The recent announcement of Pfizer's (PFE) plan to purchase Wyeth (WYE) has been met with price declines in the shares of both companies. While investors acknowledge that PFE must replace a diminishing pipeline with new products, and further acknowledge that WYE brings the new areas of vaccines and biologics to PFE at a good price to PFE, the stock prices indicates investor dissatisfaction.
Stock price behavior can be meaningless over the short-term and analysts move into this area at their own risk, but I believe that some of the issues point out some of the current challenges.
PFE has one of the most secure financial positions I have ever studied as indicated by its triple-A rating. PFE has $24 billion of investable funds and a free cash flow of $13 billion a year - at least for 2009 through 2011. These funds almost total to the $68 billion purchase price alone.
With this kind of financial strength, not including the $12 billion of cash of WYE's balance sheet (albeit with higher debt levels than PFE), PFE should be able to command a low rate. However, the banks' insistence on a seemingly high 8% combined with strict back-out provisions and a one-year term on the loan may be making investors nervous.
These demands do indicate a return to pre-Housing Bubble standards. The banks are not attempting to buy business at minimally profitable levels. Even more, banks seem to be forcing businesses to pay up for deals. By raising the price of an acquisition, the likelihood is that deals done today will look smarter in retrospect. So, what seems to be a negative today may ultimately be viewed more favorably.
Thursday, January 29, 2009
Lilly (LLY) White? Part 2
Yesterday I wrote a post about Eli Lilly & Co's (LLY) $1.4 billion dollar fine for promoting non-FDA approved uses of antipsychotic Zyprexa. I contrasted that with the 1980s when fines were significantly lower.
This fine was in addition to the $1.2 billion that had been paid to over 30,000 plaintiff at an average of $40,000 per individual. Today, Bloomberg ran an update on remaining lawsuits which may cost LLY billions more. 12 states remaining states, insurance companies, pension funds and labor unions have yet to come to an agreement; all want to get paid.
What is the message? Clearly the pharmaceutical companies understand the tremendous consequences of deceptive practices. Given that understanding, LLY's practice can only mean that such aggressive behaviors are well-entrenched in this industry.
As an analyst, I regularly see major companies with a laundry list of lawsuits. The companies regularly deride them as "without merit." Now I am paying a much greater level of attention to these suits described in SEC filings and adjusting my estimated investment value for significant liabilities.
This fine was in addition to the $1.2 billion that had been paid to over 30,000 plaintiff at an average of $40,000 per individual. Today, Bloomberg ran an update on remaining lawsuits which may cost LLY billions more. 12 states remaining states, insurance companies, pension funds and labor unions have yet to come to an agreement; all want to get paid.
What is the message? Clearly the pharmaceutical companies understand the tremendous consequences of deceptive practices. Given that understanding, LLY's practice can only mean that such aggressive behaviors are well-entrenched in this industry.
As an analyst, I regularly see major companies with a laundry list of lawsuits. The companies regularly deride them as "without merit." Now I am paying a much greater level of attention to these suits described in SEC filings and adjusting my estimated investment value for significant liabilities.
Costs at Microsoft (MSFT)
Microsoft's (MSFT) second quarter earnings revealed a continuing trend of reducing the percentage allocated to research and development (r&d) and increasing the percentage allocated to sales and marketing.
When I started studying the expense structure of MSFT in 1999, I was amazed to see that over 17.5% of the revenues and 32% of the expenses were dedicated to r&d. These numbers have dropped considerably to r&d now consuming 14.5% of the revenues and 23% of the expenses.
Sales and marketing expenses, meanwhile, have risen from 17.5% of the revenues and 32% of the expenses to a current 21% of the revenues and 34% of the revenues.
These trends seem to indicate a long-term pattern of large companies, regardless of industry, whose resources are increasingly dedicated to the purchase of smaller companies whose products are then sold through a massive distribution system.
Most notably, as a commentary on today's environment, the general and adminstrative (g&a) costs were cut dramatically. G&A costs were a paltry 4% of revenues and 8% of costs back in 1999, before rising dramatically to 11% of revenues and 18% of costs in 2005. Now, in a return to pre-housing bubble euphoria, g&a costs are back to 5% of revenues and 9% of expenses. Who said that these aren't good times?
When I started studying the expense structure of MSFT in 1999, I was amazed to see that over 17.5% of the revenues and 32% of the expenses were dedicated to r&d. These numbers have dropped considerably to r&d now consuming 14.5% of the revenues and 23% of the expenses.
