Description

Bayer AG Common, BAYN GY Equity, €62.21

Thesis

Two components + optionality to the thesis.

First component is tighter: Scared German investors have overreacted to the Monsanto Glyphosate litigation. The market is pricing in ~€32b in liability. Our view is that a poor outcome would be €10b in value destruction, and we think par is €3 – 4b. Bayer will be generating €6 – 8b of real FCF annually – any realistic liability will be easily funded. We think the company will recover this net €28b of lost value, which drives 55% upside at 12x 2020 EPS.

Second component is flabby but provides margin of safety: This is a cheap stock in a beaten-up German equity market. Setting aside the ongoing debate about what value investing is, this is an equity that meets all of the criterion for a statistical value investment. And unlike most other statistically cheap equities, Bayer generates a ton of cash, grows, and there aren’t any huge secular boogeymen. We don’t think it’s unreasonable for the stock to trade at 14x vs the 12x assumed in the first valuation above, which would drive an additional 25% upside.  

Finally, there are articles suggesting that Elliott owns the stock. An activist with a breakup and/or cost cutting plan could drive a tremendous amount of upside.

Overview

Bayer is a German agricultural and pharmaceutical conglomerate. It’s a complex business, and each piece requires work to understand. The sellside understands this business well, and a quick way to ramp up on the business is to read Initiation of Coverage reports. This writeup will focus on thesis drivers.

In May 2016, Bayer announced that it was acquiring Monsanto for $63b in cash to create the #1 player in global Crop Science. After an arduous regulatory review process, the deal was approved and closed in June 2018. The consideration was funded with €36b of cash and debt, €12b of asset sales, and €6b from an equity rights offering.

2 months after closing on 8/10/18, a California jury delivered a surprising judgement of $289mm (incl $250mm punitive) to a California man who alleged that Roundup, Monsanto’s flagship herbicide made with glyphosate, caused his non-Hodgkin lymphoma following years of Roundup use. Bayer stock traded down >16% over the ensuing week – €14b of value destruction.

Since the initial case, BAYN has had 2 additional adverse developments. On 10/22/18 a California judge only reduced the first $289mm judgement to $79mm. Many had thought that this would get reduced even more significantly. Bayer has appealed again. Second, On 3/19/19 another jury in SF California awarded another man with non-Hodgkin lymphoma $80mm (incl $75mm punitive). The stock has now underperformed the DAX by 37% since the judgements came out.

2-year performance: SPX +27% (yellow), DAX +4% (orange), BAYN -35% (white)

Consensus blended 1-year forward P/E multiple: SPX 16.7x, DAX 12.8x, BAYN 8.5x

Thesis #1 – The market is overreacting to glyphosate litigation

What’s in the stock today? (See below for discussion on valuation methodologies and why we use EPS not a SOTP)

Bayer has underperformed the DAX by 37% (€35 / sh) since the initial Monsanto judgement on 8/10/18. €35 / sh x 934mm shares out = €33b in value destruction vs a flat DAX

Street estimates for BAYN are €7.90 in 2020 EPS. BAYN trades at 7.7x 2020 consensus EPS. The DAX trades at 12.0x 2020 consensus EPS. BAYN is a better business than the average DAX component and generates a lot more cash, but let’s just assume that it would trade at an average multiple. 934mm shares out x €7.90 x 4.3x = €32b in implied glyphosate liability in the equity.

A third method is akin to a SOTP and therefore irrelevant, but one could say – BAYN had a €90b TEV on 12/31/2017. Then it acquired MON for €55b. Today (with MON) BAYN has a €93b TEV. There is no value for MON in BAYN.

What will the ultimate liability be?

Quantifying the ultimate tort liability is tricky.

These cases are brought by well-funded and competent tort lawyers in the US. This is a big business, and the lawyers who do these cases invest a lot of capital and time, typically on 40 – 50% contingency.  The process is intuitive – amass a large base of plaintiffs, bring a few exceptionally strong cases to trial in jurisdictions that are well-known to be plaintiff-friendly, win a big jury judgement that scares the corporation. Early jury awards are highly likely to be reversed and/or reduced on appeal (particularly the punitive damages), but are often sufficient to bring the corporation to the table to settle the initial cases and to develop a formulaic approach to settlement. Plaintiff lawyers are incentivized to settle for somewhat reasonable amounts to reduce their personal risk (both time and legal process) on a big payday.

Eventually this case will become a mass tort where Bayer will set up a claims administration facility and a formulaic approach to settlements will be agreed upon with the plaintiffs lawyers.

We are not going to make a high stakes legal call here. But we would note 1) sophisticated scientists and regulatory agencies (as opposed to juries) have continued to stand by Roundup, 2) there is a lack of obvious causation (unlike Asbestos or tobacco), 3) there is no suggestion of criminal activity or gross negligence. It’s actually a pretty good case for BAYN despite the recent headline jury setbacks.

Our estimates based on past tort cases and various outside legal diligence suggest that $500k would be an aggressive average settlement value. More likely is something like $250k. Asbestos cases were anywhere from $125k – $1mm, typically with materially worse fact patterns. There are currently 11.2k US Roundup plaintiffs, we think this will likely plateau at ~15k legitimate plaintiffs (the case is about non-Hodgkin Lymphoma).

