When German pharmaceutical giant Bayer moved to acquire US agrochemical company Monsanto last year, marking the largest takeover effort ever undertaken by a German company, many of Bayer’s shareholders were highly critical. The acquisition, after all, cost Bayer $66 billion (€60.6 billion), a price some shareholders deemed too steep, and many feared the deal would cause Bayer to neglect its pharmaceutical business.
Seven months after the takeover deal was announced, on Friday, Bayer Chief Executive Werner Baumann appeared for the first time to answer directly before shareholders about the all-cash deal.
It's a proving a tough sell. Prior to the acquisition announcement, many German investors knew Monsanto only as one of the most disliked companies in the world, notorious for its aggressive business practices and its controversial genetic engineering – something that Europeans in particular still remain deeply skeptical about. And while many investors understand the logic behind Bayer’s push to become the world's largest player in the agrochemical industry, others remain wary of the deal – and what it might do to Bayer's own bottom line.
In order to see the deal through, Mr. Baumann will not only have to overcome formidable regulatory hurdles, but he will have to pull off one of the largest capital increases in German corporate history.
"We're afraid that Bayer is exerting all of its energy on Monsanto and ignoring its other sectors," said Marc Tüngler, manager-in-chief at DSW, a German shareholder protection group.
Mr. Baumann has promised investors that the deal will generate considerable value from the start, and that it will put Bayer at the forefront of a potentially lucrative agribusiness sector dominated by consolidating multinational companies. Yet the path toward closing the complicated deal is filled with obstacles.
In order to see the deal through, Mr. Baumann will not only have to overcome formidable regulatory hurdles, but he will have to pull off one of the largest capital increases in German corporate history while at the same time boosting Bayer’s cash-generating business operations. To do that, Bayer needs a whole bunch of its other operations to run like clockwork.
An analysis by Handelsblatt shows that Mr. Baumann is laying the financial groundwork for the takeover by increasing the company's cash flow and profit margins across its many divisions. Bayer’s underlying earnings before interest and taxes, or EBIT, improved by 15 percent to €8.13 billion in 2016, excluding approximately €1 billion in one-time charges. On Thursday, Bayer raised its earnings forecast for this year, announcing that it expected an increase of 10 percent before interest, tax, depreciation and amortization (EBITDA).
One of the most decisive factors for its improved profitability has been lower production costs. This provided Bayer with enough flexibility to keep marketing and distribution expenditures at a high level – equivalent to some 27 percent of sales – as well as to grow its research budget. All of this means Bayer is at the forefront of German industry when it comes to having cash on hand. After investments in property and interest payments, Bayer had a free cash flow of €5.8 billion in 2016, about 50 percent more than the previous year. Even after paying out dividends, it still had more than €3 billion left over for debt repayment.
The company’s improved performance stems in part from two of its four segments, namely its pharmaceutical business and its plastics subsidiary, Covestro. The latter was spun off in 2015, but Bayer still holds a 53-per-cent stake.
Despite the fact that Covestro is no longer considered one of the group’s core businesses, it has been one of Bayer's most reliable profit generators. In 2016, Covestro's EBIT doubled to €1.3 billion. The plastics subsidiary therefore generated five times the profit growth of Bayer's Life Sciences divisions, which together only grew by 2.3 percent. This trend has continued into the first quarter of 2017. Indeed, it was Covestro's positive performance that allowed Bayer to raise its earnings forecast.
Bayer is also profiting from pharmaceutical business successes. Two medications in particular – Xarelto, a blood thinner, and the eye medicine Eyelea – have boosted profits, and sales of five of the company's six top products have demonstrated robust growth.
The positive figures coming out of Leverkusen, where Bayer is headquartered, have helped Mr. Baumann win confidence among investors worried about the Monsanto deal, but some still harbor reservations about the company's financial resilience, especially given the sheer size of the acquisition.
Indeed, a closer look at Bayer's financial performance reveals some weaknesses. The performances of Bayer’s consumer health and crop sciences divisions have been less than spectacular, for example. Last year, Bayer managed to increase its sales in its consumer health division, but revenues still declined. The crop science division, which will merge with Monsanto, isn't exactly steaming ahead either. In 2016, sales and profits stagnated, mostly due to weak demand in the sector.
It is that weakness in the agrochemical sector that is leading many investors to question why Bayer is focusing so much of its cash and energy on the Monsanto acquisition. For several years, the agrochemical industry as a whole has been suffering from a cyclical low, as prices for agricultural goods have fallen and unpredictable weather has slowed demand.
In moving to acquire Monsanto at a time when its share prices had fallen due to the downturn, Bayer was betting in an overall turnaround in the agrochemical sector. Liam Condon, the head of Bayer’s crop science division, says the sector may rebound as early as the end of this year, and recently, some unexpectedly positive earnings results from Monsanto appear to offer some support for that outlook. Yet, should the promised agrochemical sector turnaround fail to materialize in 2018, it may be difficult for Bayer to deliver the promised results with regard to the Monsanto deal.
Despite Bayer’s recent positive performance, the firm won’t be able to absorb a behemoth like Monsanto without raising considerable capital. Come the end of this year, Bayer will have to transfer around €53 billion to the St. Louis-based multinational and will take on Monsanto's more than €6 billion in net debt.
Mr. Baumann, therefore, has his work cut out for him, not only to improve Bayer's performance, but to convince shareholders that his strategy is the right one. After all, he still needs to raise a lot of money from them.
Bert-Friedrich Fröndhoff leads a team of reporters which covers the chemicals, health care and services industries at Handelsblatt. Siegfried Hofmann is Handelsblatt's chemical and pharmaceutical industries correspondent. To contact the authors: [email protected] and [email protected]