Bayer AG

Three Catalysts In Three Segments

Valuation Spreadsheet

Business Overview

Bayer is a life science company that operates through three channels. Pharma, Crop Science and Consumer Health.

Pharma generates 43% of revenues. Bayer’s pharma operations specialize in cardiovascular and cell and gene therapy, and oncology sectors. Pharma’s revenues are majorly derived from Xarelto, Eylea, and Mirena/Kyleena/Jaydess blockbuster drugs contributing 8.1 billion EUR of Pharma’s total sales of 14.1 billion EUR. In addition, Bayer has invested in cell & gene therapy and oncology markets to prepare upcoming products. Bayer’s next blockbusters are expected to be Nubeqa, Finerenone, and Elinzanetant, operating in oncology, cardiovascular, and women’s health markets.

Crop Science contributes 50% of revenues. However, in 2020 crop science was a drag on Bayer because of lower-than-expected sales, losses from currency fluctuations and glyphosate litigation resulting from the acquisition of Monsanto.

Consumer Health (CH) generates 13% of revenues. In 2020 CH grew by 5.2% through effectively leveraging e-commerce. In addition, CH improved incremental EBITDA margins from 21% to 22% through finding product cost efficiencies and digitizing its supply chain.

Stock performance

Through 2020 Bayer’s share price has had significant volatility; however, it has ended down ~5% even with most of the glyphosate litigation behind the firm and robust growth in the core business through the pandemic. Bayer’s dividend yield is 3.7%; this should increase modestly as Bayer’s management has committed to paying 30-40% of operating cashflows out as dividends.

Thesis

There are two types of company’s worthy of an investment.

  1. Companies that are undervalued because they compound at a high rate and become increasingly valuable.

  2. Companies that are cheap enough where you are almost guaranteed to make a profit. Enjoy the last puff.

Bayer has the potential to become a compounder; it benefits from multiple tailwinds, exhibits economies of scale and scope and has challenging to replicate expertise in developing complex products in two core verticals, Crop Science and Pharmaceuticals. Bayer’s Consumer Health segment is a strong cashflow generator that can grow by expanding in emerging markets; high cashflow generation allow this segment to take additional leverage lowering Bayer’s cost of capital.

Right now, I would recommend an investment in Bayer now because it is cheap. Investor sentiment is at an all-time low providing an opportunity to invest in a leading health science company at rock bottom prices. Please see the assumptions tab in the attached excel file for my revenue growth expectations, and please see the DCF tab, which shows the impact of assumptions on valuation.

Catalysts for Bayer re-rating towards Comps include.

  1. Concluding glyphosate litigation

  2. Crop Science division's rollout of fourth generation soybean traits.

  3. Commercialization of late-stage pipeline drugs Nubeqa, Finerenone, and Elinzanetant - Projection for Finerenone dived into in internal analysis

Company Industries Overview

Bayer operates in three different industries; its largest revenue source is the Global Fertilizers and Agrochemicals (GFA) market, followed by Pharma and Consumer Health.

Crop Science

The GFA market has undergone significant consolidation. Major events include Bayer acquiring Monsanto (the previously largest player in the GFA market) and the merger of Dow and Dupont, creating Corteva. GFA market is a ~$100 billion opportunity broken down into two groups Crop Protection (CP) 60% and Seeds 40%. The GFA market is critical to sustaining and growing global populations. Bayer has a strong position in both markets, with 21% and 25% market share in CP and Seeds, respectively.

The GFA market is driven by global population, available agricultural land, average crop prices, and price of inputs (natural gas and oil). As inputs to this industry are commodities, there is limited power of suppliers.

GFA producers benefit from two secular tailwinds world population rising and agricultural land decreasing. First, the global population is expected to reach 10 billion by 2050. Second, climate change is expected to decrease harvest yields and arable farmland in developing and low-income countries. In contrast, developed countries can convert forests to agricultural land to increase available farmland; however, developed countries cannot continue this practice indefinitely. These two secular tailwinds ensure that the GFA market grows at 2-3% annually.

