Thursday, 26 August 2010

Novartis' $50 billion deal for Alcon: The big squeeze

FORTUNE -- On Monday, Alcon, the world's largest eyecare company, held a emergency board meeting in a cramped conference room at a non-descript business center in Zug, Switzerland. Only four or five reporters attended, and ten of the fifteen chairs reserved for shareholders sat vacant. The conclave lasted just 45 minutes.

Yet the event, which looked bland, sounded routine, and was mainly overlooked by the press, marks still another chapter in one of the most bitter, precedent-defying -- not to mention one of the most mammoth -- cross-border merger battles in history, Swiss drugmaker Novartis' $50 billion takeover campaign for the eye-care giant Alcon.

In the view of Alcon shareholders -- and they make a strong case -- it's also an historic rip-off.

The Novartis-Alcon merger is a total departure from traditional merger activity because Novartis is offering Alcon's (ACL) minority shareholders far less than it's paying the majority owner, Nestle. And not a little less either. The gap is an astounding $40 per share. Novartis is paying a rich $182 per share to Nestle versus a lowball offer of around $142 to Alcon's public shareholders. If it succeeds in squeezing out the minority at a gaping discount, Novartis will get an almost $3 billion break on its purchase.

To save all that cash,Novartis (NVS) is brazenly and unapologetically exploiting a transatlantic loophole in merger law that's got investors from AXA of France to U.S. hedge funds, and corporate governance advisors such as Glass Lewis, in an uproar. At the Monday meeting, Novartis moved closer to its goal by electing its own slate of five board members, whose votes, it says, will seal the deal, and the fate of the minority. "I've never witnessed anything like this in 20 years as an investor," says Shane Finemore, chief of Manikay Partners, a $550 million New York investment management firm with a large holding of Alcon shares. "Novartis is being incredibly hostile to Alcon shareholders."

Finemore's shock is understandable, and widespread. According to the M&A experts Fortune consulted, no purchaser in decades, in any major deal, has managed, or even seriously attempted, to buy out minority investors for less than it's paying the primary shareholder.

The No Man's Land for shareholder rights
In America and most of Europe, the rights of the minority are scrupulously protected by merger laws. The regulations govern cases where a big company or a family owns over 50% of a company's stock, and wants to buy the rest -- which is publicly traded, and hence held by "minority shareholders." Nations on both sides of the Atlantic invariably protect those mutual funds and small investors from abuse by granting them special safeguards. The two vehicles for buying those investors' shares are a "tender offer" or a "merger agreement." In either case, the laws in both the U.S. and Europe effectively require that the buyer pays either precisely what it's offered the main owner, or if the minority negotiates an especially good deal, even more. If the minority doesn't get the deal it wants, it can keep its shares.

Those rules apply to mergers both within the U.S. and Europe, and cross-Atlantic transactions as well. Consider two relatively recent examples: In 2007, Merck (MRK, Fortune 500) bought out the minority holders of Serono, a Geneva-based biotech manufacturer, for the same price it offered its principal owner, the Bertarelli family. The public shareholders of Genentech fared even better. Last year, Roche of Switzerland paid them $47 billion for the 44% of Genentech it didn't already own. That was a premium of 16% or $6.5 billion over the Genentech's price when Roche announced its plan to buy 100%.

Novartis is doing the exact opposite of Roche, and claims the clear legal right to defy tradition, and as its critics would claim, all fairness. Here's the loophole: Alcon, though based in Texas, is incorporated in Switzerland. As I've stated, protections for minority shareholders are practically universal. But they come from different places. In Switzerland, minority holders get little protection under the official merger laws, but strong safeguards from the rules of the Swiss stock exchange. Those protections don't apply to Alcon -- because it's traded on the New York Stock Exchange. By contrast, the NYSE provides minimal protection for minority owners. In the U.S., they're shielded by merger laws, which apply only to U.S.-incorporated companies.

Hence, Alcon falls into an almost surrealistic zone. It lacks either of the two essential protections -- the Swiss stock exchange laws and the SEC merger regulations.