Sales and marketing expenses, meanwhile, have risen from 17.5% of the revenues and 32% of the expenses to a current 21% of the revenues and 34% of the revenues.
These trends seem to indicate a long-term pattern of large companies, regardless of industry, whose resources are increasingly dedicated to the purchase of smaller companies whose products are then sold through a massive distribution system.
Most notably, as a commentary on today's environment, the general and adminstrative (g&a) costs were cut dramatically. G&A costs were a paltry 4% of revenues and 8% of costs back in 1999, before rising dramatically to 11% of revenues and 18% of costs in 2005. Now, in a return to pre-housing bubble euphoria, g&a costs are back to 5% of revenues and 9% of expenses. Who said that these aren't good times?
Wednesday, January 28, 2009
Lilly White?
Just two weeks ago, Eli Lilly and Company, (LLY) agreed to pay nearly $1.415 billion in fines for "off-label promotion" of the drug Zyprexa, a drug used to treat various conditions related to psychotic disorders, such schizophrenia and acute manic episodes. Not content with these revenues, LLY promoted the drug as a treatment for dementia, including Alzheimer's dementia in elderly people.
The sum includes a criminal fine of $515 million, which the Justice Department called "largest criminal fine for an individual corporation ever imposed in a United States criminal prosecution." The company will also pay up to $800 million in a civil settlement with the federal government and the states, and forfeit $100 million in assets. Commenting on this large fine, LLY stated that it plead guilty to one misdemeanor charge and "disagrees with and does not admit to the civil allegations."
Contrast this whole process to LLY's challenges in 1982. A LLY drug Oraflex was withdrawn from the market only one month after the FDA approved because a British medical journal documented five cases of death due to jaundice in patients. The FDA accused LLY of suppressing unfavorable research findings. In 1985, the Oraflex controversy culminated when the U.S. Justice Department filed criminal charges against LLY. The Justice Department accused LLY of failing to inform the government about four deaths and six illnesses related to Oraflex. LLY pleaded guilty to 25 criminal counts, which resulted in a $25,000 fine. All counts were misdemeanors; there was no charge against LLY of intentional deception.
Oraflex was a case with documented deaths, accusations of suppressed research, numerous charges and an admission of guilt, resulting in a $25,000 fine. Zyprexa was promoted aggressively for unapproved uses, one charge and no admission of civil guilt, resulting in a $1.4 billion fine. Was the issue of "intentional deception" such a distinguising factor between the size of these fines? Or have the times really changed that much?
The sum includes a criminal fine of $515 million, which the Justice Department called "largest criminal fine for an individual corporation ever imposed in a United States criminal prosecution." The company will also pay up to $800 million in a civil settlement with the federal government and the states, and forfeit $100 million in assets. Commenting on this large fine, LLY stated that it plead guilty to one misdemeanor charge and "disagrees with and does not admit to the civil allegations."
Contrast this whole process to LLY's challenges in 1982. A LLY drug Oraflex was withdrawn from the market only one month after the FDA approved because a British medical journal documented five cases of death due to jaundice in patients. The FDA accused LLY of suppressing unfavorable research findings. In 1985, the Oraflex controversy culminated when the U.S. Justice Department filed criminal charges against LLY. The Justice Department accused LLY of failing to inform the government about four deaths and six illnesses related to Oraflex. LLY pleaded guilty to 25 criminal counts, which resulted in a $25,000 fine. All counts were misdemeanors; there was no charge against LLY of intentional deception.
Oraflex was a case with documented deaths, accusations of suppressed research, numerous charges and an admission of guilt, resulting in a $25,000 fine. Zyprexa was promoted aggressively for unapproved uses, one charge and no admission of civil guilt, resulting in a $1.4 billion fine. Was the issue of "intentional deception" such a distinguising factor between the size of these fines? Or have the times really changed that much?
Sunday, January 25, 2009
Benefits Of Boring
People have often marvelled that Warren Buffett comes from the Midwest, as if he succeeded despite his location. Recent study of mine seems to indicate that he succeeded because of his location, or at least the culture he came from.
During the past several years, I have struggled to find a bank to invest in. As the 80s and the 90s and the new century showed banks to supremely outperform all other investments, I looked for a way to get on the train. Fortunately, it never slowed long enough for me to hop on board.
