Mylan Labs Creates Too Much Uncertainty

Mylan at the Nasdaq

I recently exited a position in Mylan Labs $MYL and, I thought it would be interesting to do some equity research analysis on Mylan and the reasons why I sold.

Sometimes, with an investment, you get a nagging sense of some things that you are not quite comfortable with. When it builds so that your spider senses are tingling, I usually find it is time to sell.

 So what is about Mylan that attracted me to buy and, why did I then sell?

Mylan Attractively Positioned in Generics Market

The market for generics is a no-brainer for future growth. The US has to cutback on its burgeoning healthcare spending and indeed, one of the first things Obama did was take steps to introduce a regulatory pathway for biologic generics. Generics are not only cheaper for the consumer, they also tend to generate more profit for the distributor. Companies like CVS $CVS should see margin expansion by selling more generics. Throw in a substantive number of high profile drugs that will be going off patent in the next few years and, the outlook seems good.

Similarly, Europe has a far lower penetration rate of generics than in the US and, there will be a lot of political pressure to increase this rate in future. Moreover, an ageing population should ensure strong volume growth. In addition, whilst pricing is always an issue with generics companies (pricing declines rapidly once other entrants release copies) it should be noted that producing generics is no easy business.

Producing bio-similars is even harder because of the complicated manufacturing processes involved. The likes of Mylan, Teva, Watson and Sandoz (Novartis) do have a kind of moat.

So, why did I sell?

Herb Greenberg and Mylan

In a CNBC article, Greenberg highlighted a few causes of concern. He cited the recent investor day when Mylan outlined a $6 EPS target for 2018.  He then goes onto to point out that Mylan paid $22m to buy the right to develop Pfizer’s generic version of GlaxoSmitKline’s blockbuster Advair for Asthma and COPD.

Mylan are also getting the right to Pfizer’s dry powder inhaler which they can also use for other products. Mylan then put a contingent consideration of $376.1m on the balance sheet, which Greenberg argues gives them latitude to adjust non-cash earnings, because the consideration involves discretionary assumptions over future royalties, milestones and profit sharing.

Frankly, I think Greenberg’s skepticism is worthy but doesn't entirely hit the salient points. Biotech & Pharma investors know that the value of a company lies in its pipeline. If this program is successful, then Mylan pays the consideration. If it isn’t, Mylan doesn’t. However, the estimation of the risk weighting in the pipeline will change with investors’ perceptions and, with clinical trial, market or regulatory evidence. Investors know this and, I doubt that anyone took Mylan’s 2018 EPS target of $6 with anything other than a pinch of salt.

Mylan investors want to pay the consideration and therefore, they do not want to see earnings adjusted upward by the company reducing the liability. Investing in biotech is not for those who don’t like uncertainty!

Key Takeaway: Where I do agree with Greenberg, is with being dubious over companies talking about EPS numbers in six years time!



Vectura's GyroHaler (source Vectura)



Vectura VR315 Generic Advair?

Vectura is a UK listed pulmonary drug delivery company which is widely believed to be developing a generic version of Advair (Seretide). They have an extensive partnership with Novartis and their generic arm Sandoz. Indeed, Vectura are developing VR315 with Sandoz in Europe and analysts see in being on the market there in 2013-14.  However, in the US, Sandoz returned the rights to Vectura in 2010 and, this should be seen as a warning that the regulatory and competitive environment is likely to be tough in the US.

Vectura has subsequently agreed another partnership with a US pharma co for VR315 in the States but Sandoz really was the ideal partner. Analysts expect a 2015-16 launch but I’ve seen estimations for probability for this as low as 19%

Key Takeaway: Sandoz walked away from generic Advair in the US and, Mylan is talking about the generic as a potential ‘game changer’ for the company and baking that into long term forecasts.

Management Keep Selling Stock

If you are going to talk about $6 in 2018 (which would put the stock on 3.8x earnings) then it is not a good idea to promptly start exercising options and selling stock off. The investor day took place on the 21^st February 2012. Following that….