The GFA market enjoys high margins, with major players enjoying EBITDA margins in the high-tens to mid-twenties. High margins are achieved because customers are highly diversified, and there are no substitutes for CP or Seeds. High R&D needed to compete in the GFA market creates high barriers to entry. This market structure enhances the need for economies of scale to spread R&D and other expenses over a large customer base; an oligopolistic market structure is seen as five leading players in the space acquire and merge to create ever-larger firms.

Pharma

Bayer competes in the global pharmaceuticals & medicine manufacturing market (GPMM.). The GPMM is a $1.3 trillion opportunity. The GPMM is highly fragmented, with players carving out niches in the space. This industry’s key external drivers are an ageing population, per capita healthcare spend of OECD countries, technological change, and global per capita income.

The GPMM benefits from two tailwinds: developing countries increase in wealth, and western populations continue to age. As Western populations age, spending on healthcare by OECD countries will continue to rise to meet population needs and significant increases in global per capita income increase the demand for medical products. Both tailwinds should allow the industry to grow faster than global average inflation.

Because of the extensive R&D needed to develop products, average EBITDA margins are north of 25%. High margins reflect limited supplier and buyer power. As base chemicals are the raw supplies for industry products, there is little supplier power; however, for firms that purchase patents, there is high supplier power as patents are unique and are sold to the highest bidder. In addition, products in their exclusivity period give the patent owner ultimate pricing power as there are no substitutes. However, substitutes become readily available once drugs lose exclusivity as generic versions are available at lower prices.

Bayer and most competitors meet these KSF’s; however, Bayer stands out as it has a robust biologics portfolio, limiting generic competition as generic bio-similar drugs are more difficult to develop.

Consumer Health

The consumer health (CH) segment is very similar to the Pharma segment. CH operates in a highly fragmented market, with an ageing populating and increases in per-capita incomes driving segment demand. Producers either manufacture CH products in-house through purchasing raw materials as commodities, leading to low supplier power or may outsource production leading to a higher power of suppliers. Buyers have significant power in this market as supermarkets and pharmacies usually carry these products and make them available over the counter, making it of paramount importance to have good buyer relationships. The threat of substitutes is also high as most CH products have significant direct and indirect competition, direct from generic’s, indirect from products with a similar outcome. The threat of new entry is low as there are significant R&D barriers to creating new CH drugs which can receive exclusivity and significant financial barriers to entry for generics that require investments in fixed assets to manufacture products.

The coronavirus pandemic has caused consumers to place increased emphasis on their health. As a result, health-related spending has increased by over 5% in 2020 vs 2019. Additionally, with consumers spending more time at home, they increase acceptance of personalized nutrition and increase purchases of healthcare items through e-commerce channels.

Internal Analysis

Crop Science

Bayer is an established leader in crop science, having a dominant position in CP and Seeds, ranking #1 in market position in three segments and 2nd and 3rd in the final three segments. Bayer’s revenues are well diversified, with seeds, herbicides and fungicides comprising 27%, 25% and 14% of sales. Comparing Bayer’s sales mix to the global agricultural input market (27% Bayer vs 15% global ag market), it becomes evident that Bayer is excessively reliant on its seeds segment. Bayer has significant revenues from the Seeds segment because Bayer acquired Monsanto, an industry leader in genetically modified seeds. Another remnant of Monsanto is a strong North American presence. As a result, 44% of Bayer’s crop science revenues come from North America, making up 24% of the global ag input market.

The main competitors in the agricultural technologies space are Corteva, Syngenta and BASF. Bayer has higher sales than all competitors in both CP and Seeds, allowing Bayer to exercise economies of scale, reducing its costs seen by its ~24% EBITDA margin vs comps, which average ~18%. Greater sales and margins allow Bayer to have a sustained competitive advantage through R&D economies of scale, having over 2 billion EUR in R&D spend comprising ~ 10% of sales vs comps which spend anywhere from 400 million to 1.5 billion EUR on R&D.

