Description

I submitted this last week as my application when the European shares were at EUR 64-65/sh and press reports indicated something was imminent.  The actual settlement was expensive, but not materially different from the $10bn used in the fair value, so I'll submit is as-is in case the timing is helpful and update later.  Short story is the fair value might be 1% or so lower, after updating for the settlement, but putting RoundUp, dicamba and PCBs in the rear-view should lead to more investor focus on the fundamentals of the business.

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The report got long, so I split this report into a Summary section, and for those that have the time/interest, a Details section.

SUMMARY:
Bayer owns three quality resilient businesses with attractive medium term cash flow growth prospects, but trades at a large discount mainly due to a litigation liability that is likely to be resolved. The impending resolution to the legal issue offers investorsthe opportunity for excess returns with an uncorrelated bent.

I estimate the unlevered fair value of Bayer breaks out as follows: 51% from likely the most dominant global Agricultural Products company in the world with #1 global position in Seeds & Traits, #1 globally in Crop Protection, and #1 globally in Digital Farming, 38% from a pharmaceuticals business with a rare 4-5% near-term and mid-term growth profile, and 11% from a Consumer OTC healthcare business benefitting from COVID that has just been pruned of sputtering brands to re-focus on the highest quality pieces of the portfolio. The company has a well-supported EPS growth outlook of 10% per annum over the medium term – driven by merger synergies, a 10% global workforce reduction, and revenue growth. Most companies with these quantitative and qualitative features trade for higher than the market multiple in this post-COVID environment. Bayer trades at 8.6x P/E, 7.5% EV/FCFF yield and 4.5% Dividend Yield, all on 2021e. The dominant reason for the discount is straightforward: the RoundUp litigation issue.  

However, the culmination of this issue is approaching A) the first trial heard appellate oral arguments on June 2 with legal experts expecting a material reduction to the awarded damages to be announced over the next few months and B) persistent, credible rumors that renown arbitrator Ken Feinberg is nearing the end of settlement negotiations between Bayer and plaintiffs. The probability of a settlement happening is extremely high, but the exact date of the resolution and final settlement amount are both TBD. Therein lies the opportunity. Many investors prefer to wait for the conclusion, but this is a slippery slope because the valuation is unlikely to be 9x P/E once the RoundUp overhang is removed. A settlement will be followed by a return to business-as-usual, otherwise Bayer would not agree to pay, and we’ve seen that 21 months of adverse headlines have not caused any material change in farmer demand for RoundUp. Many farmers view it as safe because the EPA’s opinion matters more to most of them than a San Francisco jury’s, especially relative to the older toxic herbicides that RoundUp replaced. As for farm strategy, RoundUp is THE base non-selective herbicide that clears the field of most weeds and no other herbicide can replace that efficacy. With the RoundUp business very likely to remain intact after the settlement, the magnitude of the valuation opportunity overwhelms the uncertainty around whether the settlement amount will be as low as $5bn or as high as $10bn. See “The Elephant in the Room” in the Details section for more on the RoundUp issue.

Once RoundUp is settled, the truly dominant Crop Sciences business has a bright future in the long-run (see “Crop Sciences is Incredibly Dominant” in Details section). The pharma business (see “Pharma” in the Details section) has a 4-5% growth outlook for the next 3-4 years until Xarelto experiences a patent cliff in 2024/25, so I value the franchise on a post-patent cliff estimated earnings base with lower normal revenue and margins. Management will look to fill the cliff void with partnerships like the successful larotrectinib tie-up with Loxo now being marketed as Vitrakvi, but management is skeptical of M&A at elevated multiples seen in recent years. The OTC business is the smallest of the three businesses, but offers turnaround potential and there is moderate upside to the group if more investors start capping the EBITDA at the mid to high teens levels of its peer group.

