McKesson (NYSE:MCK), the largest pharmaceutical distributor in North America, announced October 25 that it is acquiring PSS World Medical (Nasdaq:PSSI) for $1.62 billion ($29 a share) and the assumption of $480 million in debt. PSS World Medical competes with McKesson's Medical-Surgical unit for the business of physicians and long-term care facilities. On the surface it seems like a straightforward acquisition. How does this deal affect each group of shareholders? Who wins and who loses, if anyone?
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The deal is a 34% premium on PSS World Medical's closing stock price as of October 24. According to Bloomberg, McKesson is paying 11 times EBITDA, considerably less than the 15 times EBITDA paid on average for 20 similar deals since 2007. Upon completion of the acquisition, McKesson's medical-surgical business will combine with PSS World Medical under the leadership of Stanton McComb, a 10-year McKesson veteran. McKesson's medical-surgical revenue in fiscal 2012 was $3.15 billion while PSS World Medical's was slightly less at $2.1 billion. The combined $5.25 billion in revenue provides it with the scale necessary to compete with bigger distributors such as Owens & Minor (NYSE:OMI) and Henry Schein (Nasdaq:HSIC). McKesson believes that the combination will result in $100 million in pre-tax synergies within four years. Ross Muken, an analyst with International Strategy & Investment Group, believes the deal adds at least 20 cents to McKesson's full-year earnings in fiscal 2013. As of the end of September, its debt to capital ratio was 31.7%. The addition of $480 million in debt from PSS World Medical bumps that up 350 basis points to 35.2%. With $2.8 billion in cash on the balance sheet as of the second quarter, it won't have to take on any additional debt to consummate the transaction.
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PSS World Medical
The usual ambulance chasers were out immediately after the deal's announcement suggesting the board breached its fiduciary duty by not shopping its business adequately enough to generate additional, superior offers. These firms forget that the business is only worth more than $29 a share if someone else is willing to pay up for the company. PSS World Medical's stock has traded above $29 just once in its 18 years as a public company and that was all the way back in May 1996. Shareholders are getting a reasonable price that erases what was a poor year on the markets (down 10.7% YTD prior to offer) up until this point; they should be thankful McKesson has come along at all.
Its interest expenses year-over-year almost doubled in the first quarter, up $4 million to $8.5 million, thanks to the issue of $250 million in senior notes in February. With a slightly lower operating margin in the first quarter, it generated pre-tax earnings of $13.2 million, 17.5% lower than in Q1 2011. Most importantly, its debt as a percentage of shareholder equity went from 61.9% in Q1 2011 to 115.6% in Q1 2012. While some of the debt was used to pay down its $127.3 million revolving line of credit and some of its 2008 notes, the remainder is for general corporate purposes including potential acquisitions. The interest rate on its 2012 notes is 6.375% compared to 3.125% for those in 2008. In the past three years it has made eight strategic acquisitions at a total cost of $146 million. Although its margins in the past few years have generally improved, being part of a company [McKesson] that has more cash than PSS World Medical has revenue, should be a game changer for its business. Shareholders can hope for a better deal but it won't come. This is as good as it gets.
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The Bottom Line
Mckesson's purchase of PSS World Medical is good for both groups of shareholders. McKesson gets the scale it was looking for in its medical-surgical distribution unit without overpaying and PSS World Medical gets the financial resources of a much bigger company. At $29, its shareholders make out like bandits. The only concern, as is often the case when combining businesses, is the employees. According to McKesson CEO John Hammergren in its Q2 conference call, it intends to retain all of the sales reps from both companies. That's not to suggest there won't be any staffing cuts due to overlap, but it appears that the $100 million in synergies won't come from major headcount reductions. If that's the case this is a win all the way around.
At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.