Saturday, 17 May 2014

AstraZeneca PLC and Pfizer Inc.

Mr Charles Pfizer (1824-1906), courtesy Wikipedia
Pfizer's Offer for AstraZeneca
Big pharmaceutical companies have been buying each other or merging for many years.
AstraZeneca (AZN) is itself the product of a merger between large British and Swedish companies. And Pfizer and AZN are serial acquirers. The reasons for this merger and acquisition activity in 'Big Pharma' are well known. As patents expire and generic competition drives down the price of drugs and as the return on research and development has declined, a sector that was once associated with steady organic growth fell into decline. Between 2011 and 2013 revenues fell at both Pfizer and AZN. One of the ways these companies can respond is to buy or merge with others and then reduce costs by, essentially, reducing staff.
So Pfizer's offer to buy AZN is par for the course. Pfizer is the largest company by pharmaceutical revenues and the fourth by R&D spend in the world. By the same measure, AZN is the sixth largest by pharmaceutical revenue and the ninth by R&D spend in the world.
But Pfizer has a further consideration - US corporation tax. Last month Pfizer reported that it had $69 billion cash outside the USA. If it were to repatriate this amount, Pfizer would have to pay US corporation tax at 35% on the $69 billion less the tax it had paid internationally. In the last three years, Pfizer has paid an average of 14.6% to non-US jurisdictions on its international earnings. This suggests that Pfizer would have to pay around $16.5 billion on its international cash pile if it chose to repatriate all the funds to the USA. (This is calculated by grossing up the $69 billion for the overseas tax and applying a tax rate of 20.4% - 35% less the 14.6% satisfied in other jurisdictions).
This hypothetical charge of $16.5 billion compares to the company's average annual ordinary pre-tax profit of $12.8 billion between 2011 and 2013. If, instead, Pfizer uses these funds to make an overseas purchase, such as AZN, then it will escape this charge for US corporation tax.
Further, given the large difference between UK corporation tax at 20% (from 2015) and US corporation tax at 35%, Pfizer would move its tax domicile from the USA to the UK. This follows in the footsteps of the US company  SmithKline Beckman (SKB) which merged with Beechams of the UK in 1989 and then moved to London. The difference is that in 1989 the respective corporation tax rates were 35% in the UK and 38.7% in the USA . Also, SKB moved its HQ and listing to London, which Pfizer does not plan to do.
No one questions the legality of Pfizer's proposals. But Pfizer has declared losses of $9 billion in the USA in the past 3 years, while reporting $43 billion profit internationally - and yet America accounts for about 40% of the world's market for pharmaceutical products. In recent years tax avoidance has become much more of an ethical issue for the public, politicians and the media and, as a consequence, for company directors. And both the UK and Swedish authorities are worried about the reduction in staff, including those engaged on research and development, that will inevitably follow any AZN acquisition.
The industrial logic for the proposed merger, at least at 50 pounds a share for AZN, is not supported by Pfizer shareholders (Pfizer share price in blue, AZN share price in red):

Graph courtesy Yahoo, click to enlarge
The individual investor will consider, in the short term:
Ø  Does the current share price of 48.23 pounds (or the proposed purchase price of 50 pounds a share or whatever is the final offer) exceed the value he or she places on AZN?
Ø  Would it make sense to invest some or all of the proceeds from a sale in the new enlarged company?

