This week we will be writing about one of our core holdings, one that the market hasn’t been very optimistic about. In doing this we will look at why we think the market has this one wrong. Sometimes the best opportunities come from running toward the fire and figuring out if the situation is quite as bad as everyone thinks. Often in investing, if you find yourself on the same side as the majority that’s when you should be asking yourself all the questions.
EML Payments (EML.ASX)
Authors: Ron Shamgar
Author: Ron Shamgar
The fire: EML Payments has been heavily oversold because of a dispute with the Central Bank of Ireland that could impact their European operations.
EML Payments Limited (formerly EMerchants) are the provider of payment solutions, offering payment technology for payouts, gifts, incentives and rewards, and supplier payments. EML issues mobile, virtual and physical card solutions to a number of corporate brands around the world and manages more than 3500 programs across 26 countries in North America, Europe and Australia.
Source: EML company filings
Central Bank of Ireland Correspondence
In March 2020 EML completed the acquisition of Prepaid Financial Services (Ireland) Limited (PFS), a multi award winning European provider of white label payments and banking-as-a-service technology which gave them a presence in Ireland. In May this year EML announced that there had been correspondence with the regulator in Ireland, the Central Bank of Ireland (CBI). The Central Bank of Ireland deems all e-money institutions to be high risk, and they require firms in such sectors to have very strong AML/CTF frameworks in place to mitigate that inherent risk consistent with their expectations. The Boards of PCSIL (the Irish regulated entity) and EML have endorsed a Remediation Plan that has been in progress for some months. EML is hoping to resolve the regulatory issues at the end of this year. The silver lining to this situation is that under the acquisition terms EML will save $110m (AUD) contingent on PFS achieving agreed rebased annual EBITDA targets for the three financial years ending 30 June 2021 to 2023, reflecting growth of approx. 20% CAGR.
EML has completed 45% of Level 1 tasks as at the end of October and we are expecting another update before the half year results. So far, the CBI has found zero breaches of AML or CTF. Our view is that the CBI is reluctant to regulate a high growth fintech like EML and is making life difficult in the hopes that EML moves on to another regulator in Europe.
While this undoubtedly has a material impact on the business, we saw the share price fall 50%, from $5.76 to today’s price of ~$2.75. This fall wiped $1bn worth of market cap off EML; we think this is too much. EML’s management team has proven that they are good at managing issues over the years as they have done with both Covid-19 and Brexit. We are extremely confident that not only will the CBI issue get resolved but that EML will transition away from the CBI and into another regulated jurisdiction like Spain or France (where they already operate). We estimate a 4-6 month time frame. Their recent AGM update tell us a different story than the one painted by the market.
AGM Update
Last week, at their AGM, EML provided an operational update for Q122. EML were able to affirm guidance for FY22, the market was clearly expecting that this would not be the case. The company noted that in Q122 it signed 23 contracts and launched 64 programs, ending the quarter with 114 programs in implementation globally (including 36 on hold due to the CBI issue). The business has still been able to grow and maintain guidance despite the issues with the CBI.
For example, management has replaced high volume-low margin programs with the CBI in order to make room for the 36 on hold high margins programs. This should be approved shortly. They also announced a new deal with Banco Sabadell, one of the largest banks in Spain, operating in twenty countries including the United Kingdom and Mexico. We expect to see more deals like this in Europe which should more than compensate for the delayed CBI contracts. Given the huge pipeline and growth in the business, the CBI issue is now potentially a significant upside scenario if successfully resolved.
EML reported gross debit volume (GDV) growth of 14% Y-o-Y in Q122, with increases across all three divisions. An increase in the group yield (Q122: 95bp, Q121: 84bp) resulted in Y-o-Y revenue growth of 29%. Their EBITDA guidance for FY22 (including acquisition costs and costs related to CBI) is $42.2m, $10m or 30% above FY21.
From a business development perspective, EML ended the financial year with 313 deals in their pipeline which we believe represent potential GDV in Years 3-4 post-launch of approximately $10.5bn. Their historical win rate for new business is approximately 40%. Using their historical GPR yield, this would generate an incremental $40-50m in revenue in 3-4 years.
Source: EML company filings
Sentential Acquisition
EML recently acquired Sentenial. Sentenial own Nuapay, a market leading open banking platform processing Account-2-Account payments. This broadens EML’s payment offerings to include alternate (non-card, non-scheme) payment products on their platform to address customer demand, complementing card scheme based payments. Sentenial is currently connected to 1,750 banks across Europe and growing. Open banking is not well understood by Australian investors, but it is the future of payments and it will bypass the rails of Visa and Mastercard. This is why both giants are scrambling to acquire any open banking data provider at ridiculous valuations.
