Dana (DCN) is the fourth multibillion dollar auto parts manufacturer in the past year to declare bankruptcy, following on the heels of Delphi, Tower and Collins & Aikman. The news not only points out the worsening troubles for the automotive sector, but reminds me again of those three all-important words: "margin of safety."
In October 2005, Delphi filed for bankruptcy, causing auto part manufacturing stocks to plummet. DCN fell from $10 to under $6. DCN has been the dominant axle manufacturer for years, actually having introduced the automotive universal joint in 1904. DCN is not simply domestic either, with 175 plants in 28 countries.
So, in 2005, it appeared with just 50% of its historical profitability, DCN's stock would be worth about $16, a significant rise from the $6 it was trading at. Other good omens were Lord Abbett's 11% ownership of the company, Capital Research's (American Funds) 10% and Gabelli's 7%. These three well respected managers had all gotten in at much higher prices. But the stock lost its appeal after a review of its financials. Why?
To sum it up in one word: debt. DCN sells almost $10 billion of axles per year and has generated about $300 million of operating profit, even in the recent lean years. However, the interest costs have run about $250 million, narrowing DCN's flexibility to $50 million. So any business blip could create a potential cash problem. That business blip showed up in the squeeze of a slowing economy accompanied by rising material prices.
Monday, March 6, 2006
Private Equity Deal in Education
Continuing the trend of private equity deals taking out public companies, Providence Equity Partners and Goldman Sachs announced the purchase of Education Management (EDMC) for $3.4 billion.
EDMC is a for-profit university, taking advantage of the rising costs of traditional universities. Two weeks ago, I tried to disguise my shock when my son Ross showed me the annual sticker price for his college of choice: $46,800. (Paying for college for children is like paying for an engagement ring - there are some things you just do, regardless of the cost.)
EDMC is the third largest for-profit, behind Apollo Group (APOL) and Career Education (CECO). The latest buyout seems similar to most of the recent deals I've studied: a 16% premium over the latest stock price.
As a footnote for the more financially minded, EDMC had 2005 sales of $1 billion with a 10% net of $100 million. In contrast APOL had 2005 sales of $2.2 billion with 20% net of $440 million. The purchase price of EDMC, offered by the new owners, implies a comparable (ave. of sales and net profit multiples) purchase price for APOL of at least $10.6 billion or about $60 per share.
EDMC is a for-profit university, taking advantage of the rising costs of traditional universities. Two weeks ago, I tried to disguise my shock when my son Ross showed me the annual sticker price for his college of choice: $46,800. (Paying for college for children is like paying for an engagement ring - there are some things you just do, regardless of the cost.)
EDMC is the third largest for-profit, behind Apollo Group (APOL) and Career Education (CECO). The latest buyout seems similar to most of the recent deals I've studied: a 16% premium over the latest stock price.
As a footnote for the more financially minded, EDMC had 2005 sales of $1 billion with a 10% net of $100 million. In contrast APOL had 2005 sales of $2.2 billion with 20% net of $440 million. The purchase price of EDMC, offered by the new owners, implies a comparable (ave. of sales and net profit multiples) purchase price for APOL of at least $10.6 billion or about $60 per share.
Sunday, February 26, 2006
Fen-phen Lessons
The history of fen-phen looms over the legal climate for Big Pharma. Wyeth has now reserved over $21 billion and paid out $14 billion of the reserve and it's not over yet. This is much higher than the worst case estimate made in 1999: $4.75 billion. What happened?
Fen-phen was a "cocktail" of three drugs. Each drug had been separately approved by the FDA years before, one as early as 1959. Combining them was thought to create the ideal weight-loss program, as the first drug suppressed appetite while the second drug reduced drowsiness. The appeal of "feel good while losing weight" was powerful. However, the combination was "off-label," meaning that it had not been studied or approved by the FDA.
In 1996, Wyeth sold $300 million of these drugs - not exactly a huge number for a company with $14 billion in revenues. But the revenues were growing quickly until doctors at Mayo Clinic published results in July 1997 that connected fen-phen with unusually high levels of heart ailments. After reviews of the FDA, Wyeth withdrew fen-phen from the market on September 15, 1997. Lesson One: use the FDA process.
Within months, Wyeth lost two dramatic cases. Alarmed, Wyeth set up a class action mechanism to address the thousands of fen-phen cases being filed. To attract participation in the class action, Wyeth defined generous benefits according to a payout matrix and, importantly, exempted participants from proving causation - expected to be a major difficulty for plaintiffs in this case.
