Events: Take-Out Analysis
June 26, 2015
- NYSE: ZTS
- Recent PPS: $55.37
- Shares Out: 502 million
- Market Cap: $27,796
- Net Debt: $2,904
- Enterprise: $30,700
News. The WSJ reported yesterday afternoon that VRX is in talks to acquire ZTS. While I do not believe that VRX will ultimately take over ZTS – as the current valuation is likely prohibitive at current levels – this news item should not come as a surprise, as A) Pershing Square has a stake in both companies, B) VRX and ZTS have been intermittently trading in an odd lock-step fashion for the past several months, and C) ZTS just hit the 2-year anniversary of its spin-off date (6/24), which means it can freely speak with potential acquirers.
“Scarcity” Valuation. Since acquiring a stake in ZTS, Pershing Square has referenced the “scarcity” value of the ZTS asset, comparing ZTS to its former BEAM investment, which was taken out at a 25% premium to an already hefty valuation. My guess is that ZTS is exploring a variety of potential merger partners, and the VRX report was simply the first leak. As stated, more than likely VRX will not be the one to provide ZTS shareholders with a ‘premium’ take-out valuation. However, If in fact Pershing and VRX agree to merge the companies, my guess is that they have something big up their sleeves, as VRX will not buy ZTS for a mere 10% IRR…
(As I am writing this, David Faber just reported that VRX made a “courtesy call” to ZTS for Pershing. Beyond bizarre.)
Standalone. On a standalone basis ZTS is worth approximately $50 on a standalone basis. This valuation assumes a 20X terminal PE, 8% cost of equity, and that ‘growth’ R&D is 50% of targeted R&D, while utilizing ZTS’s projected financial plan.
Take-Out Valuation. I estimate a “premium” take-out transaction would be done at an implied terminal PE of between 22.5X and 27.5X, or between $54.50 and $64.05.
VRX IRR. At $54.50, assuming VRX took ZTS out with leverage of 6X pro forma 2016 Adj. EBIT; a 10% tax rate; 45% EBITM; and 20X terminal PE, VRX would realize a 5-year IRR of ~22% on its required equity capital. At 25X and 27.5X, the IRRs would be 18% and 15%.
In its deals, VRX shoots for at least a 20% IRR (unsure of duration) utilizing fully-taxed earnings; and since the assumed 45% pro forma EBITM is likely (highly?) unrealistic, the VRX take-out analysis is simply an attempt to back into the required assumptions to make a VRX deal work at the three take-out valuation scenarios.
With ZTS now free to negotiate with potential acquirers, this bizarre VRX rumor at minimum puts ZTS ‘in play’. And while ZTS is trading at my standalone FVPS estimate, I will continue to hold the position in present form, as I believe ZTS’s recent strong stock price action is indicative of something in the works…with the risk of course being that this ridiculous VRX rumor was in fact THE announcement that has been driving ZTS’s stock price. Though with a favorable M&A environment in place and Pershing Square on the ZTS BOD, I am willing to ‘underwrite’ that risk here.