What’s a Merger Worth?

The Knowledge Capital Scorecard offers a new way to value the Pfizer/Warner-Lambert merger.
S.L. MintzApril 1, 2000

When Pfizer Inc. agreed in early February to pay more than $90 billion for Warner-Lambert Co. in the priciest hostile takeover ever, the deal triggered the inevitable question: Was the price tag justified?

According to final terms of the deal, 2.75 shares of Pfizer will be exchanged for each share of Warner-Lambert.

Wall Street saw a winner in the marriage of the two pharmaceuticals giants. According to a First Call earnings- consensus report, the two companies combined will grow faster than either alone. Instead of two large companies, each expected to grow earnings at 20 percent a year for the next five years, a single company emerged with an expected 24 percent annual growth rate.

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Knowledge capital exists in every industry, but seldom to the degree found in the drug business, where value resides chiefly in brand recognition, patents, reputation, and research pipelines. “Certainly, the impact on intellectual capital and knowledge is one of the critical things we are trying to achieve,” says Pfizer CFO David Shedlarz. Indeed, he adds, Pfizer launched its bid with the impact on knowledge capital in mind, “both strategically and tactically.” The endgame: “to create a new competitive standard in developing a breadth and depth of research capability.”

Measuring the returns from knowledge capital is no easy task. Traditional analytical tools, although good at keeping tabs on investment in knowledge assets, don’t record the consequences on balance sheets. In an effort to close this gap, CFO applied the analytical technique used to compute its annual Knowledge Capital Scoreboard to Pfizer’s acquisition of Warner-Lambert.

According to a Knowledge Capital Scorecard assessment, the merger creates $6 billion of knowledge capital over and above the roughly $28 billion acquisition premium that Pfizer agreed to pay. The methodology for reaching this conclusion was developed at CFO’s invitation by Prof. Baruch Lev, the Vincent Ross Professor of Accounting and Finance at New York University.

Essentially, knowledge capital represents the capitalized difference between a company’s normalized earnings and average expected returns for assets posted on the balance sheet. Ordinarily, for healthy companies, normalized earnings exceed earnings that book assets are expected to generate. The excess constitutes knowledge earnings, that is to say, the portion of normalized earnings not attributable to book assets. Thus, if a company’s normalized earnings are $100 million and book assets can be expected to earn $80 million, then the company generates $20 million in knowledge earnings.

To find knowledge capital, knowledge earnings are capitalized to reflect the present value of all future knowledge earnings growth–much like a conventional dividend discount model.

In Pfizer’s case, premerger knowledge capital was $82.5 billion; for Warner-Lambert, it was $50.0 billion. Combined knowledge capital before the merger totaled $132.5 billion. Postmerger, using Wall Street’s increased earnings expectations and growth estimates, combined knowledge capital is $166.9 billion, according to portfolio manager Marc Bothwell, of Credit Suisse Asset Management in New York.

All told, the merger appears to add $34.4 billion in knowledge capital. It does not come free of charge, however. To snatch Warner-Lambert away from American Home Products Corp., the rival bidder, Pfizer agreed to pay approximately $28 billion more than the average price of Warner-Lambert shares before American Home put them in play in August 1999. In this light, the net gain in knowledge capital is $6.4 billion.

Knowledge Capital 1/1/2000 (in $ mill.)

Pfizer (premerger) $82,481
Warner-Lambert (premerger) $50,042
Simple knowledge- capital sum $132,523
Knowledge capital created $34,381
Acquisition premium $28,000
Knowledge-capital bonus $6,381

Sources: First Call, Credit Suisse Asset Management

The More Things Change…

Would you ever buy shares in a company that confessed the following?

  • We are not profitable and do not expect to achieve profitability in the near future, if at all.
  • We have a history of negative cash flow, and we may never achieve positive cash flow.
  • We may not be able to obtain sufficient funds to execute our business plan.
  • Because we have grown rapidly and expect our growth to continue, we may have difficulty managing our growth effectively, which could adversely affect the quality of our services and the results of our operations.
  • Our brand names are difficult to protect and may infringe on the intellectual-property rights of third parties.
  • You will pay a higher price for our common stock than was paid by existing stockholders, and will experience immediate and substantial dilution.

Of course you’d buy shares, at least if you were among the avid investors who chased the recent initial public offering by Via Net.Works Inc. Eight pages of risk disclosure accompanied the prospectus for the company, which supplies Internet access and services to small and midsized businesses in Europe and Latin America.

The investors don’t seem to mind. Demand for Via Net.Works shares, coming principally from institutional investors, outstripped supply by more than 33 times. “We didn’t find that risk factors were a topic of discussion on the road show,” says CFO Catherine Graham. “People who would be scared by those risk factors are generally not investors for this market,” she says.

Call the mood drunken or prescient, it is not brand new. Consider, for example, an observation by Jack Dreyfus, former CEO of Dreyfus & Co. Here is Dreyfus, as quoted by author Burton Malkiel in his book A Random Walk Down Wall Street, describing investors’ breathless passion for high tech in the late 1950s:

Take a nice little company that has been making shoelaces for 40 years and sells at a respectable 6 times earnings ratio. Change the name from Shoelaces Inc. to Electronics and Silicon Furth Burners. In today’s market, the words “electronics” and “silicon” are worth 15 times earnings. However, the real play comes from the words “furth burners,” which no one understands. A word that no one understands entitles you to double your entire score. Therefore, we have 6 times earnings for the shoelace business and 15 times earnings for “electronic” and “silicon,” or a total of 21 times earnings. Multiply this by 2 for “furth burners” and we now have a score of 42 times earnings for the new company.

In today’s world, Electronics and Silicon Furth Burners would be more wary of shareholder lawsuits, and would accordingly issue its own eight-page risk-factor disclosure (in addition to adding a dot-com to its name). “Sophisticated investors recognize that risk-factor disclosure is essentially designed as an insurance policy for the issuer, and is therefore crafted in the most negative light,” says attorney David Bicks of Le Boeuf, Lamb, Greene & MacRae, in New York. In the current market, he adds, risk disclosure also serves a more immediate purpose: “as a badge to validate a hot issue.”