Significant problems for Wyeth emerged both in and outside of the class action mechanism. When Wyeth lost two additional cases, the "headlines" caused more than 50,000 to opt out of the class action. Responding to widespread advertising, 80,000 others who were less sure of their cases chose to the class action mechanism. This number far overshot initial estimates of 35,000. Even worse for Wyeth, the severity was much worse than predicted. Lesson Two: generous class action terms simply create more claims.
With early estimates so incorrect, Wyeth undertook a study in 2002 and discovered widespread fraud. An audit of a claim group of $50 million revealed that doctors had exaggerated the heart ailments. The result was a reduced offer by Wyeth of $3.2 million. Angry plaintiffs fought back.
In subsequent hearings, the judge found a pattern of abusive practices, resulting in his ruling that payments should be withheld until claims were audited. After audit, over half of the claims were rejected. As the claims-paying of the class action ground to a halt, claimants opted out and pursued legal action individually. The docket of cases grew to over 50,000. Lesson Three: careful and efficient claims processing is critical.
To resolve the impasse, attorneys identified that the lowest level claims were the real issue, as they were subject to exaggeration. Without these claims, the original trust ($2.55 billion) would have enough to pay everyone. The result was an amendment to the original agreement so that $1.275 billion was taken out of the trust to be paid to the low level claimants on a pro rata basis. Lesson Four: moral hazards (no risk propositions) have to be addressed.
Audits of claims show that 70% of the claims should not have been paid. Nine years into the process, Wyeth is finally applying these fen-phen lessons. More importantly, so are the other companies.
Fen-phen was a "cocktail" of three drugs. Each drug had been separately approved by the FDA years before, one as early as 1959. Combining them was thought to create the ideal weight-loss program, as the first drug suppressed appetite while the second drug reduced drowsiness. The appeal of "feel good while losing weight" was powerful. However, the combination was "off-label," meaning that it had not been studied or approved by the FDA.
In 1996, Wyeth sold $300 million of these drugs - not exactly a huge number for a company with $14 billion in revenues. But the revenues were growing quickly until doctors at Mayo Clinic published results in July 1997 that connected fen-phen with unusually high levels of heart ailments. After reviews of the FDA, Wyeth withdrew fen-phen from the market on September 15, 1997. Lesson One: use the FDA process.
Within months, Wyeth lost two dramatic cases. Alarmed, Wyeth set up a class action mechanism to address the thousands of fen-phen cases being filed. To attract participation in the class action, Wyeth defined generous benefits according to a payout matrix and, importantly, exempted participants from proving causation - expected to be a major difficulty for plaintiffs in this case.
Significant problems for Wyeth emerged both in and outside of the class action mechanism. When Wyeth lost two additional cases, the "headlines" caused more than 50,000 to opt out of the class action. Responding to widespread advertising, 80,000 others who were less sure of their cases chose to the class action mechanism. This number far overshot initial estimates of 35,000. Even worse for Wyeth, the severity was much worse than predicted. Lesson Two: generous class action terms simply create more claims.
With early estimates so incorrect, Wyeth undertook a study in 2002 and discovered widespread fraud. An audit of a claim group of $50 million revealed that doctors had exaggerated the heart ailments. The result was a reduced offer by Wyeth of $3.2 million. Angry plaintiffs fought back.
In subsequent hearings, the judge found a pattern of abusive practices, resulting in his ruling that payments should be withheld until claims were audited. After audit, over half of the claims were rejected. As the claims-paying of the class action ground to a halt, claimants opted out and pursued legal action individually. The docket of cases grew to over 50,000. Lesson Three: careful and efficient claims processing is critical.
To resolve the impasse, attorneys identified that the lowest level claims were the real issue, as they were subject to exaggeration. Without these claims, the original trust ($2.55 billion) would have enough to pay everyone. The result was an amendment to the original agreement so that $1.275 billion was taken out of the trust to be paid to the low level claimants on a pro rata basis. Lesson Four: moral hazards (no risk propositions) have to be addressed.
Audits of claims show that 70% of the claims should not have been paid. Nine years into the process, Wyeth is finally applying these fen-phen lessons. More importantly, so are the other companies.
Thursday, February 23, 2006
H.& R. Block Tax Trouble
H&R Block (HRB) announced a restatement of its 2005 earnings. The company, which prepares the tax returns of one out of every nine American taxpayers, needed some some tax help of its own, though. Because of errors in computing its own taxes, HRB understated its tax by $32 million or $0.07 per share.
