Bayer probably doesn’t need a lengthy introduction, as this German company is one of the largest and best known life science companies in the world. With a history of approximately 150 years, Bayer is ready to start a new chapter with the acquisition of seed specialist Monsanto.



2016 was an absolute top-year

The Bayer management described 2016 as ‘a very successful year’, and we couldn’t agree more with this assessment.

The total revenue increased by approximately 1.5% to 46.8B EUR and as the cost of goods sold decreased, the gross profit increased by almost 6% to 26.5B EUR. That’s an excellent result, but unfortunately Bayer saw a relatively high increase in its other operating expenses (R&D expenses increased by almost 10%, whilst the G&A expenses increased by approximately 7%). Despite this, the EBIT increased by more than 10% to 7.04B EUR.

The pre-tax income also increased, by 12% to 5.89B EUR, whilst the net income was roughly 4.53B EUR on an attributable basis. This resulted in a 5% increase in the company’s EPS as well, which went up from 4.87 EUR to 5.12 EUR. Definitely a good result, and this was also confirmed in the company’s cash flow statements.

Source: annual report

On an adjusted basis, the operating cash flow was approximately 10B EUR (which excludes changes in Bayer’s working capital position, and also takes the ‘real’ tax bill of 1.33B EUR into account, rather than the effective tax-related outflow of 2.1B EUR which was related to previous tax years). The total capex was just 2.6B EUR, resulting in an adjusted free cash flow of 7.1B EUR (including pension-related payments). That’s indeed much higher than the net income of 4.1B EUR, and this difference could be explained by the fact the capex is much lower than the annual depreciation charges.
Source: annual report

Bayer does pay a dividend, but less than 1/3rd of the adjusted free cash flow is being used for this, which means the company is able to keep the majority of its cash inside the company (and this has been invested in ‘current financial assets’, whilst Bayer also retired approximately 730M EUR of debt, which should have a positive impact on its interest expenses from this year on).

What can we expect in 2017? Will the Monsanto acquisition go through?

Bayer sounds very upbeat about 2017, as the company is now guiding for a full-year revenue of approximately 49B EUR (which would be another 2%+ increase), whilst the core earnings per share from continuing operations are expected to increase by a mid-single-digit percentage, even though the Covestro subsidiary will only be taken into account for the 64% Bayer still owns.

2017 will also be a year with yet another boost in Bayer’s R&D division, as the company now plans to spend a stunning 48B EUR on research & development, whilst keeping the capex stable at 2.5B EUR for tangible assets and 0.4B EUR for intangible assets. Bayer is aiming for a year-end net debt of approximately 10B EUR (compared to a current net debt of approximately 11.4B EUR, which already is a reduction from the 17B EUR net debt in 2015).
Source: merger presentation

It’s clear Bayer’s free cash flows allow it to pursue large acquisitions, and that’s where its deal with Monsanto comes in. Bayer is offering a cash payment of $128 per share of Monsanto, which values the deal at approximately $66B (including $10B of net debt). As this is an all-cash deal, we would expect Bayer to end the year with a net debt position of approximately 72B EUR (as the entire transaction will be debt-funded thanks to a bank financing provided by all the large US banks). This shouldn’t really be an issue at all, but investors should be aware that A) the interest charges will increase rather dramatically but B) the free cash flow result will very likely increase as well.

That being said, based on the $66B valuation, Monsanto is expected to have a free cash flow yield of 3%, and this should cover the increase of the interest expenses (which we would estimate at 1.25B EUR in the first year). With a pro-forma combined free cash flow of 9B EUR, and a dividend of 2.75 EUR per share, Bayer will be able to reduce its net debt by approximately 4-6B EUR per year (depending on the cost of debt and how fast the 1.4B EUR in synergies could be realized), and we would really hope reducing the net debt will be Bayer’s only priority once the deal closes.

Investment thesis

The Monsanto acquisition will definitely have a relatively large impact on Bayer’s financial situation at all. The EBITDA and net income will obviously increase, but as it’s an all-cash deal, we are more worried about Bayer’s debt levels, as the net debt/EBITDA ratio will very likely increase to 4.5 on a pro forma basis.

It’s manageable, but there’s no margin for errors, and every euro that won’t be spent on the dividend will have to be used to reduce its net debt to avoid the interest expenses spiraling out of control as the interest rates increase.

Disclosure: The author has no position in Bayer, but could write put options on weakness.

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