Thursday, September 30, 2004

Searching for Truth in Stock Options, I Found Veritas

September 30, 2004 - Street Insight

  • Veritas looked like a bargain, but when I adjust my cash-flow model for stock option expense, it's not cheap at all.
  • If the expense was disclosed on the income statement, mgt. wouldn't give out stock options like turkeys on Thanksgiving.

My frustration with stock options has officially reached a 52-week high. We mostly shy away from tech in our portfolios because of earnings "unpredictability" and usually very lofty valuations. Now I can safely add another reason not to own many technology companies -- stock options. This is not new news, but a very frustrating and sad reality. After a torturous quest to find an undervalued stock in this Donald Trump (expensive) market, finally I thought I found a bargain -- Veritas (VTS:NYSE) -- the king (or the queen -- the title is very disputable) of the storage market, that was trading at a 13-week low. On the surface, this darling looked like a bargain basement stock -- strong balance sheet $2 billion of net cash ($2.7 billion in cash and $700 million in debt), approximately $4.6 cash per share, stable and ample free-cash flows, and -- the best part -- incredibly attractive valuation trading in a ballpark of 10-14 times free cash flows. Another way to express the cheapness of Veritas's valuation: the street is basically factoring almost no growth into the stock. On the surface, it looked liked Veritas was trading cheaper than the dirtiest dirt. However, then I looked at the transcript of the earnings call on Street Insight (something I strongly recommend doing) and found Jay Somaney's comments on VRTS' share buy-back announcement. I did some more digging and found that most of the earnings and cash flows are wiped year after year with "free" stock options. If I adjust my discounted-cash-flow model for stock option expense, VRTS is not cheap at all; in fact, 86% of VRTS's last year earnings are wiped out by stock options. Veritas is a company that prides itself on 90% gross margins and 20% net margins. However, after accounting for stock options, its net margin fell to 2.8% -- amazing considering that one would expect to see these kinds of margins in the industrial or retail sector where products are very homogeneous. My first reaction was "bad" management is giving away the company. There is some truth in that, but the problem lies deeper. Since stock options do not appear on the income statement directly as an expense but are shown as a footnote in the 10k and 10q (which are released several weeks after the earnings release), analyst focus has never been on the stock options expense. But from the shareholder perspective, stock options are a real and tangible expense. In fact, it is not much different from cost of goods sold or sales, general and administrative expenses.

In the absence of stock options, employers would have to pay their employees higher salaries, thus reducing profitability. If the stock option expense was disclosed right on the income statement, management would not give out stock options like free turkeys on Thanksgiving, but would carefully manage it as another expense. Not all technology companies are created equal. For example, Computer Associates' (CA:NYSE) stock options expense was $70 million last year and only $8 million in the last quarter, a small fraction of CA's operating cash flows (6% of 2003 operating cash flows). Microsoft (MSFT:Nasdaq) went a step further moving away from stock options to restricted stock, and the expense associated with it is reported right on the income statement for the whole world to see. As if issues with stock options could not get any worse, Congress has passed the "Stock Option Reform Accounting Act," which is now before the U.S. Senate. This act would prevent the non-partisan and independent Financial Accounting Standards Board (FASB) from requiring the expensing of stock options. I cannot say it any better than Warren Buffett: This time Congress should listen to the slim accountants. The logic behind their thinking is simple: 1) If options aren't a form of compensation, what are they? 2) If compensation isn't an expense, what is it? 3) And if expenses shouldn't go into the calculation of earnings, where in the world should they go? If you think technology stocks are not expensive, look again at their earnings and adjust them for stock options --your opinion will change. A personal note to Congress: Please work on fixing social security, leave financial statements to accountants.

Vitaliy N. Katsenelson, CFA Copyright 2004

Tuesday, September 28, 2004

Pharmaceutical Industry Went Legit, Distributors Went Down

September 28, 2004 - Street Insight

  • Channel stuffing by pharmaceutical companies had handicapped the drug distribution industry.
  • Drug distributors are pushing distribution costs back to pharmaceutical companies in a "fee-for-service" arrangement.
  • A wait-and-see approach is best when investing in drug distributors, the situation may get worse before it gets better.