Source: EML company filings
Nuapay is capitalising on the Open Banking functionality for pulling funds direct from their customer bank accounts. They can use Open Banking to identify, upfront, if the customer is a legitimate customer or represents a higher credit risk. Additionally, they can factor that into their own unit economics. For example, one use case is a lender, using Open Banking data, can determine how much it wants to loan to a customer and having EML provision that loan instantly through a digital wallet on their phone. Open banking is expected to grow at a CAGRs in the range of 10-50% a year.
Rising Interest Rates
EML currently have around €2bn from cash received from stored value account holders. Whilst this comes with a corresponding liability, the cash is invested in high quality bonds and all the interest earned from this cash goes straight to the bottom line. For those that are predicting inflation and a rise in rates, EML should be a beneficiary. For example, for every 1% rise in interest rates we estimate that it will add €20m to EML’s bottom line.
Outlook
EML’s recent update was far more positive than the market was pricing in, yet the share price has only gone down. EML is now trading at lower multiple to its peers and sitting on half the market cap it was before the CBI issues, even though their FY22 guidance has been reaffirmed which should see a 30% increase in EBITDA. Their pipeline is huge at $10.5bn and their recent acquisition of Sentenial and their contract with Banco Sabadell gives them a huge presence in Europe. Heading out of lockdown and into Christmas they should also see an increase in their gifts and incentives segment. As a result of the huge sell down, any downside in resolving the CBI issues has more than been accounted for. At this point, there isn’t much risk if these issues can’t be resolved and any positive news out of the CBI is all upside. EML is sitting on an EV of around $900m, we think EML will do at least $80m of EBITDA in FY23 which will put them at a forward EV/EBITDA of around 11.5x. It may take time but the market will get it right. Our valuation is $4.50
UPDATE SINCE TIME OF WRITING:
Today, 25 November 2021, EML updated the market on the CBI issue. The CBI will permit PCSIL to sign new customers and launch new programs while staying within the material growth restrictions. PCSIL is confident that it can meet these obligations. Broad based reductions in limit controls on programs will not be imposed.
As mentioned throughout this article, this was a unique situation where the downside was fully priced in at this point. The announcement today should see these issues appearing in the rear view mirror.
This week we continue to look at the global pharmaceutical industry. More specifically, this week we will be looking to identify some of the trends and segments which may produce some more lucrative opportunities.
Author: Sid Ruttala
Before we begin, a quick recap of the main points from last week:
Over the past few decades the industry has been characterised by exponential declines in overall IRRs for new products;
The above scenario can be attributed mainly to increased regulatory and compliance requirements which have incentivised massive consolidation in the space along with greater focus on maximizing the potential monetisation of existing patents;
This is despite the fact that in nominal terms global biopharmaceutical R&D expenditures continue to be an outlier in comparison to even the defence and software sectors. This can mainly be attributed to significant cost increases as opposed to real growth though.
Finally, this has also created certain unique characteristics such as public, private and academia collaborations (most recently seen in the development of the Covid Vaccines) as well as success stories such as India which has become the powerhouse when it comes to manufacturing capacity and generics.
At this point, many may be arriving at the conclusion that this seems to be an argument against investing into pharma. So, why then do we feel that this is one sector that may have legs? We shall begin by returning to our base case scenario around inflation and rationalise why pharma, and biotech in particular, makes sense.
Think for a moment about a company that is undertaking R&D. Given what we just mentioned around associated costs, it is likely that a significant proportion of their financing comes via the issuance of debt (rarely is it the case that, outside of the majors, biotech companies in their infancy have positive cash flows). Similar to our thesis around listed property, issuing debt, especially longer duration and locking in rates, is effectively a transfer of wealth away from debt holders to equity holders. Moreover, once a firm passes from the R&D stage to actual commercialisation (assuming that it doesn’t make itself a takeover target, consolidation is a hallmark of modern pharma), this effectively creates a double tailwind for equities investors.
Let’s also consider the actual attributes of intellectual property in this particular instance. IP protections effectively ensure that no one else can compete against a particular product line for a given period. In real terms this means it is behaving the same way and has the same scarcity value attributes of precious metals. In effect, if inflation is rising then a seller (of IP) just adapts the asking price and valuation in a much more fluid manner than would otherwise be the case.
Last but not least, the attribute that is most prominent and which most people may be aware of is the inelasticity of demand. That is the change in quantity demanded in relation to the price. In the absence of regulatory intervention and assuming patent protection (which is effectively the highest barrier to entry imaginable), healthcare expenditure is potentially the best inflation hedge possible. In fact, one favourite piece of research is one conducted by Mark Hulbert which showcases that healthcare beats any other industry, including the gold miners or bullion which most people are familiar with. The logic is rather intuitive. With the exception of elective procedures, consumers don’t have the opportunity to turn down medical care because of price increases. The most infamous recent example of this being Martin Shkreli (currently in prison for securities fraud), hiking the price of a life saving AIDS drug from $13.50 to $750 in 2015. Consider the nominal increase in medical care expenditure since 1948, the multiple increase over the period is 40x while the increase in official CPI over the same period is 12x.