AstraZeneca PLC

AstraZeneca R&D facilities, in Mölndal, Sweden, courtesy Wikipedia
AstraZeneca (AZN), unlike many other large pharmaceutical companies, relies entirely on the sale of medicines for its survival. The company divides its activity into four therapeutic areas: cardiovascular and diabetes; cancer; respiration, inflammation and autoimmunity; and infection, neuroscience and gastrointestinal.
While trading results have been generally disappointing, AZN continues to be cash generating. Taking 2006 as a base year:
·         Revenues in 2013 were 3% below 2006 and 24% below 2011.
·         AZN bought back 20% of its shares in this period at an average cost of $48 per share. As a result, earnings per share have increased by 2% since 2006, once large impairment and restructuring charges are excluded from the 2013 results. However, 2013 EPS are 37% below the level of 2011.
·         In 2006 the company held net cash of $5.9 billion compared to $0.4 billion net debt in 2013.
·         AZN has increased its annual dividend by an average of 7% per annum. 2013 was the first year that saw no increase in its dividend.
·         Return on equity, which was 40% in 2006 has declined to 22% in 2013. While this is still an excellent return, the return on retained earnings (new equity) over this period has fallen to 7%. If this poor return on new capital continues, AZN's profitability and cash generation will suffer.
·         Over the last 5 years, net operating cash flow has covered the dividend by 1.9 times, leaving almost $16 billion for share buy backs and acquisitions.
In the past five years, AZN shares (in blue) have underperformed the FTSE 100 (in red) until Pfizer came along with its offer:
Graph courtesy Yahoo, click to enlarge
At the current price of 48.23 pounds, AZN shares trade on an adjusted PE ratio of 20 and yield 3.5%. The two main adjustments in 2013 are a $1.8 billion impairment charge for sales of a new drug, which are "below commercial expectations", and a $1.4 billion charge for restructuring. Include these charges and AZN's historical PE ratio rises to 40.
The Chairman gives a sobering account of the state of his industry in the 2013 Annual Report: "The world pharmaceutical market is still growing and underlying demographic trends remain favourable to long-term industry growth. However, many of the drivers of demand and supply in the industry are under pressure. On the demand side, we face increased competition from generic drugs as some of the world’s most successful medicines come off patent. In addition, securing recognition (through reimbursement approval) and reward for innovation (through favourable pricing and sales) is becoming more difficult in the face of intense pricing pressures, particularly in Established Markets facing rising healthcare costs. On the supply side, the industry faces an ongoing R&D productivity challenge. R&D costs have risen significantly over the past decade, while industry-wide probability of success of new medicines, though showing some recent signs of improvement, has not kept pace."
Against this background, the outlook for AZN is not good. Consider:
1.       The company's three largest selling drugs, Symbicort for asthma, Nexium for acid-reflux and Crestor for managing cholesterol levels, account for over half of AZN's sales. The first two will lose patent protection in 2014 and Crestor's main patents expire in 2016. Sales will fall dramatically. AZN has not been able to develop or acquire new drugs to replace these three 'blockbusters'.
2.       World pharmaceutical sales increased by 2.7% in 2012 and by 2.5% in 2013. The company cites the projections for world drug sales by the consultancy IMS Health. IMS expects global sales to increase by 8.6% per annum from now to 2017. AZN might be disappointed.
3.       AZN's new CEO expects core earnings per share to decline by the mid-teens, in percentage points, in 2014. His objective is that, by 2017, the company will have recovered the level of sales it reached in 2013, which was 24% below 2011's sales.
As it can take ten years to develop, test and receive the final approval of the regulators for a drug before it can be marketed, the traditional pharmaceutical business is only affordable for large companies willing to take the long view of their business.
AZN appointed a new CEO in October 2012. He has set three strategic priorities:
Ø   Achieve Scientific Leadership
The company will focus on cardiovascular diseases and diabetes; cancer; and respiration, inflammation and autoimmunity. It believes it has the best opportunities of developing new drugs in these three areas and it will support them via two autonomous biotech units and 'novel' science. It has set goals for Phase II trials. AZN is moving its corporate headquarters and global science centre to the Biomedical Campus in Cambridge. Here it will have direct access to academic scientists, which the CEO believes can contribute in the early stages of R&D.
Ø  Return to Growth
New goals for specific drugs that it believes offer the best opportunities in certain specific markets. It is seeking to accelerate growth through larger scale product in-licensing and partnerships, and with bolt-on acquisitions.
Ø  Be a Great Place to Work.
The failure of many of AZN's new drugs to get beyond Phase III - the last testing phase - prior to regulatory approval has sapped the enthusiasm of its staff. And, despite acquiring many new businesses, the number of employees has fallen by almost a quarter since 2006. By flattening the organizational chart, simplifying procedures, communicating directly with staff and focussing on 'talent and leadership', the hope is that staff morale and productivity will improve.
However, AZN will, over four years, cut 10% of its staff at a cost of $2.5 billion to realise an annual cost saving of $800 million.
Assuming that revenues and earnings recover to 2013 levels by 2017, my model values AZN shares at less than 30 pounds. No doubt AZN is worth more to an industrial buyer which is also aiming to save large sums in tax.
AZN shareholders should also consider the risks attached to AZN as an independent company:
1.       The new CEO's plans look positive but they cannot be valued by an outsider. The essence of the business, as outlined above by the Chairman, is not going to change and this must cause any investor to wonder whether the CEO's seemingly modest objectives are realisable.
2.       Net sales have declined from 55.6% of gross sales in 2011 to 45.4% in 2013. The huge and widening difference between the two reflect the increasing burden of chargebacks (from wholesalers) and rebates (from managed care and group purchasing organisations). This loss of pricing power reflects the difficult market that drug companies now face.
3.       Capitalised product marketing and distribution rights have risen from $9.7 billion to $14.6 billion in three years. 2013 results were hit with a $1.8 billion impairment charge and further impairment charges could be in the offing.
4.       Moody's downgraded AZN's credit rating for long-term unsecured debt from A1 to A2 in April 2012. The credit rating agency cited the loss of patent protection as its main concern.
5.       The company's defined benefit pension schemes are in deficit to the value of $2.2 billion. While the schemes have been closed to new entrants since 2000, they will most likely require further funding.

