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 HarrisJanuary 4, 2007

Editor’s Note: See CFO.com’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 CFO.com 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