But two banks stood out above the rest: Wells Fargo (WFC) and U.S. Bancorp (USB). So I was quite surprised to learn that both had the same genesis. During the prosperous 1920s, the nation's farmers did not share in the good times. Many banks that had overextended credit to farmers ran into serious trouble. In the Upper Midwest, 1,500 banks became insolvent. With this backdrop, just months before the stock market crash of 1929, two banking associations were formed in Minneapolis/St. Paul, Minnesota: Northwest Bancorporation - later known as Wells Fargo, and the First Bank Stock - later known as U.S. Bancorp.
As someone who grew up in the Upper Midwest, I can testify to its conservative and pragmatic culture. Like other areas in my life, distance and time have enabled me to see the merits of boring.
During the past several years, I have struggled to find a bank to invest in. As the 80s and the 90s and the new century showed banks to supremely outperform all other investments, I looked for a way to get on the train. Fortunately, it never slowed long enough for me to hop on board.
But two banks stood out above the rest: Wells Fargo (WFC) and U.S. Bancorp (USB). So I was quite surprised to learn that both had the same genesis. During the prosperous 1920s, the nation's farmers did not share in the good times. Many banks that had overextended credit to farmers ran into serious trouble. In the Upper Midwest, 1,500 banks became insolvent. With this backdrop, just months before the stock market crash of 1929, two banking associations were formed in Minneapolis/St. Paul, Minnesota: Northwest Bancorporation - later known as Wells Fargo, and the First Bank Stock - later known as U.S. Bancorp.
As someone who grew up in the Upper Midwest, I can testify to its conservative and pragmatic culture. Like other areas in my life, distance and time have enabled me to see the merits of boring.
Wednesday, January 21, 2009
IBMpressive
My first post dealt with some wise financial maneuvering by IBM. At that time, IBM was freezing its pension plan, reducing the growth of these onerous, but underappreciated employee benefits. I marvelled at the lack of an outcry.
IBM again showed its prowess in the fourth quarter results. Although IBM's fourth-quarter revenue came in a little shy of expectations, falling 6.4 percent from a year ago, the company also managed to cut costs by 3-4 percent. A lower tax rate also helped.
IBM is dealing with the reality of a top-line challenged world (read excess capacity) by reallocating efforts to top line growth (managers become sales people), outsourcing non-selling functions and controlling tax costs. Look for other companies to follow, if they're smart.
IBM again showed its prowess in the fourth quarter results. Although IBM's fourth-quarter revenue came in a little shy of expectations, falling 6.4 percent from a year ago, the company also managed to cut costs by 3-4 percent. A lower tax rate also helped.
IBM is dealing with the reality of a top-line challenged world (read excess capacity) by reallocating efforts to top line growth (managers become sales people), outsourcing non-selling functions and controlling tax costs. Look for other companies to follow, if they're smart.
UK Leading The Way?
When it comes to financial markets, I have often noticed that the UK seems to lead the US directionally by about 6-12 months. US interest rates, stock market movements and real estate patterns often have been preceded by similar patterns in the UK. I hope this pattern does not persist when it comes to banking.
While President Obama was mesmerizing the country with his inauguration, the prices of bank stocks were falling to new historic lows. Investors were asking themselves, "what is causing all of this?" The answer was in the UK. There is a movement for complete nationalization of Lloyd's Banking Group and the Royal Bank of Scotland. But the question of "what happens then?" is not clear.
The following graph illustrates the national debt level as it exist in the US:
This graph is disturbing as it indicates a level of borrowing which is unprecedented. When, and if, the government programs "kick in," there will remain an astonishing level of debt. This level of debt must be addressed through increases in profitability - a long term solution. The short run is the problem at hand.
Fortunately, the US and the UK do have different issues with external debt to GDP ratios. "External debt" is defined as the total public and private debt owed to nonresidents repayable in foreign currency, goods, or services. In this respect, US debt levels are 100%, while UK is close to 400%. This level is greater than the debt level listed for the overall US debt. Scary times for the UK, but not necessarily leading the way for the US.
While President Obama was mesmerizing the country with his inauguration, the prices of bank stocks were falling to new historic lows. Investors were asking themselves, "what is causing all of this?" The answer was in the UK. There is a movement for complete nationalization of Lloyd's Banking Group and the Royal Bank of Scotland. But the question of "what happens then?" is not clear.
The following graph illustrates the national debt level as it exist in the US:
This graph is disturbing as it indicates a level of borrowing which is unprecedented. When, and if, the government programs "kick in," there will remain an astonishing level of debt. This level of debt must be addressed through increases in profitability - a long term solution. The short run is the problem at hand.
