Investment Idea #11
Investment Idea #11
Back to looking at a European name
This company undergone a disastrous merger and stock price has languished for many years. Activists came in and shook up management, resulting in a change in CEO. So market watchers are hoping that things might finally go right. In fact, management wants to get things right so much so they published an investment case deck themselves for investors to look at.
Again let’s look at the numbers again. It still has quite a fair bit of debt (>EUR30bn) as a result of the big merger that it did. But FCF generation is strong and therefore there is an additional deleveraging story which will benefit stockholders.
Simple financials (Dec 2023 estimate, EUR)
Sales: 49.9bn
EBITDA: 12.3bn
Net income: 4.1bn
FCF: 3.5bn
Debt: 33.2bn, Mkt Cap 50.5bn
Financial Ratios
ROIC: 8.4% and ROE: 17.2%
EV/EBITDA 6.6x (Dec 24)
PER 6.8x (Dec 24)
Past margins: OPM c.10% (been volatile)
FCF yield: 6.9%
The following shows the usual FCF over the years, thanks to macrotrends.net. It has been hit by the pandemic but we can also see that the numbers are recovering strongly.
The stock we are discussing today is Bayer, the German life science company with three core businesses: Crop Science, Pharmaceuticals and Consumer Health (OTC drugs). It controversially bought Monsanto, US’ leading seeds and herbicide producer, in 2018 which came with a huge litigation issue that brought the company to its knees and saw the exit of the CEO who engineered the deal. Five years on, we are finally seeing light at the end of the tunnel and hopefully a lot of upside.
Background
Bayer was founded in 1863 as a chemical company but was better known as the company that gave us Aspirin and Heroin. In 1925, it merged with a few other German companies to become one of the largest chemical and pharmaceutical firm back then and aided German’s WWII effort supplying painkillers for Nazi soldiers, using POWs as workers amongst other deeds (or misdeeds, if you will). As with many other German companies, Bayer was subsequently penalized.
In 1995, the then CEO apologized for the company’s actions during WWII and the Holocaust and was somewhat forgiven. Well, that’s a short history, which might be too far back in time to be relevant. But an important point here is that an apology can go a long way. We should definitely do more, especially when we have let down our loved ones.
The current Bayer built its businesses in 1960s with tentacles into various chemical, consumer and pharmaceutical products. One of its most iconic products in recent times has to be the Baygon spray for killing cockroaches and insects. Many may recall how our mothers would have the Baygon spray in hand chasing down a cockroach in the kitchen. While the insect may escape, we would almost always see it bellied up a few hours later, thanks to Baygon!
The latest incarnation of Bayer came when it bought Monsanto, US largest herbicide and crop seeds producer for USD66bn in 2018, making crop science its largest business segment. As such, the business segments split today (Dec 2022) is broadly: 50% Crop Science, 38% Pharmaceuticals and 12% Consumer Health:
Revenue and EBITDA by segment in EUR
Crop Science: Revenue 25bn, EBITDA 7.5bn, EBITDA margin 30%
Pharmaceuticals: Revenue 19bn, EBITDA 6.2bn, EBITDA margin 33%
Consumer Health: Revenue 6bn, EBITDA 1.3bn, EBITDA margin 22%
As an industrial conglomerate with a long history, the business segments are also complex with many different products. The following few paragraphs hope to provide more salient details.
Crop Science: This is the original Monsanto business which Bayer acquired. As such, Bayer is currently the global leader in crop protection and seeds. Its portfolio includes resistant seeds, pest and weed control, fungicides and digital agriculture. The following chart provides a good breakdown by sub-business segment and region.
Bayer / Monsanto has leading positions in most key products with c.30% global share and its key competitors are Corteva, Syngenta (which has been acquired by China’s SOE China National Chemical and is now private) and BASF. The industry is very mature but still growing at c.1-2% thanks to emerging market demand for animal feed and ethanol production, which uses a lot corn, in the US.
