Bayer (BAYRY) has outlined its defence strategy against the legal cases mounting over glyphosate weed killers, including the Roundup products that came with its acquisition of Monsanto. We believe the market has overreacted to the initial Aug. 10 court verdict regarding glyphosate. However, based on the high number of cases--close to 8,000 pending--and likely settlements in certain cases, we have increased our litigation-related charges by €2 billion to be paid out over the next three years. This caused about 2% pressure to our fair value estimate, but we continue to view narrow-moat Bayer as undervalued.
We expect Bayer's defence strategy, which management discussed in an Aug. 23 conference call, will follow the typical pattern seen in major drug litigation, where cases are litigated one by one over a long period, wearing down the defence with heavy scientific support showing that glyphosate-related products were not responsible for causing cancer. Further, we believe the Aug. 10 ruling, which awarded US$289 million to a former groundskeeper with cancer, will be appealed and the final amount will be much lower. While nearly 8,000 cases remain, we believe most of them have low validity and are probably looking for any minor payment that might come with a potential class-action settlement. While precedent is not clear in this case, Bayer's recent settlement over its birth control drugs, which worked through close to 10,000 claims, resulted in charges of around US$2 billion.
For the Roundup product line, we don't expect usage to fall off materially, and its contribution to overall profits is relatively minor. We estimate that glyphosate, the chemical used in the Roundup brand, would account for less than 10% of Bayer's total sales and even less of Bayer's profits. While Bayer does not break out glyphosate-specific sales, we believe glyphosate accounted for a low-single-digit percentage of Bayer's profits, since it has been off patent for nearly two decades and margins are probably on the lower end of Bayer's crop chemicals.
Recent drug launches support steady growth
Largely on the basis of the strong competitive advantages of the healthcare group and to a lesser extent the crop science business, we believe Bayer has created a narrow economic moat. The divestiture of the no-moat material science group Covestro leaves the company in a stronger competitive position.
In the healthcare division, Bayer's strong lineup of recently launched drugs and solid exposure to biologics should support steady long-term growth. Two of Bayer's top-selling drugs are biologics: Betaferon for multiple sclerosis and Kogenate for hemophilia. While competition is increasing in both areas, the manufacturing complexity of these drugs deters generics from entering the market. Further, strong demand for cardiovascular drug Xarelto and ophthalmology drug Eylea should continue to drive growth.
Bayer's healthcare segment also includes a consumer health business with leading brands Aspirin and Aleve. Brand recognition is key in this segment, as evidenced by the company's iconic Aspirin, which continues to produce strong sales even after decades of generic competition. The 2014 acquisition of Merck's consumer products increased the scale of Bayer's consumer group.
Beyond human health, Bayer sells products for animal health where intangible assets and scale help its competitive positioning. Bayer's leading lines include Advantage and Baytril. While we don't expect robust growth for this mature segment, the cash flows should be steady.
Bayer also runs a leading crop science segment, which includes crop protection products (pesticides, herbicides, fungicides) and the fast-growing plant and seed biotechnology business. Similar to the drug business, this segment is research and development intensive, and Bayer has developed a strong portfolio of products. The downside to this business is that demand is heavily dictated by weather and commodity prices, which will determine how much farmers can afford to spend on crop treatment. The acquisition of Monsanto has significantly expanded Bayer's competitive position in this industry.
Wide-moat pharma contributes to overall narrow moat
We believe Bayer has a narrow economic moat. The combination of the company's wide-moat pharmaceutical business and narrow-moat consumer health and crop science businesses leads us to our narrow moat rating.
Similar to other large pharmaceutical companies, Bayer's drug unit supports a wide economic moat. The company has a diverse portfolio of patent-protected drugs and a growing number of biologic drugs. The company also has a strong global salesforce that can attract smaller drug companies to partner with Bayer for commercialization efforts, which augment Bayer's internal drug-development efforts. The company's consumer health business benefits from a narrow economic moat, largely because of its strong brand power. Consumers continue to pay a premium for Aspirin and Aleve even though significant generic competition has existed for many years.
The company also has a narrow economic moat in its crop science business. While some of the crop science business is a commodity business with few barriers to entry, other areas, including biosciences, maintain high barriers to entry--rigorous research and development efforts required to participate in this market combined with strong patent protection keep the majority of competitors at bay and support stronger pricing power.
We think Bayer's material science business has no economic moat. In this segment, Bayer faces strong competition and has very little pricing power. Although Bayer is first or second in market share for all of the material sciences businesses where it competes, it is still largely a price taker in the industry because of the high level of competition. We expect Bayer will sell its remaining ownership of this unit in 2018, which we believe will strengthen the overall moat of the remaining company.
Regulation and litigation are risks
The company faces the standard pharmaceutical risks of regulatory delays or non-approvals for pipeline drugs. With consolidation in the managed-care and pharmacy benefit manager industry and budget deficits facing many governments, payers are increasingly pushing for lower drug prices and higher rebates. Bayer faces heightened market risks as it is launching several new drugs that hold strong potential if the market embraces the new treatments. In the crop science business, demand depends heavily on highly variable commodity prices and weather conditions. Additionally, on both the healthcare and crop science segments, litigation risks are elevated, especially with ongoing litigation around Xarelto and glyphosate weed killers.
Bayer holds a relatively strong balance sheet, with close to €8 billion in cash and a manageable amount of debt at close to €15 billion. The company's 2017 leverage ratios of 28% debt/capital and 2 times debt/EBITDA suggest secure financial footing. Despite its solid financial standing, the company does carry more debt than its peers, partially because of the 2014 purchase of Merck's consumer product group. However, with its strong cash flows from operations of close to €7 billion, we are confident that the company can meet its debt obligations. The merger with Monsanto significantly increased debt levels, but we believe the cash flows from the business will easily meet the increase in related interest payments.
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