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Portfolio changes – Dairy Farm & Ramirent

Ramirent out

I continue to rotate my portfolio away from cyclical companies to safer quality havens. Ramirent has been riding the cyclical construction boom in the Nordics. I believe we are seeing the very last legs of that. Especially in Sweden construction could very soon come to a halt with daily articles commenting on the property market. This is something I have analyzed closely myself and I have seen the signs for quite some time. So I’m a bit disappointed that I didn’t manage to exit Ramirent when the stock was trading at least one EUR higher, but here we are. I kept this holding since I started the blog, to avoid the risk of follow this cyclical company all the way down again, it’s time to sell. So as of today’s close I sell my full holding in Ramirent.

Dairy Farm

I actually started to research this investment thanks to a comment I got from on of you readers. The question was if I have looked at Jardine Matheson Group. My answer at the time is that its a very complex conglomerate to research, because it contains so many different types of exposure. One of the core holdings of the Jardine Group is called Dairy Farm and as many of Jardine’s holdings it is separately listed. It’s name might lead you to the wrong conclusions, it’s not a milk company of any kind, but a diversified company of Asian retail stores, mainly focused on food. It might come as a surprise for some people living in Asia that this company is the owner of so many famous retail stores for the Asian region. Dairy Farm operates supermarkets, hypermarkets, convenience stores, health and beauty stores and home furnishings stores under all these well-known brands:

DairyFarm_companies

I have been trying the last few weeks to enter this stock at a more attractive level, but failed to find/time any weakness. Therefore I took an initially smaller position of 4% in this company at today’s close, with the possibility to add in-case I see any short-term share weakness. This is not a cheap stock, but a quality company that I intend to hold for the very long term. It has good exposure to the growing middle-class in Asia. A full analysis will follow at a later date.

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Portfolio Review Q3

The third quarter of the year has passed and the bull market is still roaring pretty strong. My guess a few years ago would have been that we should have seen a larger setback by now. On this particular point I feel pretty humbled by being wrong for so long. Performance wise I do not feel as humble. I have done quite a number of things wrong during this year, mainly selling stocks too early. But in general I did more things right than wrong and that’s what counts. Let’s go through the performance and some high- and lowlights.

Performance

Graph_20171006

Year to date the Global Stock Picking portfolio is up +24.5%, that compares favorably to MSCI World (Total Return) which is up +17.4%, but lagging Hang Seng (Total Return) which is up an incredible +29.3%. Looking at risk adjusted returns, I’m not faring that well though. Although I have run a large cash position (which lowers volatility) the volatility YTD is at 10.5%, compared to MSCI World at 5.5% and Hang Seng at 11%. So risk adjusted I come out with the worst Sharpe ratio of 2.33 vs 2.66 for Hang Seng and 3.17 for MSCI World. I guess that also says something about the state of things in the markets when a Global Index portfolio is returning a Sharpe >3.

I probably sound like a broken record soon, but this to me is a very late stage bull market and one should plan accordingly. I did make an attempt to discuss the topic recently (Where to hide – a factor approach).

Compare with Hang Seng?

That I have added Hang Seng as a comparison might be somewhat misleading, since my intention is to run a Global portfolio. The reason why I added Hang Seng was due to my heavy China tilt when I started the blog. I would argue that is not a constant tilt that I will have over time. It was an allocation call I made at the time. It is a call I’m obviously happy about, since it has given me free Beta out-performance against MSCI World, which is my true benchmark.

Lately I worry about the Chinese economy and the valuations has got more stretched also for Chinese stocks. As you know from previous posts I actively rotated away from China. Currently my portfolio has 16.5% of its cash invested in companies with most of its earnings from China (Coslight, XTEP and NetEase). I will keep the Hang Seng comparison for sometime, but I might remove it at some point.

Highlights

Buying Gilead became a very well timed investment. The market really liked the new product line their are buying themselves into through their acquisition of Kite Pharma. I honestly don’t have the knowledge to know if this will actually be so fruitful as the market seems to think. My impression is that (the market thinks) Gilead has a strong acquisition track record.

Nagacorp which we discussed extensively in the comments and I choose to double up on has come back to something closer to fair value. The company continues to execute well on attracting more VIP players and the Naga2 complex is about to open in full scale. Next Chinese New Year will be very very interesting, I’m optimistic about further share appreciation. As long as the majority holder does not decide to do something stupid (again).

LG Chem which is my long long term holding for the EV-theme (being a leader in battery technology) has performed very well lately (although not as well as the pure-play Samsung SDI). Unfortunately the battery part of LG Chem is still fairly small. I expect it to grow substantially over the coming 5 years.

Lowlights

I made a bet that XTEP, the Chinese shoe company was lagging it’s competitors who have all had great runs in the stock market and would do some catch-up after it’s semi-annual was released. It turned out being the opposite and I doubled up before the stock collapsed. I feel a bit beaten up, picking the only Chinese shoe company that is down performance wise. Still haven’t given up though, although less about my position than before.

