Wednesday, November 10, 2004

Higher Rates Are a Clear and Present Danger to Economy

November 10, 2004 - Street Insight Consumers have carried the U.S. economy on their backs for a long time, but lately they are showing signs of fatigue. Consumers' response to higher food prices shows how frail they really are. Food distributor Sysco (SYY), which reported 5.9% food inflation in the latest quarter, has passed commodity price increases on to restaurants. But when restaurants tried to pass higher prices on to their patrons, they witness a decline in traffic and volumes. From listening to other consumer companies' earnings calls, I have gathered that every time companies raise prices, in an effort to pass commodity inflation on to the consumer, demand drops off. This was the case with Sara Lee (SLE) as well. This is not the behavior of a strong consumer. The current quarter inflation experienced by Sysco is lower than the 8% it experienced last quarter, and it is unlikely that high food inflation will stay high for a very long time. A deceleration in the rate of growth in the current quarter is a good initial indication of that. Also, supply and demand imbalances in food commodities that are pushing prices up tend to correct themselves more quickly than in other industries (i.e. in natural resources). It is very likely that any improvement in the economy will be followed by rising rates. Even in the absence of economic improvement, high inflation in commodity prices is likely to push rates higher, since inflation will be eroding the already very small real return in bonds. Rising rates are a serious concern. Low interest rates have drugged and steroided consumers, sending them on a three-year-long shopping spree for bigger and greater must-haves. Ironically, rising rates from an ultra-low to a long-term average level are a lot more painful to the consumer and to the economy as opposed to an environment in which rates just remain at the long-term average. A low interest rate environment brings a significant benefit since it helps consumers refinance their balance sheets, lowering the cost of financing and, in theory, increasing discretionary income. In reality, the negatives that cheap money brings to the consumer may outweigh the positives. Consumers got used to home equity lines of credit that only cost what risk-free rates used to cost in the pre-cheaper-than-dirtiest-dirt time, thus leading consumers to use debt financing as if they discovered that Croesus had put them in his will. Though discretionary income (gross income minus taxes) has grown consistently over the last several years, consumer debt as percentage of discretionary income has reached an all-time high over the same time period. Consumers' appetite for debt has outgrown their income consistently over last decade. Total Consumer Debt as % of Discretionary Income (Send me email for the chart) The problem with the "consumer debt as percentage of discretionary income" measure (the above chart) is that it ignores the true cost of debt since higher debt levels in a low-interest-rate environment may not result in a high debt service burden (interest and principal payments) on the consumer.

However, despite low interest rates, debt service burden as a percent of discretionary income is one iota away from being at an all-time high. Consumers have benefited from all-time low interest rates, but they have taken so much debt that monthly expenses associated with paying interest and principal payments in relation to their discretionary income have actually increased despite the low interest rate environment and growth in discretionary income. In other words, this is where "theory" went out the door. Total Debt Service Burden as % of Discretionary Income (Send me email for the chart) Rising interest rates will escalate problems that stem from consumer indebtedness. Though many consumers refinanced and locked their mortgages at ultra-low rates for 30 years, over a third of total consumer debt is floating and will be readjusted upwards once interest rates rise. The impact of rising interest rates will be delayed since it takes time for higher rates to trickle through. For adjustable rate mortgages, it takes as much as a year for payment to reflect higher interest rates. Rising interest rates will have significant consequences on an already-overleveraged and over-extended consumer. Rising interest will be a stagflation-like headwind to future economic growth. It is hard to measure the magnitude of the impact that higher interest rates will have on the consumer and the economy, but it is clear higher interest rates will temper economic growth. In addition, significantly higher rates would have a tremendous impact on the housing market, driving down housing prices and reducing or wiping out any equity left in houses, pushing homeowners to be upside down on their house (not in a literal sense). For example, according to the Financial Times, U.K. housing prices have declined in October by the highest amount in four years due to higher mortgage rates. I imagine we will be seeing similar headlines hitting U.S. newsstands in the not-too-distant future. Higher interest rates will not impact homeowners that either are not selling their house or don't have a second mortgage on it. Actually, it will probably benefit them by reducing their property tax value thus resulting in lower property taxes, though personally I don't know anybody who has a house and doesn't have a home equity loan. It seems mental accounting (irrational behavior described in behavioral economics) is impacting consumers spending behavior. Money that came from borrowing against home equity is spent on discretionary and products more durable in nature . Since consumers feel that they did not have to "work for" these funds, they are placed in a separate "mental account," which has less value placed on it. Thus, money is spent with relative ease. This explains a very impressive performance by the home remodeling market and all-time high consumer indebtedness. "Hard-earned" money consumers use to pay for staples, food, and restaurants is placed into a different mental account that carries a higher value to consumers. Thus, consumers are more frugal about spending those funds, resulting in higher elasticity of demand. It is very likely in absence of the cheap money stemming from home equity loans, consumer behavior will reverse. We are gradually recalibrating our portfolios to mitigate the risk of a weakened consumer, and though we don't expect the consumer to weaken overnight, we'd rather be early to the party than late. Here are the adjustments we are making to our portfolios.