Friday, 9 May 2014

The Value of Brands

And PZ Cussons PLC

Image courtesy Walmart website
Proctor & Gamble (P&G) once commercialised two big American brands of toilet paper. Charmin was the market leader and White Cloud ranked seventh. In 1992, P&G stopped selling White Cloud to concentrate its marketing efforts on Charmin. Its ownership of the White Cloud brand was allowed to lapse and White Cloud was reregistered by a company called Paper Partners.
Paper Partners (renamed White Cloud Marketing) gave the exclusive US license of White Cloud to Wal-Mart Stores Inc., in exchange for a royalty. Simultaneously, it gave exclusive manufacturing rights to Scott Paper of Canada (now Kruger Products).  Walmart marketed White Cloud as its premium own-label brand and sales reached $600 million in 2008. In 2012, White Cloud was voted the best toilet paper in a US Consumer Report survey. Today the brand's sales, which include tissues, wipes and nappies, top $1 billion. Charmin continues to be the best-selling toilet paper in America, but the fact that Walmart was willing to pay a royalty to use the White Cloud brand illustrates the value of its name.
Himmel Brands of Florida has been revitalising discarded brands for fifty years. To a UK consumer, their best-known revival is Ovaltine. Himmel identifies brands that:
Ø  Have a rich heritage
Ø  Have withstood the test of time
Ø  Have been neglected
A brand is a slippery thing to value. Traditional accounting methods used by marketeers end up by giving the greatest value to the biggest companies - today Apple tops the table for brand value in the USA. Consumers are notoriously fickle. It might surprise many readers to learn that, according to a 2014 survey of consumers undertaken by the Centre for Brand Analysis and a panel of experts, British Airways and Rolex take the two top spots for the best brands in the UK. Consumers rate Apple at 14th, behind the BBC (4th), Heinz (5th) and Andrex (12th). Kimberley-Clark, the American owner of Andrex, must be chuffed to find their brand of toilet paper two places ahead of Apple, four places ahead of Nike and eight places ahead of Mercedes Benz in the heart of the British consumer. Could this be thanks to the adorable Golden Labrador puppy they use in their ads?
Other brands seem to have high value but make little money for their owners. Brand Finance awarded Ferrari the world's most powerful brand in 2014. It scored highest for "desirability, loyalty and consumer sentiment to visual identity, online presence and employee satisfaction". Yet Ferrari's earnings before interest, tax and depreciation were a modest $385 million in 2013 (it is part of Fiat Chrysler). In terms of value, it ranks 350th of all brands in the same report. Ferrari has not discovered how to monetise its great brand.
The charm of brands is their long-term income-generating power, which is a powerful draw for the investor. Yet only those brands that have been bought from a third party have any recognised value in a company's accounts. Brands that have been created by a company have no asset value at all. Which is why company valuations based on net assets have little relevance for the investor in brand heavy companies.
Investors would be wise to give special value to brands: 
·         Which are stand-alone. BMW is a top brand but it is useless without the technical and manufacturing skills and facilities required to design and make its cars. On the other hand, if Colgate-Palmolive sold its brand of toothpaste to another concern, the new company could, without too much difficulty, continue to realise its value.
·         That are first in their market sectors. They are worth far more than those that rank second, which in turn are worth far more than that rank third, and so on.
·         Which transcend national boundaries. This is the strength behind Coca-Cola's brand.
·         That are found in market clusters within the same company. Cadbury was valued by Kraft for the multiple brands under the Cadbury label (Dairy Milk, Fruit & Nut, Bourneville, Wispa etc.).
Although many companies can claim to own brands, few brand-heavy companies are listed on the London Stock Exchange. Some that have been reviewed in this blog are:

