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Roche's hostile bid for Illumina supports personalized medicine strategy. Roche's (RHHBY) combination of drug and diagnostic expertise is a key pillar of its economic moat, and gaining a leadership position in all facets of diagnostics will only further the synergies between these businesses. In keeping with this strategy, Roche has announced that it is appealing directly to Illumina (ILMN) shareholders with an offer of $44.50 per share, or $5.7 billion. This comes after repeated attempts to negotiate a deal with Illumina's management team. We think Roche is valuing Illumina based on depressed near-term prospects (as well as its depressed stock price), and it wouldn't surprise us if both the board of Illumina and its shareholders reject this hostile offer as inadequate, considering favorable long-term dynamics of the space. Illumina's shares now trade at approximately a 20% premium to Roche's offer, indicating the market's bet on a higher bid (or potentially a competing bid). Illumina's shares remain under review as we are taking a close look at both long-term prospects of the firm and the likelihood of a takeout. As a side note, we highlighted Illumina as a potential takeout target in our 2011 edition of M&A Healthcare Observer, but we viewed the company as expensive and difficult-to-digest at then-prevailing prices.

At a 64% premium to Illumina's price before rumors of a deal leaked in December and a 30x multiple to consensus 2012 EPS--but only roughly half of Illumina's stock price late summer of 2011--we think Roche's offer is on the market's view of Illumina as a broken near-term growth story. Roche's current approach is different from its $3.4 billion acquisition of fast-growing tissue diagnostic firm Ventana in 2008 (which was acquired at a sizable premium to Ventana's all-time highs), as Illumina's shareholders could be more receptive to a deal given both the depressed stock price and the uncertain funding environment that will likely suppress top-line growth over the next few years. At current terms, the deal is not large enough to move the meter on our fair value estimate for Roche, but it all could change if the bidding becomes more aggressive. The deal would be accretive starting next year, and Roche has the capacity to close the acquisition without raising more debt (the firm had more than CHF 8 billion in cash at the end of the first half of 2011). We anticipate maintaining our credit rating for Roche because the firm can easily handle this transaction with ongoing free cash flow. Even if the firm decides to issue more debt to fund the deal, we don't think this would change Roche's leverage position enough to cut into our credit rating. For our full take on the deal, please click here.

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