I once read that an investment manager makes all of his or her mistakes in the first five years of his or her career, and then spends the rest of the career trying to avoid making the same mistakes. Clearly, the last two years have shattered the illusion that any investor -- professional or individual -- has seen it all. As proof, perhaps, the merger deal that the management teams of
came up with last week is in a league of its own -- and a very strong contender for several dubious prizes:
- The "Total Misreading of Financial Markets" Award,
The "I Can't Believe We Drank The Investment Bankers' Kool-Aid" Award, plus
The "Worst Explanation of a Deal to a Crowd of Hostile Shareholders and
Sell-Side Analysts" Award.
grossly overcomplicated deal based upon erroneous assumptions, a reliance on New Economy math and horrendous advice, TriZetto, with what was a $1.2 billion market cap, is going to acquire IMS, which has a $6.5 billion market cap, for what appeared for the briefest of an instant on paper to be $27 per share in TriZetto stock.
Upon the deal closing, TriZetto will take IMS'
division inhouse and combine it with its own Application Service Provider, or ASP, business. It also plans to spin off an IMS division named
so that it trades publicly and independently, and then issue tracking stock in what would be the 90% or so of IMS Health that is left.
I am tempted to stop right here and say that anything this complicated is probably a bad idea (and I'd be right most of the time!) but sometimes complications create opportunities. Both stocks
after the announcement, creating what we feel is a near giveaway in the shares of IMS.
For all the wrong reasons, therefore, this mis-deal makes IMS an extraordinarily compelling opportunity. Listen to this logic from the perspective of a prospective IMS shareholder:
- Scenario 1: The deal is so bad that it won't receive shareholder approval, which means the stock will trade up from current levels back to the low 20s.
Scenario 2: If the deal does go through in four months, it can only mean that the management team has persuaded the investment community to drink the Kool-Aid, which also means that the stock will be back in the mid-to-high 20s.
Scenario 3: By being a little too cute by structuring the deal so that the TriZetto minnow is the buyer of the IMS whale, this move effectively puts IMS up for sale. In that case, our estimate puts the value north of $30 per share, at least, vs. the $16 hit last week. This scenario actually carries with it a reasonable probability.
And Now, Introducing ...
The way that this deal was introduced to investors proved almost as fun to watch as the math. The deal was announced in the wee hours of March 29, and a big conference call was scheduled before the opening that day.
As you can imagine, an announcement like this created a good deal of confusion, which management did little to dispel on the conference call. Most of the call was devoted to an explanation of the deal itself and there was zero in the way of financials.
The sell side gave a particularly dismal display of boot-licking and back-patting, which they got away with because the stock hadn't opened yet! One analyst did buck the trend, beginning his comments with, in all candor, a "Wow, I'm dazed."
Management's response was, "We'll take that as a compliment." But when IMS closed the day down 5 points, you could imagine the company's mad scrambling.
All of which led to an emergency shareholder's meeting the following afternoon in New York. Unbelievably, management offered little additional information, other than a newly acquired defensiveness and indignity. Management's basic theme was that IMS shareholders simply were incapable of "understanding" the deal, and that they would get it as time went on.
What IMS Management Saw
Here's their thinking: IMS' stock is down 50% from its high because it's tied to that Old Economy pharmaceutical industry (representing, for those with memories, another inevitable fall from valuation grace). TriZetto is an ASP company with an Internet valuation of $1.2 billion, or 40 times sales. If they simply took the $50 million in revenue from the Erisco software division (which is buried in IMS at 20 times earnings) to TriZetto, the market will hopefully use the same 40-times-sales multiple on a much higher revenue base and -- voila! -- enormous value creation.
Nor did the logicians stop there: IMS will be the same great business and get the same multiple or higher -- since it will now be accorded the same ridiculous valuations as other e-commerce companies. And new spinoff Strategic Technologies will be valued like its main public competitor,
, at four times sales, and be another value enhancer.
What Shareholders Saw
Unfortunately, the thinking by the IMS shareholders went more like this: IMS was either panicked into an e-strategy, or wanted to do something splashy because there was a problem at the core business -- no matter how strenuously management denied it.
Personally, I can't understand why IMS -- with $600 million in a cash and investment hoard, growing by $250 million a year in free cash flow -- can't afford to "e-itself" without having to subject us to a financial equation whose key variable is the maintenance of an Internet valuation ratio.
And furthermore, why with TriZetto, which came public less than a year ago and has $33 million in revenue? For IMS management to describe TriZetto's business success and their future as being "on the come" is a very large understatement. TriZetto CEO Jeff Margolis sounds great and has clearly made a lot of money for himself very recently. But, he has a way to go before proving himself to be the next Bill Gates.
Crunching the Numbers
As constructed, the deal math works as follows:
- Each IMS share gets exchanged for .46 TriZetto shares, which has 21.2 million shares outstanding, creating the new TriZetto with about 160 million shares outstanding.
Valuing Strategic Technologies at four times its $200 million in sales is $5 per share.
IMS was valued at $7 billion prior to the deal announcement, so let's conservatively assume it's worth 80% of its former self, or $35 per share.
That leaves the new TriZetto, which closed 1999 on a pro-forma basis with $81 million in revenue, at breakeven profitability with big, fat growth prospects from a low base. What's your number? Management obviously thought 40 times revenues, which is 20 per share.
Add it all up and multiply by .46 and your IMS shares are worth ... $27.60 per share. At a more modest 10 times revenues, you add another 5 per share to the pie, creating $20.70 per IMS share. There is probably a dollar or two of cash and investments to throw around here as well.
Drink my Kool-Aid
Now, the Erisco/TriZetto story is a real and sellable story: But we don't understand why IMS couldn't have sold Erisco to TriZetto for stock, thereby gaining a big chunk of whatever upside exists in blending the two businesses without going through the entire circus of this merger.
The New Age/New Economy "drink-my-Kool-Aid" thought that TriZetto is going to completely make IMS over -- generating appreciably more revenue and cash than IMS could have done on its own -- is highly questionable. IMS will also lose some 700 basis points of annual tax savings, which equates to some $30 million annually, growing at 15%.
A second problem here is that our estimate of IMS value on a stand-alone basis was at least $30. And that could be achieved in a far more methodical fashion with lower risk by either: a) chugging along, or b) by making three phone calls and putting the entire company up for sale.
Why do I want to hang my hat on hoping there is value creation because TriZetto and the technology world manage to stay at stratospheric levels? In its answer, management used the phrase "tethered to a rocket." I think the space shuttle might be more appropriate.
Looking at IMS stock another way, the company was valued at just under $7 billion before this deal, and we felt the company's intrinsic value was closer to $10 billion. The combined market cap of the two companies is now under $6 billion.
This will be interesting. But, at current prices, there seems to be little risk for the IMS shareholder. IMS has a real and very valuable business. Say what you want -- printable or otherwise -- about the IMS management: They have always done a nice job of keeping their best interests in mind, and given their substantial personal positions that are not going to be repriced or immediately vested with the proposed deal, I am sure they are rethinking this whole deal
Jeffrey Bronchick is chief investment officer at Reed Conner & Birdwell, a Los Angeles-based money management firm with $1.2 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Fund.At time of publication, RCB was long IMS Health, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at