But what if we’re wrong about inflation? A rather valid and pertinent question to ask. Even here, we feel that recent events have presented a turning point for the industry overall. Covid has shone the limelight on just how global and interconnected supply chains have become. Take the policy response in India which, as previously alluded to, manufactures approximately 50% of the global vaccine supply. The bipolar response of the central government which, much like the Trump administration Stateside, continued to hold election campaigns and enabled religious festivals (after taking a stellar initial response). The flip side of this scenario was that the second wave of the virus effectively crippled that nation’s ability to export its vaccine supply (which many emerging markets were relying on). The point here? We will likely see increased government support to subsidise and reshore certain manufacturing capacity. A certain tailwind, especially for the consolidated top end (including Pfizer which we spoke of last week).
Sticking with the topic of viruses and vaccines, resistance to second and third-line antibiotics is expected to be around 70% higher in 2030 (compared to 2005 in OECD countries). This, combined with a lack of new drugs and patents, will create a catalyst for the sector going forward. In essence, Antimicrobial resistance (AMR) will, even on conservative modelling, result in the death of approximately 10m people p.a. globally if current approval trends and increases in resistance exceed approvals. This creates another tailwind, not only in increasing regulatory efficiency for, if Covid has proven anything, it can be rather more efficient and timely in the presence of emergencies. Using current trends, even with AMRs, we are headed towards one.
Moving away from vaccines, some interesting and lucrative trends that are likely to play an increasingly prominent role are diabetes, oncology (cancer) and cardiovascular/respiratory, all of which we feel will continue to grow at exponential rates globally. On the first front, the changing eating patterns in emerging markets, incorporating more processed food and foods higher in sugar and salt, ensure that we should see a double digit growth when it comes to the diabetes segment. India, for example, is expected to roughly double its diabetic population between 2017 and 2025, from approximately 72m cases to 134m. According to the International Diabetes Foundation in 2019, “approximately 463 million adults (20-79 years) were living with diabetes; by 2045 this will rise to 700 million.” In an amusing yet somewhat twisted example of capitalism, “Nestlé would sell a problem with one hand and a remedy with the other”. With, amongst other things, their Nestlé Institute of Health Sciences, they are both enabling and profiting from the problem but also looking to enter the market for the treatment.
Oncology, given the nature of the issue, is potentially the highest margin segment; global revenue for the oncologics segment stands at an astonishing US $99.5bn.
“Worldwide, cancer incidence rate has increased to make it the second leading cause of death after cardiovascular disease. Environmental factors, such as tobacco smoking, urbanization and its associated pollution and changing diet patterns together with increased wealth associated with better medical services and extended postreproductive life span, have been considered responsible for this phenomenon.”
”Overall, the authors predict cancer incidence rates/risk to stabilize for the majority of the population; however, they expect the number of cancer cases to increase by >20%.”
Cardiovascular/Respiratory is one segment that should also continue given obesity rates across the West and smoking habits in emerging markets. The flip side of big tobacco being squeezed out of developed markets has been an increased focus on poorer countries. In fact, over 80% of the global smoking population comes from Lower to Middle Income Countries (LMIC). On a side note, the readership may be interested to read about British American Tobacco’s (BATS.LON) rather interesting legal approach to Kenya and Uganda when those nations undertook efforts to decrease smoking. On this third front, a more nuanced approach has to be taken given that the vast majority of the growth in respiratory conditions are likely to come from emerging markets like South East Asia. The pricing power and companies to benefit will be substantially different. Here it may be more effective to look towards generics manufacturers or third party manufacturers.
So, let’s sum up some key attributes that investors should look for given what we have covered so far:
Look for companies with significant patent protections and ones that operate in markets that have less regulatory intervention when it comes to pricing. In markets such as Australia or the EU, an interesting angle may be to find companies with organ drug designations. These patents protect companies that go after rare diseases and give longer term protection. One company owned personally is Neuren Pharmaceuticals (NEU.ASX) which has an interesting pipeline targeting Rett Syndrome and Fragile X, both rare but significantly debilitating conditions for adolescents. If the company does succeed in trials, it will have 7 years of exclusivity in the US, for example, in the distribution and marketing of these drugs.
Look at the duration and nature of the debt on the balance sheet in conjunction with the nature of the eventual revenues. Moderna (MRNA.NASDAQ, owned), for example, continues to hold US $603m, a figure substantially higher than its counterparts in biotech. But, assuming it continues to hold its revenue run rate, this should not be an issue. Though the same cannot be said for its valuation at US $93.4bn, which seemingly prices it for perfection. Despite this, I continue to hold personally given their exposure to MrNA therapeutics in the Oncology and Cardiovascular categories.