FAIR VALUE
My present fair value of Bayer is EUR 115/sh via a SOTP with the following components:
1) EUR 103/sh Crop Sciences excluding RoundUp settlement – Forecasting 4-5% ave organic revenue growth, which is a bit above the 3% underlying growth outlook because I assume some merger revenue synergies and a snapback after a terrible N. American growing season in 2019. I assume 31% “normal” EBITDA margin after the cost efficiencies. I cap this normalized EBITDA at a 13x EV/EBITDA multiple. Crop Sciences has many of the same characteristics of a Healthcare business (dependable but not spectacular growth, large R&D spend, patent protection, product safety disputes) and the Healthcare component of the S&P500 has traded at EV/EBITDA of 14.2x between 2014-2019 during a low interest rate regime that I assume will persist over the medium term. The Syngenta and Monsanto acquisitions occurred at 16-17x EV/EBITDA, which also implies my multiple has conservatism. Competitor Corteva currently trades 10x EV/EBITDA, but I think that's cheap and Corteva is a lower quality business.  
2) EUR -10/sh RoundUp settlement – I assume $10bn per press reports. I would actually take the under on this amount because it’s outside the $3-6bn range predicted by comparable global settlements, but this is just my speculation. For the fair value, I’m more comfortable being above the comp range because I’m not willing to plant my flag on something like this. In my view, Bayer would rather go to the Supreme Court than to settle for over $10 billion. Also, it does not make sense for plaintiff attorney firms who have nine digit paydays locked-in right now to take this all the way to Supreme Court and extend this out multiple years -- all while risking a zero settlement outcome. So, I would be surprised to see a figure higher than $10 billion and I underscore that Bayer certainly has negotiating leverage (e.g. Supreme Court case backed by safe usage opinions by all global regulators) to keep the amount to a “reasonable” level.
3) EUR 69/sh Pharma – 4-5% organic growth and 50-100 bps margin expansion in aggregate due to moderate cost efficiencies out to 2022/23, and thereafter a haircut for the Xarelto cliff. Xarelto will be c. 27% of the Pharma revenues in 2022 and are high margin. My post patent cliff EBITDA estimate is 35% lower than my 2022e. Normal EBITDA margins in this post-cliff phase are estimated at 30%, which will require an efficiency program to attain, but the business sustained 30% EBITDA margin prior to the Xarelto and Eylea blockbusters, so 30% is supported by Bayer’s own history. Capping the post-cliff EBITDA at 12.5x EV/EBITDA, which is moderately below what I would cap an average pharma business at due to the patent cliff and underwhelming pipeline.
4) EUR 18/sh OTC Consumer Health – Assume 2% organic growth and 250 bps of margin expansion due to restructuring over my 5 year forecast horizon and cap at 12.5x EV/EBITDA.
5) EUR -48/sh 2019 Net debt – Balance sheet is resilient to the settlement due to sale of Animal Health at an attractive price (rated IG by Moody’s and S&P). If a $10bn settlement is paid in 2020, estimated ND/EBITDA is 2.8x with the proceeds from Animal Health. De-leveraging profile is 0.6x turns in 2021 to 2.2x.  
6) EUR 8/sh Divestment proceeds from sale of Animal Health and parts of Consumer Health
7) EUR -25/sh Other adjustments e.g. pension, cash out needed to unlock synergy and restructuring efficiencies, haircut to license income, dicamba legal issue etc.

To bring it back to consolidated figures, I cap my consolidated normal EBITDA estimates at 12.75x, which is undemanding for a company made up of resilient cash flow streams from Ag and Healthcare. My EUR 115/sh fair value is only 12.8x 2021e EPS ex one-offs, which may seem low, and is partly correct as there is conservatism in the assumptions, but also remember that the settlement and patent cliff have material impacts to fair value. Toward the middle of the decade, I would expect the trading multiples to settle above the market multiples due to business quality.


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DETAILS:

THE ELEPHANT IN THE ROOM
The RoundUp litigation has been a significant disappointment for investors and management. On my numbers, the litigation is on track to erase all of the estimated value creation from the Monsanto deal and much of the value creation from the follow-on restructuring program. It was not reasonable for management to project the current $10bn settlement estimate as a base case scenario during the deal closing process, most notably because the original shock verdict came after the deal closed. So, management’s bear case scenario materialized and caused the deal to look a lot less attractive in the immediate aftermath. Management reacted to this bear case scenario with a major restructuring, announcing the reduction of 10% of their global workforce (over half of which are German employees) to streamline overhead of the Bayer operations to reflect Bayer’s focus on Ag and Healthcare after divesting commodity chemicals (Covestro) and Animal Health. In Germany, corporations are governed by a Supervisory Board with 50% employee representation, so getting a restructuring program of this magnitude is noteworthy about shareholder mindfulness.