The drug distribution industry is going through a significant transformation. In the past, the structure of the industry was in large part shaped by the needs of its suppliers -- pharmaceuticals companies -- to produce smooth, ruler-like quarterly earnings to please short-term focused, quarter-minded Wall Street. The majority of pharmaceutical companies, including large names like Bristol-Myers Squibb (BMY:NYSE) and many others, succumbed to the pressure to meet and beat quarterly estimates by stuffing distribution channels. To encourage distributors to play along, pharmaceutical companies provided incentives like selling large quantities of drugs to distributors ahead of the price increases. Distributors integrated this practice into their business models, which at the time made a lot of business sense. Distributors would hold a drug for six months and realize a double-digit, close-to-risk-free return on investment. This common practice helped pharmaceutical companies smooth their earnings, kept Wall Street happy, and boosted razor-thin margins for drug distributors. In fact, drug distributors made a large chunk of their profits by holding highly inflationary inventory, not on distributing drugs in a traditional sense. Inability To Smooth Sales May Result in Lumpier Sales and Earnings Growth The problem with channel stuffing was that by stuffing more inventory than what was warranted by demand into the distribution system, companies borrowed from their future sales and at some point, excess inventory needed to be worked through the system, hurting future sales. That is exactly what happened to Bristol-Myers Squibb in March 2002: The company pre-announced lower sales due to excess inventory in the distribution system, the stock was crucified and government investigation and shareholder lawsuits followed shortly thereafter. Bristol-Myers Squibb was not a lone ranger in the inventory stuffing scheme and other drug companies got the cue. Since the Bristol debacle, most pharmaceutical companies have stopped playing the inventory game, considerably cutting off inventory levels at the distributor level. Is this good news? It depends on one's perspective. From an investor's perspective, it's great news. However, for pharmaceutical companies, inability to smooth sales may result in lumpier sales and earnings growth. Drug Distributors See Need for New Model The real casualties of pharmaceutical companies "going legit" are the distributors. Distributors are currently going through mid-life crises and doing a lot of soul searching. It's obvious to distributors that the business model needs to be readjusted. Since the inventory game has basically subsidized their distribution cost, customers have become accustomed to receiving product basically at cost and are thus reluctant to pay a price higher than cost, leaving distributors in a tough spot. Cardinal Health (CAH:NYSE) is on the forefront of the industry transformation. Historically it has been the most efficient operator in the industry and has higher operating margins and ROA than Amerisource Bergen (ABC:NYSE) and McKesson (MCK:NYSE). If Cardinal Health doesn't make money distributing drugs in a traditional way, neither do the others. Amerisource Bergen and McKesson have no choice but to follow Cardinal Health's lead. Realizing that price increases may sour relationships with its customers, Cardinal Health has turned to its suppliers, asking them to pay a fee for its distribution services. At first pharmaceutical companies probably thought that Cardinal was consuming the "drugs" it was supposed to distribute. However, the fee-for-service model is not much different from the old holding-inventory model. In the past, pharmaceutical companies allowed distributors to capture a portion of pharmaceutical companies' profit (price appreciation due to inflation) by letting distributors hold excessive inventory levels of drugs. In the end, in both cases pharmaceutical companies were paying for distribution services. Based on Cardinal Health's conference call, a lot of pharmaceutical companies have switched to the new model. Industry Consolidation Has Given Distributors an Upper Hand To distributors' advantage, the industry has consolidated over the last 20 years. Cardinal Health, McKesson and Amerisource Brunswick dominate the drug distribution industry, accounting for 90% of industry sales. Pharmaceutical companies don't have the scale needed to distribute their own drugs. It is also unlikely that they will want to make an investment into distribution infrastructure; they are likely to stick what they know best -- developing drugs and marketing them. We expect the industry to switch to a fee-for-service type of structure, where suppliers will pay for the larger portion of distribution services, though we expect pharmaceutical companies to drag their feet and rationalize some of their distribution. McKesson's recent announcement that it was not able to pass price increases to customers is a good indication that customers are refusing to pay higher prices, leaving pharmaceutical companies picking up the tab for distribution services. Cardinal Health Needs a Management Change To Be a Viable Player Cardinal Health is better positioned than its competitors, since distribution accounts for a little more than 50% of its operating profits where for its competitors distribution represents about 80-90% of operating profits. However, Cardinal Health's management has absolutely no credibility. Not unlike its suppliers, Cardinal Health's past success has exerted pressure on management to resort to financial shenanigans. The company is under SEC investigation, its CFO has been fired and replaced, it has delayed issuing its 10Q and it may have to restate its financials going back three years. During the last conference call, management was beating its collective chest confirming guidance, just to revise it down substantially several months later. To gain Wall Street credibility, Cardinal's current management team needs to be replaced. If management is replaced, the distribution business shows some signs of stabilization (even at lower levels) and the stock falls to the low 30s (at that price you are not paying much for distribution business), Cardinal Health stock would definitely deserve a second look. Climate Change Could Force Middlemen Out Wall Street hates uncertainty, and the drug distribution industry has a large cloud of uncertainty floating over it. Though we expect pharmaceutical companies to switch to fee-for-service arrangements, it is unclear how profitable they will be to drug distributors. Though this industry is very important and provides value for its customers, change in the industry climate may push large pharmaceutical companies to create tighter relationships with their big customers (improvements in technology definitely make it easier) i.e. Walgreen's (WAG:NYSE) and CVS (CVS:NYSE) that are not asking for a fee-for-service from them, cutting middlemen out and leaving breadcrumbs for drug distributors. Value creation -- essence for profit -- will be a difficult task for drug distributors going forward. Disclosure: Investmement Management Associates and/or Vitaliy Katsenelson may have positoins in the stocks mentioned Vitaliy N. Katsenelson, CFA Copyright 2004

