Buying time

Will swallowing Wyeth cure Pfizer?

WHEN Jeffrey Kindler took over as the chairman of Pfizer two years ago, many looked forward to a new era at the American pharmaceutical giant. Unlike the firm’s previous bosses, typically selected from the ranks of its technocrats, Mr Kindler was an amiable outsider and a lawyer. Investors hoped that instead of gobbling up rivals in an endless quest for scale, Mr Kindler would instead slim down the company in preparation for the dramatic drop-off in revenue at the edge of a patent “cliff” it is fast approaching. Lipitor, a cholesterol drug that earned Pfizer about $12 billion last year, loses patent protection in America in 2011; by 2013 products accounting for 38% of current sales will be exposed to price competition from generics.

But it seems that Pfizer has tamed the outsider, rather than the other way round. On January 26th Mr Kindler declared that his firm was making one of the industry’s biggest acquisitions ever, buying Wyeth, a middling American rival, for some $68 billion. The deal is to be financed with a mix of cash, shares and short-term bank debt.

Financial markets’ reaction was not kind. Pfizer’s share price fell by roughly a tenth on the news, though it later recovered a bit. Moody’s and Standard & Poor’s, two credit-rating agencies, put the firm on their watch lists for potential downgrades. Mr Kindler did not help his case by saying that financing the purchase would mean a big cut in the firm’s dividend, or by using the deal to bury news of a stunning $2.3 billion charge arising from settlement of a legal investigation into the allegedly improper marketing of a pain reliever.

So why did Mr Kindler take the plunge? One reason, he said, was that he could squeeze out some $4 billion in cost savings from the two firms. Claimed synergies have rarely materialised in past pharmaceutical deals, but this time Pfizer seems to mean business: it plans to shed nearly 20,000 jobs. Another attraction of the deal, Mr Kindler argued, is the chance to fill Pfizer’s flagging distribution channels and weak research pipelines with fresh products. Wyeth sells consumer and animal-health products, which could help diversify Pfizer’s revenue base (though it also suggests that Pfizer erred in selling its well-regarded consumer-products division to Johnson & Johnson, an American rival, two years ago).

This deal is a useful “half step” forward for Pfizer, says Charles Farkas of Bain, a consultancy, but no more. He thinks Wyeth’s assets will buy it some time but will not be enough to replenish the research pipeline or to replace Lipitor—not least because Wyeth faces its own patent cliff. Adding Wyeth’s products to its mix would, by one estimate, reduce the share of Pfizer’s sales exposed to generic competition in 2013 by just a few percentage points.

And that assumes that the deal will work. History provides one reason for scepticism. Michael Rainey of Accenture, a consultancy, who has scrutinised big deals in the industry, reached the damning conclusion that “nine out of ten deals created no value or negative value.” Asked recently about mega-mergers, David Brennan, boss of Britain’s AstraZeneca, scoffed that if big efficiency improvements were really possible, good managers would do them anyway, rather than pursuing mergers.

What about economies of scale in research? In fact there seems to be no connection between size and success. If anything, larding on extra layers of research managers stifles the entrepreneurial spirit that makes nimble biotechnology firms successful. That points to another potential weakness of the deal. Although Pfizer will gain access to novel vaccines and biotechnology, those innovative bits will come wrapped in big-company bureaucracy.

The final reason for concern arises from the vagaries of the financial crisis. Pfizer has obtained some $22.5 billion in bridge financing for this deal from five banks. If its credit rating drops sharply, the banks have the right to revoke the loan—and Wyeth could walk off with a $4.5 billion break-up fee. That is unlikely given Pfizer’s financial strength and solid credit rating, says John Moore of 3i, a private-equity firm.

But what will happen to the deal’s financing if politics enters the fray is less clear. The American banks helping to finance the deal have benefited handsomely from taxpayer bail-outs. What will Mr Kindler say if he is hauled down to Washington, DC, to explain to Congress why he is using billions of dollars borrowed from such banks to implement a deal that, as he insisted this week, will result in the swift sacking of thousands?

www.economist.com

Big opportunities for small banks

The deepening gloom at Citi, BofA and other large institutions gives community banks like Sterling Bancorp and First Niagara a chance to shine.

