The 0.1 Percent Solution

When is an acquisition not an acquisition? When the acquired company thinks it's a merger.
Carla RapoportJuly 11, 2002

On April 1 this year, anyone with a bank account with Japan’s Mizuho Bank was in big trouble. The new bank, created through the merger of Industrial Bank of Japan, Fuji Bank and Dai-Ichi Kangyo, was spitting out ATM cards, refusing to pay out cash to its own customers and causing general chaos up and down the country.

The problems got sorted out, but anger raged for a lot longer. It turns out that when the three banks tried to integrate their operations, they simply couldn’t agree on whose computer systems would survive the merger. Instead, in Japanese fashion, they knocked out a compromise, involving a relay system to bridge the Dai-Ichi Kangyo and Fuji systems. The deal saved face, but it ended up destroying the bank’s important first week in business. And the moral of the story? In a 1:1:1 merger, no one can effectively take charge.

Not far from a major Mizuho branch in Tokyo’s central Ginza district, the CFO of Chugai Pharmaceutical, one of Japan’s leading drug companies, watched the Mizuho drama closely. In the middle of a merger himself, Yuji Suzawa had good reason to take note of the chaos. Last December, US$1.7 billion-a-year Chugai announced its intention to tie-up with Roche, the Swiss drug giant, and its Japanese arm, Nippon Roche. This month, Suzawa takes the deal to his shareholders. Still, despite the Mizuho debacle, the 65-year-old exudes confidence. In the Japanese context, he’s a brave man.

Acquisitions, mergers, takeovers – they’re all an anathema to the change-phobic Japanese. But with tougher competition globally and dull economic performance dragging into a second decade, Japanese companies are starting to accept that having a new owner or co-owner is better than going it alone. M&A is rising (see “Shock Value,” May 2002). For companies with cash, this change of heart offers a real chance to gain a foothold in the notoriously slippery Japanese market. Groups such as GE Capital and Ripplewood Holdings of the US have been showing the way with a string of recent Japanese acquisitions in the financial services arena and property sector.

A Swiss Roll

From the Japanese perspective, however, face-saving mergers remain preferable. But, as the Mizuho story shows that mergers can create new problems, namely raising the question of who’s in charge. Roche’s acquisition, valued at between 155 billion and 198 billion yen (US$1.6 billion), shows how a competitor can widen its access to the Japanese market if the predator is prepared to tread very, very carefully and be generous with autonomy. For one thing, Suzawa and the rest of his team consistently refer to the deal as a merger. In fact, US$18.5 billion-a-year Roche will end up with a controlling 50.1 percent of Chugai, assuming shareholders endorse the deal. But Suzawa and the rest of his team don’t believe the extra 0.1 percent is anything more than a number.

“We’re merging with Roche Japan only,” he says, referring to Roche’s own substantial Japanese business. And he points out, there won’t be any Mizuho-type dramas with that part of the plan. “The name and management of Roche Japan go to us,” he explains, meaning that Roche employees in Japan will work for Chugai. “We negotiated with Roche in Basel but we are merging with Roche Japan,” he says.

A different approach from Roche, he claims, would never have been successful with the Chugai board. “If the [offer had come] from a US company, it wouldn’t have been so easy. The US company would have wanted more than 50 percent and a blank check on management,” he says. Pharmaceutical industry expert Hidemaru Yamaguchi at Nikko Salomon Smith Barney agrees. “The deal is one of the rare cases where the acquired party was allowed to retain management autonomy by the buyer. Most Western companies would want full control,” says Yamaguchi. In this case, Roche is proposing to simply put the head of Nippon Roche on Chugai’s board and add three Swiss non-executive directors.

Daring Dilutions

No wonder Suzawa’s delighted these days. The deal gives the Japanese company real clout in overseas markets through the Roche sales network as well as strong synergies at home, allowing for cost-cutting and better profitability. There’s just one small problem. To an outsider, especially one unfamiliar with M&A, the deal looks like more effort went into preserving Chugai’s autonomy than getting the best terms for its shareholders.

The deal’s structure is part of the problem. Roche’s business conflicts with Chugai’s California-based biotech subsidiary, Gen-Probe. So, as the first step toward the Swiss acquisition of Chugai, the Japanese company is seeking a US listing for Gen-Probe, with the intention of distributing the new shares to Chugai shareholders. Next, Roche will make a tender offer for 10 percent of Chugai’s shares at 2,136 yen (US$17), a hefty premium over the price at the end of May. Then Roche will buy another raft of shares – dubbed a third party allotment – at a lower premium of 1,780 yen (US$14) per share. The size of the second part of the deal will depend on how many of Chugai’s shareholders take up Roche’s tender offer. At the end of the day, this structure ensures that the Swiss giant will end up with a majority but only by a face-saving 0.1 percent.

Still, the company’s extensive PowerPoint presentations, posted on its website, do not highlight one major fact. The deal represents an 80 percent dilution for Chugai shareholders. Suzawa is not shy about admitting this. But after four months of working together with the Roche team, he firmly believes that the cost savings created by the merger will mean that the effect of the dilution, on an operating profit per share basis, will be eliminated within a year.

Of course, shareholders in Japan are not known for their aggressiveness and the two sides have clearly banked on this cultural fact. However, with the number of M&A deals growing monthly, murmurs of unrest are starting to grow. A recent news article in Japan’s leading business daily, the Nihon Keizai Shimbun, reported that pension funds and other institutional investors are preparing to cast negative votes on a number of deals, including the Chugai deal, although no investors were bold enough to be quoted by name. In the meantime, the best indication of investor sentiment, the company’s share price, is not faring well. In the third week of May, it was trading at 1,441 yen, compared to 1,725 yen on the day the deal was announced.

Still, fund managers in Japan know about as much about M&A and its benefits as they do of yodeling. Synergy doesn’t really translate in Japanese. So, it’s now up to Suzawa and his team to explain that the combined sales force of Roche and Chugai in Japan alone takes the Japanese company from 11th in Japan to fourth. And in terms of worldwide sales, Chugai goes from 45th to being part of one of the world’s ten biggest drug companies. In the drug industry, these are important numbers.

Even better, after four months of working together, the “integration team” came up with some big news last month. Following the merger, Chugai and Nippon Roche plan to shutter two R&D facilities and reduce their seven manufacturing plants to four. Sales branches will be cut from 24 to 13 and 95 sales rep offices will drop to 55, with headquarters at Chugai’s Tokyo offices.

The new group will also eliminate 8 percent of its workforce. In three years, the new company expects to turn in operating profits of 63 billion yen (US$509 million) on sales of 315 billion yen (US$2.5 billion). That amounts to a 50 percent increase in sales and double the operating profits achieved by Chugai in the year to March.

If Suzawa and his Swiss colleagues can pull this off, never will 0.1 percent have created so much value.