Stick to the more lucrative categories of Oncology, Diabetes and Cardiovascular. These categories are not only relevant due to the number of people they impact but because of the nature of the markets they are prevalent in which remain lucrative. So, while viruses such as HIV may still have a massive impact on emerging economies and vast swathes of the global population, especially Africa, the ability to price is quite limited. Put another way, cancer’s continued prevalence in developed markets makes it a margins game whereas diabetes and cardiovascular is both margins and growth. That is, greater pricing power combined with volume growth in markets such as India and South East Asia. Some personal favourites: Fate Therapeutics (FATE.NASDAQ, owned) for oncology, DexCom (DXCM.NASDAQ, owned) for diabetes, Bristol-Myers Squibb (BMY.NYSE) for cardiovascular.
Outside of the three aforementioned categories, there is also much to be said for generics manufacturers who are able to get licensing agreements and scale across emerging markets. Here we are looking at not particularly high margins but great growth potential. Some firms that remain interesting are Sun Pharma (SUNPHARMA.NSE, owned), Lupin Pharmaceuticals (LUPIN.NSE, owned), Biocon (BIOCON.NSE, owned) and Cipla (CIPLA.NSE, owned). All of these working across the lucrative categories but playing the lower cost and poorer markets.
Next week we take a more in-depth dive into a number of the aforementioned companies including Moderna, Fate Therapeutics, DexCom and Bristol-Myers Squibb. Following which we shall conclude with a few of the generics manufacturers.
Disclaimer: Author holds a position in a number of the companies mentioned in this article, all have been disclosed.
Over the past few weeks we have been covering stocks we believe are poised to benefit from the ongoing reopening of Australia and New Zealand. This week we will be writing about a small cap payments company that should be a huge beneficiary of this reopening thematic.
Author: Sid Ruttala
The stock in question today is Smartpay. While most stocks that have “pay” in their name have been pumped at some point in the last few years by investors desperate to find the next BNPL unicorn, SMP is not one of them. Smartpay is a profitable business operating in both New Zealand and Australia, trading at a significant discount to the value of its businesses and we will show you why.
Smartpay (SMP.ASX)
Smartpay Holdings Limited is a provider of technology products, services and software to merchants and retailers. The business designs, develops and implements payment solutions for customers in New Zealand and Australia. Smartpay is a merchant-facing, in-store EFTPOS payments provider; they have a significant position in the New Zealand payments market and a fast growing Australian business. SMP currently provides payment terminals for over 30,000 merchants.
Smartpay has a huge presence in the New Zealand market but right now they are focusing on expanding into the Australian market which will provide a huge platform for growing the company. They currently have almost 7,000 operating terminals in Australia and are looking to add around 4,000 terminals per annum. Smartpay also has a huge SME market to attack in Australia. They currently have a tiny piece of the market but Smartpay’s reliability and competitive cost structure, through their zero cost eftpos solution, are seeing them winning market share in Australia, having grown Transactional (Acquiring) revenue almost 7x, from $2.5m in FY19 to $17.1m in FY21.
Source: SMP company filings
Revenue Model
Smartpay generates their sales through the transaction volume of terminals and processing those payments at a fee of about 1.6%. They earn a fixed fee per terminal and also receive income from software development, sales of terminals, short term rentals and other ancillary services. Their business model is mainly recurring and, once they acquire a customer, quite sticky; the churn rate is very low given the complexity involved in changing providers.
Each terminal in Australia adds around $3,900 of recurring revenue per year. If Smartpay are able to achieve their goal of adding 4,000 terminals in Australia p.a., considering the operating leverage SMP have from scaling their merchant base this would add over $6m of EBITDA p.a.. The majority of Smartpay’s cost base is fixed and sits across compliance, IT, marketing and employee costs. If Smartpay executes on their growth in the Australian market they will see a huge lift in their bottom line earnings figures given the mostly fixed nature of their costs.
Source: SMP company filings
Reopening Tailwind
The past few years have seen significant changes occur in the payments industry, the pandemic further accelerated the use of electronic payments opposed to cash payments for hygienic reasons; however, lockdowns have had a stupendous impact on volumes. Heading out of lockdown and into the holiday season, retail and hospitality should receive a huge boost in activity and, given the length of the most recent lockdown, there is a lot of pent up demand. Revenues from transaction processing made up over 50% of Smartpay’s sales in FY21. In their recent trading update management said “The impact of COVID lockdowns, primarily in NSW and VIC, throughout Q2 FY22, resulted in approximately 1,400 terminals in their Australian fleet unable to transact in the month of September.” Direct competitor Tyro has seen their November transaction value (to the 12th) up over 40% compared to the same period last year. Smartpay will no doubt be experiencing a similar rise which will have a significant impact on their FY22 result.
