A takeover of Smith & Nephew (LSE: SN) (NYSE: SNN.US) has been long due. S&N’s share price rallied at the end of April when Zimmer agreed to acquire Biomet for $13 billion-plus, and it is still pricing in an M&A premium.
Suitors
While among trade buyers Johnson & Johnson could emerge as the most likely acquirer, the four private-equity firms exiting Biomet — Blackstone, Goldman Sachs Capital Partners, Kohlberg Kravis Roberts & Co, and TPG Capital — could be tempted to join forces again and place a bid for a medical device maker whose relative valuation is still below historic highs. Equally important, S&N’s balance sheet is virtually debt-free.
So whilst all eyes seem to be on Pfizer and AstraZeneca, other large deals could be in the pipeline.
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Attractive Target
In December 2006, Biomet was taken private for almost $11 billion at the height of a credit binge that fuelled leveraged buy-outs mostly financed by debt. That buyout was back by so much debt that Biomet’s net leverage shot up to 8.8x from 0.2x when private equity took control of the business.
S&N’s balance sheet could carry $10 billion of debt based on consensus estimates for earnings before interest, taxes, depreciation, and amortization (EBITDA) in the next couple of years ($1.6 billion in 2016). S&N snapped up ArthoCare Corp. for $1.7 billion in early February, so synergies are also up for grabs.
S&N boasts a market cap of £8.1 billion ($13.7 billion). A low-ball offer would make strategic sense for private equity; the all-time high of S&N stock is about 4% above its current price of £9.23. A 15% premium would value S&N at $15.8 billion.
Levering Up
S&N’s balance sheet could be loaded with $8 billion of new debt, for an implied net leverage of 6.6x, on a pro-forma basis. The resulting capital structure (50/50 debt/equity), however, would be way too conservative for private equity.
If a private-equity consortium can lever up S&N at 8.8x net debt/EBITDA, their equity check will have to cover only 31% of the total financing. It could be do-able on those terms.
The trailing net leverage of Biomet was still above 5x when it was sold to Zimmer.
“Zimmer is committed to repaying outstanding debt,” the U.S. company said in April, yet it can easily refinance Biomet debts at cheaper rates while exploiting meaningful synergies. A buyer like Zimmer is precisely what new private-equity owners of S&N would need by the end of 2019.
S&N is cash generative and trades below top-cycle multiples. It took 7.5 years — i.e. almost two investment cycles for private equity — for Blackstone, Goldman Sachs Capital Partners, KKR and TPG to get rid of an asset that yielded an internal rate of return well below 20%, according to our estimates.
Will S&N be a case of second time lucky?