PZ Cussons PLC


Image courtesy PZ Cussons website
PZ Cussons (PZC) traces its origins to Africa, where it was founded in 1879 as a trading post in Sierra Leone. Today the company specialises in personal care products, which are mainly sold in a small number of countries. With a market capitalisation of 1.5 billion pounds, it is far smaller than its main multinational competitors. These include Proctor and Gamble, Colgate-Palmolive, Johnson & Johnson, Unilever, Reckitt Benckiser, Henkel and L'Oreal.
By concentrating on selected products in a few markets - Nigeria, the UK, Indonesia and Australia - PZC can compete on an equal footing with these consumer product giants.  PZC claims it is the CAN DO company and it finishes its vision statement with We do well, we do good and we have fun! The founding family controls 35% of the company's shares.
This year Manchester-based PZC celebrates 40 years of uninterrupted increases in its dividends. And the company has a good trading record. Consider:
1.       Earnings per share (EPS) increased smoothly throughout the financial crisis. From 2006-8 to 2012-14 EPS has increased by an average of 6% per annum cumulatively. Net margins are a healthy 11%.
2.       Return on equity averages 12%. While this is hardly spectacular, it has been achieved without any substantial gearing. In most years, the company has held net cash. In its interim accounts of November 2013, net debt was 18% of equity, inflated by the purchase of an Australian baby food company for cash. The company pays just 2% for its sterling denominated loans.
3.       Net asset value has increased by 7% per annum from 2006 to date.
4.       In the past five years, net operating cash flow has covered the dividend by 2.6 times. 
PZC's share price (in blue) has matched Reckitt Benckiser's (in red) in the last 10 years and it has been a far superior investment to Unilever (in yellow), which suffered from listless management in the mid-2000s.