Thursday, September 23, 2004

Ending Channel Stuffing Will Pressure Drug Companies' Multiples

September 23, 2004 - Street Insight

  • The premium valuation multiple that the healthcare industry commanded in the past is in the past.

Last week I was teaching a Practical Equity Analysis class and describing the concept of channel stuffing to my students. As an example, I brought up the large pharmaceutical and drug distributors industries. After describing what happened in the not-too-distant past in those industries, I came to a shocking realization: The drug distributor industry structure was created solely to satisfy pharmaceutical companies' need to produce smooth, ruler-like growth in revenues and earnings. In other words, an industry that has generated more than a hundred billion in sales was largely shaped by the pressure of large pharmaceutical companies to meet or beat Wall Street quarterly estimates. For a long time, pharmaceutical companies have commanded a premium valuation to the market for several reasons: pristine balance sheets, unbelievably high return on investment, predictability and sustainability of earnings growth and last but not least, very favorable demographic trends guaranteeing sustainable, ever-increasing demand for their products. Though return on investment is likely to remain high, it is likely to contract going forward due to increased competition from within the industry and from generics. Balance sheets are likely to still be better than average, but earnings predictability is likely to decline due companies' inability to utilize channel stuffing. The tsunami of aging baby boomers who are supersizing Big Macs while on Lipitor will be emptying the drug shelves at a pharmacy near you for years to come. Political risks that seemed remote are becoming real with every passing day, as the importance and affordability of healthcare is becoming a larger political issue with every election. Though we don't believe the U.S. healthcare system will suffer the fate of the Canadian less-than-functional healthcare system, the threat of drug re-importation and a larger role of Medicare and Medicaid will likely curb some of the inflation that was a big driver of industry growth in the past. Due to increased uncertainty and higher volatility, the premium valuation multiple that the healthcare industry commanded in the past is in the past. Relative valuation models should be thrown out the window and absolute valuation models that utilize a higher risk factor (discount rate) should be used in valuing pharmaceutical companies. Vitaliy N. Katsenelson, CFA Copyright 2004

