How does Bayer do its sums?
The pharmaceuticals giant is planning a £50bn takeover of Monsanto. Is the deal only affordable in an era of zero interest rates?
Bayer’s chief finance officer, Johannes Dietsch, talks about a deal to create the world’s largest pesticides and seeds company.
brand eins: Is Bayer getting free credit? Does the company perhaps even get a bit extra on top when it borrows money?
Johannes Dietsch: “We do sometimes get a bit on top. In the accounts department, we jokingly describe it as a cash storage fee. But that only happens when we borrow short-term capital.”
Doesn’t cheap money lead to wastefulness?
“As far as our company is concerned, the answer is a clear ‘no’. Cost discipline is very strict at Bayer, regardless of the level of interest rates.”
Dietsch is a numbers man, known for his accuracy. A Rhinelander, trustworthy and calm, he has been with Bayer for 35 years. However, although trust is a good thing, control is better. Compare the annual results for 2007 and 2016. Ten years ago the world financial crisis had not yet erupted and the base rate of the European Central Bank (ECB) was high, at 4%. If Bayer is always thrifty, regardless of interest rates, then the company’s costs in relation to turnover today should not be much higher than in 2007. Back then, it recorded annual profits of €32.4bn, almost 31% less than today’s €46.8bn (£43.5bn). Looking at the profit and loss accounts, cost ratios are easily recalculated and compared:
Production costs / turnover 2007: 50%
Production costs / turnover 2016: 43%
Administrative costs / turnover 2007: 5.5%
Administrative costs / turnover 2016: 4.8%
Research expenditure/ turnover 2007: 8%
Research expenditure / turnover 2016: 10%
In fact, costs have fallen, with the exception of spending on research. Wastefulness does not seem to be an issue where Bayer is concerned.Insertion ends.
Isn’t there a danger that investments go ahead simply because they can be financed so advantageously?
“Not at Bayer. We calculate for the long term and current interest rates play only a minor part.”
So why do the experts in the ECB hope their interest rate policy will stimulate investment, particularly in the eurozone?
“This has been tried in Japan, too, a country where I have worked twice during my career. It was done once in the 1980s, when share prices and property prices were at record levels and a huge bubble developed. And again later, when the bubble had burst and the Japanese central bank hoped to kickstart the economy by a policy of zero interest rates. In the end, it did not work. I think that is also true of the ECB’s strategy. We have very low interest rates, but that does not lead to more credit being extended, at least not to the extent desired.”
How do you explain that?
“We are living in a globalised world where competition is intensive. As a business enterprise, you do not invest just because interest rates happen to be low but because you hope to achieve good yields. What counts is the expected return on investment.”
Bayer is in the process of buying the US seed specialists Monsanto, a transaction costing $66bn, the ultimate takeover deal. Is it really all about returns? Or is it actually a strategic deal?
“By taking over Monsanto, we want to make Bayer even stronger and in the long term gain considerable additional value: for the company, for our shareholders and for society as a whole. I don’t like the label ‘strategic’ – that is often a euphemism to conceal the fact that a takeover is not profitable. For us, it all depends on the returns. They must be higher than our capital costs. Only then is that investment worthwhile for our shareholders.”
It is hard to believe that the low interest rates play no part ...
“Yet that is exactly how it is. To understand it you must know how we calculate our capital costs.”
Dietsch and his colleagues use the English term “weighted average cost of capital” (WACC), which has two components: the cost of borrowed capital and the cost of equity capital. For borrowed capital, Bayer calculates on the basis of the long-term average interest rates for 10-year bonds issued by companies with a good credit rating. In 2007 these still had a return of about 5%. Although bonds being issued today only offer about 1.5%, the 10-year average is still about 4%. As interest is usually tax deductible for firms, the cost of borrowed capital is ultimately a little lower, about 3%. In contrast, the cost of equity capital is high, because it reflects what shareholders expect when they invest in a concern like Bayer.
How do you know how much that is? Do you ask the investors?
