“Reckitt Benckiser (LSE: RB) was among the beneficiaries on speculation that it might become a target for Pfizer,” a broker wrote this week — adding that Pfizer had reportedly been investigating a break-up of the business.
Speculation is mounting about the next big takeover target in the UK, and if rumours are to be trusted then you may well be right to wonder what is going to happen with Diageo (LSE: DGE).
Under Pressure
A takeover of Reckitt by Pfizer would go to the heart of corporate strategy for big pharmaceutical companies, which I doubt have a keen interest to diversify away from their core businesses into more commoditised, albeit less cyclical, sectors.
Big pharma have tried to protect their drug portfolios by looking at the consumer space over the years, but the market reaction has never been great. Consider that Pfizer has a core operating margin of 36%, as gauged by its Ebit margin, while Reckitt’s stands at 26% — and it’s not even to say that Reckitt is projected to grow fast over the medium term.
The allure to invest in the shares of RB is obvious to me, however — you’d be backing a strong management team, betting on a solid portfolio of assets, efficiency and rising earnings, among other things. While it’s true that financial engineering could help Reckitt release value, a break-up might be engineered by its own management team, who decided to spin off Indivior at the end of 2014.
Pfizer is under pressure but will have to find another target to deploy its huge cash pile.
Living On My Own
SABMiller is the most obvious fit for Diageo. Alternatively, Diageo could have been targeted by AB Inbev — very bad news on all counts for speculators.
Of course, there remains a possibility that Diageo decides to spoil the plans of AB Inbev, but the odds are short that if the price is right then SAB will choose AB Inbev over any other partners.
Moreover, I doubt that Diageo’s management team is brave enough to try and approach the board of SAB, so we really need to look at its prospects on the basis that the booze maker will continue to trade in its current form. To me its stock looks a lot like an overpriced bond, based on growth prospects, forecasts for margins, earnings and dividends. Moreover, its trading multiples point to downside of at least 10% from its current level of 1,782p, based on certain assumptions for mid-cycle margins.
According to marker consensus estimates from Thomas Reuters, its stock is undervalued by about 10% — but I think analysts will have to reconsider their models based on a lower level of core profitability in 2016 and 2017, and possibly a lower level of revenues. If I am right, its net leverage will rise more quickly than expected — it will be manageable anyway, but then it will leave very little room for shareholder-friendly activity.