Big Pharma II: Marketing vs. Research
Big Pharma's "in-house" researchers are not simply bureaucratic. As stated in Part I, drugs come from three venues: internal development, alliances and acquisitions. Internal development can be more profitable, but those resources are more frequently directed to evaluate effective alliances and acquisitions.
Once a drug "candidate" is identified through one of these venues, it must be produced. Like the movie business, production is a capital-consuming process. In order for a drug to become available to consumers, the FDA defines an approval process which moves from the "candidate" level through three successive phases before becoming an "NDA" (New Drug Application) and then finally a "product."
The process typically requires a six year period of time, as each level has a higher hurdle to overcome. The success rate to move from "candidate" to "product" averages somewhere between 1 in 10 and 1 in 20. Given the level of competency and pre-screening to get to a "candidate," these are not favorable odds. (Here is where the movie studio analogy breaks down. If the movie business had odds of 1 movie in 15 being profitable, we would have few movies.) The resulting cost is somewhere between hundreds of millions or over two billion, depending on how many of the failures are included in the cost of a success.
Because of this extraordinary cost, the major pharmaceutical companies are very desirable partners. Just as a writer prefers a major movie studio's assistance in production, so too do governments, academics and small firms look to Big Pharma for financing, testing and developing the prospective drug.
But, like the movie business, the costs do not stop once there is a "product." Once a film has been produced, movie studios must advertise and sell through "windows" such as theater, cable, DVD and various networks. This is similar to the pharmaceutical process, where companies must advertise and then sell to doctors, consumers, government agencies and managed health care providers. Just as sales of movies may be supplemented through related CDs, toys or clothing so too,there are even supplemental pharma applications, as demonstrated by the reapplication of Viagara from pulmonary problems to erectile dysfunction.
The one critical exception is the limited life of the patent. At the very beginning, the patent is applied for and the "clock" starts running. By losing years to simply get the product into the marketplace, Big Pharma races to ramp up understanding and usage. Otherwise, the ability to fund the development and testing of drugs is impaired. Typically a company has just nine years left to recover its costs (which necessarily includes the failed attempts) and make a profit adequate to incent continued investment.
Once a drug "candidate" is identified through one of these venues, it must be produced. Like the movie business, production is a capital-consuming process. In order for a drug to become available to consumers, the FDA defines an approval process which moves from the "candidate" level through three successive phases before becoming an "NDA" (New Drug Application) and then finally a "product."
The process typically requires a six year period of time, as each level has a higher hurdle to overcome. The success rate to move from "candidate" to "product" averages somewhere between 1 in 10 and 1 in 20. Given the level of competency and pre-screening to get to a "candidate," these are not favorable odds. (Here is where the movie studio analogy breaks down. If the movie business had odds of 1 movie in 15 being profitable, we would have few movies.) The resulting cost is somewhere between hundreds of millions or over two billion, depending on how many of the failures are included in the cost of a success.
Because of this extraordinary cost, the major pharmaceutical companies are very desirable partners. Just as a writer prefers a major movie studio's assistance in production, so too do governments, academics and small firms look to Big Pharma for financing, testing and developing the prospective drug.
But, like the movie business, the costs do not stop once there is a "product." Once a film has been produced, movie studios must advertise and sell through "windows" such as theater, cable, DVD and various networks. This is similar to the pharmaceutical process, where companies must advertise and then sell to doctors, consumers, government agencies and managed health care providers. Just as sales of movies may be supplemented through related CDs, toys or clothing so too,there are even supplemental pharma applications, as demonstrated by the reapplication of Viagara from pulmonary problems to erectile dysfunction.
The one critical exception is the limited life of the patent. At the very beginning, the patent is applied for and the "clock" starts running. By losing years to simply get the product into the marketplace, Big Pharma races to ramp up understanding and usage. Otherwise, the ability to fund the development and testing of drugs is impaired. Typically a company has just nine years left to recover its costs (which necessarily includes the failed attempts) and make a profit adequate to incent continued investment.
Wednesday, February 22, 2006
Big Pharma: Marketing vs. Research
The major pharmaceutical companies, collectively known as Big Pharma, are often criticized for not enough new drugs and too much marketing. In my post "Changing Reaction to Drug Industry," I stated that only 20 new drugs were generated in 2005 for an aggregate R&D cost of $38 billion. Since at least that much was spent on marketing, critics assert that companies could double the number of new drugs if they would stop spending so much on marketing. To evaluate such criticism, let's look at the system of discovering, developing and delivering drugs.