  • We are shying away from companies whose products and services are highly discretionary and constitute a large portion of consumer budgets. Reduced home equity and higher interest rates will have a significant impact on these businesses. Names that come to mind to avoid are Home Depot (HD), Lowe's (LOW), Best Buy (BBY), Circuit City (CC), and Fortune Brands (FO), among others.
  • We are shifting our focus to industries that have very little exposure to a weakening in consumer discretionary spending. There are plenty of names that fit the bill starting with healthcare, consumer staples (with unique and strong brands), defense, and many other industries.
  • We are identifying beneficiaries from a higher interest rate environment and consumer weakness. There are fewer names in this category. Though banks in general should benefit from higher interest rates, they will likely suffer from higher loan defaults caused by a weakened consumer. Collection agencies sound like a logical alternative, but they actually perform worse in such an environment. The only company I've found so far is that fits the bill is Jefferson-Pilot (JP). It should benefit from higher interest rates, and demand for its products is unlikely to decline in a weaker consumer environment.
Vitaliy N. Katsenelson, CFA Copyright 2004

Sunday, November 07, 2004

IMS Health: A Dusty Gem

November 7, 2004 -

Values are a very rare occurrence in this market unless an investor is willing to go down on the quality curve. In the quest for value, we seek gems that have collected the dust of confusion and misunderstanding. A Dusty Gem IMS Health (IMS) is one such gem. On the surface, its financials look very rocky. Its sales and net income have not grown much over the years. (Some years they even declined.) Its equity-to-total-capital ratio stands at a pitiful 11%. At first glance, RX doesn't look like a company worth a second look. This is where investors are wrong. The less-than-attractive income statement and terrifying balance sheet hide a truly unique, financially strong company that poses a very unique, sustainable, competitive advantage with great return on capital. (EVA numbers look great.) The business generates an abundance of free cash and trades at a very attractive valuation. Sales and net income lumpiness are explained by RX's history. IMS Health was spun off from Dun & Bradstreet (DNB) in the mid 90s. At the time of the spin-off, RX consisted of a collection of loosely related companies that DNB wanted to get rid of. Over time, RX either sold off or spun off unrelated companies, which resulted in lumpiness in sales and earnings. RX used its abundant free cash flows and proceeds from spin-offs to buy back close to two billion dollars of its common stock over the last six years, which represents close to 30% of its current market value. Since the market value of the stock repurchased significantly exceeded the book value of the equity (a combination of common stock and retained earnings), stock repurchases wiped out most of the equity on the balance sheet, thus creating an appearance of over-indebtedness. Even though RX appears to be overleveraged -- debt represents close to 68% of its assets -- debt is not a concern. First of all, RX's debt of $640 million misrepresents RX's indebtedness since it has $425 million in cash. Second, investors should ignore the debt-to-asset ratio and pay closer attention to interest coverage ratio or debt payoff ratios, which tell a more accurate story about RX's capital structure. The interest coverage ratio stands at approximately 22 times. Ignoring RX's cash position, the company can pay off all of its debt using operating cash flows in a little less than two years. Both numbers are very respectable for any company, and even more impressive for RX considering its revenues are very predictable and cash flows are very stable. High Barriers to Entry RX collects data on pharmaceutical sales from drug manufacturers, wholesalers, retailers, pharmacies, mail order, long-term care facilities and hospitals in over 100 countries. It has 29,000 relationships with data providers and collects data from 225,000 data sites that provide detailed yet anonymous information on billions of pharmaceutical transactions worldwide. RX usually collects about 50 pieces of information from every transaction including information about the doctor who wrote the prescription, the name of the drug, dosage, illness, customer's age and gender, payer's (insurance company) name, and much more. RX processes billions of transactions a month; the company claims to process more transactions than the NYSE. RX has almost complete dominance in the market in which it operates. Its only other significant domestic and international competitor is NDCHealth (NDC), which has its share of internal problems and lacks RX's depth and breadth of data. In most cases, it faces small local competitors that lack RX's scale. Barriers to entry in this industry are very significant. In addition to negotiating thousands of contracts with data providers and gaining access to several hundred thousands of data sites, an entrant would have to overcome investments in intellectual property RX has made over the years. For example, the German subsidiary of NDCHealth tried to use the geographical grid created by RX to track sales of pharmaceuticals in Germany. But, RX sued NDCHealth's subsidiary and won. The ruling forced NDCHealth's subsidiary to withdraw from Germany. Though Germany is an extreme example, RX's intellectual property investments and investments in its information systems are incredibly difficult for new entrants to overcome. Vital Information and Services IMS Health's data and services are crucial to pharmaceutical companies, and they are becoming even more important as competition among pharmaceutical companies intensifies and forces pharmaceutical companies try squeeze every penny they can out of the limited patent-protected life of their drugs. Also, global product launches require timely information on product sales worldwide, and IMS Health is the only company that can provide that information on a global basis. Aside from research and development, the sales force is the largest expense for pharmaceutical companies. Using data collected by IMS Health, pharmaceutical companies are able to measure sales force effectiveness and are therefore able to compensate their salespeople appropriately. Without RX's, data it would be nearly impossible for pharmaceutical companies to have merit-based sales force compensation, leaving them blind as soon as drugs shipped to the distributors. In addition to sales force compensation, pharmaceutical companies use RX's data to devise and measure the effectiveness of their marketing campaigns. In the late 1990s, due to its success in the marketplace and the lack of serious competition, RX grew complacent. In early 2000, RX's management became so complacent that -- likely out of boredom or fascination with the dot-com revaluation -- it tried to do a reverse merger with a company a fraction of its size. Fortunately, the market saw through the ridiculousness of the merger and sent RX's stock to an all-time low. RX's management took the hint and discarded the merger. Several months later, RX hired a new CEO from IBM, Dave Thomas. Thomas has revitalized the company. He has shifted the focus back to the customer. He's changed RX's emphasis from being a data provider to being a solutions provider (which RX has developed internally and through acquisitions). Thomas realized the size of the global pharmaceutical data market is at best about $2 billion, and RX had about half the market. Thomas also realized the size of the analytics and solutions market is about $4 billion, and RX had/has very little presence in it. Risks There are two factors that could create potential headwinds for RX: mergers in the pharmaceutical industry and introduction of generics. Mergers have a partially negative impact on RX's sales since a combined entity is likely to cut its spending on (macro) market research products. Usually spending on sales-force-effectiveness products (micro) is not effected since merged companies are selling the same products they sold before and usually there is little overlap in therapeutic classes between them. It is very difficult to figure out the impact mergers would have on RX. However, RX's management says it expects the impact of industry consolidation on the top line to be only about one to two percent. I'll take management's word for it; it has more data than I do. So far, management has not made empty claims or promises. Growth Opportunities There are several factors fueling the growth of RX's data revenue:

  • New data elements and types are constantly introduced permitting RX to charge higher prices for existing products.
  • RX is constantly developing new tools to analyze its data and increasing the penetration of its products into pharmaceutical companies, thus increasing the volume of data sold.
  • Even large pharmaceutical companies don't buy data for all therapeutic classes. As pharmaceutical companies branch out into new therapeutic classes, they'll buy more data from RX.
  • When a new entrant enters a therapeutic class, it creates several selling opportunities.

First, RX sells data on that therapeutic class to the new entrant. Second, it raises prices for the therapeutic class, since due to the new entrant, it starts trucking more brands. However, growth in data revenue is only the icing on the cake. The real opportunity is in analytics and consulting. Constant-dollar organic growth in consulting services has been 35% over the last couple quarters, and acquisitions pushed that number north of 45%. Though consulting represents only about 10% of total sales, it has contributed about 3% to total revenue growth this year. RX's customers are not just looking for data. They are looking for solutions and tools that will help them become more efficient. It seems RX's repositioning efforts are paying off. Constant-dollar revenue growth in IMS Health's core business has accelerated from 4% in 2002 to 6% last year. It has reached a peak this year of 8%. Top, Bottom Line, and Margins Top-line and bottom-line growth (excluding spin-offs and sell-offs) pre-Dave Thomas was fairly disappointing. Earnings growth was in the low to mid-single digits. However, this may be an indication that without much effort by management (which was the case before late 2000), RX can grow earnings in the low-to-mid single digits. Recent acceleration of the top-line and bottom-line is an indication of a much brighter future for RX. RX's profit margins took a hit over the last year and half, mostly due to the following:

  • A significant decline of sales in Japan. Japan is a situation where operational leverage worked against the company. Since costs did not decline, a decline in sales translated into significantly lower operating margins.
  • In 2002 a drug wholesaler in Japan stopped providing data to RX. Though the Japanese market is very fragmented, the Japanese mentality is not. Other competitors followed the lead of the wholesaler and stopped providing data to RX, as well. Japan is the second largest market for RX after the United States, and it was one of RX's faster-growing markets.
  • In 2003 RX's sales in Japan were down 19%. But, there are several bits of good news in this area. First, RX has renegotiated contracts with Japanese wholesalers and signed every single one of them back. (However, this time around RX will be paying for the data.) Second, despite its second biggest market suffering a major setback, RX grew constant dollar revenues 6% in 2003. Finally, Japan coming back online should lift operating margins and drive sales growth.
  • Heavy investment in new data and product development. The good news is these new data in areas like long term care, mail order, oncology, etc. are about to start translating into new products and services, which will help drive revenue growth and margins. (It is very interesting how much RX has changed since 2000. In 2000, RX introduced three new products. In 2003 RX introduced 25 to 30 new products and will keep that pace going forward. Management estimates half its growth now comes from new product offerings.)
  • Very fast growth in consulting. The consulting business carries somewhat lower operating margins, thus it hurts overall operating margins. But, management swears growth in consulting will not impact overall margins that much.