Fortunately, the US and the UK do have different issues with external debt to GDP ratios. "External debt" is defined as the total public and private debt owed to nonresidents repayable in foreign currency, goods, or services. In this respect, US debt levels are 100%, while UK is close to 400%. This level is greater than the debt level listed for the overall US debt. Scary times for the UK, but not necessarily leading the way for the US.
Wednesday, January 14, 2009
Pensions Plans Rejiggering
My first post was on IBM's decision to freeze its pension plan. Subsequently I posted on the GAO's study of pension plan underfunding. It is significantly frustrating for analysts to study companies, to spot dreamy thinking and have no ability to correct it.
Pension plan assumptions have been a leading concern, after stock options and management compensation agreements. Today's International Tribune Herald put it succinctly: "That 8 percent annual return on investment you and your pension fund manager were banking on is looking almost as optimistic as Bernard Madoff's magic 12 percent, as deleveraging and deflation bite."
The article quotes, "David Zion at Credit Suisse in New York estimates that the pension funds of the S&P 500 companies could be underfunded by $362 billion, a drop of $420 billion in the year. This is far worse than back in 2002, after the last stock market slump, and leaves 70 of the 500 with underfunding equivalent to more than 10 percent of their market cap."
Based on earlier studies, I think this number is optimistic and could well exceed $500 million. If forced, these companies will be forced to take a hit to earnings to more fully fund. However, I believe that companies will find a way to do as IBM has - to freeze benefits and reconfigure employee commitments to a lower level.
Pension plan assumptions have been a leading concern, after stock options and management compensation agreements. Today's International Tribune Herald put it succinctly: "That 8 percent annual return on investment you and your pension fund manager were banking on is looking almost as optimistic as Bernard Madoff's magic 12 percent, as deleveraging and deflation bite."
The article quotes, "David Zion at Credit Suisse in New York estimates that the pension funds of the S&P 500 companies could be underfunded by $362 billion, a drop of $420 billion in the year. This is far worse than back in 2002, after the last stock market slump, and leaves 70 of the 500 with underfunding equivalent to more than 10 percent of their market cap."
Based on earlier studies, I think this number is optimistic and could well exceed $500 million. If forced, these companies will be forced to take a hit to earnings to more fully fund. However, I believe that companies will find a way to do as IBM has - to freeze benefits and reconfigure employee commitments to a lower level.
Having A Citi (C) Day
Citigroup's (C) stock continues its downward path. The dramatic downward movement has beaten the management of C into a state of reasonableness: bigger is not simply better.
From the inception, C's dreams of "synergies" have been murky. The architecture was created by sprinking Weill dust into the eyes of analysts who saw nothing but higher and higher earnings. The piles of poorly contrived investments are simply the result of a culture of push created long before the Prince arrived. But all is not lost.
Today's NYT has the following graphic:
There are now logical investors for each piece. The pieces on the left confirm C's natural business: a global banking franchise. C has tremendous clout and, if run by a banking culture, should be able to regain leadership in a wide-open space. The pieces on the right all have significant value and might each do very well.
Importantly, each piece on the right has a culture unrelated to a banking culture. To put the process of banking with its "just say no" driving principle into the mix with any other business with its "go for it" driving principle is to create the outcome we are experiencing. Breaking up is hard to do, but here we could look back on and see tremendous benefits of being forced to do the difficult on these Citi days.
From the inception, C's dreams of "synergies" have been murky. The architecture was created by sprinking Weill dust into the eyes of analysts who saw nothing but higher and higher earnings. The piles of poorly contrived investments are simply the result of a culture of push created long before the Prince arrived. But all is not lost.
Today's NYT has the following graphic:
There are now logical investors for each piece. The pieces on the left confirm C's natural business: a global banking franchise. C has tremendous clout and, if run by a banking culture, should be able to regain leadership in a wide-open space. The pieces on the right all have significant value and might each do very well.
Importantly, each piece on the right has a culture unrelated to a banking culture. To put the process of banking with its "just say no" driving principle into the mix with any other business with its "go for it" driving principle is to create the outcome we are experiencing. Breaking up is hard to do, but here we could look back on and see tremendous benefits of being forced to do the difficult on these Citi days.