Valuation + Outlook
Note: all AUD
When looking at the valuation of Smartpay we need to separate their Australian and New Zealand segments. Their New Zealand segment has 20% market share and is far more mature. The NZ business is a solid, mostly recurring stream of income and gets most of its income from a service fee for the terminals. The NZ business is not where SMP’s growth will come from. The real driver of the business going forward will be growth in the Australian market as opposed to the NZ.
Source: SMP company filings
In 2019 Smartpay received an offer for their New Zealand business; the offer was a cash consideration of $70m NZD. At the current exchange rate (~96c as opposed to ~94c at the time), that values the NZ business at 29 cents per share.
Looking to the Australian business, we are going to make comparisons with their peer Tyro Payments (TYR.ASX). Tyro has struggled to gain traction as a public company and earlier this year they had severe operating issues with their terminals. Short research firm Viceroy also launched an attack which, in all fairness, was a bit overstated.
Tyro:
Note: FY21 figures
Smartpay currently has 6,737 terminals operating in Australia. Using their average revenue per terminal of $3,900 this would give the group around $26m of revenue p.a. but if you account for their growth plans (adding 4,000 terminals a year) as well as the increased transaction volume heading out of lockdowns, this figure could be well north of that. To be conservative, we will say that their Australian segment will do $26m of revenue for FY22. If you apply the same EV/Sales ratio that the market affords Tyro, this would value their Australian business at $173m or around 75 cents per share.
Accounting for SMP’s net debt (3.8 cps), now the maths becomes simple:
Giving us a valuation of about $1, approximately 33% higher than it is currently trading (~$0.75). At current prices, we think SMP is significantly undervalued, there is a sizeable margin of safety here too as there are multiple ways to win on the upside.
As mentioned, the reopening should see a big boost in transaction volumes across all payment terminals. This should see Smartpay’s revenue per terminal rise above what it has been the past couple of years thanks to on and off lockdowns around the country. Smartpay is a cheap way to get exposure to the digital payments thematic and, given their growth plans in Australia, Smartpay can expand their service offerings and offer new solutions such as business loans, bank accounts, data analytics, insurance while using their existing customer base to cross sell products.
We believe SMP will do over $40m in sales in FY22 revenue and over $8m in EBITDA. SMP is growing much faster than Tyro yet it is trading at a discount, we see Smartpay having a significant multiple expansion re-rate. If SMP is able to execute their goal of adding 4,000 terminals p.a., they will be doing around $18m of EBITDA by FY23. This would put them at a forward EV/EBITDA of around 10x.
Given the cheap valuation that SMP is trading at, they could also be an interesting potential takeover target having already fielded an offer for their New Zealand business.
We value SMP at $1+ and it is a core holding for the TAMIM Fund: Australia All Cap portfolio heading out of lockdowns and into the holiday season. SMP’s recent trading update saw a 58% YoY increase in total transaction volume; SMP’s half year result is due this month.
This week we begin a new series centred around the global pharmaceutical sector with a particular eye to ascertaining where the opportunities and risks may be. Going back to our broader macro views, in particular around inflation, this sectoral allocation is one that we feel may have legs.
Author: Sid Ruttala
Before proceeding further, a disclaimer. We are experts in neither the field of medicine, pharmacology nor epidemiology. As such, what follows is simply an investors quest to understand and find opportunities. Moreover, throughout this piece a great degree of data is ascertained from the International Federation of Pharmaceutical Manufacturers & Associations (IFPMA), given the lack of nuance (in this author’s view) provided vis-a-vis theoretically independent agencies such as the World Health Organization (WHO) and our very own Therapeutic Goods Administration (TGA). Nevertheless, we shall try and keep the argument as impartial as possible.
Background & Context
For the history buffs among you like myself, this is one sector whose evolution has never ceased to fascinate and tells the story of human ingenuity and enterprise. What began with local apothecaries, expanding their traditional role distributing botanical drugs, turned first into wholesale manufacture, not least aided by discoveries in morphine and quinine, to now becoming a sophisticated global industry central to modern economies (as was illustrated in our most recent global pandemic). My own fascination came about from reading into the prolific use of Laudanum for the most mundane of problems in the Regency Period to the opioid wars that led to the handover of Hong Kong to the British Empire. That particular tangent aside, let’s look at the nature and structure of the modern pharmaceutical industry.
It may come as no surprise that it can be quite difficult to disentangle the structure of the industry and the regulatory framework from its evolution in the USA. From its rudimentary form of oversight starting as a result of early outbreaks of tetanus and distribution of contaminated smallpox vaccines (though even here we have seen instances of regulatory capture arguably as recently as the Nixon administration’s War on Drugs) and passage of acts such as the Biologics Act of 1902; the modern regulatory framework has evolved to create a diverse range of actors both private and public with national bodies, such as the FDA in the US and TGA domestically, becoming the final and peak arbiters. With that, lets look broadly at the process of firstly bringing new drugs/treatments to market.
