategically analyzing.
We also understand from previous conversations with management that there are no
major areas of concern regarding anti-trust for Bayer Animal Health and Zoetis. With few
standalone Animal Health assets of scale left in the industry, we believe Zoetis remains the
last viable option for Bayer in the near term to give sufficient critical mass to its Animal Health
operations before the current CEO, Marijn Dekkers, retires at the end of 2016.
Reverse engineering the accretion model: If Bayer were to bid for Zoetis, we believe
that the potential revenue synergies and cost savings should be driven on the Bayer Animal
Health side of the transaction. This is because it represents the smaller entity within the
deal and results in lower levels of cost saving than might be arrived at otherwise. We
have attached a summary of our pro forma accretion model in Exhibit 1, assuming: 1.
Transaction occurs in 2015, and closes at end of 2015; 2. 25% premium paid for Zoetis
($53.30 per share), representing 5.4x 2015E revenues (note Novartis Animal Health (NOVN
VX, CHF89.50, Buy) was agreed to be sold to Eli Lilly (LLY, $67.40, Hold) at 4.9x 2013A
sales); 3. 5% revenue synergies off Bayer Animal Health’s revenue base by 2020E; 4. 25%
cost savings off Bayer Animal Health’s total operating costs by 2018E; 5. Blended tax rate
(weighted average basis), though this may significantly underestimate the tax benefits of
the transaction to Bayer; 6. Debt funded at 4% interest rate. On this basis we believe that
Bayer would be a determined buyer of Zoetis and could potentially make a transaction work
at valuations of $53 per share or more.