In my move to rotate away from China (Time to rotate away from China) I have sold a number of holdings lately. Two which I sold after very strong returns were YY and BYD. It has been a bit hard to see the shares continue to surge another 30-40% after I sold, but such is life. As I wrote at the time for YY, I got scared of the Chinese Gov clampdown on streaming services, but these things often go away and so it did. And the upside I saw very shortly after came true.

Catena Media which I just bought into also had a negative event right after I bought. The CEO was fired with immediate effect. This gives me some worry that something might surface in the Q3 report. I have considering to reduce my initially fairly ballsy position. The only positive keeping me from doing it is the interim CEO which I have very high hopes about.

I bought two bricks and mortar stocks, XXL and Tokmanni, I reversed my decision with a smaller loss for XXL and kept Tokmanni. So far I should have done the opposite, since XXL has rebounded nicely whereas Tokmanni is treading water.

Current Portfolio

Holdings_20171006

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New holding Essity

As of yesterday’s close I entered a 6% position in Essity, the newly formed personal care and tissue products company. Essity was the Hygien part of SCA and was spun out of SCA earlier this year. That left SCA with forest ownership and pulp production in SCA.

I have kept SCA on the radar for a long time and it has always been the Hygien part of the company that I found attractive. After the spin-off the Essity share has traded down whereas the SCA part has continued up. I like Essity for the quality of their products and I believe there is room for Essity to increase margins to similar levels like competitors. I think they have especially strong products for growth in Asia, for example through their majority holding of Hong Kong listed Vinda. I have considered investing in Vinda instead, but I see more room for multiple expansion in Essity and also a more diversified holding (less concentrated on China).

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New holding – Catena Media

After listening to interviews with both the CEO and the largest owner of Casino and betting affiliate Catena Media, I started to understand this niche market a bit better. I decided to take a position in this gaming industry niche. Gaming affiliates has been a pretty murky business, with a high number of very small companies (more or less one guy sitting at home creating a homepage). But it has also been an insanely fast growing and lucrative business. Catena Media is organically and by acquisitions building up to be a large dominant player in this market. They recently took a step to invest in the Japanese market. It probably won’t be easy to break through in the Asian markets, but the Swedish gambling companies are very much at the forefront in general. So this can be a first step towards new growth for Catena.

This is a high risk position, but I feel I have space to take risk in my portfolio right now, cash-levels are very high and I lowered my Beta my taking less bets on China and buying more quality companies. So I initiate this at a 6% position, since I believe it is a good entry point, where the market has oversold this holding on scares of majority owners exiting the company. Which was in a pretty clear way denied, by the majority owner in a recent interview. Also the company looks cheap valuation-wise. A full analysis might come at a later date, but right now I’m focusing on finding more new investment cases.

 

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Sell BYD and EV mania

Sell full BYD holding

A quick post to state that as of today’s close I sold my full remaining position in BYD.

EV mania

When I started this blog 1.5 year ago the first EV mania wave had passed, Tesla had been treading water in the 200 USD range for a few years. But I was convinced that this rally still had more steam, the wide public had not yet caught this massive change that was upon us. Now I would say everyone is on the “EV-train”, in the sense that everyone now believes EVs will take over the world in the coming 5 years. I have no idea how far this EV-mania can go, perhaps are we still in early stages and valuations will double from these levels. But I feel the easy money has now been made. I was right, EVs are taking over, now the whole world agrees and anything touching EVs is rallying like no tomorrow. Look at the Global X Lithium & Battery Tech ETF share price and traded volumes.

LIT_ETF_perf

So for me this it the time to start being cautious, be thankful that the investment thesis worked and stop being so heavily tilted towards this theme. Outside of this “blog fund” I also been invested in this ETF, which I now also sold.

Portfolio wise I still have 2 holdings geared towards EV exposure, LG Chem and Coslight. For the long-term I keep LG Chem, will I believe will be one of the big battery providers to the western car makers. I also keep Coslight which as a small cap is still at a low valuation, and I think there is a potential for a multiple expansion if this mania continues. It has lately also sold parts of its battery factory for laptops, to gear itself more towards batteries for the Chinese EV market, which I don’t think the market really picked up on (yet).

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The Perfect Storm – Teva – Part 2

Recent development

This is the continuation of my post (Teva – Part 1) more than a month ago on Teva Pharmaceutical Industries. At the time the ADR was trading at about 18.5 USD per share. The share price would continue to deteriorate over the coming month down towards a low of 15 USD per share. But a week ago the stock made a huge jump upwards after the new CEO was announced. So before we dive into the valuation, let’s look at recent development.

The 3 billion CEO

As was mentioned Teva has been in a long (and desperate) search for a new CEO. When it finally was announced that Kåre Schultz, the danish drugmaker Lundbeck’s CEO has taken up the position, the Teva share rallied about 20% and increased Teva’s marked cap with about 3bn USD. At the same time Lundbeck saw it’s share drop with -13%, so the value of a CEO can apparently be very big. I suspected a pop the day the CEO was announced, but this was way out of proportion in my oppinion. Showing Teva’s desperate state is the size of Schultz sign on bonus, which all-in amounts to about 44 million USD, with 20m in cash. Nicely done for some who earned the equivalent of $6.1 million in salary and bonus last year!

