Buyout or Sell Out?

From tiny acquisitions to conglomerate combinations, Wall Street's urge to merge remains strong. Some of these deals might generate sought-after synergy, but others could create what Peter Lynch called "diworsification" -- weakening a business's core competency by grafting on wildly unrelated subsidiaries. How can we tell the good deals from the deal breakers?

Breaking down the buildup
To help, we'll turn to the 80,000 investors in Motley Fool CAPS. A combination of two companies with high CAPS ratings should bode well for the new firm's results, while a high-rated company that joins a lower-rated one may benefit one set of investors more than the other.

Despite troubles in the capital markets, the deals won't stop; they simply might involve more stock and less cash. Here's a handful of recently announced deals, and the ratings for each participating company on CAPS' five-star scale:

CAPS ratings courtesy of Motley Fool CAPS; NR = not rated.

Deal activity has jumped when compared with last week. Still, as the credit crunch deepens, a number of investors are looking to back out of previously announced deals. Private equity firms may soon have to reassure target boards of directors that they won't renege on acquisitions when things get tough.

So what do CAPS investors think about these targets and acquirers? While this week's announcements follow a trend toward smaller deals -- only one exceeds $1 billion -- most of the companies are well-favored by these investors, having earned ratings of three stars or better.

Feeling woozy from R&D
A pharmaceutical company derives its profits from its drug pipeline. Even if they're not blockbusters, successful drugs and therapies can keep these companies profitable for years -- but the research doesn't come cheap. Some companies, with their own pipelines running dry and patents on their existing drugs soon running out, have been buying up smaller biotechs, while others have been taking a different approach to reducing development costs.

The high cost of R&D has created a cottage industry of outsourcing firms, and the pharmaceuticals are turning to them in greater numbers. For example, WuXi PharmaTech's revenue has more than tripled over the past two years, up 78% in the latest quarter. Of course, that's created a pretty rich valuation for WuXi, at more than 60 times current earnings and nearly 40 times next year's estimates. But with analysts forecasting 48% growth over the next five years, such valuations may not be unreasonable.

That kind of potential attracts CAPS investors like SurfingUSA, who sees the low cost of outsourcing R&D to China as a major catalyst for this company:

WuXi PharmaTech is the leading China-based drug R&D outsourcing service company. Founded in December 2000 with the mission to transform the drug R&D industry and a vision to provide fully integrated drug R&D services to improve the success of research and shorten the time of development.

If I said no more you should be thinking [...] hmm what are the largest cost drivers for Pharma. Scratching my chin, I would have to say [...] hmmm R&D, FDA, Phd's, and of course marketing. ... 

R&D and PHd's are large drivers of cost, so is the development and testing as well as prep for mass [production] of said compounds. Phd's in China work on average [for] $.15-$.20 on the dollar compared to US counterparts (sometimes $.10) The Drug & Biotech companies can't shave costs from the FDA, nor Marketing like they can save major $ outsourcing research. Oila!! just like my ole alma mater semiconductors & [software], we have found another item to export ... you guessed it. Nuf said.

A value-added offer
What's your take on these deals? At Motley Fool CAPS, your opinion is as valuable as the pros'. Tell the CAPS community whether the urge to merge is good -- or whether you think it's better for the firms involved to remain independent.