Source: IFPMA
The above figure shows the process by which a new drug/medication is brought to market. To sum up some numbers that may be truly eye-opening, here are some key points:
2.5% – 5%: The success rate of compounds passing through the screening process to proceed to pre-clinical trials.
Chances of Success: <0.01% in pre-clinical, 57% in Phase 1, 39% in Phase II, 68% in Phase III
9.5 – 15 years: The average time it takes for a new treatment to go from initial screening to market.
US $2.6bn: The average cost of bringing a successful medicine to market. Some more context: this was US $179m in the 1970s…
More concerning than the above numbers, is the graph below. It showcases the exponential declines in IRR (Internal Rate of Return) from pharmaceutical innovation over time for a cohort of the twelve largest biopharmaceutical companies by 2009 R&D spending. It shows that returns have declined from about 10% in 2010 to just 1.8% as of 2019. Little wonder then for the rather extraordinary underperformance of the sector for shareholders in recent years.
Source: IFPMA
So, that brings us to the question why has this been the case? Especially given the per capita expenditure on healthcare across most of the developed world. To answer that question, let’s look at a similar graph which rather prominently shows the disconnect from overall expenditure on healthcare amongst OECD nations. It shows that while overall expenditure increased significantly, the expenditure on biopharmaceuticals has remained broadly constant.
Source: IPFMA
It is perhaps not that particularly difficult to fathom why. Given the likelihood of success in R&D combined with declining IRR, firms are by extension incentivised to increase profitability of existing products (before patent expiration) as opposed to take on the risk of bringing new products. So, on to the next question, why are IRRs declining?
In a world saturated with conspiracy theories, pharma PR debacles and general pushback against the industry, it may not be a popular opinion but the increased regulatory requirements which, although well intentioned, also had the effect of stifling new innovation and increased consolidation of the space. This is the flipside of regulation, creating high barriers to entry most prominently seen within the financial services sector. Across the planet we have increasingly stringent testing requirements and the cumbersome process of receiving regulatory approvals, national health authorities also require companies to track and report patients’ experiences while reporting requirements also substantially raise investment cost (for the duration of time that the medicine is marketed). To put it simply, we remain of the view that the investment and regulatory landscape has swung too far. But, what’s at stake here?
Quickly, for those that think that Covid-19 was a outlier event in terms of the overall impact upon the global economy. $500bn is the estimated yearly cost of pandemic influenza to global GDP. $3tn is the estimated loss worldwide due to antimicrobial resistance, in the form of superbugs, to the global economy per annum in worst case scenario modelling. By 2030 it is estimated that the cost of tuberculosis every year will be $1tn USD.
Current Landscape
With that context, let us actually get to the current reality of the global biopharmaceutical industry. While overall R&D has seemingly declined (and in our view still remains woefully underwhelming given the centrality of global efforts to the overall economy), the sector still remains an outlier in terms of the amounts spent on R&D, 7.3x greater than aerospace and defence and 1.5x that of software and computer services. Great numbers, aside from the massive cost increases involved in the process over the last four decades.
Conversely however, there have been ways in which the pharma industry has evolved in order to tackle the often prohibitive costs associated. New and novel collaborations through joint ventures, including with non-corporate entities such as academia, and cross sector collaborations are just some of the more recent trends. The most recent and obvious example of this has been the global effort to bring Covid-19 vaccines to market in record time; AstraZeneca’s collaboration with Oxford or the creation of the global COVAX initiative alongside public sector organisations such as the WHO, the Coalition for Epidemic Preparedness Innovations (CEPI), and UNICEF (i.e. for delivery) is a prime illustration of the changes that have taken place.
This unique and complex landscape has also led to certain dislocations. For the truly global investor, we are certain at least some may have taken advantage of the growth in generics in emerging markets such as India. That particular country now accounts for close to 50% of global vaccine manufacturing capacity, 40% of generic medicine demand in the US and 25% of the same in the UK. Combine that with a domestic market that has grown in the high double digits for the last two decades, likely to go 3x over the next two, and equities investors in the overall sector would have seen on average return of close to 15x over the last two decades. The growth in the generics market has been the second trend and the centrality of India is the third that remains crucial to understanding the global market.
No longer is the market characterised by blockbusters being bought to market and the exceptional cashflows generated re-used to generate further blockbusters. We have a truly global supply chain, one which many may have become painfully aware of when India’s own bipolar policy response to Covid put the entire global vaccination program at risk. Increased capex is required while patent expiration for existing medicines combined with competition from generics provides massive headwinds to the market. Combine that with an aging population and future growth coming from emerging markets such as India (which require different pricing), for the non-discerning investor, it is a nightmare to sift through.
