Consumer goods giant Reckitt Benckiser (LSE: RB) is in the headlines, after the firm admitted it is bidding to buy the consumer health arm of pharmaceutical firm Merck & Co, for a rumoured $14 billion.
One key question for Reckitt shareholders is whether their firm can afford the Merck deal — and whether shareholder returns are likely to suffer as a result.
I’ve used three measures commonly used by credit rating agencies to take a closer look at Reckitt’s finances.
1. Interest cover
What we’re looking for here is a ratio of at least 2, to show that Reckitt’s earnings cover its interest payments with room to spare:
Operating profit /net interest costs
£2,345m / £24m = 97 times cover
Reckitt’s finance costs are low, and this, combined with its high profit margins, mean that interest cover is an exceptionally strong 97 times. An increase in debt — as is likely if the Merck deal goes ahead — shouldn’t be a problem for shareholders.
2. Gearing
Gearing is simply the ratio of debt to shareholder equity, or book value. I tend to use net debt, as companies often maintain large cash balances that can be used to reduce debt if necessary.
At the end of 2013, Reckitt reported net debt of £1,959m and equity of £6,336m, giving net gearing of 31%. This is well below my personal preferred maximum of 50%, but it’s clear that $14bn would be a big chunk of cash for Reckitt to find. However, one possible source of funds for Reckitt is its pharmaceutical division, which the firm is considering selling.
3. Operating margin
Reckitt reported an operating margin of 23.3% in 2013, down from 25.5% in 2012, due to exchange rate fluctuations.
Reckitt’s high profit margins generated £1.5bn of free cash flow in 2013, covering the firm’s dividend payment by 1.5 times, and allowing Reckitt to reduce its net debt by more than £500m.
Buy, hold or sell Reckitt?
Reckitt’s share price has risen by 83% over the last five years, rewarding long-term shareholders. However, for new buyers, the shares aren’t cheap, trading close to their 52-week high on a P/E of 18.5, with a prospective yield of just 2.8%.
Reckitt’s goal of becoming a dominant player in the consumer healthcare market offers strong growth potential, but a deal of this size is always risky. In my view, existing shareholders should sit tight, but for new buyers, there’s no need to rush in.