Big Merger Coming to a Close in the Medical Equipment Industry

Mike is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In late October, diversified healthcare distributor McKesson Corporation (NYSE: MCK) announced its intention to purchase Jacksonville, Florida-based medical components manufacturer PSS World Medical (NASDAQ: PSSI). The all-cash deal has been valued at more than $1 billion and would create a company with $125 billion in annual revenues. At this point, the deal appears likely to go through in its current form. If no last-minute legal actions or shareholder revolts serve to delay or derail the deal, it should close by the end of the second quarter of 2013.

About McKesson and PSS World Medical

San Francisco-based McKesson Corporation is one of the leading North American healthcare logistics companies. The company maintains a wide-reaching distribution network through which it sells drugs, pharmaceutical components, medical supplies and office supplies to hospitals, independent doctors, and clinics. It also supplies chemicals and other raw materials to drug manufacturers. McKesson's "specialty pharmaceutical" unit provides custom drug cocktails and other services for specialized clinics and patients with rare medical conditions. It also engages in a range of technology-driven operations that physicians and clinicians use to increase the efficiency of their practices and clinics. The company employs about 38,000 people and earned $1.6 billion on $123.2 billion in revenues in 2012.

PSS World Medical is a smaller distributor that focuses on supplying physicians and clinics with many of the same products that McKesson produces and distributes. Its principal products include diagnostic materials, disposable supplies, pharmaceuticals and drug components. The company also sells a variety of higher-cost specialty products like orthopedic attachments, palliative care products and deep-tissue wound dressings. Like McKesson, it also leverages its significant technology-driven assets to provide efficient billing services, practice management solutions and other services. In 2012, PSS earned $69.6 million in gross revenues of $2.2 billion.

How the Deal Is Structured

The terms of this all-cash deal are relatively straightforward. According to the October announcement, McKesson intends to purchase PSS for cash consideration of $29 per share. As a condition of the deal, the larger company must also assume about $480 million in long-term PSS debt.

This deal provides an attractive premium for current PSS shareholders. Relative to the company's pre-announcement closing price of $21.60 per share, the $29-per-share offer represents a premium of over 34 percent. Relative to its recent closing price of $28.97, the deal represents a premium of about .1 percent. In an indication of the high hopes that many investors and market-watchers have for this merger, McKesson's stock rose by more than 4 percent on the day after the announcement. Since then, it has continued to rise and is currently up by more than 10 percent over its pre-announcement closing price near $93 per share.

Complications and Competition

In late December, this merger received a major boost from the surprise declaration that the customary pre-deal waiting period would terminate ahead of schedule. In theory, this could accelerate the merger's completion timetable and facilitate its closure by the end of the first quarter of 2013.

However, a potential legal challenge threatens to delay or rework the deal. The "investigation" filing alleges that PSS's board of directors violated its fiduciary responsibility to its shareholders by accepting a low buyout offer. It cites past price actions and analyst recommendations to assert that the company's fair value should be several dollars per share higher than its $29-per-share valuation.

While it is true that PSS's share price briefly exceeded $29 in 2011, this action was not sustained. Aside from this temporary spike, the company has traded below $25 per share since the late 1990s. At this point, it appears unlikely that this potential suit will derail the deal. In fact, PSS's valuation is high enough that the appearance of a rival bid is a remote possibility.

Although the long list of potential rival bidders includes such medical-device behemoths as Medtronic (NYSE: MDT) and Boston Scientific (BSX), bids from either of these companies would face serious regulatory scrutiny. Medtronic has a massive $47 billion market value so tacking on another billion dollar company may be difficult.  However, its $2.68 billion in cash would be more than enough to pay for the company.  In this light, McKesson's decision to achieve horizontal integration with this purchase appears masterful. It is unlikely that either Medtronic or Boston Scientific would risk a protracted bidding war or regulatory battle over this particular asset.

Long-Term Prospects and Outlook

By acquiring a smaller competitor in a quickly-expanding industry, McKesson appears to be making a classic arbitrage decision. As a result of the merger, McKesson expects to achieve over $100 million in annual cost reductions and significantly broaden its distribution network. With steadily-rising cash reserves, McKesson could leverage these synergies in the service of its relatively weak dividend. Although it currently yields less than 1 percent, it is not unreasonable to speculate that a dividend boost could be in the works within two years. Relative to its annual revenues, the amount of debt that McKesson must assume as a condition of this deal is not consequential.

Going forward, investors who wish to profit from this deal have several options. Although PSS shares do not currently offer much of a premium, McKesson appears to have considerably more room to run. Market-timers would do well to watch the company's shares for a potential post-deal pullback. Should this occur, it could represent a tremendous long-term buying opportunity.



mthiessen has a short position in PSSI. The Motley Fool recommends McKesson. The Motley Fool owns shares of Medtronic. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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