Bayer’s higher R&D spend created a robust pipeline with key new products being introduced in all three critical areas of CP (herbicides, fungicides, and insecticides), which are expected to grow crop science revenues by north of 4% annually. In addition, new product launches focusing on emerging markets have the potential to reduce Bayer’s reliance on the North American market.

Risks to the crop science division include

·       Higher losses from glyphosate litigation

·       Consumer’s voting with dollars to reduce GMOs in foods

·       Volatility in commodity markets reducing demand and margins on products

·       North American “Next-Gen” corn and soybean upgrades receive poor reception

The crop science division faces risks; however, Bayer has adequately prepared for these risks. Bayer has set aside over 13 billion EUR in reserves for litigation which is wrapping up. Well-off consumers in western countries may use dollars to vote against GMO crops; however, less well-off consumers worldwide and especially in developing countries will see significant benefits from using GMO products. Although a flawed rollout of next­-gen seeds would increase demand for current-gen products, over time, I believe that farmers will choose to use next-gen products as they increase harvest potential and profits through lower maintenance and faster/more efficient growth.

Pharma

Bayer’s Pharma segment is a leader in the following therapeutic areas with revenue breakdown

·       Cardiovascular – 37%

·       Hematology – 5%

·       Women’s health – 16%

·       Radiology – 9%

·       Oncology – 9%

·       Ophthalmology – 14%

Most of Bayer’s Pharma division is highly diversified in terms of available products; however, most pharma sales come from five products, comprising 9.6 billion EUR of 14.1 billion EUR in total sales.

Xarelto is the largest revenue driver for Pharma, with 4.5 billion EUR in sales. However, Xarelto’s forthcoming loss of exclusivity without another massive blockbuster coming out has reduced analyst’s expectations of Pharma’s revenues in the future. Xarelto lost exclusivity in China in 2020 and will lose exclusivity in key markets from 2022-2025, with significant revenue geographies losing exclusivity in 2024. Bayer expects to make up for Xarelto’s lost revenues by introducing three new products that it estimates will generate revenues of over 1 billion EUR each. Nubeqa, Finerenone, and Elinzanetant are the anticipated blockbusters. All three operate in different rapidly growing markets. Bayer maintains a strong product pipeline investing in oncology which analysts and the company believe will be a growth platform for the firm in the next three years. Additionally, through completing a series of acquisitions, Bayer has bought capabilities in the cell and gene therapy market expected to generate products post-2025 and signed 25 business development contracts expected to grow Bayer’s pharma pipeline.

Finerenone is particularly promising. Finerenone isn’t a general inhibitor and is better at targeting the MR receptor in kidneys than diabetes treatments such as Metformin, the current industry leader. As a result, Finerenone goes beyond the capabilities of Alpha-Glucosidase inhibitors or Biguanides (Metformin is Biguanide), which manages type two diabetes but does not prevent chronic kidney disease (CKD) Finerenone is the only drug that prevents CKD.

Finerenone is a big deal because, in America alone, 12.5 million are at risk of CKD. The number is anticipated to continue rising, with obesity a pre-cursor for type two diabetes on the rise. Harvard research shows that the USA has a 34% obesity rate, which they expect to reach 50% by 2050. Age is another risk factor, with developed economies experiencing a demographic shift towards older populations provides another tailwind for Finerenone sales.

Current products meant to manage type 2 diabetes must be taken three times a day, with each pill costing from 41-71 cents. Finerenone is anticipated to cost north of one dollar per pill and can be taken twice a day. My analysis concludes to reach one billion in sales, Finerenone only needs to capture 5% of the American market. Without including revenues from the rest of the world, we can comfortably say that Bayer is understating the size of this opportunity.

Consumer Health

Bayer’s Consumer Health (CH) segment provides products, services, and information to improve their health. Bayer is the #3 OTC player globally, with leading positions in seven of the top ten OTC markets. In addition, CH focuses on non-prescription products in the following markets.