Graph courtesy Google, click to enlarge
PZC's largest single market is Nigeria, accounting for 36% of its sales and one-third of its profit. Here the company has market-leading personal care brands and it is the largest distributor of white goods. Sales have barely increased in the past 5 years, with the difficult security situation in the North of the country cited as a reason. This has not stopped PZC investing further in Nigeria via a joint venture in palm oil plantations and a refinery with Wilmar International. Based in Singapore, Wilmar, with revenues of US$44 billion, claims to be the global leader in the processing and merchandising of palm oil. The palm oil refinery has begun to contribute to PZC's results in fiscal 2014 (the year end is May) and at the interim Nigerian sales were up by 6% and profits up by 13%. PZC has much smaller sales to Ghana and Kenya.
PZC derives 38% of its sales and 42% of its profits from Europe. Sales have increased by 20% and profits by 30% since 2009. Well over half of European sales are in the UK, where Imperial Leather is PZC's main brand. PZC also sells the leading UK antibacterial hand wash, Carex, and beauty products under the St Tropez label and others. The company has successfully launched a range of products for mother and baby, called Cussons Mum & Me. The remaining European sales are in Poland, Greece and Germany.
The Asian business, with revenues up by 30% since 2009 and profits up by 80%, is the fastest growing region for PZC. It now accounts for 15% of sales and profits. PZC's main markets are Indonesia and Australia (an honorary Asian). PZC concentrates on beauty products, including its Imperial Leather brand, in Indonesia. After reorganising its Australian dishwashing, detergent and soaps business, the company acquired Rafferty Garden, which manufactures baby foods, for 42 million pounds in July 2013. Rafferty contributed just under 1 million pounds to profits in the first few months of fiscal 2014. PZC plans to take the brand outside Australia.
PZC Nigeria has refined a distribution system for a large, poor, dispersed population that is served by poor infrastructure. This experience has evidently been used to set up its distribution in Indonesia, which shares, in this respect, the same challenges as Nigeria.
Supply chain optimisation programme
In March 2012, the company announced a plan to reorganise its manufacturing facilities with two aims:
Ø  Reduce its reliance on high cost manufacturing facilities in Australia and Ghana and, possibly, Poland and elsewhere.
Ø  Reduce overheads associated with manufacturing and move to a variable cost procurement model.
The initial cost was estimated at 39 million pounds, half in write downs of plant and machinery and half in cash disbursements. The payback on the cash element was estimated at less than three years. In its April 2014 trading update, the company reported that "the supply chain optimisation programme was completed on budget early in this financial year, and the realisation of the benefits remains in line with previous expectations."
The final cost for the three years 2012-2014 will have been 56.4 million pounds. 2014 results will include the final charge of 20 million pounds, which the company says will be offset by the profit on the sale of its Polish homecare business.
In the short term, the strong pound is an obstacle for a company that has 78% of its business outside the UK. However PZC has confirmed that it is trading in line with expectations, and expectations are for 18p 2014 earnings per share and a dividend payout of 8p. At the current share price of 355p, that leaves the share on a prospective PE of 20 and yielding 2.2%.
Longer term the company is moderately optimistic (14 April 2014 trading update):
"Looking ahead, the Group is focussed on a dynamic and fast brand renovation and innovation programme, an ongoing cost reduction programme and successful delivery of new areas of growth such as Rafferty's Garden and the Wilmar joint venture. These initiatives will help counter the ongoing macro challenges and the reduction in profits from Poland as a result of the homecare sale."
My valuation model values PZC's shares at around 310p.* This assumes that PZC meets its earnings forecast for the year ending May 2014 and that the company continues its steady rate of growth supported by cash generation. Given that the strong pound is likely to be a passing phenomenon and that the two new businesses should be contributing significantly to earnings, these are fairly realistic assumptions. *Assumptions: EPS growth 6% p.a., ROE 12%, equity per share growth 7%, 50% dividend payout, average PE ratio of 23, all discounted at 8.3% for the years 2014-18.
The seasoned investor will note:
·         The supply chain optimisation programme was designed to reduce product cost. But competitors will also be reducing costs. Consequently, such investments often lead to fewer benefits than originally calculated. They are necessary to stay in business.
·         The palm oil joint venture was agreed in 2011 when the price of palm oil had reached a peak. The price of palm oil has fallen by 32% in US$ since then, which must have reduced the project's rate of return.
·         Nigeria is facing a well-publicised insurgency in the North East, which could destabilise the country. However, PZC has long experience of trading in West Africa.
·         The share price reached a one-year high of 439p in September 2013 before falling to a 320p low in March 2014. Three directors sold shares worth 0.6 million pounds in August 2013 at 390p a share. There have been no significant director share purchases.
·         PZC carries on its books a 28.5 million pound receivable from Wilmar. However, the company acknowledges that this is not collectible and is, in practice, an investment in the joint venture. This odd state of affairs is not explained and should be regularised. If it is written off, then this is a large charge for a company that recorded a pre-tax profit of 95 million pounds in 2013.
·         Although the defined benefit pension scheme was closed to new accruals in 2008, it might require further funding by the company.