Looking at what Schultz has accomplished. Schultz comes with a strong track record at Novo Nordisk and lately as Lundbeck CEO where he navigated the company through a difficult period that saw patents expiring for its biggest drugs. He cut about 17 percent of the workforce and oversaw a $480 million restructuring and brought a number of new medicines to the market. Lundbeck is now on track to report record sales and earnings this year and its stock price has almost tripled since Schultz’s appointment.

So this is obviously a big positive for Teva and it increases the probability for a successful execution of their very crucial strategy going forward.

Asset sell-offs

Teva needs to sell assets to meet debt covenants. I have been trying to build an model of future cash-flows over the last few weeks. One of my starting assumptions was around the anticipated asset sell-offs. I spent some time trying to estimate how much Teva would be able to get for it’s “non-core” units. This exercise became less meaningful now, since half of the asset sales already been announced.

Women’s health unit

What has been announced so far, in 2 tranches, is Paragard and the rest of the Global Women’s health portfolio, for a total sales value of 2.48bn USD. Here I have to say that Teva surprised on the upside. In my estimates I had a range for potential sales value of about 3-6x Sales, with me leaning closer to the 3x Sales valuation. But here they got paid close to the 6x range for the whole unit. It seems the Paragard unit which sold for 1.1bn USD with sales of only 168m USD, was worth a lot more than I anticipated. Well done Teva!

Future asset sales

I previously assumed that Teva would want to sell it’s Respiratory business to bring in enough cash, but it seems they got paid enough for the Women’s health unit, to be able to keep it. Which brightens my analysis of the future somewhat. The other unit up for sale is the European Oncology and Pain unit. Again it’s hard to guess on multiples, but sales 2016 was 285m USD and high estimates of valuations has been in the 1bn USD range. So I will assume 1bn and with that sell, in total shaving off a total of 3.5bn on a 35bn USD debt burden.

Valuation discussion

It has not been an easy task to come up with detailed estimate of Teva’s future cash flows. The Generics business is at an infliction point, where margins have been expanding for a number of years for all companies. As with most businesses, when margins gets more attractive, competition moves in. As we will see from my analysis, the million dollar question for Teva’s future is how will margins for Generics products develop over the coming years.

Teva has two main business units

The two main business units are: Generics and Specialty Pharma (meaning mostly pharma under patents). The two units are further split into the following and also a “other” unit:

  • Generics (Sales 11,990m)
    • US (4,556m)
    • Europe (3,563)
    • Rest of the World (3,871)
  • Specialty Pharma (Sales 8,674m)
    • Copaxone (4,223m)
    • Other CNS (1,060m)
    • Respiratory (1,274m)
    • Oncology and Pain (1,139m)
    • Women’s Health (458m, now sold)
    • Other Specialty (520m)
  • Other Revenues (1,239m)

Although Generics Sales is higher, the total Operating Income is slightly higher for Specialty Pharma, given its a higher margin business. In my analysis I try to forecast at least partly on this sub-level.

Assumptions – Future Generics market is the key

I quite quickly realized that valuing Teva is about understanding how the Generics market will look like in the future. Up until now Teva has managed to substantially increase its margins on Generics, so has also other companies, like Actavis that Teva bought. With margins now decreasing, both due to pricing power of major buyers (See link) in the US, as well as increased competition from Indian and Chinese players, the investment case might look very different. One the other hand, the sales volumes of generics seems to have a continuously bright future. Generics sales have exploded over the last decade, but with more big drugs falling out of the patent cliff as well as countries pushing for usage of generic alternatives to lower costs, it seems plausible that growth continue at an above market rate.

The more I read about Generics, it looks like any other maturing market with limited barriers to entry. Volumes go up, margins come down and left are the largest most skillful players who can use its scale to out-compete smaller players. So what is left to find out is if Teva is one of those players, has the market in its panic priced Teva way too low, even if what is left is a lower margin business but with good volume growth over the coming 10 years.

Assumption Details

Given that Teva is such a huge company, it’s very hard to accurately model each units future cash-flows but hitting the right assumptions for revenue and margin. I have focused on the broad picture and spent most of the time trying to get the figures right for Generics and Copaxone. It would be too lengthy to go into all the assumptions on margin deterioration and sales.