Thursday, September 09, 2004

Merck - Positioning for a Sum-of-All-Fears Scenario

September 9, 2005 - Street Insight September 17, 2005 -

  • Recent clinical studies on Vioxx and Zocor do not bode well for the stock.
  • A negative FDA ruling and/or tight restrictions from insurance companies would hurt sales dramatically.
  • A 30% decline in sales could result in 45-65% lower earnings, according to my firm's estimates.

Recent news on Merck (MRK:NYSE) made us rethink our position in the stock. Kaiser Permanente's study showed that Merck's Vioxx, Cox-2 arthritis drug, may increase the risk of serious heart problems. If that was not enough, several days later a study showed that Merck's Zocor, a cholesterol-reducing (statin) drug, administered in high doses did not reduce the risk of heart attack when measured against a placebo (sugar pill) or lower dosage of the same drug. In addition, high dosage of Zocor increases chances of developing rare but dangerous side effects in a patient's muscles.

The street believes the news is priced in, but Merck's sales will take a hit. Surprisingly (considering that Vioxx and Zocor together represent approximately 30% of Merck's sales), neither of these headlines put even a dent in the stock price. The street's view is that both headlines are already priced into the stock's low valuation. Also adding fuel to the optimistic camp's fire were recent polls showing improving chances of Bush's reelection. The news drove Merck a little bit higher along with its other large pharma comrades. The main reason for the indifference in the stock's behavior, however, is the thinking that the above-mentioned studies will not impact Merck's sales significantly. We disagree.

It is very likely that doctors already are thinking twice about prescribing Vioxx and Zocor to new patients in addition to monitoring existing patients who are taking those drugs very carefully. Fortunately for doctors (and unfortunately for Merck), there are plenty of substitutes available on the market that are just a prescription away. Why prescribe a potentially dangerous and/or ineffective drug if there are plenty of good, clean substitutes in the market place? For Zocor, there is Pfizer's (PFE:NYSE) Lipitor, the highest selling drug in the world, and Bristol-Myers Squibb's (BMY:NYSE) Pravachol (although Pravachol has also had its share of problems). For Vioxx, there is the highly effective Celebrex, also manufactured by Pfizer. The FDA and insurance companies are still evaluating study results. Kaiser Permanente's study was sponsored by the FDA and it's very hard to predict the FDA's reaction to the study's results. Insurance companies are also still evaluating the results of both studies and have yet to make their decisions. The hidden risk brought closer to the surface by those studies may have a shocking impact on Merck's sales if either the FDA makes a ruling on the efficacy or safety of Vioxx and Zocor or insurance companies will put tight restrictions on drug prescriptions (which to some degree were already instituted on Vioxx). We call this the sum-of-all-fears scenario.

A decline in sales would result in a disproportionally higher earnings decline. Should this scenario materialize, the impact on Merck's bottom line could be devastating for two reasons. First, Vioxx and Zocor represent a very significant portion of Merck's sales. Second, most of Merck's costs (R&D, sales, general and administrative expenses, and a large chunk of cost of goods sold) are fixed; thus, a decline in sales would result in a disproportionally higher earnings decline. According to our estimates, a 30% decline in sales could result in 45-65% lower earnings.

Pfizer is likely to be a beneficiary of Merck's difficulties. It is not hard to imagine how the marketing and sales machines of Merck's competitors (especially Pfizer's) are likely already devising ways to capitalize on these studies at Merck's expense. Thousands of Pfizer's salespeople will be drumming on doctors doors, explaining in great detail the pitfalls of Merck' drugs. Pfizer is a likely to be a beneficiary of Merck's problems. Risk/Reward is unappealing.