• 22-24 Feb Wendy Cameron exercises a cumulative 106,875 shares worth of options and then sells 106,875.
• 23 Feb-13 Mar  Douglas Leech exercises 33,750, sells 33,750
• 2-15 Mar Robert Coury exercises 231,771 and sells 184,342

Prior to the investor day, 

•  17 Jan-15 Feb Coury exercised 300,000 and then sold 300,000

Incidentally, all numbers are sourced from Yahoo Finance.

Key Takeaway: Management are exercising options and selling stock.

My Mylan Conclusion

Putting all these things together makes me feel uncomfortable. I like the sector, I like Mylan but biotech investing is already full with uncertainty, it doesn’t need more. It doesn’t need management’s making ambitious projections and, then exercising options and selling stock. As for the pipeline, respiratory is competitive and biogenerics are fraught with ‘known unknowns’.

I am also slightly skeptical with some of the language used to promulgate Mylan’s future success. For example, at the investor day, Mylan’s ability to generate cash was championed and, then the CFO announced that Mylan would ‘generate over $1bn annually and beyond in financial flexibility’.

Everyone else talks about free cash flow generation, so what does ‘financial flexibility’ mean?  Apparently, it means free cash flow plus borrowings. Are we supposed to applaud the fact that Mylan can borrow money?

From the investor day presentation, the mid-point of guidance for 2012 adjusted free cash flow is $600m (flat on 2011) and for a business with an Enterprose Value of $14.67bn this does not make the stock cheap at the current price of $22.89

Moreover, Mylan has refused to reinstate a dividend, despite the management’s confidence in the outlook.

Frankly, there are too many questions here and I decided, perhaps wrongly, to close my position.

Software Company Stocks Moving to Cloud Computing



Intuit, Sage and Cloud Computing



Intuit $INTU is a stock that offers investors exposure to the shift towards SaaS (Software as a Service) amongst software providers. This makes Intuit a stock set to benefit from cloud computing growth. It is also attractive as a way to play an economic recovery in the US via its tax offering.

So with Intuit, you have a structural growth story with the shift to cloud, combined with the cyclical growth story of increasing US employment leading to increased tax filing.  I thought it would be interesting to do some equity research analysis on Intuit and compare it with a UK stock called Sage, which competes in some of its end markets.

Intuit Earnings Analysis

Firstly, these set of results beat estimates but what is really important is the outlook for the April quarter, which usually makes up around 85% of earnings for the year.  Intuit confirmed previous guidance and forecast $2.47-2.51 in non-GAAP EPS for April, which is in line with analyst estimates of $2.49.

Similarly, the conference call made some positive noises on the next quarter, although cautioned that there was a lack of data from the IRS this year on tax returns. No matter, payroll data has been strong recently and most of the economic data- as well as commentary from the likes of Robert Half $RHI – has been indicative of decent employment gains.

Moreover, INTU noted in the conference call that (despite it being early in the season) tax returns are up on last year even though the evidence is that there is a trend towards tax returns being filed later and later each year.

Cloud Computing Stocks

However, Intuit isn’t just about a cyclical growth story, there is a real secular shift occurring in their digital business. Intuit was an early investor in the cloud computing and selling SaaS, and a company like Sage needs to take notice. The shift to online is progressing across the whole company and it is leading to increased ROI (return on investment) and lower churn rates. Indeed, as Intuit pointed out with QuickBooks Online, it has a 20% increase in life time value (LTV) as compared with QuickBooks Desktop.

A company like Sage should take note because the possibility to leverage its leading position in the UK (accountancy software) into the cloud is significant. Sage is talking about doing this but is far too slow in adoption and, runs the risks of having its market share eroded and ultimately facing a disruptive shift when it does finally make the move aggressively.