Protections for naught
It's not that the Alcon directors failed to protect the minority holders, or at least try to. Alcon represents one of the great corporate investments of the past half-century. In 1977, Nestle bought 100% of Alcon for just $280 million. In 2002, it sold 25% of the now giant manufacturer of contact lenses and solutions, ophthalmic surgery products, and eye-care pharmaceuticals in a public offering. At the time of the IPO, the board enacted protections for its new class of shareholders, requiring that an independent committee approve any offers to purchase their holdings.

Then, in April of 2008, Nestle agreed to sell Novartis 25% of Alcon for $143 a share, and granted Novartis an option to purchase its remaining 52% for just over $180. The $180-plus deal for the second, biggest tranche was extremely expensive. It represented a 22% premium to Alcon's share price, which had already risen sharply with takeover speculation. With that $50 billion deal, Nestle is reaping 180 times its original investment in Alcon.

Faced with a powerful new owner, Alcon strengthened the protections for minority shareholders. In December of 2008, it issued updated regulations requiring that a committee of three independent directors approve a merger proposal before the board could vote on it. On January 4th, 2010, Novartis announced that it would exercise its option to purchase the remainder of Nestle's shares at around $182. Since their price stood at $164, the transaction looked extremely attractive for Nestle. The Nestle deal was also risk free, since it involved all cash.

Then came the corker. The same day, Novartis offered the minority shareholders a paltry $153 a share, a 7% discount to the market price. It was also paying entirely in stock, making the deal's value vulnerable to a drop in its shares. The drop happened. Today, the Novartis offer is worth just $142, 22% below the price Nestle is receiving. At Nestle's price, Novartis would be paying the minority $12.6 billion. Instead it's offering $9.8 billion.

The offer turned even usually passive institutions into outraged activists. Laurence E. Cranch, the general counsel of AllianceBernstein, the investment outfit owned by AXA, wrote the Alcon board that "We were stunned by the gross inadequacy of the of Novartis' proposal." The independent directors are heeding AllianceBernstein and the other angry investors. They're demanding that Novartis respect the safeguards the board put in place, which would give the minority holders the right to either negotiate a better offer, or refuse to sell and simply keep their publicly-traded tranche of shares.

"Novartis is behaving like a schoolyard bully who takes your money," Thomas Plaskett, a Texas investor who heads the independent directors committee, told Fortune. Plaskett points out that in late 2008 Novartis chairman Daniel Vasella voted for the same safeguards he now apparently wants to ignore.

Defining fairness
Plaskett and the independent directors claim that Swiss law indeed offers an important protection. They say that the takeover regulations require that only independent directors vote on buyouts of minority shareholders. That would leave the vote to the three independents, who've pledged to reject the deal. Novartis counters that the law simply requires that 50% of the directors and two-thirds of the shares approve the transaction.

With the vote last Monday, Novartis effectively controls six of the 11 board seats. In response to the view that only independent directors be allowed to vote, Novartis responds, none too convincingly, that its nominees are independent. That's a stretch, since three of the five are former Novartis executives and a fourth heads a Novartis research foundation.

What's Vasella's justification for breaking so sharply with corporate practice? He says that the price is "fair" for Alcon's shareholders and for Novartis investors, based on Alcon's fundamental value. But most of all, Novartis' main justification for for acting so tough is simply because it can. "Well, (the independent directors) have something to say as long as they are in the current situation," Vasella stated in a conference call in January. "But once they basically hand over to us and we close the deal then it's a different game."

Right now, it's impossible to predict whether Novartis will win a complete victory. But a partial win is indeed possible. Here's why: Novartis is paying an extremely rich price for Alcon -- around 25 times its $2 billion in 2010 earnings. It clearly feared that the minority shareholders might demand even more than $182 a share that Nestle received, making the deal even more expensive and further alarming Novartis shareholders. Alcon's minority investors held considerable leverage, since Novartis needs to own 100% to generate the cost savings it needs to make the deal work.

Novartis has already succeeded in driving down the expectations of the minority, as well as holding Alcon's share price in check.

So Novartis may indeed pay more in the end to avoid years of litigation, not to mention damage to its reputation for fairness. A bully may win by grabbing all your money and keeping it. But the bully also wins if he returns some if it, so you leave the playground to avoid more fighting, thankful you got anything back at all.
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