Friday, January 9, 2009
Generic Drug Activity
Significant changes have been developing in the world of generic drugs. Two major players, Actavis - an Icelandic-based generic company owned by the former billionaire Thor Bjorgolfsson and Ratiopharm - a Germany-based generic company owned by the recently deceased Adolf Merckle are both up for sale.
The ultimate sales price will be interesting. Teva, one of the major generic companies, acquired Barr for about 2.5X sales and 12X EBITDA. Actavis would need to get close to this price to simply pay off the Deutsche Bank debt. Ratiopharm has similar challenges with the financing problems at the crumbling Merckle empire.
My bet? A deal with either Pfizer or GlaxoSmithKlein at roughly 10X EBITDA or 2.2X sales. An acquisition in this space would help these companies cost-effectively transition to generics that might allow for more profitably moving off patent expirations. More importantly, there are no financing challenges with either company.
The ultimate sales price will be interesting. Teva, one of the major generic companies, acquired Barr for about 2.5X sales and 12X EBITDA. Actavis would need to get close to this price to simply pay off the Deutsche Bank debt. Ratiopharm has similar challenges with the financing problems at the crumbling Merckle empire.
My bet? A deal with either Pfizer or GlaxoSmithKlein at roughly 10X EBITDA or 2.2X sales. An acquisition in this space would help these companies cost-effectively transition to generics that might allow for more profitably moving off patent expirations. More importantly, there are no financing challenges with either company.
Walgreen (WAG) Downsizing
Today's announcement that WAG is cutting 1,000 management jobs seems to exhibit classic human behavior: overextend when times are good and overcontract when times are bad. I have personally experienced these cycles, wondering "what was I thinking?"
But WAG is not my small business and would seem to have better controls in place. I have long admired WAG with their corporate motto of "crawl, walk, run," which embodies a sure-footedness and a preference for organic growth. WAG has not had a history of making acquisitions because they did not fit the existing culture. The result has been steady, quality performance.
What to make of this pruning? It would indicate either WAG has changed strategies or lost control during the fun times. Neither is good. Personally, as an investor, I would rather see earnings take a hit and maintain organic focus than do the slash and burn routine.
But WAG is not my small business and would seem to have better controls in place. I have long admired WAG with their corporate motto of "crawl, walk, run," which embodies a sure-footedness and a preference for organic growth. WAG has not had a history of making acquisitions because they did not fit the existing culture. The result has been steady, quality performance.
What to make of this pruning? It would indicate either WAG has changed strategies or lost control during the fun times. Neither is good. Personally, as an investor, I would rather see earnings take a hit and maintain organic focus than do the slash and burn routine.
Monday, January 5, 2009
Bonding With Swensen
In an earlier post on First Data Corporation (FDC), I hailed the expertise of David Swensen, the investment chief at Yale University. I favorably compared his assessment of FDC to my own and include him as one of my cochamim "wise ones."
Friday's Bloomberg reports on his latest forays. After dropping nearly $6 billion or 25% in 2008, Swensen's best opportunities for investments are not in the "credit world." He says that "everything, from bank loans to investment-grade bonds to less-than-investment grade bonds, is priced at really extraordinarily cheap levels.”
He does caution “You want to make sure you’re with companies that have the ability to survive in a really tough economic environment” while declining to name any of the companies.
His selection of bonds rather than stocks is sensible, given an extraordinarily high level of cash payouts described in the article. But his commitment to this approach does point to where the best returns are likely right now: high-yield, high quality corporate bonds.
First, these bonds will deliver high cash yields without regard to valuation. Second, these bonds are priced with a high coupon, providing some hedge against high inflation returning. Third, these bonds are higher in the capital structure than stocks, but priced at stock-like returns.
Friday's Bloomberg reports on his latest forays. After dropping nearly $6 billion or 25% in 2008, Swensen's best opportunities for investments are not in the "credit world." He says that "everything, from bank loans to investment-grade bonds to less-than-investment grade bonds, is priced at really extraordinarily cheap levels.”
He does caution “You want to make sure you’re with companies that have the ability to survive in a really tough economic environment” while declining to name any of the companies.
His selection of bonds rather than stocks is sensible, given an extraordinarily high level of cash payouts described in the article. But his commitment to this approach does point to where the best returns are likely right now: high-yield, high quality corporate bonds.
First, these bonds will deliver high cash yields without regard to valuation. Second, these bonds are priced with a high coupon, providing some hedge against high inflation returning. Third, these bonds are higher in the capital structure than stocks, but priced at stock-like returns.
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