This puts our base case at ~$4b. As mentioned in the summary, a very high case would be a €10b.

Will this materially impact EBITDA or cash flow?

Maybe, but it would be a downside scenario. Roundup has received explicit regulatory approval in most countries, and US regulators have sided with Monsanto despite the recent lawsuits. Quoting the WSJ:

“In the U.S., Roundup has become almost as fundamental to farming as tractors. American farmers use it or other glyphosate-based herbicides on the vast majority of their corn, soybean and cotton acres, making it a factor in American agriculture’s steadily rising productivity.”

“The chemicals agency and the European Food Safety Authority both re-examined glyphosate studies questioned by plaintiffs’ attorneys and let stand their approvals. The agencies said they look at the raw data in research, so that the kind of study the attorneys question—a review of past research—generally doesn’t carry much weight.”

“Health Canada also recently took a second look at studies on which it had based its approval of glyphosate herbicides, after critics raised concerns about Monsanto’s role in research. The Canadian agency assigned a separate group of its scientists to go over the studies. Their review didn’t change its conclusion.”

“The U.S. Environmental Protection Agency is currently doing a periodic review of the glyphosate science, ahead of a decision expected soon on extending glyphosate’s longstanding U.S. approval. The EPA’s most recent review of glyphosate’s potential human risk, in late 2017, continued to find the chemical unlikely to cause cancer in humans.”

Importantly – glyphosate is actually one of the safest herbicides around. Most other pesticides and herbicides are incredibly carcinogenic and poisonous. The main problem here isn’t the carcinogenic properties, it’s the failure to put a warning label on the bottles.

If one did want to sensitize glyphosate cash flows, we estimate that the company does $1 – 1.5b in glyphosate EBITDA or 8 – 10% of total. A total zero would reduce 2020 EPS by €0.85 – 1.40.

Thesis #2

As highlighted above, BAYN has underperformed, is cheap on traditional metrics, generates a lot of FCF, and isn’t a terrible business.

Even if the glyphosate issues “normalize” and BAYN were trading in-line with the DAX at 12x, it would still be somewhat compelling. The S&P 500 trades at 16.5x, and we would opine that BAYN is in-line with the average S&P 500 equity in terms of quality and growth. We get it, this is a German conglomerate subject to recurring bad things and the S&P 500 has MSFT, AMZN, BRK/B, and GOOG. But XOM, WMT, and PG (not trying to pick on anyone) trade at 17.5x, 20.5x, and 15.5x. MON consistently traded at >10x EBITDA and 20x EPS.

Valuation

We’ve talked about the glyphosate liability, but the reality is that the absolute quantum doesn’t matter that much. EPS isn’t going to change much regardless of the liability: 1) BAYN is generating €6 – 8b in FCF minus €2.7b in dividends per year to pay down debt and service any liabilities, 2) BAYN can borrow in EUR at ~3% and USD at ~4.5%, 3) cash settlement payments are likely to be 5 years or more down the road.

Several analysts value BAYN on SOTPs or EBITDA multiples. Our view is that this conglomerate is highly unlikely to split up, and will therefore trade on EPS, particularly as a big component of the DAX Index. A SOTP would show a higher value given high multiples for ag, animal health, and consumer health assets. The only scenario where this would be relevant is if a very strong-willed activist came along.

Company “core EPS” (i.e. strips out deal amortization and closer to FCF) is €10 / sh in 2022. See appendix. We will stick with Consensus 2020 number of €7.80 for our base case 12-month out valuation. In our downside valuation, we assume €1.25b of lost glyphosate EBIT, 5% haircut to EPS, €10b glyphosate liability, and an 8x EPS multiple. Important to note that it’s still trading at 7.5x EBITDA in that scenario given somewhat elevated leverage.  We would also note that BAYN management is selling non-core assets to de-lever – these asset sales are unlikely to be accretive to EPS given the company’s low cost of debt.

Risks that matter but we struggle to heavily opine

One of the issues with these large (European) conglomerates is that something is always going wrong. There are always fires popping up which result in 1) tons of wasted, non-alpha generating reactionary research burn and 2) a seemingly perpetual multiple discount. Bayer is unfortunately classic. Bayer’s other issues du jour:

The Pharma business has patent cliffs in the mid-2020s. This undoubtedly weighs on the multiple and is one of the persistent bear cases pre-dating the glyphosate litigation. Bayer does have a pipeline of other “highly prospective” drugs which should/could offset some or all of the cliff declines. Who knows? Cash flows through 2023 should not be affected so this is a multiple vs cash flow issue over our time horizon.

Crop science has become a lightning rod for social activists. Monsanto was aka “The World’s Most Evil Coorporation”, aka “a pop cultural bogeyman, the face of corporate evil.” It’s not going to get better, particularly with the litigation backdrop. The offsets to this are 1) there is a powerful secular growth driver behind this business, 2) governments and farmers realize they cannot operate without this technology, 3) Bayer has the best Crop Science technology portfolio in the world.

German management team, stodgy, conservative, not going to do creative things to create shareholder value, as focused on saving face after the Monsanto deal as getting the share price higher. The offset is that management is highly unlikely to do anything other than sell some small assets, pay down debt, and pay dividends for the next 3 – 5 years.

Appendix – Company Guidance

Catalyst

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