According to Intuit, the company is already generating 62% of its annual revenue from connected services.  I doubt Sage is anywhere near that, but the company should be thinking aiming for it. Let’s look at what Intuit said in the conference call and see how it demonstrates the power of the cloud to steal market share. In this case with QuickBooks…

“3 years ago, we used to get 40% of our new customers outside of QuickBooks Desktop. We're now getting 70% of new customers beyond QuickBooks Desktop. So as we shift to more Connected Services and mobile apps, it's helping us get new customers into the franchise and it's easier for us to identify additional problems that we can introduce them to a product through a simple link and so that drives cross sell and up sell and attach.”

Indeed, Intuit’s Turbotax is the highest grossing iPad app in the Apple store. It is initiatives such as this that have lead to online tax returns growing to 75% of the market versus 25% for retail. Intuit is trouncing the likes of H & R block $HRB.

Sage Future Challenges and How Intuit Shows the Way

Intuit competes with Sage with its QuickBooks accountancy software and, it is worth looking at what Intuit said about growth rates of QuickBooks online and Desktop…

“Well, what we're seeing right now in QuickBooks is year-to-date, the desktop customers, the units are down about 2% in terms of the units sold. With that being said, the online version's up 35%, but you've got to keep that in perspective. We've got 4 million installed QuickBooks customers and we have 326,000 odd or 230,000 odd QuickBooks Online customers. So it's growing off of a smaller base. If we had to take a look at what we think the future will be, you're going to continue to see a faster growth rate in online than desktop. But a lot of customers really want to have their accounting information on the desktop. “

In other words, unless Sage wants to continue along the conservative low single digit revenue growth path, it had better get into the cloud and quickly. There will always be a core demand for desktop but the growth is online.

Not only is the growth online, but the ROI is higher. The LTV is higher and the marketing is more targeted, which results in lower churn rates. Sage has the chance-given its market dominance in the UK- to aggressively make an ‘Intuit’ style shift, but does it have the commitment and are the management being slow to adapt?

Sage is launching several versions of their mid-market offerings in the cloud this year and, if successful, Sage has the potential to generate some upside surprise. Although, potential investors will have to consider that nearly 60% of revenue comes from Europe and notably the SME market. These headwinds create a fair amount of uncertainty for Sage.

Intuit Equity Research

Turning back to Intuit, INTU currently trades at $57.57 which gives it an enterprise value of $17.23bn.  Over the last five years, revenue growth has had a CAGR of 9.6% and EPS growth is forecast to grow this year at 17.9% and then 13.2% for July 2011-12.  These are excellent numbers and, furthermore INTU is very good at converting income growth into free cash flow..

(m)	July 2009	July 2010	July 2011
Non-GAAP Net Income	600	685	798
Operating Cash Flow	812	998	1013
Ocf conversion	135%	145%	127%
Capital Expenditures	131	74	114
Free Cash Flow	681	924	899
Fcf conversion	114%	135%	113%

…so if we take a rough estimate of 120% FCF conversion, and the analyst of non-GAAP EPS of $2.96 we will get FCF of 2.96*1.2= $3.57 for 2012. For the next year, estimates are for $3.35 in earnings which would give around $4 in FCF for 2013.

This equates to FCF/EV of 3.57/57.57= 6.2% and 4/57.57= 7% for the next two years. This is cheap for a business that should be able to generate earnings growth with the shift to online services for many years to come. Compound this with the relatively defensive nature of the company (SME’s tend to have a high failure rate, but they all need tax and accounting software) and this evaluation of $57.57 looks cheap. 

Analysts mean price target is for $64 but I think that is too conservative. Intuit could trade closer to $70 if the economy continues on track. I bought some more after the results.

As for Sage, it has economic headwinds for the first half of 2012 but potential investors should watch events closely. If Sage is committed to the cloud then it could see a re-rating with a lighter than expected recession and he beginnings of traction in the move to the cloud. However, I would like to see hard evidence of the latter first, before piling in.

Telecity Set to Benefit From Cloud Computing Growth

A good set of results from Telecity $TCY which highlight how this stock benefits from the growth in internet traffic and cloud computing. Data centers are a very good ‘picks and shovels’ play and companies like Equinix $EQIX are seeing strong growth in end demand. Inevitably, this is causing increased capital expenditures as the data center providers expand capacity.

