A few months ago, in the August issue of Extreme Value, I recommended shares of IMS Health (RX) at around $13 a share. This morning, the headlines told me IMS would be bought out by Texas Pacific in a private-equity deal for $22 a share, about 70% above my recommended price.
I'm thrilled, right?
Wrong.
IMS Health is not being sold. It's being stolen from its shareholders for less than 12 times free cash flow. If you want to understand why I'm upset about this, take another recent buyout for example.
Just a few days ago, Warren Buffett bought Burlington Northern Santa Fe railroad, valuing the whole company at more than 40 times free cash flow. BNSF has high barriers to entry. In fact, it's virtually impossible to compete with it. If you ship goods by rail in the West, you have little choice but to deal with BNSF. This gives the railroad what all great business have: pricing power. When inflation pushes up costs, BNSF pushes up prices.
As Porter pointed out yesterday, that's why Buffett loves it so much. He knows its competitive position and its nature as a mover of tangible goods will keep its pricing power intact and it'll be able to beat inflation.
And what about IMS Health? It, too, is very, very difficult to compete with. It owns a database six times larger than the Library of Congress, some 50 years worth of pharmaceutical transaction data. It's virtually impossible to replicate, just like BNSF's rights of way and physical assets. IMS tracks 90% of the U.S. pharmaceutical transactions, some 1 billion transactions per day. Like BNSF, there's no substitute for IMS Health. You deal with it or you go empty-handed.
And yet, management agrees to sell this cash-gushing business for less than 12 times free cash flow? IMS' free-cash-flow margins at around 15% are more than three times thicker than BNSF's at less than 4.5%.
So why is IMS Health going out so cheap? And why is the current spread between the market price and the lowball deal price an enormous 5.9%? That's too wide. It should be more like 1% or 2% for an all-cash deal for a company of such high quality – which isn't all that big at around $5.2 billion total, including assumed debt.
Surely Mr. Market couldn't be wrong... could he?!
Of course he could. Mr. Market is wrong far more often than he's right. Last March, Mr. Market said BNSF was worth about half what Warren Buffett said it was worth a few days ago. Truth is, Mr. Market doesn't know how to value a business. He only knows how he feels, based on what he reads in the paper or sees on CNBC. To value a business, you need someone who knows what he's doing... someone like Warren Buffett, not someone like IMS Health's management team.
That said, I think I know why IMS Health is going out so cheaply. I think I know two reasons why so much fear surrounds this deal. First, IMS could continue to face legal hassles. If more lawsuits prohibiting it from using doctors' names go against IMS, there's a chance its business might become impaired (though so far, there's no sign this will become a big problem).
The second – and bigger – reason for this is the same reason I've been telling readers for over a year to avoid banks and homebuilders.
You can't expect to inflate and reflate burst asset bubbles ad infinitum. You're putting a penny behind the fuse. Eventually, you'll burn the whole house down. The banks and homebuilders can't be bailed out forever without turning those industries into zombie-infested boondoggles. (Sound familiar? That's where we are right now: no housing demand, enormous supply coming from foreclosures, and homebuilders caught with leveraged balance sheets loaded with overvalued inventory.)
Likewise, private equity can't continue to count on low interest rates forever (i.e., earning artificially wide spreads, like the banks). Pretty soon, the market notices the mistakes and interest rates go up.
At some point, there's so much misallocated capital in so many deals that never should have happened that everyone becomes afraid of making a mistake... to the point that even a one-of-a-kind cash gusher like IMS Health goes out at 12 times free cash flow. It screams "FEAR."
It's weird to talk about fear with U.S. stocks going for 29 times earnings and yielding 1.8%. But that's what it looks like. The fundamental reason for cheap securities prices is fear.
So maybe some sort of capital misallocation tipping point was reached last year. Maybe many mistakes were made. Maybe this time it's all too big and bad to fix without years of pain and suffering. Maybe the IMS deal signals a return of fear that will take U.S. stocks back to more reasonable valuations.
Think about it... The biggest debt market in the world (U.S. mortgages) got more inflated than any market has ever gotten, and one of the world's most coveted assets – U.S. housing – got more capital thrown at it than ever before and more than it'll need for years to come. If anything could produce the mother of all financial debacles, requiring the mother of all recovery periods (which will certainly be drawn out by the mother of all ill-conceived government interventions), the Great Bubble to End All Bubbles was it.
And after all, shouldn't someone be afraid when stocks are expensive? Shouldn't someone somewhere be cautious? Maybe Texas Pacific's bankers just said, "We'll lend if you pay $22 a share, but not a penny more." Who knows? Somebody somewhere is obviously afraid of something.
In the meantime, IMS shareholders need a white knight. They need Carl Icahn to swoop in and offer 16 times free cash flow, knowing someone will see that's low, too, and offer 20 times or more. A bidding war could ensue, which is the best way to get IMS shareholders a better price.
Worst case, Icahn gets the company for a bargain price. A shareholder lawsuit would be OK, but they're too easy to ignore until the deal goes through. A bidding war is the real solution.
As for the mistakes in the homebuilders and banks, they seem to be coming at a great rate in some of the worst bubble markets... At lunch with Porter yesterday, Whitney Tilson said he spoke with several realtors in Phoenix when he recently gave a presentation there. They said the market was "great" and they're seeing three bidders for each property. In some cases, it's actually cheaper – on a monthly basis – to own a home than to rent one. And with the average Phoenix home costing around $130,000 and requiring only $5,000 down, buyers are actually getting paid to buy a home when you factor in the $8,000 tax credit. Who wouldn't buy in that case?
With the market drinking the mortgage Kool Aid, the government is doing everything in its power to keep this rally going... The Senate is voting to extend the housing stimulus – which is slated to end this month – through April 30, 2010. And the new stimulus would include a $6,500 tax credit for existing homeowners who have owned their current home at least five years. First-time homebuyers would still get up to $8,000. Remember, it's only temporary. Bank and homebuilder shareholders will eventually pay for it... along with taxpayers.
I've recommended a bunch of World Dominating franchises – ones like BNSF and IMS Health – companies with which it's nearly impossible to compete. I only recommend them when they're dirt-cheap. Consequently, every single one of those recommendations is showing a profit now. And they're some of the greatest dividend payers of all time.
While other businesses struggle to compete on the price of their goods and services, my World Dominator recommendations remain highly profitable, earning steady returns for investors, year in and year out. To access my recommended portfolio, click here...
New highs: Cresud (CRESY), Visa (V), BNSF (BNI), Keyera Facilities (KEY-UN.TO), European Goldfields (EGFDF.PK), Barrick Gold (ABX), Jinshan (JIN.TO), Encore Acquisition (EAC).
Another light mailbag... but one good tip for people living at our northern border. Send your ideas to feedback@stansberryresearch.com.
"I live within an hour from the Canadian border and have a bank account in a major bank. When I cross the border, I NEVER tell them that I'm going over there to do my private banking. It's shopping, visiting, or gambling at the casino but anything else but banking. I don't want to give them any reason to hassle me and have never had a problem." – Paid-up subscriber Gary
Regards,
Dan Ferris
Medford, Oregon
November 5, 2009