  • For both business units when calculating margins, R&D, Selling & Marketing and General & Admin expenses has been added into the cost structure. For a bull case, more synergy effects from the merger have been assumed than in the bear case.
  • Discount rate in Bear Case 10%, Base Case 9% and Bull Case 8%. 1% change in discount rate, changes valuation by about 2-3 USD per share.
  • 31.5bn USD debt assumed

Copaxone and other Specialty Pharma

Copaxone is a case about it’s patent expiring on it’s 40 mg drug. It’s not so much a question if the patent will expire, but just how soon, and how quickly generics will take over the market. Here are my assumptions on Specialty Pharma:

copaxone

otherspecialty_Teva

Generics Markets

Teva does not specify how much of the recent margin deterioration in Generics is affecting the different regions. But since Teva still produces Actavis Sales numbers separately, together with total sales numbers, one can back out, at least an approximate Sales deterioration per region. The Sales deterioration is not due to less sold drugs in volume, but due to margins shrinking so quick that top line decreases. What is not really mentioned by Teva is that “Rest of the World” margins and revenue is suffering even worse than the US market, while Europe is seeing more of a mild margin deterioration. I therefore make different revenue decrease assumptions for the different regions. Unfortunately Teva does not produce Generics margins for the regions, so only Sales numbers are modeled with such detail. I have used what I can find in terms of short term and long term forecasts for the generics market.

generics_revenue_teva

generics_grossmargin_teva

generics_operatingmarg_teva

Total

The Total becomes mainly a combined effect of Copaxone income falling off a cliff and the future for the Generics market:

Teva_totaloperatingInc

Other costs

Teva is very good to hide costs and show PowerPoint presentations with very hyped up figures, showing figures excluding for example Legal settlement costs, which is more or less a re-occurring item every year. So on top of the business units Operating Income above I have afterwards deducted legal and settlement fees of 500m USD per year.

The issue with leverage

Naturally with leverage the company becomes more risky, how much more risky is really shown in a DCF of the above cash-flows. I value the company including it’s assumed remaining debt of 31.5bn USD, meaning NPV of Cashflows has to be larger than the debt, to give a positive value to equity. This is of-course does not become a realistic case close to zero equity value. Since an option value kicks in, the option that the companies future cash flows will improve.

But this leverage also makes it more easy to understand why some analyst has a buy recommendation with a target price 100% above current market price and others come to the conclusion it’s still a sell. The difference in assumptions is actually not that large.

Valuation results

Bear Case

The bear case gives a negative equity value of about -2 USD per share, accounting for option value and dilution, the value per share is set 3 USD.

The meaning of this result would be there is only option value left (as described above). It also gives an indication of how hard it will be for Teva to service it’s debt, especially if funding costs goes up for the company (which it will, when cash flow deteriorates). If funding cost reaches 10% as the WACC in my DCF, then the company really can’t service it’s debt anymore on the cash flow it generates. There is really a non negligible probability for the company defaulting, then one can argue that the Israeli state would never allow that, and that it probably true. The bear case anyhow, indicates a share price with possible future share dilution in the low single digits.

I would give this cash-flow scenario a probability of about 20%

Base Case

The Base case gives a share price of 14 USD per share.

I have done my best to try to estimate a realistic base case scenario for Teva, short-term and long-term. Against the Base case Teva currently is slightly over-valued and before the CEO announcement was fairly valued. The panic pricing I had anticipated before my analysis rather came out as being in-line with my base case.

I would give this cash-flow scenario a probability of about 60%

Bull Case

The bull case gives a share price of 43 USD per share.

Here the company manages to execute on all it promises and also very optimistically margins of its Generics business improves again in 2018 and onwards. On a gross margin level, they will still slightly decrease from the best levels seen, but thanks to synergy effects, the operating margins come out very good. Also Copaxone generics versions will be delayed by a couple of years. I have found only one example of a generics company that lately managed to keep its margins fairly stable and that is Perrigo, but they still state they expect weakening going forward (Perrigo surprises). So the expectation of a quick turn-around in margins is very optimistic and rather a blue sky scenario in that sense, rather than a very realistic bull case

I would give this cash-flow scenario a probability of about 20%. I think the CEO hire has taken this probability from 10% to 20%.

Summary

Weighted valuation: 20% * 3 USD + 60% * 14 USD + 20% * 43 USD = 17.6 USD, which is 10 cents from where it is trading at this moment.

To be able to buy the stock, either the stock price needs to go lower, or the probability for the bull case needs to go higher. As soon as the market sees that generic margins are not turning as bad as expected, the stock has as we can see great potential. This explosive share price potential is of course due to Teva’s very heavy leverage. But this kind of leveraged bet on the generics market is not anything I’m willing to do without a serious margin of safety. I would not be comfortable to buy the Teva stock before we see almost a single digit stock price. Therefor my recommendation right now is wait and see. Most likely they will deliver another larger good-will write-down during next year, since the cash-flow the Actavis division is generating is nowhere near what they paid for it (they need to shave off probably another 8-10bn USD). Since Teva is such a large and complex company, this analysis has taken a lot of time from researching other interesting stocks, so somewhat frustrating to come to the this conclusion, which was somewhat surprising to me.

As always, any comments are highly appreciated.