I believe margins will stabilize at the current level as increased data collection costs will gradually be transferred to RX's customers as contracts renew. RX has incredible operational leverage since the bulk of its costs are fixed, with the exception of consulting. Operational leverage coupled with high sales growth should help to lift RX's profit margins. The aforementioned factors should also help offset some of the margin deterioration driven by consulting growth. Also, according to RX, consulting contracts are renewed 70% of the time. In addition, almost 70% of the time consulting contracts result in incremental sales of data which carry close to a 100% margin -- great operational leverage. RX's top line should grow about 8% to 10% a year. (My estimates are a bit more conservative than the company's. The company's guidance is 8% to 13%.) RX's data and analytical products should contribute about 5% to 7%. (The company's guidance is 6% to 9%.) The consulting business is likely to contribute 3% to 5% to the top line. (I expect organic growth in consulting to slow to 20% to 30% from the current 35%.) I feel fairly comfortable RX will be able to achieve my growth estimates, but I want to see RX hitting 10% constant-dollar growth for at lest several quarters before I become comfortable with the high end of the company's guidance. In other words, it is "show me the money" time for RX. RX will continue to make small acquisitions. In the long run, this should help offset the negative impact of mergers in the pharmaceutical industry. EPS should grow at a faster rate than revenue, ranging from 12% to 14%. EPS should be helped by margin expansion due to operational leverage and by share buybacks as described above. Year-to-date, RX has purchased 11.2 million shares, which represents close to 5% of the total share count. I don't expect share repurchases to be that high going forward, but it should contribute 2% to 3% to EPS growth in the long run. Valuation RX is trading at about 17 times 2005 projected earnings. I believe it deserves a higher multiple that is more in line with its counterparts that provide similar services in different industries. Comparing RX's valuation to NDCHealth doesn't make sense since NDC has been marginalized by RX. (It is not the same quality nor does it have the growth prospects of RX). Two counterparts that look somewhat comparable to RX are Dun & Bradstreet and Moody's (MCO). (Ironically, RX, DNB, and MCO used to be a part of one company some time ago.) I believe RX's growth is more predictable than DNB's since much of DNB's growth comes from margin expansion -- not a very sustainable source of growth. RX's growth prospects look brighter than DNB's, yet DNB also trades at about 17 times 2005 earnings. It seems RX is more comparable to MCO. Both have a similar capital structure and enjoy semi-monopolistic status in their respective industries. However, at 26 times earnings, MCO looks overvalued. I think RX should be trading between DNB and MCO. A P/E of 21 times earning looks very appropriate, though some may consider that to be too conservative. At that valuation, RX would be trading at $28, a 22% increase from its current price. Not surprisingly, my magic discounted cash flow model puts RX's intrinsic value somewhere in the $28 to $36 range, depending on the assumed discount rate, profit margin, and sales growth. As I described in my Place of No Returns 'Spotlight' piece, I expect the stock market's valuation to contract in the future. Therefore, to project the annual rate of return for five years, I use both a contracted P/E and a normal P/E (a two-scenario model) to arrive at the stock price in five years. I expect EPS growth to decelerate a couple percentage points after five years. Thus, RX's P/E should naturally contract from 21 times to 19 to reflect lower growth ahead. In the contracting P/E scenario, I expect RX's PE to decline 3 points from the normal scenario to 16 times. In both scenarios, I use 12% EPS growth to project EPS five years, a fairly conservative assumption, though I think a higher growth rate is achievable. In the contracting P/E case, the expected annual rate of return is 10.8%, where in the normal scenario it is 14.8%. Both are acceptable rates of returns considering the relatively low risk of RX. Bottom Line IMS Health is our side play on the pharmaceutical industry. RX should ride the giant wave of aging baby boomers without facing the risks and volatility of pharmaceutical companies. A very high component of RX's sales is recurring, so its earnings and cash flows are very steady and predictable. I believe the downside in RX is very limited while appreciation potential is

Disclosure: position in RX

Vitaliy N. Katsenelson, CFA Copyright 2004

Friday, November 05, 2004

Becton Dickinson Finds 'Sweet Spot' Pharmas Have Missed

November 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