The deepening problems at big banks are giving their smaller, nimbler rivals a chance to play catch-up.

After years of willy-nilly expansion and soaring stock prices, the nation's biggest institutions are in deep trouble. Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500) each have received two infusions of government aid, and once-mighty firms such as Goldman Sachs (GS, fortune 500) and Morgan Stanley (MS, Fortune 500) needed government support to help them get through the funding crisis.

Weighed down by the enormous losses at major institutions, banking industry profits recently hit an 18-year low, and early trends in 2009 aren't promising.

The KBW Bank index dropped 35% in January, as investors fretted over rising loan defaults and the possibility that further government aid could wipe out shareholders.

But as serious as the biggest banks' problems are, it would be a mistake to assume the entire industry is suffering.

"A lot of bankers are saying there's unique opportunity right now," said John Millman, president of Sterling Bancorp (STL), the New York-based parent of Sterling National Bank. "There's a window of opportunity for banks like ours, because people running small companies feel disenfranchised by the way the big banks have operated."

Millman said the problems at big banks give Sterling, which has $2.1 billion in assets, and other community banks a better chance to expand than they have had in years. He said Sterling has the advantage of "knowing its customer" better than big rivals such as Citi and JPMorgan Chase (JPM, Fortune 500), whose assets run into the trillions of dollars.

That, Millman said, is why Sterling -- which got $42 million from the government under the Troubled Asset Relief Program in December -- has continued lending even as the economy has stumbled in recent months.

"We have shown double-digit increases in loans in each of the past three years, and we plan to keep doing that," said Millman.

Bigger may no longer be better

Growth for the nation's smaller banks represents a reversal of trends from the last twenty years, when the biggest banks got much bigger and many of the smallest players were gobbled up or driven under.

Over the past decade and a half, banks with more than $10 billion in assets more than doubled their share of the nation's deposits, to 71% last year from 32% in 1992, according to an industry study published last month by Celent, a Boston-based consultancy.

At the same time, market share of deposits at the smallest institutions -- those with less than $100 million in assets -- has dropped by more than half.

There are several reasons for this. Consolidation in the banking industry has been driven in part by increasing technical challenges, such as the rise of Internet banking, online bill payment as well as various compliance regimes, including a Treasury department program that keeps an eye on overseas wire transfers.

The more tasks that banks had to juggle, the less efficient the smaller banks became, wrote Celent analyst Bart Narter in a report detailing the decline of community banks.

This is clear when looking at the high level of noninterest expense as a proportion of income -- what's known in the industry as a bank's efficiency ratio -- for many small banks.

But while some banks have tended to become more efficient as they grow larger, Narter noted that the largest banks often don't show the greatest efficiency. This now seems unsurprising given the deep problems that the biggest institutions have faced over the past year.

"They actually experience diseconomies of scale," Narter wrote of the biggest banks. "There are so many large autonomous divisions of the bank that the complexity of connecting them overwhelms the advantage of size."

Smaller banks look to expand

As big banks struggle to find a way forward and rising loan losses threaten to punish poorly run banks of all sizes, smaller but well capitalized institutions have a long-awaited chance to expand.

"There's no question it's a good time to look for purchases," said John Koelmel, CEO of First Niagara Financial (FNFG), a Lockport, N.Y., bank with $9.1 billion in assets that got $184 million from TARP last year.

Koelmel said that while First Niagara's first priority is to strengthen its foundation so it can take advantage of the "tremendous opportunities" that may arise over the next year or two, he believes the bank may have opportunities to grow even sooner than that.

Indeed, some smaller banks are so confident of their prospects -- or so unwilling to part with their freedom to operate as they see fit -- that they are turning down Treasury capital infusions.

Banks ranging from tiny Friendly Hills Bank of Whittier, Calif., to New York Community Bancorp (NYB), a Westbury, N.Y. bank with $32.5 billion in assets, have declined to accept TARP injections ranging from $1.6 million to $596 million.

The TARP rejection letters are coming even as the Federal Deposit Insurance Corp.'s third-quarter banking industry profile, published in November, portrayed an industry crumbling under the weight of bad loans.