 

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Another Portfolio change

Defensive is my new offensive

So I continue my quest of reducing China exposure and finding good defensive plays. My portfolio changes are the following as of market closings today (Tuesday):

  • Buy 6% of my NAV into Gilead Sciences
  • Add 50% to my current holding in Xtep International
  • Sell 40% of my current holding in BYD
  • Sell my full holding in CRRC

All in all this slightly reduces my very large cash position. Some quick comments on the changes:

Gilead Sciences

As I have mentioned in several posts, I have been circling the Pharma sector for quite some time now. Since it is, at best, a murky area to try to estimate the value of a big companies research pipeline, I have struggled to come to an investment decision. It’s easier with companies where current cash-flow motives more of the value. I tend to end up a bit too much on Seeking alpha, trying to find people who do understand the intricate details of this industry and especially the pipeline. Someone that I do trust though on the topic is Martin Shkreli, who freely shares on his thoughts in his Youtube streams. He is a fan of Gilead lately (when the valuation has come down). That gave me some comfort to keep looking at the stock. After seeing this (WertArt Capital on Gilead) very in-depth review of Gilead, I realized I might be a bit late to the party. But nevertheless, I want exposure to the sector which I feel have come down valuation wise and is defensive. Giliead is the best I have been able to come up with after a long search. I feel confident enough to take a position at what I believe is still a decent entry point, with some confirmation that the down-trend is broken.

XTEP International

The case is simple, if this company is not a fraud, it is undervalued. All other Chinese shoe companies have continued to perform fairly well and outperformed XTEP. This might be the ugly duckling, but I don’t believe it is THAT ugly. We will also get a very quick answer on my bet, since the earning report is released tomorrow, I’m hoping for a +10% pop upwards in the stock-price.

BYD

The countries outside of China keep disappointing me in how much they dare to commit to electric buses, it’s already proven to work fine in China. This is where BYD is very strong and have a top product. On top of that I still don’t see BYD releasing a car anything near to Tesla Model 3 or Chevy Bolt, so my thesis from over a year ago, that I’m unsure of BYD’s success in the car market, stays the same. I haven’t given up on BYD, but I could see this one visit the high 30’s again and choose to reduce my position.

CRRC

This was my Belt and Road play, perhaps somewhat sloppily implemented. I decided to not invest in the theme before I understand it much better than I do right now. It has a holding I don’t have a strong view on and selling it reduces my China exposure, so out it goes.

My next post..

..will be about Teva. I have been very occupied lately and I still need some time to dive into the details. So stay tuned for Part 2 and let’s see if it becomes a new investment or not.

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Portfolio changes

I made a mistake..

when I bought XXL 1.5 month ago. The Norwegian sporting goods retailer is expensive without continued growth that I knew. But how solid is the ground in their home markets? After both visiting one of their stores and not having the same positive feeling as before (maybe too much Peter Lynch here) and reading an article from one of their competitors about the very tough environment I started to turn more skeptical.A podcast that I followed woke me up to the fact that I have probably overpaid. I realized today I have probably underestimated the risks in the company. Luckily I’m in USD terms able to come out at a very slight loss. So I reversed my decision today and selling the full position as of today’s close.

Something that I did right..

was buying Skandiabanken when I started this blog. Not my fastest, but a very steady and my largest gain (+120%). During this time the stock has gone from trading at a slight discount to the large banks, to today trading at a good premium. Just as it should be in my opinion, with it’s superior growth rate. But this bank is almost entirely reliant on the Norwegian housing market, which has been in a slide for some time now. Nothing major, and probably it is fine but for the first time I see some clouds on the horizon. Judging from how hot the Swedish property market is and I know the Norwegian one is in a similar state, there is some worry. Any kind of further outside shock which creates higher unemployment could trigger something very nasty. Now it’s up to the company to keep executing and stealing market share from the big boys. I think they can do it, but any failure will set the stock price back now. So I will reduce this holding just before their earnings release, take some handsome profit and keep a smaller position as a long term case. I sell 60% of my holding as of today’s close.

A new defensive..

..in my portfolio. Already as a kid studying finance, I found out that I could increase my Sharp ratio by adding Swedish Match to my portfolio. It didn’t have the highest returns, but it had this wonderful characteristic of being negatively correlated to the rest of the market. That did wonders in terms of risk adjusted returns. Swedish Match does not anymore have a negtive Beta, but it is very defensive and very well run company. There is some huge political risk if for example the European Union would manage to ban snus in Sweden, but I see it as highly unlikely. I start with a small position of 4% and I intend to look at more tobacco companies going forward. I would also be very interested to hear your thoughts on the E-cigarette/Vaping industry, if you believe in that, what would be the best way to gain an exposure?