The potential downside here is that this ramping of capacity (the likes of Equinix and Telecity are expanding aggressively) will cause a supply glut which will lead to falling margins just as the data centers need cash flow in order to pay back the debt needed to expand capacity. No matter, right now, this doesn’t look like being a problem and investors will see the early signs when Telecity et al, start reporting slipping EBITDA margins. The growth in internet traffic is progressing at an exponential rate and increases in cloud computing will only strengthen the case.

Telecity is a Good Play on Cloud Computing

Turning to the expansion program, Telecity has nine simultaneous locations in development at the moment. Over the course of the last year, they expanded capacity to 68MW from 58MW last year. A further 10MW is expected to come online within the next six months and, longer term plans for a total of 124MW in three to four years are already in place. This is almost a doubling of current capacity, but Telecity has good reason for confidence over these plans.  

For example, 95% of last year’s revenues were recurring and 60% of organic growth came from existing customers, with only mid single digits churn. Clearly, Telecity’s end demand is very sticky and they are seeing strong growth from existing clients who need expansion to meet their mission critical demand.  Ultimately, this provides Telecity with a high visibility of earnings.

Telecity’s Growth Drivers

Moreover, the growth in internet traffic is broad based across sectors and, has proved to be recession resistant. This looks like a structural growth story and, will only increase as cloud computing and data traffic increases. Whilst, superficially, there is no moat in data center provision, it is in fact a mission critical application which requires substantial planning and trust on behalf of the clients.

An example of the broad base of Telecity’s clientele can be seen when looking at the breakdown of new customer wins by application type

• 29% content
• 24% financial
• 16% connectivity
• 16% systems integrator
• 15% cloud computing

Financial simply refers to financial transactions through the centers. The diversification in usage belies the growth potential for Telecity.

Telecity Financials

At a current price of 650p the stock is valued at £1287m. Telecity currently has £164m in net debt, which put together gives an Enterprise Value of £1451m. This stock is obviously not bought for its dividend, even though Telecity is promising to pay 20-25% of its earnings in dividends. For those interested, this would make 6p or 1% yield based on analyst forecasts for 2012. The company expects to commence dividends at the half year in 2012.

The key to Telecity is to think if it as a cash generating ‘annuity’ type stock. It is in the expansion phase now so, superficially, cash generation looks weak but the underlying picture is much stronger. At the full year, Telecity generated £106.5m in operating cash flow from £109.9m in EBITDA and, cash flow conversion has been similarly strong over the years. Telecity spent £109.9m in expansion capex but maintenance capex was only £21.8m. This means that the operating free cash flow was £106.5-21.8m=84.7m or 5.8% of EV.

Telecity Stock Analysis

The underlying cash flow generation is strong and investors should consider that it will, roughly, take four years for a location to reach peak demand. Therefore, the expansion now will generate future revenue growth in the next  few years. Furthermore, the net debt situation of £164m is easily manageable given cash flow generation and a five year £300m debt facility hich was signed in May 2011. There is ample head room for more expansion.

The key thing here is that any investor will need to be confident in the long term growth rates of internet traffic and then try and ‘price’ in this confidence. The correct approach might be to watch gross margins across the industry and see that as a marker for over capacity. However, we are not there yet and Telecity’s stock price is probably at least capable of ‘doing its earnings’ for 2012. On this basis it is better priced at 750p then the current price of 650p.

Source:

Telecity Results Presentation

Google Earnings, Motorola and the Pay Per Click Challenge

Google $GOOG came out with earnings numbers that disappointed the market and received no end of negative commentary from journalists and commentators. The stock declined 10% in after hours trading and the next day closed 8.5% down.

  However, I suspect this is more to do with adjustments to the game of hitting analyst estimates rather than any weakness in the underlying performance of Google. Granted, there are some changes in terms of accelerating paid clicks (up 34%) but declining cost-per-click (down 8%) but I don’t consider them to be a major issue and will discuss this later.

