August 18, 2014 5:26 pm

Roche / Chugai: uptown problems

An expensive but low risk investment, if it happens

An uptown problem, if there ever was one: whatever to do with all that money. Roche has thrown off, on average, SFr12.6bn ($13.9bn) in free cash flow a year over the past five years. It has only SFr9bn of net debt. Despite paying a solid dividend, the money is piling up.

Against this prosperous backdrop, there is logic to reports that Roche is considering buying the nearly 40 per cent of Chugai it does not own already. If the Swiss company paid a 40 per cent premium to chase the minority holders out of its Japanese subsidiary, the bill would come to about SFr9bn – under SFr7bn net of cash in the target – leaving Roche’s debt ratios conservative.

But a cash deal gets no smarter because the buyer has a lot of cash (just as a deal is no smarter for being done with expensive shares). The test is always whether the returns from the deal are greater than the buyers’ costs of funding, and superior to its other options. Here the logic looks more strained because the price paid is so high.

Roche would be paying over 40 times earnings for the shares. Its own multiple is less than half that, and the growth rates of the two companies are similar. That means it would have to find quite significant savings at Chugai, or push its drugs much more effectively, in order to make the deal economic. Simply emptying out the executive suite would not be enough. JPMorgan, for example, sees half of Chugai’s overhead and research spending cut. Even this, and very low financing costs, makes the deal accretive by only 1 per cent or 2 per cent.

More reassuringly: Roche must know all there is to know about Chugai. Its bean-counters should be able to estimate the returns from full control with some accuracy. Those returns, then, might be more attractive in risk-adjusted terms. In an industry known for volatility, there is much to be said for that.

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