European Large Pharma: Clearly Differentiated from US Counterparts
Familiarity breeds Mediocrity
We've all heard the saying, "invest in what you know". This saying, coined by Peter Lynch, refers to the hope that good investments might be found at your very doorstep.
The mantra should be accompanied with a pharmaceutical "black box" warning, or at the very least a caveat. Investing in familiar names, by default, implies that we overweight in local or domestic companies. This creates the possibility of a "false confidence". In order to stay within our comfort zone, a very real risk exists that we wind up owning highly ordinary (or less than ordinary) companies. A confirmation bias is created for domestic firms at the expense of foreign firms. Such a view has been borne out by a host of academic research. One seminal paper "Familiarity breeds Investment," by Gur Huberman at Columbia University, is worth a read. (click here to download the article)
Perhaps it is time to put the notion of investing in what we know aside. False confidence is no substitute for fundamental investment research and thorough peer analysis.
Nowhere has this "invest in what you know" premise been more of a failure than in large cap US pharmaceuticals.
Long term investors piled in almost a generation ago. The lure was pie charts full of favourable demographic data on drug use. After all, companies produce a pill for every real (or imagined) need. And as we age, don't we all consume more drugs? The business model was touted as being recession proof.
This confirmation bias has produced a decade or more of disappointment. Investors bought into demographic trends while ignoring balance sheets, global competition and government regulation. Consider how investors would have done had they held the big three US drug companies based on enterprise value. These are Johnson and Johnson (JNJ-NYSE, $56.12), Pfizer (PFE-NYSE, $15.17) and Merck (MRK-NYSE, $26.21).
A dinner party to honour the outcome of these three purchases would be a "bleak tie affair" indeed. If JNJ was purchased back in September 24th, 2001, one has just broken even (before dividends). If Pfizer had been purchased way back on January 2nd, 1997, investors are now roughly even before dividends. Based on a purchase of Merck 14 years ago (July 1995), investors are STILL not even, before dividends.
Those who are bullish on US large pharma blithely explain away a decade of lost returns on the current recession and global market selloff.
However, they fail to explain why such so called "recession proof" US companies are acknowledging potential revenue and profit declines for the next several years. Bulls further fail to address how it can be that US large cap pharma firms are doing so poorly on a business basis, whereas European and Asian large pharma are quietly reporting record sales and earnings.
The latest tool in the corporate finance divisions of large pharma is to merge the weak.
Merck has agreed to buy Schering-Plough (SGP-NYSE, $23.76). SGP is forecasting flat to declining 2009 revenues and profit. Pfizer has agreed to merge with Wyeth (WYE-NYSE, $44.59). Once again, Wyeth is forecasting revenue and profit declines in 2009.
I personally fail to see how merging four firms into two solves the revenue decline issue. If Pfizer and Wyeth sales are dropping, combining these firms achieves nothing. If Merck sales are dropping and Schering sales are dropping, an acquisition of Schering with a healthy cash payout does not address the coming round of patent expirations.
It also remains to be seen how leveraging up the balance sheets of Merck and Pfizer does anything more than add capital risk for shareholders. I consider the recent wave of weakness mergers in the US to be acts of corporate finance desperation.
Sophisticated investors evidently don't buy the premise either. Bleak near term industry prospects for the US industry have compressed valuations. The median EV/EBITDA ratio for the top 7 drug companies globally has fallen to the lowest average level in more than a decade.
Investors should not assume that the global pharmaceutical industry is in the same leaky boat as US drug firms.
Three of the top seven global firms based upon enterprise value are based in Europe. Roche (ROG-Zurich, $131.5), Sanofi-Aventis (SNY-NYSE, $30.99) and Novartis (NVS-NYSE, $40.47) are forecasting revenue growth in 2009 and beyond. All three companies posted record 2008 fiscal results. All raised their 2009 dividend payouts. All suggest that new drug approvals and existing product growth may more than offset patent expiries through 2012.
The compression of large pharma valuation ratios has made these successful firms look incredibly cheap on a historic basis
The European giants are doing just fine. Clearly all are differentiated from US peers in a number of important areas. Capital ratios are much stronger, with lower levels of debt than US peers. In contrast to US counterparts, European firms already operate under widespread price controls for many drugs. Like US firms, the big three in Europe grow by acquisition. To the benefit of their existing shareholders, these firms generally pay with cash rather than dilutive stock. The companies are geographically closer to key emerging markets in Asia and Eastern Europe. And finally, European firms tend to be "asset heavy", with an emphasis upon building new pharmaceutical plants. They have made substantial inroads into China and emerging markets with major capital investments.
