Despite losing investor confidence over the past few weeks, Bayer remains the fifth largest pharmaceutical company in the world. After its successful merger with chemical giant Monsanto, Bayer has the opportunity to become the dominant player in the crop science business via digital farming and other practices. Management’s recent steps to divest from/sell non-core businesses such as Dr. Scholl and Coppertone are encouraging. The non-core Animal Health business should be divested while unprofitable businesses such Scholl and Currenta should be sold for fair value. More in-depth analysis below.
Reasons why we believe that Bayer is an opportunity before results
1. Crop Science Focus
Management highlighted the ongoing need for more innovation in the crop science industry in order to increase crop yields, due to shrinking arable land combined with the negative impact from climate change (e.g. more frequent droughts) on yields and long-term crop fertility. In addition, we note that the tougher regulatory environment requires the need for more sustainable yet efficient solutions. With the largest and broadest R&D platform in the industry, we continue to believe Bayer is best positioned to meet those needs.
Management provided sales and EBITDA margin targets for the Crop Science division, stressing those targets do not assume an ag cycle recovery thus allowing for an upside risk:
■ The company targets sales growth of 4% in 2019 based on 2018 pro forma sales of €19.3bn implying sales of ~€20bn in 2019. Between 2019-2022, the company targets average annual sales growth of > 4%, broadly in-line with our expectations and 100 bps above expected market growth rate of ~3%. Key drivers of above-market growth include continued penetration of Roundup Ready Xtend system (incl. Dicamba), Transition to XtendFlex with expected US launch in 2020, continued penetration of Intacta RR2PRO; transition to Intacta 2 Xtend with expected launch in Latam in 2021 in addition to annual germplasm refresh across the seeds portfolio driving price increases, maximizing sales synergies/share gains from the Monsanto acquisition (including higher crop protection sales on the >400m acres seed and trait footprint) and new launches in crop protection (e.g. new fungicide near term).
■ Crop Science EBITDA margin is expected to be at ~23% in 2018 with a target of 25% in 2019 and over 30% from 2022. The new targets imply EBITDA of ~€5bn in 2019 and ~€6.8bn in 2022 translating into EBITDA CAGR of 10.8% (vs. consensus at 9.5%). The margin improvement is underpinned by the achievement of synergies which were reiterated at ~€1bn by 2022 of which ~€170m are sales synergies (1% of 2018 PF sales) and ~€870m cost synergies (20% of 2018 PF EBITDA), split between commercial/R&D operations (€0.3bn), support functions and country integration (€0.3bn), procurement and product supply (€0.1bn) and consolidation of IT infrastructures (€0.1bn). We remain more conservative, assuming 60% retention rate, partly explaining our lower EBITDA margin forecast in 2022 onwards (28% vs. company guidance at 30% pipeline).
Bayer Crop Science has an industry leading R&D platform (€2.4bn R&D spend in 2017, nearly twice the level of its closest competitors). Management believes that the next leg of growth in the industry will be delivered through the ‘smarter’ convergence of R&D platforms in order to offer ‘holistic’ solutions to farmers that can optimize their yields and ROI, including a leading quality germplasm (e.g. in corn, soybean, cotton and vegetables), biotech (with >20 new and next generation GM traits in development) combined with chemistry, biologicals and data science optimization (e.g. Climate Field view, an integrated data system that helps farmers take smarter decision). The Crop Science division has a pipeline of more than 75 projects with peak sales potential of up to €30bn (1.6x 2018 pro forma sales) spread across corn (peak sales potential of €11-14bn), soybean (€6-7bn), cereals & other (€4-5bn) and horticulture (€3-4bn). The company expects €17bn in peak sales (0.9x 2018 pro forma sales) from the recent and near-term launches with significant opportunity for digital transformation and tailor made solutions.
Bayer's announcement of a range of restructuring and efficiency took investors by surprise. The company intends to reshuffle its portfolio to mitigate concerns over profitability and conglomerate structure. Underlying these previously announced measures is an attempt to reduce the sprawl of the company and increase its focus on the core Pharmaceuticals, Crop Science and Consumer Health businesses. In addition to various divestments, Bayer expects a range of efficiency measures to produce total annual synergies of €2.6bn from 2022 onwards (including Monsanto acquisition synergies of ~€1.0bn). The one-off, largely cash costs, associated with this are ~€4.4bn (including an existing ~ €1.3bn from the Monsanto integration), likely to be staged over a number of years.
Exiting Animal Health & Currenta; Cutting losses on Coppertone & Dr. Scholl's
The planned disposal of Animal Health, which generates ~4% of underlying EBITDA, makes sense to us given the limited strategic rationale for maintaining this in the Bayer group. High peer asset prices in the segment (~19x EBITDA) are attractive and allow capital redeployment to Bayer's core business. Additionally the disposal of the 60% ownership stake in Currenta, which provides industrial site services is a positive move but its impact on potential valuation is limited. In Consumer Health, the decision to shed the underperforming Coppertone and Dr. Scholl's brands, coupled with various non-cash write downs of €2.7bn in 4Q18, removes an obstacle to the recovery of the division. This allows for a re-focusing of resources to core 'real OTC' brands. The underperformance of this business has been a cause for concern for investors and the portfolio changes are an initial step in bringing this issue to a close (although a return to the overall market growth rate is likely to be a multi-year journey). Combined annual sales of Coppertone/ Dr. Scholl's of ~€400m are immaterial (~7% of Consumer Health division) and have limited overlap with the wider portfolio, making this a sensible proposal.
Our analysis suggests the planned divestments could yield high single digit billions worth of proceeds.
Broad efficiency measures, a "portion" to be reinvested
In addition to the portfolio restructuring plans, Bayer expects to reduce its global headcount by ~10% (12k positions) by 2022. The majority of these fall into Crop Science (4100), as a natural result of the integration of Monsanto. Additionally, many of these positions are support functions (5500-6000). The reductions in Consumer Health (1100) reflect the Coppertone/Dr. Scholl's disposals along with changes to the organizational structure to improve profitability. In Pharmaceuticals, headcount reductions of 300 and a non-cash write downs of €0.6bn, are prompted by the competitive factor VIII environment, which has eliminated the need for the company's newly-built manufacturing facility in Germany. Whilst we generally view any cost reduction programs with a degree of skepticism as savings are likely to be reinvested, the scale of these proposals are a clear signal of management’s intent. Aside from improving underlying profitability across divisions, Bayer has highlighted the reprioritization of resources in Pharmaceuticals in order to focus on accessing external innovation and collaborations. This is a sensible move given the limited productivity recently of the company's internal R&D activity and the Xarelto patent expiry in 2024, which has yet to be offset by pipeline candidates. Without guiding on specifics, management expects "a portion" of the annual savings of €2.6bn to be reinvested in the business.
We believe that Bayer's management is working towards increase of shareholder value. Bayer CEO Werner Baumann underscored this objective through his recent visit to Singapore to meet with Temasek Group, a major shareholder with approximately 3bln dollars in Bayer. We strongly support Mr. Baumann’s collaborative approach and are looking forward to further such updates from management - specifically in regards to the Bayer/Monsanto merger and ongoing litigation in the US.
Source: DB analysis of Bayer and Bayer's reports
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BAYZF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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