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Background Almost nine months after reaching an agreement to combine their operations, the merger between Life Technologies Corporation (Life Tech) and Thermo Fisher Scientific Inc. (Thermo Fisher) was completed on January 14, 2014. Thermo Fisher is the largest provider by market value of analytical instruments, equipment, reagents and consumables, software, and services for scientific research, analysis, discovery, and diagnostics applications. Life Tech is the second largest by market value provider of similar products and services to the scientific research and genetics analysis communities. While the fanfare surrounding the closing echoed sentiments similar to those expressed when the deal was first announced, the hard work of integrating the two firms was just beginning. What led to this moment illustrates the power of financial models. Life Tech had been evaluating strategic options for the firm since mid-2012, concluding that putting itself up for sale would be the best way to maximize shareholder value (See Case Study 11 titled \"Life Tech Undertakes a Strategic Review\" for more detail.). After entering into discussions with Thermo Fisher in late 2012, the two firms announced jointly on April 15, 2013 that they had reached an agreement to merge. Exuding the usual optimism accompanying such pronouncements, Mark N. Casper, president and chief executive officer of Thermo Fisher stated, \"We are extremely excited about this transaction, because it creates the ultimate partner for our customers and significant value for our shareholders ... enhancing all three elements of our growth strategy: technological innovation, a unique customer value proposition, and expansion in emerging markets.\" Expressing similar confidence, Greg T. Lucier, chairman and chief executive officer of Life Tech noted, \"This transaction brings together two companies intent on accelerating innovation for our customers and achieving greater success in a highly competitive global industry. \" 4 This case study utilizes the publicly announced terms of the merger of Life Tech into a wholly owned subsidiary of Thermo Fisher, with Life Tech surviving. The terms were used to develop pro forma financial statements for the combined firms. These statements are viewed as a \"base case.\"51 The financial model discussed in this chapter is used to show how changes in key deal terms and financing structures impacted the base case scenario. The discussion questions following the case address how the maximum offer price for Life Tech could be determined, what the impact of an all-debt or all-equity deal would have on the combined firms' financial statements, and the implications of failing to achieve synergy targets. Such scenarios represent the limits of the range within which the appropriate capital structure could fall and could have been part of Thermo Fisher's pre-deal evaluation. As announced by Thermo Fisher, the appropriate capital structure is that which maintains an investment grade credit rating following the merger. Thermo Fisher senior management could have tested various capital structures between the two extremes of all-debt and all-equity before reaching agreement on the form of payment with which they were most comfortable. Therefore, the form of payment and how the deal was financed were instrumental to the deal getting done. Payment and Financing Terms According to the terms of the deal, Thermo Fisher acquired all of Life Tech's common shares outstanding, including all vested and unvested outstanding stock options, at a price of $76 per share in cash, with the Life Tech shares cancelled at closing. The actual purchase price consisted of an equity consideration (i.e., what was paid for Life Tech's shares) of $13.6 billion plus the assumption of $2.2 billion of Life Tech's outstanding debt. The purchase price was funded by a combination of new debt, equity, and cash on Thermo Fisher's balance sheet. Thermo Fisher executed a commitment letter, dated April 14, 2013, with JPMorgan Chase Bank, N.A., J.P. Morgan Securities LLC and Barclays Bank PLC that provided a commitment for a $12.5 billion 364-day unsecured bridge loan facility. The facility enabled the firm to pay for much of the purchase price before arranging permanent financing by issuing new debt and equity in late 2013. Maintaining an Investment Grade Credit Rating In an effort to retain an investment grade credit rating52 by limiting the amount of new borrowing,53 Thermo Fisher issued new common equity and equity linked securities such as convertible debt and convertible preferred totaling $3.25 billion to finance about one-fourth of the $13.6 billion equity consideration. The $3.25 billion consisted of $2.2 billion of common stock sold in connection with its public offering prior to closing, and up to a maximum of $1.05 billion of additional equity to be issued at a later date in the form of convertible debt and preferred shares. Thermo Fisher financed the remaining $10.35 billion of the purchase price with the proceeds of subsequent borrowings and $1 billion in cash on its balance sheet. Thermo Fisher and Life Tech compete in the medical laboratory and research industry. The average debt-tototal capital ratio for firms in this industry is 44.6%,54 and the average interest coverage ratio is 4.0.55 Thermo Fisher expects that available free cash flow will allow for a rapid reduction in its debt. The firm expects to be below the industry average debt to total capital ratio by the end of the third full year following closing and about twelve percentage points below it within five years after closing. The firm's interest coverage ratio is expected to be equal to the industry average by the second year and well above it by the third year and beyond. These publicly stated goals established metrics shareholders and analysts could use to track the Thermo Fisher's progress in integrating Life Tech. Consistent with management's commitment to only make deals that immediately increase earnings per share, Thermo Fisher expects the deal to increase adjusted earnings per share during the first full year of operation by as much as $.70 to $1.00 per share. Adjusted earnings per share exclude the impact on earnings of transaction-related expenses and expenses incurred in integrating the two businesses. Including these expenses in the calculation of EPS 51While this case study investigates the role of financial modeling in business combinations, the case study at the end of Chapter 11 entitled \"Life Technologies Corporation Undertakes a Strategic Review\" discusses the application of financial modeling to assess the impact of alternative strategic options for a single firm, Life Tech. 52 According to Bonds Online, Thermo Fisher Scientific has a BBB (the low end of the investment grade range) currently. See http://www.bondsonline.com/Todays_Market/Credit_Rating_News_.php?DA=view&RID=30687 53 Investment grade ratings indicate that a municipal or corporate bond has a relatively low risk of default. Bond rating firms, such as Standard & Poor's, use different designations consisting of upper- and lowercase letters 'A' and 'B' to identify a bond's credit quality rating. 