Pharmaceuticals: Bayer has a long history in prescription drugs and currently has a healthy portfolio of drugs generating profits supported by several potential blockbusters in the pipeline. As with above, the chart from its investor deck provides a good picture.
Despite negativities like patent cliffs and lawsuits that constantly surround Bayer, this business grew 1% above market at 6% CAGR as depicted above. Its two key drugs, Xarelto for blood clot treatment and Eylea for diabetic treatment to prevent blindness, will go off patent in 2024-2026 but will be replaced by Nubeqa for prostate cancer treatment with USD3bn in peak sales potential (PSP) and Kerendia for chronic kidney disease similarly with USD3bn in PSP. The track record above shows this business should continue to do well.
Consumer Health: This is the third and smallest business segment with the brands that most people would be familiar with. These include Aspirin, Claritin, Redoxon etc. i.e. drugs we find in Guardian Pharmacy. Many have pushed for Bayer to sell this business to better focus the company on its two core businesses but growth has been strong and margins decent. It is unclear if management is really inclined to divest this business.
With that, we now have a brief overview of this conglomerate and can now formulate the investment thesis. This is the essence on why we buy something. It should be simple enough for layperson to understand and for ourselves to remember.
Investment Thesis
Bayer owns two strong businesses: Crop Science and Pharmaceuticals which have generated above average margins and high returns, while enjoying stable growth. Both businesses are essential for human development. Crop Science has allowed for better production yield to feed the world. In Pharmaceuticals, its key drugs have also saved and improved lives. However, Bayer will stand to rerate significantly if it can simplify its business structure. Multiple activists have called for transformation and the new CEO might just make things happen. If executed well, Bayer FCF can directionally increase c.50% from current EUR3.5bn to EUR5+bn, thereby generating double digit FCF yield.
1. Fundamentals
Let’s look at the business moats each of its three businesses which will further justify the thesis above:
Largest Crop Science Player in the World
Bayer is the world’s largest crop science company after merging with Monsanto in 2018. While the Roundup saga (which we will discuss later) created huge issues, the fundamental business is intact and once the issues are resolved, Bayer will benefit as the dominant player in this field with its huge economies of scale, dominant R&D position and extensive distribution network to farmers and agriculture businesses.
To delve more into the above, Bayer’s strength in R&D and distribution allows for development of better seeds and products, which sells faster to its customers, at cheaper price resulting in higher margins. As such, Bayer’s crop science EBITDA margin at c.30% is higher than most of its peer’s (see below).
Strong Pharmaceuticals Track Record
In the Pharmaceutical business, the patent expiration of its main profit driver Xarelto (blood clot treatment) has been an overhang for many years, but the company has demonstrated its track record to deliver growth and its current drug pipeline should offset the patent cliff with the launch of new assets.
The two key drugs Nubeqa and Kerendia are instrumental. Nubeqa has the chance to become the foundational prostate cancer treatment by Kerendia will help change the game for chronic kidney diseases. The story doesn’t end there and Bayer has various other products in the different phases to keep driving growth until 2027 as shown above.
To reiterate, the two larger core businesses are pretty essential for human development. One thought experiment that we have discussed before is to think about what happens if this company disappears tomorrow:
If Bayer did not exist, billions of people may starve as inferior seeds cannot grow enough food, crops are not protected from insects and weeds and certain innovative drugs will not find their ways to save lives. For some of us, we won’t have aspirin, which might be worse than death!
Ok, so consumer health is also indispensable. We certainly do not want live in a world without aspirin. On these counts, Bayer is worth investing but let’s discuss more deeply about business portfolio restructuring and management:
Consumer Health Spin Off
Bayer’s consumer health business could be worth c.EUR19.5bn if we simply apply 15x multiple on its EBITDA of EUR1.3bn. This is c.40% of its market cap and if used to buyback its shares at current low multiple, the value creation could be tremendous. This is one reason why it has been targeted by activists. That said, it is unclear if Bayer’s management is keen to execute this.