·       Allergy, Cough & Cold

·       Nutritional’s

·       Dermatology

·       Pain & Cardio

Some marquee products include Aspirin, Claritin and Aleve. These and other OTC products generate ~5 billion EUR in revenues. CH has achieved a growth rate CAGR of ~2% over the past five years; however, CH has grown at 5.2% in the past year and achieved EBITDA margin expansion from 20.1% in 2018 to 22% in 2020. CH plans to continue its focus on preventative care and expand its sales and product lines globally by more effectively leveraging e-commerce and marketing its products. Geographically Bayer is investing in developing a stronger brand presence in the USA, India, China and South-East Asia. By expanding in these geographies, Bayer can tap a lucrative market the is rapidly growing. The CH segment also cuts costs by achieving production cost efficiencies, implementing cost-cutting programs at facilities, and limiting investments into Capex, opting for a more variable cost structure.

Financials

Bayer has a strong balance sheet with ~55% of capital provided by debt. Bayer intends to pay down their debt; however, under my assumptions, this is improbable unless Bayer cuts their dividend. Bayer maintaining more debt on their balance sheet is a positive for equity investors; Bayer’s pre-tax average cost of debt is ~3.45%, and Bayer recently rolled debt at lower rates. Bayer benefits from global reach, allowing access to markets where credit is cheaper – mainly Europe. With Bayer’s cost of debt low, low exit risk, and revenue visibility into the following three years, why would equity investors want to reduce the use of debt?

Over the past five years, excluding the pandemic, Bayer has grown its revenues rapidly, increasing by 5% in 2018 and 19% in 2019. Growth has mainly come from Crop Science as post-acquisition of Monsanto; Bayer received a solid portfolio of seeds and CP products from which it could develop. As a result, Bayer has maintained a 63% groupwide gross profit margin over the past few years, down from 68% it maintained during 2016 & 2017, caused by CH, which was a drag on margins over the past two years.

Since 2018 even with rising sales, Bayer has failed to earn their cost of capital. Bayer’s cost of capital is 6.8%, earning a ROCE of 3.8%, 5.0% and -39.8% in 2018, 2019, and 2020, respectively. Bayer is on track to earn its cost of capital in the future due to significant cost savings measures and finishing up a restructuring program increasing net income.

My model using below consensus revenue growth for all segments shows that Bayer is undervalued. Bayer will benefit from multiple secular tailwinds and is well-positioned to grow in the crop science and consumer health markets. However, I believe that Bayer’s Pharma segment will represent a drag on revenues resulting in a five-year revenue CAGR of 1.36%. In my base case, EBIT margins slightly shrink from 2020-2027; Bayer cuts back on Capex while annual depreciation and amortization hover around 5% of gross property plant and equipment. I have used a 1.5% terminal growth rate when valuing the firm using Gordon growth and a 10x EBITDA exit multiple under the multiples method. I wanted to be very conservative with my financials for two reasons; first, Bayer is out of my comfort zone; second, Bayer has a history of disappointing expectations set at capital markets days. The result of my valuation revealed that Bayer is undervalued by ~17% as of May 10, 2021. I believe that the fair value for Bayer is around 63 euros per share.

Please see the linked spreadsheet.

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Websites & Resources Used

Bayer Capital Markets Day – Presentations, Slides and Transcripts

Bayer – Annual report

Bayer – Debt investors presentation

Exane BNP Paribas – Agrochemicals into the weeds

Morningstar – Bayer AG ADR

Kepler Cheuvreux – Bayer 360

BMO Capital Markets - $6 Corn

Deloitte – Consumer Healthcare Products Industry Outlook

IBISWorld

·       Global Pharmaceuticals & Medicine Manufacturing

·       Global Fertilizers & Agricultural Chemicals Manufacturing

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html

https://www.un.org/development/desa/en/news/population/world-population-prospects-2019.html

http://www.fao.org/3/i6583e/i6583e.pdf

https://www.hsph.harvard.edu/obesity-prevention-source/obesity-trends/

https://care.diabetesjournals.org/content/24/11/1936#:~:text=RESULTS%E2%80%94The%20number%20of%20Americans,%2B437%25%20in%20men