On the question of pricing, let’s use a simple and quite recent example: the introduction of the first oral treatment for Covid-19 by Merck (MRK.NYSE) which has ascertained regulatory approval (before you get excited, it is not a cure but simply reduces the chance of hospitalisation by 50% if administered within three days of onset). The actual pricing and distribution of the product is likely to be tiered with developed markets such as the US, which has already agreed to buy US $1bn worth of product, being used to subsidize distribution in poorer or emerging markets. This is done through licensing deals with generics manufacturers, though in the instance of Merck they have decided to distribute it for free. Call me a cynic but we are quite certain that, as they bring to market newer versions and are no longer in the limelight, we will see nice little margins ascertained over the next decade or so (not to mention the PR bump in the short term). The development of the drug itself, to illustrate the other point of collaborations, was done in conjunction with Ridgeback Biotheraputics.
Not to be left behind, Pfizer (PFE.NYSE) has also seemingly come up with its own antiviral pill that is 85% effective (compared to Merck’s 50%) if administered within five days of onset (compared to Merck’s three days). Both work in slightly different ways, with Pfizer being a protease inhibitor (blocks the enzyme and multiplication) while Merck’s is a nucleoside analogue (introduces errors into the genetic code of the virus). Pfizer’s own mRNA vaccine and Covid-19 pill is, by the way, a collaboration with German company BioNTech (BNTX.NASDAQ).
The above example of the Covid-19 anti-viral pill illustrates another example of the modern context. Merck effectively giving away its own IP stands in contrast to Moderna and Pfizer’s ongoing refusal to transfer technology to mRNA vaccine producers in Africa, LATAM and Asia. As mentioned, we have a feeling that Merck’s strategy could be a PR coup which we believe puts them in a better place in those particular growth markets for monetization later. For now however, Pfizer has been the frontrunner in terms of its vaccine efficacy as well as in Covid-related research to date.
With that let us finally get to the first security we like and one which we own in the TAMIM Fund: Global High Conviction portfolio, Pfizer.
Pfizer (PFE.NYSE): Investment Case
We originally bought Pfizer years ago, trading out in early 2016 due to the potential merger between the company and Allergan Plc, which was at the time a potentially lucrative windfall due to tax inversion (i.e. shifting headquarters to Ireland).
“So, if the regulators and governments allow the merger to proceed, it is our view that Pfizer may have just bitten off more than they can chew…doing something for tax reasons alone is seldom a good reason.”
Unfortunately for the company, the US Treasury (at the time under the Obama administration) issued new rules to effectively prevent the deal (though it was not pointed out). There was a US $150m breakup fee and somewhat lacklustre performance since.
We bought back into the stock in 2019. Why?
For one we feel the company is often misunderstood. Even before their Covid-19 vaccine, they had a strong pipeline of drugs which fit in perfectly amidst an aging and increasingly obese population. Although mature, Lipitor (cholesterol), Viagra and Celebrex (anti-inflammatory) are three core products. This is combined with prudent acquisitions throughout the 2000s (i.e. effectively ensure stable cash flows for the foreseeable future). With the advent of Covid-19 however, we feel that the company has hit a new period of potential growth. Granted, given the global environment and an increasingly confrontational approach to the sector in the presence of vaccine shortages (yes, this is an issue for a vast majority of the global population despite it not being the case in the West), we will see incremental monetisation going forward. As Covid-19 continues to evolve in the presence of vaccines (superbugs are all but guaranteed) and we see continued rounds of yearly vaccinations globally, this will potentially remain a sticky revenue stream. Believe it or not, the real money is likely not made now when there is a great degree of immediate necessity and potential PR nightmares, we expect increased margins over time as the world learns to live with it.
Arriving at the numbers, revenues for the company grew at a stellar 130%. Even stripping out Comirnaty (their Covid-19 vaccine), the company continued to meet expectations with 7% growth. That second aspect is important given that the flipside of Covid has been a decline in OTC medications and healthcare expenditures. We believe that this is due to Pfizer’s unique product line, aside from lockdowns providing a tailwind for Viagra sales, there has been consistent growth across product lines such as Vyndamax (heart failure – transthyretin-mediated amyloidosis), Ibrance (Breast Cancer) and Eliquis (blood clots), all three of which have grown at high double digit rates. On the negative, cost of sales increased close to 41% (granted, a result of vaccine distribution requirements). What is more concerning however is the 5% increase in Selling, Informational & Administrative Expenses (SI&A), this goes back to our point about the increased expense burden across the sector.
What is more interesting, in our humble opinion, is the all important R&D metric, that is the success rate of the drug pipeline. Across all three phases, Pfizer stands out in having a rate approximately 20-30% higher than industry averages; Phase 3, for example, at 85%. Using simpler metrics, PE at 16.2x (compared with the S&P500 at 29.51x) and a dividend yield of 3.3% (don’t use Australian standards, this is reasonably attractive for US equities) with a payout ratio of 52.45%, we expect this to go sequentially higher over the coming two year period.