Profits for all banks in the first nine months of 2008 -- the latest period for which data are available -- plunged 58% from a year earlier.

But Koelmel said banks such as First Niagara have shown they appreciate the need to "earn it every day" with customers, investors and others.

"We're very pleased with what we've been able to accomplish," Koelmel said of the bank, which last week reported a 9% rise in 2008 operating profits and a 14% rise in commercial loan volume.

First Niagara shares, despite a 40% drop over the past year, have outperformed those of its peers, giving the bank a bigger market value than some rivals with more assets and deposits.

"The lesson is that the big guys weren't necessarily smarter than the rest of us," Koelmel said.

money.cnn.com

Rio Tinto and Chinalco: The big owe

Rio Tinto's hefty debts have pushed it to seek investment from China

BIG mining companies have suffered an astounding reversal of fortunes in the past few months. As boom has turned to gloom, commodity prices have slumped, leaving mining firms with painful decisions to make. Rio Tinto is the latest to suffer. On Monday February 2nd the Anglo-Australian mining giant was forced to confirm press speculation, acknowledging that it is in talks with Chinalco, a state-owned Chinese aluminium maker. The Chinese firm may agree to a deal to help to alleviate Rio’s debts which were taken on before the credit crunch led to a foundering world economy.

Rio’s debt pile of some $40 billion was mostly run-up through its purchase of Alcan, a Canadian aluminium firm, in 2007. Around $9 billion is due later this year, and refinancing will be a tricky proposition given the parlous state of debt markets. Another $10 billion must be repaid in 2010. Rio has started a firesale of assets: it raised $1.6 billion last week by selling iron ore and potash businesses in Brazil and Argentina to Vale, a Brazilian rival. But prices are depressed and making a sale is not always possible—Rio has still not managed to offload Alcan’s packaging business, although it is reportedly in talks with a potential buyer.

Firms are also trying to cut costs. Rio will lay off 14,000 workers and will slash capital expenditure by $5 billion this year. In addition, the Chinese deal may provide much-needed ready cash. Chinalco is already Rio’s biggest investor with a 9% stake acquired expensively last year when shares were bubbling. Although Chinalco’s exact motivation was unclear, it probably invested in the hope of derailing a bid for Rio from BHP Billiton, another vast mining firm. China’s government had feared the pricing power of the pair together, which with Vale would dominate the market for seaborne iron ore. BHP’s bid was subsequently abandoned as business conditions deteriorated.

The talks may bring about a complex deal that would allow Chinalco to raise its stake in Rio over 11% through the purchase of a convertible bond. The Chinese firm is also likely to buy minority stakes in a variety of Rio’s prime assets. For its part Rio would receive some $15 billion. Although Rio has not revealed what assets might be included, there is speculation that it might even let go of its prized 30% stake in Chile’s Escondida, the world’s biggest copper mine.

As a result, Rio’s purchase of Alcan may prove to have been more costly than the bumper price tag first suggested. If it goes ahead with the deal Rio may, in turn, come to regret selling interests in valuable assets to a firm controlled by China, its most important customer. The prospects for Rio’s growth, already hurt by a sharp fall in investment, will be worsened by any sale of its better assets.

Yet, however unpalatable Rio may find going cap in hand to China, the alternative is no more enticing. Last week Rio said that it was considering a rights issue, but that would doubtless need to be deeply discounted. Xstrata, another highly indebted miner, announced a heavily discounted rights issue last Thursday. Minority shareholders were deeply concerned that Glencore, a commodity trader that owns a 35% stake, sold Xstrata a coalmine for $2 billion to meet its part of the cash call. The value of the mine is unclear and Glencore has an option to repurchase the mine for slightly more over the next year. But the uproar highlights the problems associated with having a leading shareholder (as Chinalco might become with Rio) with potentially differing interests to other investors.

A rights issue would also have the unfortunate effect of reminding shareholders of how much better off they might have been had Rio not rebuffed the advances of BHP. Tom Albanese, Rio’s boss, spent a busy year in 2008 explaining in detail why the takeover should not happen, before BHP pulled out anyway. Explaining how he is going to get Rio out of its current mess will put Mr Albanese’s oratorical powers to a similarly stiff test.

www.economist.com