Google Don’t Give Estimates or Guidance

Google don’t give guidance nor do they give estimates. Ever. This makes life that bit tougher for analysts. It also happens to cause significant variance with actual earnings and estimates, because analysts do not have a number from the company from which to ‘anchor’ their estimates. We can see the variance expressed in the stock chart below. Note the high volume big gaps that occur, up and down, every three months after earnings are given

 

Indeed, the standard deviation of the difference between earnings and estimates is nine per cent over the last five earnings! However, this mainly represents the inability of analysts to forecast correctly what the numbers will be, rather than the underlying progress at the company.

Google’s Underlying Performance

The underlying performance was strong, although there are some structural changes taking place at Google. Most notably Google is increasing operating expenses quicker than revenues so earnings are not growing as strongly as the top line.

The strategy is to grow Google advertising in the mobile space and the acquisition of Motorola Mobility is a key part of ensuring the primacy of Google’s Android operating system. According to NPD, Android based smart phones have 53% of the market vs. Apple iOS at 29% and RIM Blackberry at 10%

It is inevitable that screen time will increasingly be taken by smart phones and tablets so it is essential that Google grow in the mobile sector. In fact, some analysts are looking at the eight percent decline in cost-per-click as a sign that mobile will be less profitable than pc advertising. Moreover, the acquisition of Motorola Mobility is seen as a challenge to Google because it is a hardware rather than Software proposition.

 I’ll discuss this below, but firstly let’s look at the numbers…

• Net revenues rose 27.6% to $8.13bn
• Total Costs and Expenses Rose 29.6% to $5.46bn
• Free Cash Flow rose 300% to $2.97bn
• Full Year Free Cash Flow was $11.1bn
• Non-GAAP EPS rose 8.6% to $9.5
• Paid Clicks rose 34%
• Cost-per-click declined 8%

…clearly, there is a need to look closer at some aspects of these numbers.

Why Google Cost Per Click Declined

Frankly, I don’t think this is as much of an issue as much of the media made it out to be. Google explained that currency effects (stronger dollar) had an affect as well as a conscious shift to increasing paid clicks at the expense of cost-per-click.

An example of this is the increase in site links. These are the individual links to various parts of a website that appear after a search. Whilst they are great for encouraging interaction with a site and thus increase paid clicks, I suspect they do generate less cost-per-click. This is not a problem as long as the overall revenue increases in the mix.

As for the issue of increasing mobile ads, this too, should not be seen as a particular issue. Smart phone internet usage is definitely different but probably involves more focused search (via engines) and re-occurring visits to favourite websites (facebook, youtube)  then the meandering browsing experience of sitting in front of a pc.

 There is every reason to expect that Google will be able to continue to generate growth even though internet usage shifts to online.

Google can meet its Challenges

Whilst a lot of negative commentary is directed towards what management will do with Motorola Mobility, I think this is somewhat misguided. Motorola is a hardware company, but increasingly, the value in a handset is actually coming from the operating system, software and mobile applications!  Google knows what it is doing here.

 In addition, the shift to advertising on mobiles involves a change in activities that Google has performed endlessly and iteratively, with pc advertising. It is not a significant strategic shift, Google knows how to generate revenues from links and advertising and has

Google’s Evaluation

In summary, at the current price of $586 we are looking at a business that is growing net revenues at 27.6% and has just generated 11.1/154.5bn=7.2% of its Enterprise Value in free cash flow over the last year.Trading on a PE ratio of 16.3x I think this business is cheap despite the ‘disappointment’ in these results.

There are issues with the management’s attitude to shareholders and refusal to pay a dividend despite having a $35bn on the balance sheet. However, Google’s prospects look bright and fears look overdone. There is more to investing than meeting analysts estimates!

Alcoa's Outlook Not Really a Cause for Optimism

Alcoa $AA gave results recently and the markets liked the outlook given by the company. Indeed any sign of an optimistic outlook from a bellwether like Alcoa will have equity investors excited. But what was really behind the underlying assumptions in Alcoa’s bullish outlook statement?  Moreover why are some investors taking this macro economic outlook from Alcoa and concluding that it’s now time to pile into equities?

