What’s a Merger Worth?

The Knowledge Capital Scorecard offers a new way to value the Pfizer/Warner-Lambert merger.

When Pfizer Inc. agreed in early February to pay more than $90 billion for Warner-Lambert Co. in the priciest hostile takeover ever, the deal triggered the inevitable question: Was the price tag justified?

According to final terms of the deal, 2.75 shares of Pfizer will be exchanged for each share of Warner-Lambert.

Wall Street saw a winner in the marriage of the two pharmaceuticals giants. According to a First Call earnings- consensus report, the two companies combined will grow faster than either alone. Instead of two large companies, each expected to grow earnings at 20 percent a year for the next five years, a single company emerged with an expected 24 percent annual growth rate.

Knowledge capital exists in every industry, but seldom to the degree found in the drug business, where value resides chiefly in brand recognition, patents, reputation, and research pipelines. “Certainly, the impact on intellectual capital and knowledge is one of the critical things we are trying to achieve,” says Pfizer CFO David Shedlarz. Indeed, he adds, Pfizer launched its bid with the impact on knowledge capital in mind, “both strategically and tactically.” The endgame: “to create a new competitive standard in developing a breadth and depth of research capability.”

Measuring the returns from knowledge capital is no easy task. Traditional analytical tools, although good at keeping tabs on investment in knowledge assets, don’t record the consequences on balance sheets. In an effort to close this gap, CFO applied the analytical technique used to compute its annual Knowledge Capital Scoreboard to Pfizer’s acquisition of Warner-Lambert.

According to a Knowledge Capital Scorecard assessment, the merger creates $6 billion of knowledge capital over and above the roughly $28 billion acquisition premium that Pfizer agreed to pay. The methodology for reaching this conclusion was developed at CFO’s invitation by Prof. Baruch Lev, the Vincent Ross Professor of Accounting and Finance at New York University.

Essentially, knowledge capital represents the capitalized difference between a company’s normalized earnings and average expected returns for assets posted on the balance sheet. Ordinarily, for healthy companies, normalized earnings exceed earnings that book assets are expected to generate. The excess constitutes knowledge earnings, that is to say, the portion of normalized earnings not attributable to book assets. Thus, if a company’s normalized earnings are $100 million and book assets can be expected to earn $80 million, then the company generates $20 million in knowledge earnings.

To find knowledge capital, knowledge earnings are capitalized to reflect the present value of all future knowledge earnings growth–much like a conventional dividend discount model.

In Pfizer’s case, premerger knowledge capital was $82.5 billion; for Warner-Lambert, it was $50.0 billion. Combined knowledge capital before the merger totaled $132.5 billion. Postmerger, using Wall Street’s increased earnings expectations and growth estimates, combined knowledge capital is $166.9 billion, according to portfolio manager Marc Bothwell, of Credit Suisse Asset Management in New York.

All told, the merger appears to add $34.4 billion in knowledge capital. It does not come free of charge, however. To snatch Warner-Lambert away from American Home Products Corp., the rival bidder, Pfizer agreed to pay approximately $28 billion more than the average price of Warner-Lambert shares before American Home put them in play in August 1999. In this light, the net gain in knowledge capital is $6.4 billion.

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