The discovery of new drugs is similar to the initial development of movies. At times, a studio develops a movie from its own staff of writers. Successful "in-house" writing is ideal for profits as the material is much lower in cost. Unfortunately for the studios, much of the best material for movies comes from a popular writer like J.K. Rowling whose ideas are much more expensive. Despite the studio's preference for "in-house" writing, the seemingly disproportionate success of authors outside the studios is partially the natural result of so many more searching for that "great story" needle in the haystack of everyday life.
The same principles are at work in drug discovery. Big Pharma has many talented "in-house" researchers. Yet major discoveries have more frequently occurred outside Big Pharma labs. Criticism lodged against Big Pharma for this result ignores a basic dynamic: the sheer number of researchers in academia, government and small business naturally result in more discoveries. In the same vein, sheer numbers also benefit creativity.
Drug discovery is a long distance from developing and delivering a drug. To shorten this distance, academia, government and small business seek the capacities of Big Pharma. Alliances and acquisitions are necessary for the discoveries made outside of Big Pharma to impact society on a timely basis. Just as the primary purpose of a movie studio is not to write stories, but to produce and deliver movies, so the primary role of Big Pharma is not to discover drugs but to shorten the time from the discovery of a drug to its widespread use. In fact, marketing costs more than R&D provide Big Pharma's critical societal benefit: lowering "sickcare" costs while providing higher "healthcare" benefits through the safe, yet rapid application of our discovered drugs.
The discovery of new drugs is similar to the initial development of movies. At times, a studio develops a movie from its own staff of writers. Successful "in-house" writing is ideal for profits as the material is much lower in cost. Unfortunately for the studios, much of the best material for movies comes from a popular writer like J.K. Rowling whose ideas are much more expensive. Despite the studio's preference for "in-house" writing, the seemingly disproportionate success of authors outside the studios is partially the natural result of so many more searching for that "great story" needle in the haystack of everyday life.
The same principles are at work in drug discovery. Big Pharma has many talented "in-house" researchers. Yet major discoveries have more frequently occurred outside Big Pharma labs. Criticism lodged against Big Pharma for this result ignores a basic dynamic: the sheer number of researchers in academia, government and small business naturally result in more discoveries. In the same vein, sheer numbers also benefit creativity.
Drug discovery is a long distance from developing and delivering a drug. To shorten this distance, academia, government and small business seek the capacities of Big Pharma. Alliances and acquisitions are necessary for the discoveries made outside of Big Pharma to impact society on a timely basis. Just as the primary purpose of a movie studio is not to write stories, but to produce and deliver movies, so the primary role of Big Pharma is not to discover drugs but to shorten the time from the discovery of a drug to its widespread use. In fact, marketing costs more than R&D provide Big Pharma's critical societal benefit: lowering "sickcare" costs while providing higher "healthcare" benefits through the safe, yet rapid application of our discovered drugs.
Tuesday, February 21, 2006
Repatriation of earnings
On Pfizer's (PFE) fourth quarter earnings conference call, the size of PFE's "earnings repatriation" surprised me - $37 billion! Earnings repatriation has been driven by the American Jobs Creation Act of 2004 which provided U.S. corporations a one-time opportunity to repatriate foreign profits at the extraordinarily low tax rate of 5.25%.
There is a catch to this earnings amnesty: the earnings "must be invested in the U.S. pursuant to a domestic reinvestment plan..(other than as payment for executive compensation), including .. infrastructure, research and development (r&d), capital investments or the financial stabilization of the corporation for the purposes of job retention or creation."
My surprise appears well-placed. An article by Daniel S. Levine of the San Francisco Business Times reports that PFE is "by far" the leader in the repatriation of earnings. Overall, U.S. corporations are expected to repatriate $400 billion, making PFE's nearly 10% of the entire U.S. business sector. That's a huge financial resource for a company whose 2005 r&d expenses were $7.8 billion.
There is a catch to this earnings amnesty: the earnings "must be invested in the U.S. pursuant to a domestic reinvestment plan..(other than as payment for executive compensation), including .. infrastructure, research and development (r&d), capital investments or the financial stabilization of the corporation for the purposes of job retention or creation."
My surprise appears well-placed. An article by Daniel S. Levine of the San Francisco Business Times reports that PFE is "by far" the leader in the repatriation of earnings. Overall, U.S. corporations are expected to repatriate $400 billion, making PFE's nearly 10% of the entire U.S. business sector. That's a huge financial resource for a company whose 2005 r&d expenses were $7.8 billion.
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