These days I wouldn’t like to be in the shoes of Werner Baumann, the CEO of the German pharmaceutical and life-science company Bayer (OTCPK: OTCPK:BAYZF) (OTCPK: OTCPK:BAYRY). During the last annual shareholder meeting, investors were pretty outraged and at the end management received a “no confidence vote” which has never happened before with any company that was or is listed in the German DAX. The vote is not legally binding but it throws Baumann’s future into question – especially as Bayer is currently worth only €50 billion and therefore less than the amount Bayer payed for the acquisition of Monsanto, which is the reason for all the riot.
I thought that Bayer might find its bottom at about €60. Now we know that the support level didn’t hold and the stock fell even lower with no signs of forming a bottom so far. In this article we take a closer look at Bayer and try to figure out if Bayer can survive.
Monsanto Acquisition: A Mistake?
The big question is very simple: Has Bayer made a mistake by taking over Monsanto? While Monsanto has been extremely profitable in the past, its reputation has always been a disaster in the last years (and already before the acquisition) and the company is often called the “most hated company in the world.” And there have been discussions about the safety of Roundup for many years, and as the talks between Monsanto and Bayer began there already have been some lawsuits, but now the number increased to 13,4000 plaintiffs claiming that they have been exposed to glyphosate-based products manufactured by Bayer’s subsidiary Monsanto. These plaintiffs are claiming that they have been exposed to Roundup and suffer personal injuries resulting from exposure to those products, including non-Hodgkin lymphoma (NHL) and multiple myeloma, and seek compensatory and punitive damages.
As I'm not an expert, I won’t state any opinion if Roundup is causing cancer or not as it's not my level of expertise. But as I see it right now, it's not proven that Roundup is causing cancer, but it's still a heavy debate about the health effects Roundup might have or not. Despite any scientific opinion about the safety of Roundup, Bayer (and Monsanto) lost the third lawsuit related to Roundup a few weeks ago. A Northern California jury has ordered Bayer to pay more than $2 billion to a couple who said they were diagnosed with cancer after using Roundup. In August 2018, a jury ordered Monsanto to pay $289 million in damages to a janitor who also is claiming to suffer due to the exposure to Roundup.
A Short History Of Fines And Settlements
Although investors fear the amount Bayer has to pay will be extremely high, it still is very difficult to present a reasonable estimate how much money Bayer will have to pay in a settlement or how high the fines could be. In the past few months, estimates were $5 billion, but after the latest jury decisions, these estimates seem unrealistic. Current numbers that are discussed fluctuate between $10 billion for a settlement with all the plaintiffs or even $20 billion in the worst case.
Like I already said – it's difficult to give a reasonable estimate right now. But it makes sense to do a little research on the topic. First of all, I tried to search for companies that went bankrupt due to class action lawsuits or settlements that destroyed companies. Without any doubt there are several companies that were massively affected by lawsuits and companies certainly had to file for bankruptcy due to a lawsuit, but I couldn’t find any information on huge corporations that got in severe trouble due to lawsuits. I could however find information on the biggest fines and class action lawsuits in the past decades.
- Tobacco Settlements: In 1998, four tobacco companies – including Philip Morris and RJ Reynolds – agreed to a $206 billion settlement, which had to be paid over 25 years.
- British Petroleum (NYSE: BP): In June 2016, BP was found guilty of criminal manslaughter and environmental crimes and had to pay $20.8 billion for the Deepwater Horizon oil spill in the Gulf of Mexico.
- Bank of America (NYSE: BAC): In 2014, the Bank of America had to pay a fine of $16.65 billion for the financial fraud that led up to the mortgage crisis of 2008.
- Volkswagen (OTCPK: OTCPK:VWAGY) Emissions Scandal: The German carmaker got caught cheating on emissions tests and deceiving its customers who bought the diesel cars. In June 2016, a federal judge approved a $14.7 billion settlement.
- JPMorgan Chase (NYSE: JPM): In 2013, JPMorgan Chase agreed to pay $13 billion for its role in the financial crisis of 2008.
When talking about fines, we could also mention the fines Alphabet (Nasdaq: GOOG) (NASDAQ:GOOGL) had to pay in the recent past because of three separate antitrust investigations. Due to the formal charges against Google related to Google Shopping, Google AdSense and the Android operating system, Alphabet had to pay over €6 billion in fines so far.