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The Perfect Storm – Teva – Part 1

Teva Pharmaceutical Industries

I have had Teva on my watchlist for a while now. In my spare time I scan the market for many companies and recently quite many have been Pharma companies. A few of them has sparked my interest and Teva was one of them, at the time due to the “low” valuation and attractive dividend. So I kept it on my watchlist without taking further action. A few days ago when the stock lost another 30% after news that the company risks a breach of bond covenants, I decided it’s time to take a closer look. Teva is a huge and well researched company, I might need to spend weeks analyzing every detail of the company and it might still be hard to get any edge knowledge wise. But, I think that matters less right now. I think something else is dictating the market value of the company. Right now that is investor panic and fear, which is fairly obvious if you look at the stock performance below. So without having a very deep insight in the company I take a stab at this to see if there is a case for taking a position.

Teva_shareprice

 First some background on Teva

To understand why we today are looking at such a sharp stock decline, we have to look at Teva’s history. First starting with some general company background. Teva Pharmaceutical Industries Ltd. is an Israeli multinational pharmaceutical company headquartered in Petah Tikva, Israel. Teva specializes primarily in generic drugs, but also has patented drugs. The main patented drug, Copaxone, has been the companies largest cash cow for many years. Teva is in fact the largest generic drug manufacturer in the world and if I have understood things correctly a very important part of Israels economy. Many Israeli are proud of their Pharma giant, which has grown to a world leader. Teva shares trade on both the New York Stock Exchange (via ADRs) and the Tel Aviv Stock Exchange, the main volume of the stock trades through the ADR.

Teva has a very long history, the modern day Teva was formed in 1976, so it’s hard to give a comprehensive backdrop. As many Pharma companies it has grown through a number of acquisitions throughout the years. Some larger acquisitions were made already before the 08 crisis, but it was really after 2010 that the shopping spree began.

5 year spending spree

The is just an overview of the largest acquisitions made from 2010 onwards. This is important obviously because of the assets that now form Teva, but also to understand how Teva’s huge amount of debt (which we will come back to later) was built up.

Teva started of in 2010 and acquired German generic Ratiopharm for US$5 billion. The deal was completed in August 2010. In May 2011, Teva bought Cephalon for US$6.8 billion. The same month, Teva announced the ¥40 billion purchase of a majority stake in Japanese generic drug company Taiyo Pharmaceutical Industry, a move to secure a Japan-local production facility. Teva completed the $934 million acquisition on July 2011.  In June 2014, Teva acquired Labrys Biologics for up to $825 million, the aim being to strengthen the company’s migraine pipeline. In March 2015, Teva acquired Auspex Pharmaceuticals for $3.5 billion growing its CNS portfolio.

And after 5 years of intensive fairly large scale buying. One would think that Teva probably planned to slow down a bit and consolidate, no, not at all. In April 2015, Teva offered to acquire Mylan for $40 billion, only a fortnight after Mylan offered to buy Perrigo for $29 billion. Teva’s offer for Mylan was contingent on Mylan abandoning its pursuit of Perrigo. However, both Mylan’s bid for Perrigo and Teva’s bid for Mylan were rejected by the boards of the intended acquirees. Things became messier almost by the day, as Mylan activated a “poison pill” defence against Teva. The entire process could have degenerated into a nasty, lengthy and very expensive legal battle, had a “white knight” not emerged, totally unexpectedly. This was Brent Saunders, CEO of Allergan — the pharmaceutical giant that had emerged from a rapid-fire series of mergers. The essence of the deal Brent had was simple: Teva will buy Actavis, which is the generic arm of Allergan, so that Allergan exits generic pharma and Teva becomes a bigger and more powerful player in that sector, cementing its position as global leader. And so it became, Teva paid $40.5bn ($33.75 billion in cash and $6.75 billion worth of shares) for Actavis. It followed that up with being Allergan’s generic distribution business Anda for another $500m and  in October, the company acquired Mexico-based Representaciones e Investigaciones Medicas (Rimsa) for around $2.3 billion.

To read the full story of this “mess” where Teva bought Actavis I recommend this article: Why Teva Paid $40.5 Billion for Allergan’s Generic Business.

Copaxone

Capaxone the world’s best selling MS drug for treatment of Parkinson’s disease has generated a substantial part of Teva’s revenue/profit over the years (20% of revenue and 42% of profit last year). The Copaxone 20mg patent expired in 2015 and Novartis subsidiary Santoz is now selling a generic version. Teva has extended it’s patent right by introducing a new long-lasting Capaxone 40mg dosage. Teva obtained new US patents covering pharmaceutical formulations for long-acting delivery. Litigation from industry competitors in 2016-2017 has resulted in four of the five new patents being judged invalid, and the fifth remains under challenge. The case reflects the larger controversy over evergreening of generic drugs. At the same time as they sue Teva, Sandoz is now also developing a long-lasting 40mg generic called Momenta Pharmaceuticals M356.