'AAA' and 'AA' (high credit quality) and 'A' and 'BBB' (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ('BB', 'B', 'CCC', etc.) are considered low credit quality, and are commonly referred to as "junk bonds." 54 Yahoo Finance Industry Center 55 pages.stern.nyu.edu/~adamodar/pc/datasets/covratio.xls 5 is expected to result in a $(.16) per share during the first full year following closing, but excluding these expenses will result in $.99 per share.56 Quantifying Anticipated Synergy Realizing synergy on a timely basis would be critical for Thermo Fisher to realize its publicly announced goal that the deal would be accretive on an adjusted earnings per share basis at the end of the first full year of operation. Synergies anticipated by Thermo Fisher include the realization of additional gross margin of $75 million and the realization of $10 million in SG&A savings in 2014, the first full year following closing. Gross margin improvement and SG&A savings are projected to grow to $225 million and $25 million, respectively, by 2016, and to be sustained at these levels indefinitely. Most of the cost savings are expected to come from combining global infrastructure operations. Revenue-related synergy is expected to reach $25 million annually from cross-selling each firm's products into the other's customer base by the third year, up from $5 million in the first year. Conclusions Mark Fisher, CEO of Thermo Fisher knew that the key to unlocking value for shareholders once the deal closed was realizing the anticipated synergy on a timely basis. However, rationalizing facilities by reducing redundant staff, improving gross margins and increasing revenue was fraught with risk. Eliminating staff had to be done in such a way as not to demoralize employees retained by the firm and increasing revenue could only be achieved if the loss of existing customers due to the attrition that often follows M&As could be kept to a minimum. He also knew to expect the unexpected, despite having completed what he believed was an extensive due diligence. Having been through postmerger integrations before, he knew first-hand the challenges that accompanying these types of activities. At the time of closing, many questions remained. What if synergy were not realized as quickly and in the amount expected? What if expenses and capital outlays would be required in excess of what had been anticipated? How patient would shareholders be if the projected impact on earnings per share, a performance metric widely followed by investors and Wall Street Analysts alike, was not realized? Only time would tell. Discussion Questions: Answer questions 1 to 4 using as the base case the firm valuation and deal structure data in the model available on MyLMU Connect entitled Thermo Fisher Buys Life Technologies Financial Model. Assume that the base case assumptions were those used by Thermo Fisher in its merger with Life Tech. The base case reflects the input data described in this case study. To answer each question you must change selected input data in the base case, which will change significantly the base case projections. After answering a specific question, either undo the changes made or do not save the model results. This will cause the model to revert back to the base case. In this way, it will be possible to analyze each question in terms of how it is different from the base case. Website to go to for EXCEL: 1. Thermo Fisher paid $76 per share for each outstanding share of Life Tech. What is the maximum offer price Thermo Fisher could have made without ceding all of the synergy value to Life Tech shareholders? (Hint: Using the Transaction Summary Worksheet, increase the offer price until the NPV in the section entitled Valuation turns negative.) Why does the offer price at which NPV turns negative represent the maximum offer price for Life Tech? Undo changes to the model before answering subsequent questions. 2. Thermo Fisher designed a capital structure for financing the deal that would retain its investment grade credit rating. To do so, it targeted a debt to total capital and interest coverage ratio consistent with the industry average for these credit ratios. What is the potential impact on Thermo Fisher's ability to retain an investment grade credit rating if it had financed the takeover using 100% senior debt? Explain your answer. (Hint: In the Sources and Uses section of the Acquirer Transaction Summary Worksheet, set excess cash, new common shares issued, and convertible preferred shares to zero. Senior debt will automatically increase to 100% of the equity consideration plus transaction expenses.57) Undo changes to the model before answering subsequent questions. 3. Assuming Thermo Fisher would have been able to purchase the firm in a share for share exchange, what would have happened to the EPS in the first year? Explain your answer. (Hint: In the form of payment section of the Acquirer Transaction Summary Worksheet, set the percentage of the payment denoted by \"% Stock\" to 100%. In the Sources and Uses Section, set excess cash, new common shares issued, and convertible preferred shares to zero.) Undo changes made to the model before answering the remaining question. 4. Mark Fisher, CEO of Thermo Fisher, asked rhetorically what if synergy were not realized as quickly and in the amount expected. How patient would shareholders be if the projected impact on earnings per share was not realized? Assume that the integration effort is far more challenging than anticipated and that only one-fourth of the expected SG&A savings, margin improvement, and revenue synergy are realized. Furthermore, assume that actual integration expenses due to the unanticipated need to upgrade and co-locate research and development facilities and to transfer hundreds of staff are $150 million in 2014, $150 million in 2015, $100 million in 2016, and $50 million in 2017. The model output resulting from these assumption changes is called the Impaired Integration Case. What is the impact on Thermo Fisher's earning per share (including Life Tech) and the net present value of the combined firms? Compare the difference between the model \"Base Case\" and the model output from the \"Impaired Integration Case\" resulting from making the changes indicated in this question. (Hints: In the Synergy Section of the Acquirer (Thermo Fisher) Worksheet, reduce the synergy inputs for each year between 2014 and 2016 by seventyfive percent and allow them to remain at those levels through 2018. On the Newco Income Statement Worksheet, change the integration expense figures to reflect the new numbers for 2014, 2015, 2016, and 2017.)