Dietsch shakes his head: “We look at the historical excess return of the stock market in comparison with government securities and then add in the so-called beta coefficient. This reflects the fluctuation intensity of the Bayer share price compared with the market as a whole.”
That means that if Bayer shares fluctuate more, the risk is higher and investors expect a premium. If the fluctuation is less, then it is the reverse. What is the final result?
Dietsch says: “8.6% for equity capital.”
That is high, but plausible. At times when interest rates are low, more people invest in shares, so the stock exchange returns are higher.
In establishing the WACC, the respective costs are also weighted, equity capital at 80% and borrowed capital at 20%. For equity capital the proportion is based on stock market value rather than balance sheet. That is what an investor who buys a Bayer share wants to see interest on. That produces the following formula for total capital costs:
(0.2 x 3%) + (0.8 x 8.6%) = 7.5%
So after being taken over by Bayer, Monsanto has to yield a return of more than 7.5% a year? That’s a lot.
“To be precise, it’s 7.7%, because Monsanto is a US company and the capital costs in the dollar area are a trifle higher. And this figure has not changed a great deal in recent years, despite zero interest rates. Our total capital costs have always been between 6.5% and 8%. That shows that we do not cut our expectations for returns just because interest rates are low. No matter how we invest our money, whether into a takeover like Monsanto or research projects or factories, the total cash flows to be expected, discounted to the present value, must be higher, appreciably higher, than the investment or the purchase price.”
Discounted to the present means that using a compound interest calculation, you work out what the yields, which are uncertain and only realised in 10, 15 or even 20 years, are worth now? Isn’t that like gazing into a crystal ball?
“Of course, the further you look into the future the harder it gets. But discounting means the distant returns have a much lower cash value, so are worth less and thus carry less weight in the amount being compared with the purchase price. The first 10 years are critical. At the beginning you have consultancy costs, integration costs, one-off costs to realise synergies. After 10 years, at least with Bayer, the inflows from the takeover should be higher than the capital costs. And after 15 years, the purchase price should have been recouped.”
Now, we’d like to know how that works in more detail: how high is the present cash value of, say, €10m that you hope to be able to be earning in 20 years, by 2037? Bayer uses its total capital costs again as a discount factor. The idea is: if you had the €10m today, you could achieve a 7.5% return every year until 2037. The point of the discounting formula is to calculate those missed returns (as the €10m doesn’t arrive for 20 years):
€10m / (1+0.075)20 = €2.35m
So, an expected yield of €10m leaves only about €2.4m relevant to the present-day decision-making. It sounds fairly reasonable, and against this background the calculations don’t seem so fantastic. Yet they remain expectations, which need critical scrutiny.
As chief finance officer, are you the one who insists on the assumptions being kept realistic?
“The decisive factors are the 20-year business plans of the operational units and in my department we subject them to critical scrutiny. We check the calculations very clear-headedly. How plausible are they? Is someone just painting us too nice a picture?”
Are you counting on the competition authorities to approve your takeover of Monsanto?
“Yes, I am confident that we will get the necessary permission. Bayer and Monsanto focus on very different activities and research areas, so there is hardly any overlap.”
You are planning to finance the purchasing price in part by issuing new shares, meaning fresh equity capital. But the larger part, about €40bn, is coming from borrowed capital in the form of corporate bonds. Even if low interest rates have no great impact on the long-term yield analysis, don’t they still help you finance the deal?
“The capital structure is a compromise between the interests of the lenders and the shareholders. The more money we borrow, the worse our credit rating and the greater risk of being downgraded by the rating agencies. And the more shares we issue, the less the old shareholders like it because their stake in the company is then worth less, at least temporarily. The structure we have now contains a relatively high proportion of borrowed capital, so it is a concession to our shareholders. At the same time, we have devised a plan to show the rating agencies we will pay back our loans relatively quickly. On that basis, we calculate that despite comparatively poor grades from the ratings agencies initially, for example in the ratio of cash flow to debt, our rating will still remain in the investment grade area and will rapidly regain an A credit rating. So Bayer bonds will not become junk, which is important for us …”
… because the financing would otherwise get too expensive?
