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The Year of Living Strategically

While private-equity bids got lots of attention, some public-company mergers aimed to remake their industries in 2006.
Roy Harris, CFO Magazine
January 10, 2007

Editor's Note: See's exclusive look at "Why Cisco Loves Private Equity" at the end of this article.

Only half in jest, Wall Street debt analyst Carol Levenson suggests that the 2006 surge in merger-and-acquisition activity reflected companies combining "to make themselves less vulnerable to a private-equity bid." Indeed, private equity (PE) accounted for more than a quarter of total proposed deal values last year—with the $25 billion–plus buyout bids for HCA Inc. and Harrah's Entertainment Inc. leading a long list of monster transactions. And it was the main reason that the 12-month M&A rampage was challenging the $1.7 trillion record for U.S. transaction values set in 2000.

Moreover, private acquirers are fundamentally changing 21st-century M&A with their deep pockets, lower internal-rate-of-return hurdles, and tough approach to valuations. "Private equity is raising expectations for all mergers," says Punit Renjen, leader of Deloitte Consulting's merger-integration practice, noting how its operating style offers "zero tolerance for nonperformers."

But that doesn't mean strategic deals in the public-company arena are dead. Far from it. The $16.5 billion proposed merger of Bank of New York Co. with Pittsburgh's Mellon Financial Corp.—part of a rush of giant announcements toward the end of the year—aims to blend Mellon's huge wealth-management business and BNY's asset-servicing and short-term-lending specialties into a new brand of global banking under the name Bank of New York Mellon Corp. (See On the Record.) Adding scale was another motivation, with huge examples being the $22.6 billion Freeport McMoRan and Phelps Dodge copper-and-gold merger and Anadarko Petroleum's acquisitions of Kerr-McGee and Western Gas Resources for a total of $23.3 billion. AT&T's $89.4 billion overture for BellSouth in March, the year's biggest proposed deal entering late December, of course, may smack of irony after years of phone-company breakups. Still, its completion will have a major impact on 2007 M&A. Look for the "cascading effect" of smaller equipment-supplier combinations as that and other telecom deals go through, suggests Deloitte's Renjen.

"The big private-equity transactions get noticed first because they've come so far so fast, but the majority of deals still get done by corporates," says Steven M. Bernard, director of M&A market analysis for Milwaukee-based investment banker Robert W. Baird & Co. "And we've seen some substantial strategic moves in this favorable environment of high stock prices and the ability to borrow at low rates."

One other strategic theme in 2007 will be the transforming of product delivery across entire industries, Bernard predicts — a quality reflected in two life-sciences deals that weighed in at more than $10 billion in 2006. One created Thermo Fisher Scientific Inc. as a laboratory- instrument leader. The other, proposed in November, would combine CVS Corp. and Caremark Rx Inc. into a behemoth managing more than a quarter of the nation's prescriptions (through Caremark), while dispensing many of those drugs via CVS-run pharmacies coast to coast.

One-stop Shopping
The Thermo Fisher deal had to wait until Thermo Electron pulled itself together — literally.

In 2001, Thermo Electron integrated dozens of majority-owned companies that were part of an unusual corporate structure involving spin-outs of its businesses into majority-controlled public entities. "We spent the last five years convincing people that we were one company, with one brand called Thermo," says Thermo Fisher CFO Pete Wilver. During that time, Waltham, Massachusetts-based Thermo Electron concentrated on its scientific-instrumentation business and rarely acquired. There were, however, occasional conversations between its CEO and the CEO of Fisher Scientific International, a Hampton, New Hampshire–based firm that specialized in "consumable" products used in labs, often in conjunction with Thermo products. The talks didn't amount to anything, at least initially.

As Thermo and Fisher grew independently in their own corners of life sciences, they each ignored "one major piece" of the industry, says Wilver, Thermo Electron's CFO at the time. Thermo steered clear of consumables, while Fisher avoided instruments. But once Thermo's reorganization was complete, the two CEOs began to discuss a corporate combination that "would allow customers to do one-stop shopping" for their lab equipment and materials. The ensuing $12 billion reverse merger gave Fisher holders two shares of Thermo common for each Fisher share owned and combined the two managements under Thermo Electron's CEO and CFO.

Investors have bought the logic, which Thermo Fisher CEO Marijn Dekkers describes as the laboratory equivalent of joining the leading computer-printer maker with the top cartridge company. The combined company is a third larger than its closest lab-equipment rival, its stock price is up to $45 a share from the low $30s in the months before the announcement, and most securities analysts have raised their estimates on the company. Moreover, the new entity didn't take on any new debt, replacing existing borrowing with a new $1 billion credit facility, and in the process raised Fisher's rating to investment grade, from one notch below.