Cash generating company

We will soon move over to a lot of nasty negatives, before that, we should know that Teva has been a very cash generative company, partly due to Copaxone, but also thanks to other parts of the business. Coupled with strong dividend payments one can understand that as long as the business has shown good profits it has been a fairly attractive investment case (although one have had to turn a blind eye to the debt pile).

dividend_history

Although GAAP numbers are far from perfect, I prefer to use those over the numbers Teva wants to focus on, where a lot of adjustments are made. This is back to basics, not trusting anything but an accepted accounting standard (although there is plenty of room to fiddle around with those figures too).

netincome_gaap_teva

Recent events

Although this is not the first time the company is forced to Goodwill impairments, it was still a massive blow a week ago when Teva needed to announce a large write-down on it’s US generics business, which is related to the Actavis acquisition. The impairment was $6.1 billion, and although it’s not a cash outflow now, it shows how the company overpaid for Actavis from Allergan. From a GAAP earnings perspective it will also affect the Net Income. If it had only been a goodwill impairment things would still have been OKish, but second quarter earnings fell short, the company warned that if proceeds from divestment or cash flow fall short, the company could breach debt covenants with lenders. It therefor slashed dividends with 75%.

Due to this Teva has also announced the intention of divesting non-core companies, to raise cash.

So lets list all the negatives

I would argue that almost everything that could go wrong, has gone wrong. And the worst part seems, most of it is still far from solved. In my opinion Teva really is in a perfect (shit) storm right now. I will list all the negatives I have been able to find over the last few days of due diligence.

1. Debt

You all have understood by now that Teva has amassed a huge debt pile and risks to break it’s covenants to it’s debtors. Teva’s MCAP today at 18.5 USD per ADR is about $18.8 billion, whereas it’s debt is a grand total of $34.7 billion. With everyone focusing on this debt and the risk of the company not being able to meet it’s obligations, it’s very important to look at the maturity profile. As with any debt, it’s easier to survive if you just need to pay the interest, rather than paying back principal. Teva is still a cash generating company and if given time, should at least in theory be able to survive this, if the just have time. This is the maturity profile of the debt

debt_dist_teva

As we can see, Teva does actually have a bit of time. Nothing of it’s debt does actually mature before 20th of July 2018, then 1.5 billion USD of bonds mature. That amount the company should be able to scrape together just from the cash the business generates. It’s actually all smooth sailing until Q3 of 2019, when a huge amount of debt matures. So if Teva is not allowed to roll the Term Loan they need to come up with about 4.5 billion USD in cash and they basically have 2 years to do it, most likely by sales of parts of it’s business. Is that a tight deadline? Yes I would say so, but far from impossible to execute. If all debt including Q3 2019 is paid off, the debt load of Teva will have shrunk by almost 10 billion USD and if the business generates cash at same levels as historically, that should be manageable. But that might be a big if, which leads us to the next negative.

2. The Generics industry

By buying Actavis, Teva doubled down on the Generics industry, one would hope that was a good bet. Well short term it does not really seems so. The pricing pressure on generics seems to have increased a lot lately. The U.S. Food and Drug Administration sped up drug approvals, flooding the market with products from smaller companies that compete on price, while pharmacy chains and retailers began consolidating their orders to the point where four groups account for 80 percent of the purchases, Teva said on its recent earnings call. So they doubled down on a business which is in a decline, at the same time as they are in dire need of strong cash flow to meet the debt obligations.

So how bad is this pricing pressure, short term and long term? Well that is very hard to say. But without knowing all the details about the generic drug markets, reasonably the worlds largest player should have a scale advantage and a distribution advantage to smaller players. So the margins might be smaller than in the past, but as a well run company that ought to be positive at least.

3. Company Leaders

Again, we have already understood that some of these acquisitions that were made during the last 7 years, were value destructive for shareholders. So from that point of view the management and board of the company has failed the shareholders. In a time of crisis one would look to a strong CEO to steer the ship through the storm. Well the next problem is that the company hasn’t managed to find one. The previous CEO Erez Vigodman was ousted in February 2017 and currently Yitzhak Peterburg acts as the interim chief executive. A very odd appointment, given that Yitzhak was chairman of the board of directors which supported the Actavis bid. The current chairman, Dr. Sol Barer, said that in the past six months he has devoted all of his energies into appointing a permanent CEO. Barer said repeatedly that the next CEO will be a person of stature with extensive experience in the pharmaceuticals industry. This requirement makes Peterburg’s candidacy irrelevant.

Benny Landa the largest active private investor in Teva, did not go easy in his latest round of comments: “Landa adds that someone on the board of directors is trying to undermine the efforts of Teva chairman Sol Barer to bring a CEO with an international reputation to the company. He explains, “There’s a person on the board of directors on whom we pinned great hopes — Sol Barer. We assumed that he would be able to bring a well-known CEO to the company, but it’s clear that someone on the board of directors doesn’t want him to succeed, and is trying to undermine his efforts.”

So there is plenty of drama to go around in the upper echelons of Teva management now when they have a crisis on their hands.

