The prospect of making a giant acquisition often seems to infect CEOs’ minds with delusions of glory. They envision themselves standing triumphantly atop a corporate colossus, commanding an empire that Alexander would have envied. Eventually they forget that their field is business, not global conquest, and that the definition of success is not closing the deal but rather benefiting shareholders. Signs suggest that Bayer CEO Werner Baumann has succumbed to this malady.
His $62-billion cash bid for Monsanto would create a vast, globe-girdling company, and he justifies it by projecting impressive synergies and cost savings. Monsanto has rejected the bid, as it wants an even higher price for its assets. Meanwhile, investors don’t seem to see the value. They’ve stampeded away from Bayer’s stock since rumors of the deal began circulating, sending it down to a 52-week low yesterday and reducing the company’s value by $25 billion. This, sad to say, is utterly typical when a company proposes a giant takeover. The stock of the target company, by contrast, typically leaps, and that’s just what happened; Monsanto gained $7.2 billion of value, hitting a 10-month high yesterday (before Monsanto rejected the bid this morning).
That is, investors expect this deal to be a value destroyer for Bayer shareholders and a value enhancer for Monsanto shareholders. The reason is surprisingly simple, and you’d think CEOs would figure it out more often than they do.
The value of a business is based on how investors expect its return on invested capital to exceed (or not) the cost of all the capital in the business. The result is what finance types call economic profit. It’s an elementary concept, yet most financial reporting doesn’t tell you much about it. So I turned to the EVA Dimensions consulting firm, which crunches the numbers needed to figure economic profit. Here’s what they show, using Bayer’s initial bid for Monsanto as a starting point.
If Bayer were to pay $62 billion for Monsanto, that’s $62 billion of new invested capital. The dollar cost of that capital for Bayer would be about $4.7 billion a year. So the Monsanto deal is a value creator for Bayer only to the extent it can bring in profit (net after-tax operating profit, if you’ll forgive the finance jargon) beyond that amount. What are the prospects of that happening? Well, by that measure Monsanto’s profit last year fell far short, at only $2.6 billion. Not encouraging, especially since the numbers would increase if Bayer ups its bid.
Maybe Baumann thinks he can make up the difference through synergies and cost savings. But Monsanto CEO Hugh Grant can calculate those potential economies about as well as Baumann can and is thus well positioned to extract most of them for his shareholders in the price negotiation. Or maybe Baumann figures he can get the returns up to the needed level in a few years; but of course future profits must be discounted back to the present at Bayer’s cost of capital (about 7.6%), so they lose value quickly as they get pushed out.
Even deals that make sense strategically turn into losers if the price is too high. Think of Boston Scientific’s disastrous purchase of Guidant in 2006 or Xerox’s deal for Affiliated Computer Services in 2009. This looks like another classic example. At least that’s what investors think, and CEOs need to stay focused relentlessly on investors, despite a big deal’s glittery allure.
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