Merck has a reputation of being a blue-chip stock; it has a very strong balance sheet, high return on capital, very strong cash flows and a nice 3.3% dividend. But all these factors could change overnight if this scenario -- which is a lot a less remote now then it was before the Vioxx and Zocor studies surfaced -- comes to fruition.

The risk in Merck's stock is very real. Though at 13 times "projected" 2004 earnings the stock appears to be cheap on relative and absolute basis, this cheapness could end up being a P/E trap if "projected" earnings are revised downwards. We therefore find the risk-reward in Merck's stock very unappealing.

Vitaliy N. Katsenelson, CFA Copyright 2004

Thursday, September 02, 2004

Becton, Dickinson Finds 'Sweet Spot' Pharmas Have Missed

September 5, 2004 - Street Insight
  • Predictability of revenue and earnings along with a likely dividend increase make BDX an appealing investment.

It is hard not to be impressed with Becton, Dickinson (BDX) and its management. The company is producing consistent organic growth in both the top line and bottom line through innovation. It has invented a safety needle category. It dominates most of the segments where it competes. Due to the one-time use nature of most of its products, a very large portion of its revenue is recurring, resulting in steady, predictable growth in revenue. It is consistently increasing its R&D spending which will further ensure continuation of product innovation. Impressive margin improvements this year and projected improvements in 2005 stem not just from increased efficiencies, but also from constantly evolving and shifting product mix from conventional products to higher-margin, more innovative products. Also, migration from the first generation's already high-margin products to the second generation's even higher-margin products is a decided plus. Yesterday, the company reported it had exceeded earnings expectations of 68 cents per share, delivering 70 cents per share. The performance was good company-wide. Sales were strong across all segments. Even after adjusting for FX, constant dollar sales were up about 5%, all of which was organic growth. BDX net margin increased 1.1% despite increase of 30 basis points in R&D expense, which has helped to fuel 14.2% operating income growth. Sweet Spot BDX, like many other device makers, is in a very sweet spot. It enjoys the benefits of very favorable demographic trends that create an incredible backwind. However, it doesn't face a slate of problems that are hovering over its pharmaceutical comrades.

  • An absence of political risks. BDX products are fairly inexpensive, especially relative to branded pharmaceuticals. Products (i.e., syringes, needles, etc.) have very tangible characteristics, whereas pharmaceuticals have tangible results (which is often taken for granted by consumer). Also, pharmaceutical products appear to have little intangible value, since most of the value in a pill is not in the manufacturing but in the R&D that went into the pill's creation. This makes pharmaceutical companies an easy political target. I don't remember politicians complaining about syringe prices.
  • BDX's products are not usually purchased directly by the consumer. The end users are usually nurses in hospitals and doctors' offices, though the company is bringing more consumer products to the market. The product price is usually embedded in a medical bill, which is not seen by the consumer and usually represents a very small fraction of the total medical bill.
  • All aforementioned factors reduce political risks substantially. The chances of price controls and syringe/needle/surgical instruments reimportation from Canada or other countries with socialized healthcare are very unlikely.
  • A very diverse product line. The company's success is not driven by several blockbuster products that account for a large chunk of its revenue, which is a very common problem in the pharmaceutical industry.
  • Patent expiration not as significant an issue as with big pharma. Intellectual rights are very important, but by the time a patent has expired, the company has already created several new generations of products that make the original protected products obsolete.

Outlook Risk/reward characteristics in the BDX core business are very favorable. Though there is not much upside in the P/E expansion, the downside is very limited as well. I expect revenue growth in the 6%-8% range, and earnings growth in the 9%-10% range due to constantly improving product mix and increasing operating efficiencies (the company's guidance was in the 10-12% range).

Management indicated a likely dividend increase, which is the right thing to do considering the strong capital structure and very strong free cash flows. Sustainability and predictability of revenue and earnings make this company a very appealing investment.

Vitaliy N. Katsenelson, CFA

Copyright 2004