The Equity Risk Premium

One argument relies on the valuation of the equity risk premium. In other words, equities look cheap compared to bonds right now. Whilst I’m sympathetic to this argument, I think it is flawed. I think the traditional academic treatment of bonds vs. equities is predicated on bonds having a risk weighting of 1 and then building in a premium for what you would then pay for the 'riskier' equity. 

All of which is fine, if you are happy to believe that the risk weighting of bonds really is 1. Clearly, some parts of the market thinks that Germany is more than 1, otherwise why buy debt on negative yields...

http://ftalphaville.ft.com/blog/2012/01/10/825611/german-negative-yields-as-harbinger-of-deflation/


...whilst the reluctance to lend Italy money for 10 years goes on unabated...

Church & Dwight a Recession Proof Small Cap

Church & Dwight Co $CHD is a great stock to do some equity research analysis on because the co is largely recession resistant, trades on a good evaluation and offers the prospect of some upside from a fall in commodity input costs.

Church & Dwight are in the personal and homecare space and, are a small cap  company which is comparable to the like is Reckitt Benckiser, Colgate, Clorox, Unilever etc.  The company is little discussed but has an excellent track record of generating earnings through the cycle. This analysis seems them being able to generate at least double digit returns for a stock investor from here.

Church & Dwight Brands

The brands can be categorized as a diversified collection of personal and homecare goods. Much of their brands are value propositions which offer upside in a stagnant economy as consumers trade down to cheaper brands. In terms of profits and sales, 80% of them come from their eight leading ‘power’ brands…

• Arm & Hammer (toothpaste, baking soda, detergent, cat litter)
• Trojan Condoms and Vibrators
• OxiClean Laundry Additive
• Spinbrush Battery Powered Toothbrush
• First Response Pregnancy Kit
• Nair Hair Removal
• Orajel Pain Relief
• Xtra Extreme Value Laundry Detergent

…which reads like a roll call of US value brands found in the home. However, Church & Dwight is far smaller than its major competitors and its business model is tailored towards grabbing leadership in niche markets.  What makes this company special is its execution.

Church & Dwight Earnings

The management has demonstrated a tremendous ability to grow earnings and revenues over the years and this can easily be summarized below…

(m)	2006	2007	2008	2009	2010	2011E
Revenue	1,955	2,221	2,422	2,520	2,589	2,710
Gross Profit	761	877	972	1,101	1,157	1,205
EPS	1.04	1.23	1.43	1.74	1.98	2.18
EPS Growth		18.3%	16.3%	21.6%	13.8%	10.1%

Analyst estimates for 2012 are for a further 4% revenue growth and 10% EPS growth.  

All of which paints a picture of a recession proof company but 2011 has proved challenging as end demand was lower than initially expected and rising commodity costs put pressure on margin expansion. No matter, the outlook for 2012 presents upside potential as the US economy generates employment gains and commodity costs abate with slowing emerging market growth.

 It is also worth noting that gross margins jumped in 2009 with the fall in commodity prices and, Church & Dwight has managed to hold onto them despite rising costs in 10-11. Similarly, with such a well run business, working capital management is excellent and the co generated large amounts of free cash flow. 

Church & Dwight Evaluation

The stock trades at a price of $44.51 with a market cap of $6.37bn. There is $275m in cash on the balance sheet with $250m in outstanding debt. FCF has grown from $200m to $364m from 2007-2010 at a CAGR of 22% with trailing FCF currently running at $391m.

Obviously, a PE ratio of 20.4x for 2011  makes little sense and even in further ahead where analysts see EPS of $2.19, the PE ratio only drops to 18.5x in 2012. However, the true value in an investment lies in its ability to generate cash and on a current FCF/EV of 391/6350= 6.2% the stock is attractive.

For a relatively secure double digit growth over the next couple of years, this stock could trade on an evaluation closer to $50 with upside potential from reducing commodity costs.  A decent 12% upside.