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It is only now that the market is finally switching its attention toward the important issue of valuation as the board at FTSE 100 firm AstraZeneca (AZN) firmly rejects a final offer of £55 a share from Pfizer (PFE:NYSE).

Some shareholders may be encouraged to hear AstraZeneca is holding out for £59, others will be frustrated. Both sets of investors must decide what to do with the shares trading at £42 as Shares goes to press. They should make their decision in the context of the following two questions:

What were the reasons for the bid in the first place?What do they believe AstraZeneca to be worth, in the context of the growth, risk and quality framework?

Our research suggests £55 a share leaves Pfizer's team with some margin for error in the integration process, £59 much less. Had I been a shareholder, my inclination would have been to take the money and run. Fair play to AstraZeneca's chairman Leif Johannson and chief executive officer Pascal Soriot for the faith they have in their strategy. They now have to deliver and if they are unable to check the decline in the £53 billion cap's earnings in the next year or so both could start to come under a lot of pressure from investors.

AstraPfizer

The real deal

Pfizer has a track record of making big acquisitions designed to boost its drug pipeline and create scope for cost synergies. In this case, there appears to be some tax-planning potential, given how UK corporate tax rates compare favourably to those in America. AstraZeneca shareholders should note Pfizer's investors do not seem convinced, if the drop in the American giant's share price since the deal's announcement is any guide. Pfizer is supposed to be a drug firm whose primary purpose is to cure illness and do it so well that doctors and governments want to buy its products. It is not a financial planning agency.

When it comes to valuation, the best way to look at this is free cashflow analysis - such an approach explained perfectly why the last overseas lunge for a FTSE 100 firm proved unsuccessful exactly a year ago, when a consortium refused to increase its bid for Severn Trent (SVT) (see Opinion, Shares 23 May '13). Based on earnings estimates from broker Liberum, which is bullish on AstraZeneca, the price demanded by the board equates to a free cashflow (FCF) yield of 5.8% out to 2017.

Opinion Table 2

Pfizer may be able to borrow at around 3% after tax and extract cost and tax synergies to boost that 5.8% FCF yield but the history of other big deals shows these benefits can be hard to extract to the full. The US firm's boss, Ian Read, must also consider whether and when interest rates will rise, as even assuming a 7% FCF yield it will take him 14 years to get his money back.

Moreover, AstraZeneca's profits and cashflow show a consistent decline between 2010 and 2016, even using Liberum's numbers. That is not a great record and while the broker expects big improvements from 2017 there is no guarantee they will come through, despite the thoroughness of the broker’s work. The poor growth profile, the risk that AstraZeneca's pipeline does not come good and the question marks over the quality of its earnings mean Read should not pay top dollar, given the margin for error.

Opinion Table 1

Patient shareholders will bank a 3.5% dividend yield from AstraZeneca while they wait to find out what happens, although such a consideration may only serve to further highlight the 5% yield on offer at GlaxoSmithKline (GSK).



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