“No, it has more to do with our competitors, which all have very good credit ratings. We don’t want to slip too far in comparison. We could still complete this deal with much higher interest rates.”
With €40bn additional loans? Every single percentage point means €400m more in interest to be paid – nearly as much as Bayer paid in interest in 2016 for the whole year.
“That is true, but it wouldn’t be a problem. You mustn’t forget that Monsanto will give us much higher money inflows from which we can pay interest. But above all, our capital costs come into play again. The fact is, we could have shouldered the takeover even if interest rates had been much higher.
Our capital costs are around 7.5%, you recall. Monsanto will bring us returns higher than 7.5%. So any financing that costs less than 7.5% is advantageous because it increases the profit per share, and does so right from the first year.”
Hold on a moment. What about all those costs at the beginning? Hadn’t Dietsch said the annual yield might only exceed the capital costs from the fifth year?
He nods. A sample calculation: let us assume that in year one Monsanto would bring a yield of only 4.5% on the purchasing price of $66bn, making about $3bn revenue. Let us further assume that after tax the financing costs the company about 2.5% interest, making €1.7bn. The profit from the Monsanto investment would then be:
$3bn - $1.7bn = $1.3bn
For Bayer, interest of 2.5% after tax means the returns for the investors are appreciably higher, 3-4%. Nevertheless, you would still make a profit from the Monsanto investment from the first year?
“Yes. Even at a rate of interest far above what we actually have to pay at present for a 10-year bond.”
This calculation also shows that when interest rates are low, investments that are not particularly profitable can still pay off in the short term.
“Right. If you can finance them at 1.5% or 2% you can buy anything that brings in a minimal cash flow and still increase your profit per share. That’s what I would call a simple calculation.”
Doesn't that lead to excesses in the capital markets? At the moment there is one takeover after another. Most countries have seen a double-digit increase in share prices in the last 12 months.
“That is true, but at the moment I don’t see any exaggerated developments, either in Europe or worldwide. Rising stock market prices reflect rising company profits. They seem realistic to me.”
Many experts are more sceptical, including about the Monsanto takeover. Even if you have calculated very carefully and can cope with rising interest rates, Monsanto has got to deliver and Bayer must realise the promised synergies. That means cutting costs. You have predicted $1.5bn a year.
“At Bayer, we have already carried through a lot of big and little acquisitions, Aventis Crop Science, for example, Schering, or Merck & Co’s consumer-care business. And in the capital market we have the reputation for being very critical and disciplined. As far as the synergies are concerned, in the past we have always achieved or exceeded the promised cost savings. On turnover in some cases we have not quite fulfilled our plans, but the bottom line is that so far our takeovers have always brought an increase in value for our shareholders. You can also see that from the speed with which we reduce our debt. In 2014 our net financial debt rose by €12.9bn to €19.6bn, largely because of taking over the Merck business. Since then we have been able to reduce it by nearly 50% to €10.4bn today.”
All the same, the stock market was initially unhappy with the Monsanto deal. Bayer’s share price plummeted because a lot of shareholders sold after the takeover announcement. Are you perhaps being too optimistic?
“We have talked to a lot of investors since then and explained why the businesses of Bayer and Monsanto go well together. Many of them are now convinced of the strategic value of the transaction, as you can see from the way the share price has recovered. In addition, more and more investors have realized that we selected a favourable moment for our purchase offer. Last summer the cycle of the agriculture economy, which Monsanto depends on, had touched bottom, so that made the share price fairly advantageous. Since then Monsanto has had two very good quarters, with rising turnover and profits margins.”
It seems interest rates play a less important role for a company like Bayer than developments in the real economy.
“That is correct. It is not only Bayer – the same applies to the whole of German industry. We work strictly in accordance with profitability targets, which are very largely independent of interest rates. And that is right, that is the way to do business. I am often asked if the ECB president, Mario Draghi, buys up all our debt, meaning all the bonds we issue. But even at the height of the financial crisis we had enough private investors.”