Recently, legendary short-seller Jim Chanos warned how acquisitions are a means for companies to double-up on research & development spending without recognizing it in the company's earnings. R&D spending is immediately expensed according to US GAAP (Generally Accepted Accounting Principles) but is largely capitalized in an acquisition. This difference allows acquiring firms to keep reporting higher earnings with reduced R&D expense relative to their peers that internally develop their brands and technology.
Inspired by Mr. Chanos, I utilized this insight to analyze the cost of acquisitions to big pharmaceutical companies, many of which are losing patent protection for their prescription drug products. Despite enticing dividends, investors should look elsewhere.
Acquisitions as R&D
The same logic Jim Chanos used to select Hewlett-Packard (HPQ) as a short candidate applies to the pharmaceutical industry:
"The patent cliff in its own right may not be the problem: more the reactions of management to it. For a company facing a patent cliff, a declining share price could even be seen as a sign of a successfully run company - if excess cash is being returned to shareholders via dividends. If a drug company were simply to collect the cash flows and put the money in the bank the share price would remain stable …But because most managers do not follow this business model, they start spending the surplus cash, thereby creating a riskier company, with the assumption that revenues and earnings can be smoothed." - Evaluatepharma.com World Preview 2018
He cites a structural change in the form of the Apple (AAPL) lead exodus from personal computers to mobile devices as a dire threat personal computer companies like Hewlett-Packard. Mr. Chanos is concerned that Hewlett-Packard's management will refuse to age gracefully and instead will acquire other companies in desperate attempts to acquire lost market share. This prognosis is eerily similar to concerns Evaluatepharma.com's fears for big pharmaceutical company shareholder value.
Checking Valuations
First, investors should check to make sure that these firms are cheap:
Ticker | Company | P/E | P/S | Dividend Yield | Payout Ratio |
AstraZeneca PLC | 7.18 | 1.79 | 6.01% | 42.20% | |
Bristol-Myers Squibb | 17.33 | 2.97 | 3.77% | 49.00% | |
Eli Lilly & Co. | 12.29 | 2.2 | 4.42% | 54.00% | |
Sanofi | 14.06 | 2.46 | 4.17% | 48.00% |
These firms were selected on the basis of attractive dividend yields and sustainable (<60%) payout ratios. From their price-to-earnings and price-to-sales ratios, AstraZeneca and Eli Lilly are attractively priced. Sanofi is reasonably priced and Bristol-Myers Squibb is a rich. Bear in mind that these firms are facing rough headwinds and should be priced cheaply.
Screening for Cash Inflows
Mr. Chanos warned how acquisitions are back-door way to double-up on research & development spending. R&D spending is immediately expensed according to US GAAP (Generally Accepted Accounting Principles) but is largely capitalized in an acquisition. This distinction allows firms which engage in acquisitions to keep earnings free from R&D expense. Their peers that internally develop their brands and technology would be at a disadvantage vis-à-vis accounting rules, since their earnings would be lower after expensing research and development costs.
This means that investors should pay careful attention to acquisition expenditures and free cash flow adjusted for acquisition payments. Net acquisition cash flows were subtracted from free cash flow below:
Free Cash Flow ($B) | 2007 | 2008 | 2009 | 2010 | 2011 |
AstraZeneca PLC | 5.831 | 4.703 | 10.153 | 8.499 | 6.524 |
Bristol-Myers Squibb | 2.31 | 2.766 | 3.335 | 4.067 | 4.473 |
Eli Lilly & Co. | 4.0721 | 6.2264 | 3.4805 | 5.6701 | 5.5416 |
Sanofi | 5.496 | 6.917 | 6.73 | 8.197 | 7.537 |
Acquisition Cash Flow, Net ($B) | 2007 | 2008 | 2009 | 2010 | 2011 |
AstraZeneca PLC | -14.891 | 0 | 0 | -0.348 | 1.772 |
Bristol-Myers Squibb | -0.159 | -0.191 | -2.232 | -0.762 | -0.211 |
Eli Lilly & Co. | -2.6732 | -6.083 | 0 | -0.6094 | -0.3078 |
Sanofi | -0.214 | -0.661 | -5.563 | -1.659 | -13.59 |
Adjusted Free Cash Flow ($B) | 2007 | 2008 | 2009 | 2010 | 2011 |
AstraZeneca PLC | -9.06 | 4.70 | 10.15 | 8.15 | 8.30 |
Bristol-Myers Squibb | 2.15 | 2.58 | 1.10 | 3.31 | 4.26 |
Eli Lilly & Co. | 1.40 | 0.14 | 3.48 | 5.06 | 5.23 |
Sanofi | 5.28 | 6.26 | 1.17 | 6.54 | -6.05 |
These numbers for adjusted free cash flow after acquisitions reveal how Bristol-Myers Squibb does not rely heavily on outside acquisitions while the other firms have relied on big acquisitions in the past. Eli Lilly managed to keep cash flows positive after acquisitions, though just barely in 2008. After adjusting for acquisitions, the cash flows to investors are not consistent for Sanofi or AstraZeneca.
Future Acquisitions
Consider the sales projections for 2018 from Evaluatepharma.com:
Company | 2011 Sales ($B) | 2018 Sales ($B) | % CAGR |
Sanofi | 39.3 | 48.2 | 3% |
Bristol-Myers Squibb | 16.9 | 21.4 | 3% |
AstraZeneca | 32.4 | 21.9 | -5% |
Eli Lilly | 20.4 | 13.7 | -6% |
It appears that there will be motive for Eli Lilly and AstraZeneca to try to make abundant acquisitions in the future in order to patch up their leaky sales pipeline.
Conclusion
These four big pharma dividend companies each have issues which should give income investors pause. Bristol-Myers Squibb is richly priced, so investors should wait for its valuations to become attractive. Sanofi has a history of massive acquisitions. Eli Lilly's past acquisitions have been more modest, but it will be pressed to make more in the face of declining revenues. AstraZeneca both has a history of acquisitions and will be tempted by declining sales projections to strike again. In summary, wait on Bristol-Myers Squibb and pass on the others.
Disclaimer: This article was written to provide investor information and education, and should not be construed as a guarantee or investment advice. I have no idea what your individual risk, time-horizon, and tax circumstances are: please seek the personal advice of a financial planner. This article uses third-party data and may contain approximations and errors. Please check estimates and data for yourself before investing.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