Little Fish, Then Big Fish
Far from the laboratory side of life sciences, the world of drug dispensation was shaken by the proposed CVS-Caremark deal. But there, too, the road to the acquisition was paved by years of development by one of the parties — as Woonsocket, Rhode Island–based CVS expanded its pharmacy franchise out of the low-growth Northeast and into the Sunbelt. Starting in 2004, it acquired 1,268 Eckerd and 701 Savon and Osco stores, extending the chain into 43 states with a total of 6,200 outlets.

CVS began 2006, however, with a relatively tiny acquisition: it bought retail drugstore diagnostic center MinuteClinic for an estimated $170 million. More than just giving CVS a new business line, the MinuteClinic acquisition let the drugstore chain be seen more as a healthcare provider. The deal prompted rival chains to consider similar strategies. Even some people at CVS figured it was time for a rest. "With MinuteClinic in hand, we thought we were in for a nice little time when we'd be expanding internally in various ways," says CFO David Rickard.

The strategic thinking behind the MinuteClinic deal, though, led CEO Tom Ryan to ponder more ways that CVS could be part of the evolving delivery of medical services. Ryan and Caremark Rx CEO Mac Crawford "had dinner one night, just checking in with each other," as executives in related industries often do, says Rickard. Nashville-based Caremark is among the largest providers of pharmacy benefit management (PBM) services, administering drug distribution through 2,000 health plans. During their conversation, "the two CEOs realized they shared a vision of the way U.S. health care will evolve in the next several years," says the CFO.

What they saw was a need to repair a rift in the system: consumers being penalized by higher copayments and reduced service in company-sponsored plans, while companies sought to deliver more value to employees. As Crawford and Ryan discussed the dilemma, "their conclusion was that this whole market is going to become more consumer-centric," and the combination of PBMs and pharmacies is aimed at facilitating that. A $21.8 billion merger proposal resulted.

Such a reorientation could change drugstores' relationships with PBMs, which tend to dictate terms to drugstores, forcing them to raise prescription rates. The combined PBM-and-pharmacy clout of CVS-Caremark, in theory, might allow the company to help create better deals for consumers, while it gives itself new revenue opportunities. Other drugstore chains and PBMs would also have to join forces, according to this scenario.

Fundamentally, a CVS-Caremark combination would change the structure of the drug-distribution business by putting company administration and drug delivery in the same hands. It would also have phenomenal reach: Caremark works with a national network of 60,000 pharmacies, seven mail-service pharmacies, and nine call centers. And CVS predicts that the "merger of equals" would generate $400 million in synergies from purchasing, operational efficiencies, and overhead reductions, with savings being passed on to consumers.

"We have a growth engine here that is phenomenal," Rickard says of the current CVS operation. "But in combination with Caremark, and with the cash-flow-generating capacity of the drugstores, we'll just gush cash."

Investors bid both CVS and Caremark lower after the deal was announced, though. Rickard thinks the hit to their shares reflected a lack of clarity about the vision for a combined company. "The two businesses — PBM and the drug business — are very different. They've been somewhat at war until now, and investors have been on both sides of it," he concedes.

At press time, a competing $26 billion bid for Caremark had been received from St. Louis–based Express Scripts Inc. — a classic PBM "scale-building" proposal that set the stage for a bidding war. While CVS's rival was not a PE player, Rickard had prepared for a private bid when he did his premerger valuation. "As a so-called strategic buyer, we base our values on improved growth, improved margins, and such, while the private-equity guys are looking at a set of cash transactions only. They buy it, squeeze it for a few years, and sell it," says Rickard. "We ran the numbers both ways."

That approach to valuation will increasingly become part of strategic deal-making. Indeed, Carol Levenson, the director of research at New York–based Gimme Credit, concedes that the enormity of last year's PE bids undermines the humor of her joke about public companies banding together defensively. It won't be long, she says, before being a huge public company "offers little or no protection, as size and leverage barriers continue to fall for private-equity deals."

Roy Harris is a senior editor at CFO.

Why Cisco Loves Private Equity
(A Exclusive)

Some acquisitive public companies might be worried about the competitive threat from deep-pocketed private-equity players. But not Cisco Systems.