My personal choice as a GARP investor, among the three European names mentioned above, is Sanofi-Aventis.
With 2.62 billion ADRs outstanding, SNY is the world's 3rd largest pharmaceutical company on a global basis by revenues. Sales were $36 billion for 2008, and should surpass $40 billion US in 2009, primarily from pharmaceutical products. EBITDA could exceed $16.1 billion in 2009. The company generates more than 69% of its revenues outside of the US. In the current quarter, the US dollar has fallen rather sharply against the global currency basket. At Sanofi, this should be of benefit. Recent currency moves should also assist Roche and Novartis in 2009.
SNY is the world's leading producer of vaccines. The Sanofi-Pasteur division holds 21% of the global market, and is increasing share. Management has determined this division to be a major driver of revenue and earnings growth. Accordingly, significant capital is being invested to double global vaccine output in the next five years. Of major significance is the potential commercialization of a Dengue fever vaccine. SNY hopes to bring this product to market in 2014. A $475 million plant in France is now being built to produce the vaccine. Second only to malaria in terms of commercial potential, this vaccine could post sales in excess of $1 billion US.
Sanofi also has core strengths in the diabetes market. On a global basis, SNY is #2 behind Novo Nordisk (NVO-NYSE, $52.28). Both firms have been capturing market share from Eli Lilly (LLY-NYSE, $34.77). SNY forecasts its forecast 2009 diabetes revenues ($4.5 billion) to virtually double by 2013. The global diabetes market has the potential to become a de facto duopoly.
Sanofi makes acquisitions. Existing shareholders are well served, since SNY pays cash (not stock) for small bolt on purchases. Thus far in 2009, three emerging markets generic drug makers have been acquired just off the market lows. Over one full fiscal year of operations, these acquisitions will add $1.2 billion of revenues.
On the basis of all key metrics, Sanofi-Aventis appear to be a bargain vs. peers.
At forecast EBITDA and revenues, Sanofi would appear to deserve a top three enterprise value on a global basis. The company is only valued as the 7th best in the peer group. Sanofi sells for a 2009 EV/EBITDA ratio that I forecast to be 6.8X, well below the industry average of 8.9X.
SNY's sheet is the strongest among the top #7 global peers, and by far. Only Novo Nordisk (another current holding of RMG#1) boasts a better balance sheet.
Profit and dividends are likely to grow in the near term.
In 2009, management of Sanofi anticipates revenue growth rate of about 7%, tops among large companies.
The current dividend payment provides for a gross yield of 4.9% and is just 34% of forecast 2009 profit. On an absolute basis, the dividend payment has grown by 83% since 2004
The dividend growth rate contrasts to large cap US peers, most of which have produced limited dividend growth since 2004. PFE has recently slashed its dividend in half. Merck's dividend payout is touching 50% of forecast earnings, and is unlikely to increase in the near future. JNJ's payout ratio appears to be almost 45% of forecast 2009 earnings, and is unlikely to be increased substantially in the near term.
A lack of research coverage may account for the limited number of Sanofi shareholders in the US.
Only 4 US firms provide coverage. 1 firm rates SNY as a buy, 1 as a hold, and 2 as a "sell". I find this inexplicable.
In contrast, 15 US analysts provide coverage on Merck. 13 report on Pfizer. 17 cover JNJ. Despite the fact that the three US peers are faced with the prospect of declining revenues and earnings in 2009, not a single US analyst in the bunch will dare to publish a sell.
It seems clear that a North America confirmation bias exists. US large cap pharmaceuticals are praised, irregardless of investment merit. Taking into account the lack of coverage on Roche (1 analyst), Sanofi (4 analysts) and Novartis (4 analysts), it also seems clear that a negative confirmation bias exists for international large pharma.
An analyst buy rating seems unnecessary to confirm my investment case here.
Sanofi's industry leading growth rate, world class business model, best in class balance sheet and high, sustainable and potentially growing dividend are all the validation I require.
The shares appear undervalued by 20%-32% to the peer group in the near term. My view is that this gap will close in the years ahead. If success in the vaccine and diabetes franchise continues, SNY may ultimately deserve a premium valuation. I consider Sanofi-Aventis to be a core holding in a globally themed large cap portfolio and own shares personally.
RMG #1 has recently initiated a position in Sanofi. This holding will be gradually increased to a core weight as funds permit.
The corporate website may be found here: http://en.sanofi-aventis.com/