Chances are very high that a settlement Bayer might reach will go down into the history books as one of the highest amounts a company ever had to pay. And aside from the $200 billion four tobacco companies had to pay, the largest amounts were $20 billion in fines, and while we should expect a high fine, it seems rather unlikely that the fine Bayer will have to pay is much higher than what companies had to pay in the past.
When looking at the companies mentioned above, it's also interesting to take a closer look how these companies performed since the fine was imposed. Volkswagen for example performed rather lousy and the stock price could increase only 8% since then.
Bank of America however increased its stock price 80% since it had to pay the fine, JPMorgan Chase climbed even 150% since the fine was imposed and Altria (NYSE: MO) (the parent company of Philip Morris) increased 400% since 1998.
While Volkswagen might be an example of a company that's still struggling, it seems like most of the companies managed to be profitable after the fines were imposed and even continue to grow.
Terrible Balance Sheet
In this case, the company’s balance sheet and financial health becomes extremely important. Alphabet for example – or in particular Google – has been fined with more than €6 billion by the European Union. And although the amount ranks among the top fines a company ever had to pay, it won’t put much pressure on Alphabet as it has $113.5 billion in cash and cash equivalents, almost no long-term debt and “only” $18 billion in goodwill on its balance sheet.
However, when looking at Bayer, the situation is a little different. While Alphabet has a great balance sheet, Bayer is not looking so great. As a consequence of the Monsanto acquisition, the German giant has about €38.8 billion in goodwill on its balance sheet, which could lead to huge problems in the future. Additionally, the company has currently €42 billion in debt on its balance sheet (about €36 billion in bonds and about €4.2 billion Bayer owes to credit institutes). These high amounts of debt also result from the Monsanto acquisition, and Bayer’s €5 billion in cash and cash equivalents are a rather small number compared to the debt and the potential fines the company might face.
When thinking about potential fines Bayer could face, it could lead to huge problems as Bayer would have to take on additional debt, which would lead to even higher interest payments. And of course, it would take long to repay the outstanding debt.
Two Very Pessimistic Scenarios
In our first scenario, we assume that Bayer has to pay a fine of €25 billion or reach a settlement where it has to pay €25 billion. This would be one of the highest amounts a single company ever had to pay. Aside from the fine, we assume that Bayer is still allowed to market Roundup and its herbicides and also that Bayer can grow its revenue and free cash flow about 3% annually and won’t be affected by the litigation over the long run and that its reputation won’t suffer in any damaging way.
In the last five years, the net cash provided by operating activities has been about €7.5 billion (and we can assume that due to the Monsanto acquisition it might even be a little higher). Capital expenditures have been about €2.5 billion in the last few years, which leads to a free cash flow of €5 billion for Bayer. In that scenario, the settlement amount would eat up the free cash flow of almost five years and Bayer would generate free cash flow in 2023 for the first time again (about €1.5 billion). When calculating with a 10% discount rate, the intrinsic value of Bayer would be €53.44 and the company would almost be fairly valued right now.
Of course, Bayer would still have to repay its huge amounts of debt and the company still has large amounts of goodwill on its balance sheet, and if Bayer really has to pay a €25 billion fine, it will have to take on additional debt as the €5 billion in cash and cash equivalents on its balance sheet are not enough, and for the new debt Bayer will also have to pay interest (an aspect we didn’t consider in our calculation).
A second scenario we consider here is even more dramatic than the first one as it also assumes that Bayer not only has to pay a huge fine, but also is forbidden to sell Roundup in the future or any other herbicides. This would lead to much lower revenue and free cash flow for Bayer. Last year, herbicide sales were €4.2 billion and therefore accounts for about 10% of Bayer’s total revenue. In the last quarter, crop science had an EBITDA margin of 36% and we can assume that Bayer will lose about €1.5 billion in operating income, and a similar amount also has to be subtracted from the operating cash flow.
When subtracting €1.5 billion due to the potential prohibition of herbicides we get about €6 billion in operating cash flow, which leads to a free cash flow of €3.5 billion for Bayer. As Bayer is not just selling herbicides and the crop science segment isn’t the only revenue stream for Bayer, pharmaceuticals, animal health and consumer health will contribute to revenue growth. And although crop science is one of the growth drivers, we still can assume about 3% annual growth for Bayer even without herbicides in its portfolio.