4. The 100 million shares

Another “small” detail when Actavis was acquired, was that part of the payment was in Teva shares, 100 million of them. Meaning that Allergan is the largest shareholder in Teva, holding 10% of outstanding shares. The lock-up on those shares happened to expire a little bit more than a week ago. Allergan has stated that they have no intention to stay as shareholders in Teva. That is a pretty big overhang on the stock. They might have sold some already, the stock has turned over about 300 million shares in the last 3 full trading days. But it would surprise me if Allergan got it’s 100 million shares out in the middle of that selling panic, I think honestly the share would have traded down much more than that. A lot of volume in these cases is not true sellers or buyers, but traders flocking to a highly volatile stock, buying and selling back and forth, creating huge turnover. Most likely they are still sitting on all the shares, a lot less rich than just 4 days ago.

End of Part 1

This is the end of Part 1, in Part 2 we will make an attempt to see if its worth to try to catch this falling knife. Since we are in the middle (or at the end? Stock trading up right this moment) of the free-fall. I will try to be quick to produce a follow up. Although as we see from all the listed problems above, the will most likely not have gone away, by next week, or perhaps not even by next year. Anyhow this might be the first investment case I present, which I will not invest in, depending on where the stock trades when Part 2 is finalized. Right now I don’t know the answer either, so please fill in with your comments to help me make a wise decision in Part 2.

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The USD effect & Portfolio comments

The USD effect

I want to start with a graph of EURUSD, because it has such profound effects on the market when it starts moving.

EURUSD_20170807

With the risk of being called something of a Chartist, to me this is a significant move. We are breaking out of a 2 year side-way trend. This could be the beginning of the normalization of major currencies, where we see EURUSD moving back to it’s previous range 1.20-1.50 which lasted for about 10 years. What is a normal range though? It all depends on what time perspective you take. If we look at 30 years of data, we are today already very close to the average exchange rate. The 360 month moving average is at 1.21 and the 500 month moving average is where we are now, at 1.18. If EURUSD moved to for example 1.4 over the coming year, that would definitely have profound effect in the stock markets and on all ours portfolio returns.

EURUSD_20170807_30y

Exporters vs domestic

The kind of currency move we see now, leaves its mark on a Global portfolio and it’s returns. The effect is largest for domestic companies. For example if we take my largest holding Skandiabanken, which is a Nordic online retail bank, generating majority of it’s revenue from Norwegian Krona (NOK). Since all it’s costs and revenue is in NOK, its a purely domestic company. So when USDNOK moves, the portfolio experiences the full currency move, whereas the fundamentals for the company stays the same. Since investing in Skandiabanken I have realized an extra 6% return from the NOK strengthening, pure luck!

In comparison my holding in LG Chem, is traded in Korean Won (KRW). But the company exports all over the world meaning a lot of it’s revenue is priced in USD. So if KRW strengthen against USD, the company will earn less in KRW terms and the stock should fall. At the same time the KRW stock price is worth more in USD terms, so the effect negate each other.

This means that companies that mostly sell domestically adds an extra component of FX-risk into the portfolio. To make it even more complicated, the domestic company might have it’s cost in USD and chose to either hedge it or leave the currency risk open. If you as an investor compare yourself to a benchmark, your definition of taking risk in this sense, is if you have another mixture of exporters vs domestic companies, per market, compared to the benchmark. This will make you over and underweight a number of currencies. It all sounds very complex, but since weightings of for example MSCI World is so heavily tilted to the larger markets and large companies, in effect, you mainly have under/over exposures to a few major currencies (USD, EUR and JPY). The tricky part is that you won’t really notice this effect, before one of the major currencies really start moving, like now.

Conclusion?

So what’s the point of this analysis? My point is that major benchmarks is made up of large companies with revenues worldwide, so the majority of your portfolio from a Global benchmark will be USD exposure. But if you as a stockpicker, find smaller domestic companies, which have their revenues and costs in a local currency (either naturally domestic or hedged to a domestic currency). You will have an implicit bet on that currency versus the USD.

The reason why I bring it up, is because two of my holdings that have performed the best, is such holding, Skandiabanken and Ramirent. It’s nothing I lie sleepless at night about, just something to keep in the back of your head before you fill your portfolio with such holdings.

Portfolio Update

A quick look at the portfolio performance and composition shows continued strong performance, both for my holdings and the benchmarks. Especially Hang Seng is on a tear lately, somewhat frustrating when I already have come quite far in rotating away in my Chinese holdings (and the ones I have left have not really moved). For example my two previous large positions in Ping An Insurance and YY has in the month after I sold surged 15% and 33% respectively. Whereas the stocks I bought in Europe have trades more or less sideways (Tokmanni being the exception), I have also been somewhat saved by the weakening USD in these holdings. Cash level is still high, as always I’m spending a lot of timing searching the markets for something investable. And as always lately struggling to find anything worth buying. In my Portfolio page I have made my Watchlist a bit longer (in reality it is much longer than this) but maybe those stocks can give you some investment ideas.

Graph_20170805

Holdings_20170805

Going forward

I will take one final slash sometime this year, to further reduce my China exposure (it will not go to zero as long as I find very interesting investment cases there). And according to my previous post about “where to hide”, I will try to move my portfolio one more step defensive (less cyclical) than it currently is.

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