Management
Bayer is current helmed by Bill Anderson who started the job only in Jun 2023. But he is supported by experienced industry veterans as well as Bayers’ lifers who worked up the ranks. He probably understands there is a job to be done which is to lift up share prices. CFO Wolfgang Nickl has been on Bayer’s board since 2018 and has a wealth of experience at Western Digital and ASML, the dutch semiconductor equipment powerhouse.
2. Risks
The largest risk for Bayer is the litigation risk which has crippled the company for years. Right after it bought Monsanto, Bayer was sued for causing non-Hodgkin’s lymphoma, a type of cancer, with its leading glyphosate based herbicide called Roundup. Bayer lost the initial lawsuit and this opened the door for tens of thousands of cases which are ongoing today.
In Jun 2020, Bayer agreed to settle over a hundred thousand claims by paying USD10bn including future claims. The bulk of this has been paid out and will not affect future numbers and what is more promising was that Bayer started winning lawsuits because claims were getting erroneous. For instance, in one lawsuit, the plaintiff claimed that Roundup caused a 10-year-old to suffer from cancer but the evidence was very unclear. Bayer won the case.
As of today, Bayer estimates that 80% of the cases have been resolved although the risks remain with other lawsuits surrounding PCB chemical and other products. Analysts have estimate another c.EUR4bn of provisions might be needed to cover all future legal claims. While not insignificant, it represents about one year’s FCF and less than 10% of its market cap. It is also likely that the market has already factored in this risk.
This litigation risk has plagued Bayer for many years and we believe we are near the end of it as things run its course. We also have an American CEO who would be a better steward to navigate the US legal battleground supported by now a well trained legal team.
3. Technicals
As we can see from the share price chart below, Bayer’s stock has simply crashed since its purchase of Monsanto. Its market cap is trading below what Monsanto traded as a stand alone company in the US. Drawdowns ranged from 30-60% and the one in Mar 2020, at the height of covid, did not mark the bottom in share price. This is the only instance in the last 11 names we discussed. Investors really hated this name.
Today, we are just hovering around the Mar 2020 low and while this could be worrisome for some, I believe it is an opportunity and with the litigation issue going away and with the new CEO on board, there is a good chance that we can finally see upside.
For full disclosure, we wrote about this name on the main infosite in 2018. While we identified the key litigation risk, we could not fathom how big the issue was and how the share price could have languished for so long. But today, things do look different and valuations, as we shall discuss, looks even more compelling.
4. Valuations
We have put together a peer comparison table for Bayer and we can see that the stock is the cheapest amongst all its peers on almost all measures. That said margins are also lower but with the potential to improve once the litigation costs are removed.
Using our usual valuation methodologies, we can determine that Bayer gives decent upside with both FCF and PER but not EV. The heavy debt drags down the upside for its EV but if we believe in its FCF generation, Bayer will pay down all its debt in a few years and its market cap (which will equate to its EV when there is not debt) will reach EUR85bn near the same no.s achieved for FCF and PER.
Based on the peer comparison chart above, we can also see that the valuation ascribed for Bayer is below peer averages. This means that we have conservatism inbuilt and therefore upside could be higher especially for EV.
5. Intrinsic Value
In conclusion, I would ascribe the intrinsic value of Bayer at EUR78 by taking the average of the three market caps (EUR80bn, 85bn, 67.5bn) divided by the share count which implies 53% upside from current price. As mentioned we have seen drawdowns of 40-60% for this stock but it is hard to imagine it can further crash 40% from here as this brings share price to EUR30, which implies PER of 6-7x and Bayer has never traded at such low PER over the last 20 years. Using its absolute low over the last few years, we have EUR40 which was hit in Oct 2020. So, we have the downside at c.28% (51/40 = 27.5) but upside at 53%. As such, the risk reward is 28% vs 53% is good and my portfolio would be adding at this level or lower.
It is also not unimaginable that Bayer can see EUR100 again if it continues to grow both businesses and compound FCF in the years ahead.
Huat Ah!
Main blog:
http://8percentpa.blogspot.com/
This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.