Over the coming weeks we will continue to explore the pharmacuetical sector. Given the events of last couple of years, it is easy to have Covid-blinkers on when looking at the space but we will look to explore some of the other dislocations and interesting vaccines/treatments currently in develpoment and the opportunities that these present.
Robert Swift takes a look at what happened in October in markets. This is an excerpt from Robert’s Global High Conviction report for October 2021.
Author: Robert Swift
Global equity returns were unusually strong in October rising over 4.5% in USD terms and essentially flat in AUD as the Australian dollar strengthened.
The USA rose 7% driven by decent corporate results, and a continued postponement of the tapering of central bank intervention. Inflation is rising quite clearly, even using today’s somewhat massaged construct, and with wage rates also rising, the chances are high that inflation expectations become embedded. In the short term this is a tailwind for equities given that they are a claim on nominal growth and a better inflation hedge than bonds. In the long term it is a problem for asset market stability, but a problem, as yet, unacknowledged by policymakers.
The USA continues to provide contradictory messages in the domestic and international arenas. President Biden recently indicated that the United States would defend Taiwan if that became necessary which is somewhat at odds with the official line that respects the “One China” policy. Taiwan’s President Tsai Ing-wen confirmed that there are a small number of US forces located in Taiwan to help with training of Taiwanese soldiers, an admission that annoyed Beijing with a call for the United States to immediately cease military and other official interactions with Taiwan. This will raise tensions and provides a source of volatility to a complacent equity market. The deal to export US LNG to China was announced while at COP26 as the need to reduce fossil fuels further was announced by the US delegation. The infrastructure bill remains mired in Congress with some Democrats now removing their support for the ‘social’ spending aspect. Popularity ratings continue to fall. (The infrastructure bill has passed through Congress since writing, the social spending and climate package are up next).
Essentially, investors are becoming confused about US monetary, economic, and foreign policy.
Japan was the weakest market in our portfolio with the index declining by 3.7% ahead of the general election called by recently appointed Prime Minister Kishida. There were fears that the ruling LDP would lose their majority in parliament, however, this fear proved unfounded as results announced on 1st November indicated a clear single party majority for the LDP. Prime Minister Kishida now has a mandate to push ahead with the additional budget spending that was promised during the campaign. This will include increased military spending to counter a more assertive China. The market responded positively to the election result. The election could be seen as the beginning of a change of generations within the LDP, having seen several senior lawmakers losing their long held seats while younger lawmakers including Taro Kono and Shinjiro Koizumi achieved emphatic victories. The equity market should enjoy better returns now that this major period of uncertainty is out of the way.
We sold ABB (ABBN.SWX) in Switzerland after moderate results but a clear indication that next year was going to be tough as the European economies continue to struggle. We purchased Cheniere (LNG.NYSE American), a US LNG provider, and ONEOK (OKE.NYSE), a pipeline company supplying to the US export terminals in Texas. The US is now an exporter of LNG, a clean energy source. Such businesses are stable and thus attractive investments if a sell-off in the exuberantly priced equities is forthcoming.
Results were strong for Norfolk Southern (NSC.NYSE), Seagate Technologies (STX.NASDAQ), KLA (KLAC.NASDAQ) and Simon Property Group (SPG.NYSR) and all rose 10% or more.
We see irrational exuberance in many pockets of the market; and rapid and punishing share price falls on adverse news. Tesla rose 10%, or many billions of dollars in value, on a ‘deal’ announced by Hertz that they were buying Tesla cars for their rental fleet. It transpired that there was no signed deal. In any event, the sale of cars to the rental companies was long considered to be poor quality business for the auto manufacturers because they were at low margins and the quick resale of these cars hurt the second-hand prices of all models. More confusing to us is that if demand is so strong for high margin retail sales, why would Tesla countenance this move? The company is now capitalised at about $2m per vehicle produced and is worth more than the next nine auto companies combined even though it may produce c. 700,000 vehicles next year in a global market of over 75 million. It is on a P/E of over 300 x
We obviously ‘don’t get it’ but were told the same in 2001 and in 2008.
The words of Scott McNealy, CEO of Sun Microsystems, in April 2002, come to mind. “At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
There are currently 28 companies in the S&P on over 10x revenues.
Snap Inc. (SNAP.NYSE) fell 20% plus when it blamed a shift in Apple policies for a dramatic and ‘unexpected’ reduction in ad revenues, and Zillow (ZG.NASDAQ) fell almost 40% in three trading sessions as its punt on flipping houses proved both difficult and costly.
Smartpay Holdings Limited is a provider of technology products, services and software to merchants and retailers. The business designs, develops and implements payment solutions for customers in New Zealand and Australia. Smartpay is a merchant-facing, in-store EFTPOS payments provider; they have a significant position in the New Zealand payments market and a fast growing Australian business. SMP currently provides payment terminals for over 30,000 merchants.
