The M&A wheel continues to turn in med-tech, spurred on in part by the reality that making money the old fashioned way ("earning it", for those too young to remember the John Houseman commercials) is getting harder and harder. The latest rumor, that Stryker (SYK 0.61%) was taking a look at Smith & Nephew (SNN 3.06%), was not only confirmed by Stryker but goes to show the depth of consolidation in med-tech as maturing markets leave fewer and fewer opportunities for sub-scale players.
To be, or not to be...
In response to a story in the Financial Times that Stryker was working with investment banks to prepare a bid for Smith & Nephew, the U.K. Takeover Panel requested a statement from Stryker on the matter. Stryker acknowledged that they were in the process of evaluating such a bid, but were not prepared to make an offer at this time.
As investors may have learned from the Pfizer-AstraZeneca bid process, the U.K.'s rules on takeovers are more structured and quite a bit different than in the U.S. With this denial, Stryker is basically prohibited from making an unsolicited bid for Smith & Nephew for six months and is reportedly not even supposed to move forward with additional internal due diligence (although how that can be prevented is a completely different subject).
There are some exceptions to that six-month ban. Stryker can make a bid if another company announces a bid for Smith & Nephew and the two companies can announce a friendly mutual deal in three months.
So, what's the story?
It's difficult to know exactly how far along Stryker was in the process of evaluating a bid for Smith & Nephew. After all, many companies talk of routinely reviewing peers/rivals as M&A prospects, and Stryker could conceivably have just been updating its due diligence (not unlike how an investor will review/update their research on a stock).
More likely, though, is that the announced deal between Zimmer (NYSE: ZMH) and Biomet has opened eyes as to what may be possible and necessary within the orthopedics space. While Zimmer and Biomet are likely to encounter sales disruptions and lose some sales through their merger (some top-line dysynergies are common in large med-tech margins), they would nevertheless hold about one-third of the global hip implant market and more than 40% of the global knee market if/when the deal is approved and consummated.
If Zimmer and Biomet can move forward, Stryker can likely move forward on Smith & Nephew and may well see a need to do so. With Smith & Nephew, Stryker will hold about one-third of both the hip and knee markets. Such share would go a long way toward ensuring that Stryker is always in the mix when a major hospital is evaluating its vendor(s) of choice for major joint reconstruction. There would likewise be meaningful synergies in terms of R&D and marketing, and Smith & Nephew's (relatively) large emerging market exposure is certainly appealing as more and more of the world's growth potential in orthopedics shifts away from developed markets.
Additional benefits could come from a merger
Consolidation of the major joint market may be the first reason to ponder such a deal, but it's not the only potential benefit from an acquisition of Smith & Nephew. The latter also has a sizable endoscopy/arthroscopy business that would complement and expand Stryker's existing efforts. Smith & Nephew also has a large wound care business that would represent another business platform for Stryker, and one that fits in well with its existing hospital-oriented business focus.
I'm less certain of the tax inversion angle that is being discussed in conjunction with this deal. Stryker's current effective tax rate is actually lower than Smith & Nephew's, though the U.K. corporate tax rate is set to decline next year. It's also important to note that the closing of various tax loopholes would mean that redomiciling would not necessarily free up access to Stryker's overseas cash pile. That said, even if the near-term tax benefits would be modest (or perhaps the opposite of what some expect, as Stryker would lower Smith & Nephew's effective rate), the greater growth and profitability of non-US medical device operations would likely make the move a logical one from a long-term tax perspective.
Doing some quick back-of-the-envelope math, I believe that Stryker could pay a 15% to 20% premium to Smith & Nephew and still see mid-to-high single-digit accretion in the first full year and low to mid teens accretion by year three, suggesting a return on capital from the deal in the neighborhood of 7% to 10%.
The bottom line
If Stryker ultimately chooses not to make a move for Smith & Nephew, the company's options may be more limited. The company has been losing share in hips and knees and is the lagging player now, and Johnson & Johnson recently made it clear that they are not really looking for large-scale M&A in devices, let alone orthopedics. Likewise, while Medtronic could theoretically see some synergies between its spine business and a larger orthopedics operation, I don't think Medtronic wants to get more involved in the lower-growth, very competitive market for large joint reconstruction.
For Stryker, Smith & Nephew would more like a solid single or double than a home run. Smith & Nephew would not radically transform the business, nor would it add much to the company's organic growth rate, but it would create a more efficient, more enduring orthopedics franchise that could better compete with Zimmer and Johnson & Johnson in the coming years. As such, it would not be a poor use of cash and could be a good incremental opportunity for its shareholders.