The San Jose-based technology company—whose $6.9 billion acquisition of TV cable-box maker Scientific-Atlanta was one of the top 20 deals of 2005, a year with only 11 deals of $10 billion or more—sees the enormous expansion of merger-and-acquisition activity by private investors as creating collaboration, not competition.

"We’re not a turnaround shop," says Ned Hooper, Cisco’s vice president, corporate business development. "Private equity can do that." And if private buyers play the corporate doctor, taking underperforming companies and applying strict financial discipline to their operations, Cisco would be more than happy to reap the benefit by snapping a target up if it was the right fit.

Cisco, which grew huge primarily by acquiring makers of routers and switches for the Internet, tends to seek smaller targets. "We see new-market entry as a constant business process for us," says Hooper. And the operations it buys "are not initially billion-dollar businesses," he says—until they are combined with one or two more acquisitions in the same field.

Cisco’s deal this week to buy closely held IronPort Systems was one of its bigger plays—costing Cisco about $830 million in cash and stock. Hooper, who spent much of the year-end holiday on the deal, notes that private equity—precisely speaking—wasn’t involved.

"It depends on how you define private equity," he says, noting that IronPort has about $95 million in venture capital backing. While most investors think of private equity as dealing with late-stage start-ups, VCs, strictly defined, are a subset of private equity.

Even though it's somewhat larger than the average Cisco acquisition, messaging-security company IronPort fits the Cisco M&A profile in many ways. IronPort would expand Cisco’s existing security-products line. "Security has been an important business for us," Hooper says, "but messaging security is not a business we're in today. And IronPort is the leader, so it provides a market-leading platform for us to expand in that area."

The purchase of IronPort is expected to close in the third quarter of the current fiscal year, which ends July 29. Cisco expects it will be neutral to fiscal-year earnings on a non-GAAP basis.

The Scientific-Atlanta deal marked a shift for Cisco. "It was the largest deal we've ever done in terms of number of employees and the scale of the business," Hooper says. "It demonstrated our ability to do larger deals," even though its primary function was taking Cisco into a consumer field that it believes is critical to the future. "Scientific-Atlanta is about the transformation that video is causing in the network," the executive says.

Within the M&A framework of concentrating on smaller deals and occasionally plunging into a larger acquisition, Cisco envisions the prospect of partnering with one or more private equity players when a big one comes around. And certainly, according to Hooper, it would consider buying operations that private buyers have put through a restructuring, though that hasn’t happened yet. "Private equity now has a scale and capability to address large companies that are very inefficient," he says. And one of Cisco’s strengths, he says, is identifying "good assets stuck in bad companies." —R.H.

Crowded at the Top
U.S. deals of $10 billion or more announced in 2006*
In $ Billions Target Buyer Announced
1. 89.4 BellSouth AT&T Mar 5 (Pending)
2. 32.5 Equity Office Properties Blackstone (Private) Nov 19 (Pending)
3. 32.1 HCA Investor group Jul 24 (Completed)
4. 27.5 Kinder Morgan Investor group May 29 (Pending)
5. 26.8 Clear Channel Investor group Nov 16 (Pending)
6. 25.6 Harrah’s Entertainment Investor group Oct 2 (Pending)
7. 25.5 Golden West Financial Wachovia May 7 (Completed)
8. 22.6 Phelps Dodge Freeport McMoRan Nov 20 (Pending)
9. 21.8 Caremark RX CVS Nov 1 (Pending)
10. 18.2 Kerr-McGee Anadarko Petroleum Jun 23 (Completed)
11. 18.0 Cablevision Systems Investor group Oct 8 (Pending)
12. 17.5 Freescale Semiconductor Firestone (Private) Sep 15 (Completed)
13. 17.4 Western Union Financial Shareholders Jan 25 (Completed)
14. 17.4 Albertson’s Investor group Jan 22 (Completed)
15. 16.6 Pfizer Consumer Healthcare Johnson & Johnson Jun 26 (Pending)
16. 16.5 Mellon Financial† Bank of New York Dec 3 (Pending)
17. 15.8 Delta Air Lines US Airways Nov 15 (Pending)
18. 15.1 North Fork Capital One Financial Mar 12 (Completed)
19. 14.7 Lucent Technologies Alcatel SA Mar 24 (Completed)
20. 13.4 Univision Communications Investor group Jun 27 (Pending)
21. 12.0 Fisher Scientific International Thermo Electron May 8 (Completed)
22. 11.9 KeySpan National Grid Feb 27 (Pending)
23. 10.0 AmSouth Bancorp Regions Financial May 25 (Completed)
*As of December 14, 2006 †Based on market price Source: Thomson Financial