In that scenario, free cash flow would be €0 until 2024 for Bayer and assuming a 10% discount rate (as always), the stock would be fairly valued at €33.15 in that very pessimistic scenario for Bayer. And even if Bayer will not be forbidden to sell herbicides, the reputation of the company might still be damaged and sales of the product might decline (although the company can still report solid growth rates).
When looking at the chart, we see that Bayer is currently fighting with massive support levels. It seems like the stock already broke through the 200-month simple moving average (red), but it's still possible that the 23er Fibonacci retracement as well as the highs from 2007, 2008 and 2011 (green dotted line) support the stock and lead to a turnaround.
If the current support levels won’t hold (and chances are high), we have two other potential support levels and areas where the stock could turn around. First of all, we have the declining trendline connecting the highs from the years 2008 until 2012 (orange dotted line) and we could see a pullback to that trendline meaning the stock would decline to about €45, which is definitely possible.
A second potential target for the decline could be the lows of 2008, 2009 and 2011 meaning the stock would decline to about €33. This scenario seems to be unlikely right now, but we never know (and it would be the fair value in our second scenario from above).
Solid First Quarter Results
Right now, when talking about Bayer, we are only talking about Monsanto, Roundup and the pending lawsuits and the billions and billions of dollars Bayer might have to pay. But we always should remember that Bayer has several business units, a 155-year successful history and that the company is one of the most successful German companies. And when we look at past numbers, we see a very solid performance.
(Source: Own work)
Over the last decade, revenue increased 2.7% on average, but the numbers are misleading as Bayer spun off its Material Science segment, which is trading as Covestro (OTCPK: OTCPK:CVVTF) and is generating about €14.6 billion in revenue right now. To get a realistic revenue growth rate, we have to add Covestro’s revenue to Bayer’s revenue – leading to about $53.5 billion in revenue for 2018. Taking these numbers, revenue would have grown about 6.2% annually during the last decade.
And Bayer reported not only great numbers in the past, but also first quarter earnings results of 2019 were solid. These numbers however got almost lost in the shuffle. Overall Bayer could increase its sales 42.4% compared to the first quarter of 2018 – mostly due to the acquisition of Monsanto. Earnings per share however decreased from €2.21 in last year’s first quarter to €1.27 this quarter. When looking at the different segments, crop science could report the highest growth numbers – 125.2% compared to last year’s quarter. When adjusting growth for FX effects and the portfolio expansion (due to the Monsanto acquisition), sales from crop sciences still grew 6%. But not only does the crop sciences segment contribute to growth. Bayer also could increase sales from the pharmaceutical segment (+6.8%) and sales from the animal health segment (+1.7%). Only the consumer health segment had to report a decline of 1.0%. Pharmaceutical sales increased mostly due to 6% higher sales volume and the sales were especially driven by Xarelto and Eylea, which both grew about 15% YoY.
(Source: Bayer Q1 Investor Presentation)
According to its own guidance, Bayer expects €46 billion in sales and between €3 billion and €4 billion free cash flow for 2019. For the crop sciences segment, the pharmaceuticals segment and the animal health segment, Bayer is expecting about 4% growth for 2019. For the consumer health segment, the expectations are a little lower and Bayer expects only 1% growth. For the next four years, Bayer is expecting about €23 billion in free cash flow, which is even more optimistic than our estimates in the first scenario from above and would lead to an intrinsic value that is even higher than the calculated €53.44 (still including a €25 billion fine).
For the shorter term (next few months), I would assign Bayer a neutral rating as I don’t see much positive catalysts which will make the stock trade higher. But for the long term (several years), I'm definitely bullish on Bayer as it's fairly valued even in case of a €25 billion fine or settlement. With the current valuation, a lot of negativity is priced into the stock already, and even with the possibility of record-breaking fines for a single company, Bayer will survive and is fairly valued. We can’t really know how high the settlement or fines will be, but a look into history should make us confident that the amount will not exceed €25 billion.
Everybody knows that you should buy stocks when there is blood in the streets, and in case of Bayer, we are looking at a bloodbath right now – for the stock, but not the business which is pretty stable so far. Investing is about assessing the risks and trying to find out where investors as well as investor sentiment is wrong. Great companies are seldom very cheap. A great company gets only cheap and a good investment when there's some risk associated with the company, and it’s our job to find out if it's a permanent and threatening risk for the business and then buy before everybody else figured out that the risks are less of a problem than people thought.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.