Cancer is a terrible disease and empathy for the victims’ suffering is clearly warranted. However, the causes of cancer are notoriously elusive even for world class oncology researchers, much less jury members without a scientific background. Management adamantly defends RoundUp as safe – citing 800+ of research papers and approval by all global regulatory bodies. RoundUp is one of the most scientifically studied chemicals in history. This includes fresh re-endorsements from the USA (EPA), Canada, and Australia performed after the DeWayne Johnson shock verdict in August 2018. I find these numerous endorsements from the global scientific community as a very compelling defense of RoundUp’s safety. Thus, I believe the $10bn settlement amount in the press is mainly attributable to: 1) the undeniable skill of quasi-theatrical and highly intelligent trial attorneys harnessing the emotions of non-scientist jury members in the context of the ongoing anti-corporation lawsuit lottery in American courts, 2) the potentially corrupted research process in the IARC paper that is the foundation of plaintiffs’ cases (IARC’s guest panelist Christopher Portier promptly parlayed the IARC paper’s published findings into $100k+ consulting fees from plaintiff law firms), and 3) Bayer’s war-torn management capitulating that it’s best to simply put the litigation overhang in the rear view and move on. While those are my opinions, here are the two realities necessary for Bayer to agree to a settlement: A) the RoundUp settlement is extremely unlikely to result in commercial restrictions on the farm and B) Bayer will not admit any guilt. In other words, once the settlement is agreed upon, it will be business as usual because RoundUp remains approved for safe usage commercially and farmer demand is un-impacted.  


CROP SCIENCES IS INCREDIBLY DOMINANT
For the Ag business, business as usual is quite compelling for investors. Bayer’s seeds & traits business has actual pricing power led by its innovation engine and it’s 40-60% market share positions in row crops (corn and soybeans) both in the USA and Brazil. A bit more than half the value in a bag of seeds is the quality of the seed germplasm itself, which is the product of highly sophisticated breeding operations to maximize the yield potential for a given climate. Bayer’s breeding ops are only rivaled by Pioneer (Corteva) and there is no one else even close to these two germplasm leaders. This duopolistic structure is the result of an industry rollup of smaller breeders in the 90s. The other ~half of the value of a bag of seeds is the trait stack, which protects the yield potential of the germplasm from various threats like weeds, insects and fungus. In traits, there is no debate – Bayer completely dominates. This can be tested objectively in two ways: 1) Corteva’s listing docs, where they disclosed for the first time the massive $600m+ royalty stream that they pay Monsanto for the use of Monsanto’s traits (heading above $800m over the mid-term) and 2) Corteva’s much lower Seeds margins. The stark truth is without licensing these traits from Bayer, Pioneer/Corteva would experience very large market share erosion because its high quality germplasm would struggle to reach its full potential as it would be more successfully attacked by threats from bugs and, in particular, weeds. Each attempt by Corteva to become more independent of the Bayer traits platform has been a disaster for Pioneer/Corteva – with the most recent example being Pioneer’s market share erosion from 35% to 5% in Brazil soybeans in the aftermath of moving off the Bayer traits platform. This is essentially because the Bayer traits platform is world class and constantly improving, which creates a moving target. So, if you get off the platform, you can’t just jump back on because the germplasm breeding and trait insertion process takes multiple-years, so your existing franchises can become very exposed to the risk of a game-changing innovation like Bayer’s Intacta trait package that took acreage share in Brazil hand over fist – with farmers voting with their wallets that Bayer’s trait package offered superior protection against oppressive bug pressure in Brazil’s hot humid climate.  

To close out the pricing power point, Bayer controls the market with its trait innovation engine, from which the only other global player licenses prolifically. When Bayer comes out with a new trait innovation, they initially price it to give the majority (~2/3) of the economic benefit to the farmer. This encourages uptake. However, a lesser-covered dynamic is that Bayer tends to price the previous gen trait packages to be increasingly economically unattractive in relation to the newest innovations. This creates a win-win situation for Bayer: either the farmer stays with the old trait package and Bayer experiences the drop through of real pricing gains on that legacy trait package or the farmer adopts the new tech, generally at a higher price point justified by a higher yield to the farmer. The end result is that the newest innovations generally spread through acreage rapidly and drive the price-mix component of revenue growth via mix – critically, this refresh dynamic also extends the life of the patent protection horizon because each new stack comes with a new window for protection.

This aforementioned market clout helps Bayer navigate the volatilities inherent in farming, but corn prices and soybean prices are still important drivers year to year. In periods of prolonged corn and soybean price deflation, some farmers will trade down and this can be enough to offset the structural growth of the innovation engine and cause revenue growth to stagnate. This deflationary dynamic has been the case in recent year coming off a biofuels-related price spike in the 2012/13 timeframe. While those abnormally high levels should not be considered “normal,” if corn prices or soybean prices rise off their current multi-year low levels, Bayer will do well. Notwithstanding the commodity price volatility, the US-China trade war has been manageable for Bayer, mainly due to the fact that the shift from soybean acreage to corn acreage in the US is a net positive for Bayer (corn is more lucrative) and diverting displaced soybean acreage from the US to Brazil is a neutral-to-slightly positive to Bayer because of Bayer’s dominant position in Brazil soybeans. The soybeans need to come from somewhere and Bayer is dominant in all the viable animal feed oriented soybean acreage globally.

Bayer’s crop protection is #1 in the Industry as well, so the long-run pipeline of seed traits that work with Bayer’s crop protection portfolio is quite compelling. No company is better positioned in this regard. This positioning is further strengthened by Bayer’s lead in Digital Farming via the Climate Fieldview platform. Corteva admitted to me that they are far behind in Digital. This can be validated by vastly different paid acreage between Climate Fieldview (90m paid acres) and Pioneer’s Granular offering (undisclosed, but rough est. <15m paid acres) and 5x more farmers surveyed by Brand Health Monitor “currently use” Climate Field View vs Granular. In fairness, third party research suggests that John Deere’s digital platform is also quite good, although they are structurally disadvantaged as an equipment player within Bayer’s core digital value add -- seed selection and crop protection decisions.


PHARMA
The Pharma business is solid, but not best of breed – with strength in cardiology, opthamology and women’s health offset by a sub-scale position in oncology and underwhelming pipeline. The two most important compounds are Xarelto (oral anticoagulant developed internally) and Eylea (eye injection co-developed with Regeneron to treat Wet AMD and DME). These two blockbusters are growing, so Bayer’s pharma business has a good outlook until 2024. Thereafter, the Xarelto patent cliff will cause a profit reset of the pharma business. I value the perpetuity value of the Pharma business on the post-cliff estimated base. I split the Pharma business into four buckets:
1) Xarelto – The displacement of legacy anticoagulant Warfarin is driving growth for both Xarelto and main competition Eliquis. Eliquis has taken more share in the US because of a debated scientific paper and Bayer is unhappy with the commercial prowess demonstrated by Xarelto’s US partner JNJ. Outside the US, Bayer does the marketing and Xarelto grows double digit.
2) Eylea – Patent protected until 2027 and likely has a far less severe cliff outlook because an injection directly into the eye makes opthamologists and patients averse to change. There was concern in 2019 about Novartis’ new entrant compound Beovu, but this concern alleviated with an adverse safety datapoint for Beovu in 2020, so the medium term outlook for Eylea has improved with lower concern about transformative competitive entry.
3) Everything Else – This bucket is so highly diversified that it doesn’t make sense to break it into its constituent parts here (3rd largest product is 7% of segment revs and 4th is 5%). This bucket has a growth profile of moderate decline over the medium term.
4) Pipeline - Assuming the pipeline adds EUR 2bn in aggregate revenue over the next 5 years, nut no obvious blockbusters. I have Darolutamide (prostate cancer) in the pipeline calculations and give it $850m of peak sales. I give about half a billion each for Finerenone (kidney disease) and Copanlisib (NHL) on a probability adjusted basis. 

Catalyst

1) By far and away the primary catalyst is the resolution of RoundUp litigation issue
2) A secondary catalyst is upcoming years of EBITDA growth due to merger synergies and overhead efficiencies
3) Lapping the current period of accounting complexity coming from a major acquisition and multiple divestments
4) Activists have suggested a split of the two main operations, which is unlikely to happen in the near-term, but cannot be ruled out over the long-term