Bayer beware: what are we missing?
Updated: Jun 14, 2019
Bayer's share price has been monkey-hammered from a high of EUR 116 two years ago to EUR 53. Depending on the size of the ultimate RoundUp litigation settlement and the impact on the underlying Crop Science business, there seems to be plenty of value for the brave. What could we be missing?
Bayer is one of Germany’s most prominent companies, founded 156 years ago in Leverkusen, and the firm behind some of the world’s most recognizable brands in medicine such as Aspirin. It is also one of the largest prescription pharmaceutical companies and since last year it is now the largest agricultural science business in the world. It is a leading player in each of these segments with powerful competitive advantages and a wide economic ‘moat’ driven by trusted brands, patented intellectual property, strong customer relationships and scale. The barriers to effective competition are high.
In the pharma business Bayer is a developer or co-developer of original small molecule and biotechnology drugs, with enormous barriers to entry given the cost of pre-clinical R&D, clinical trials and patents that protect products from competition for a limited period.
The consumer health business benefits from a portfolio of some of the most widely recognized and trusted over-the-counter medicines in the world. These brands remain strong, although the competitive advantages of FMCG brands in general has waned in recent years given changes in the retail landscape, private-label competition and shifting consumer purchasing behavior.
Bayer now has the largest agricultural science business globally. It is the world’s largest developer of seed trait technology, genetically modified crops and producer of herbicides and pesticides. It is around a third larger than the number two player. Decades of R&D into development of key seed traits in corn, soybeans, cotton and wheat, linked in a system to its key herbicide and pesticide products allows farmers to increase yields and maximize productivity, making Bayer an indispensable partner in large-scale farming.
This last business is controversial for a number of reasons and Monsanto, which Bayer acquired in 2018, was one of the most widely reviled companies in America. There are legitimate concerns around the long-term consequences of genetically modified crops, the excessive application of herbicides and pesticides and associated health risks, growing weed resistance and significant corporate power over farmers. These are emotive issue, and the science is vigorously debated by people of integrity on both sides.
The science suggests these produces are safe in the quantities used, at least to the level of knowledge we have today, and regulators keep a close eye on it. Ultimately it seems pretty unrealistic to expect that the advances made in genetic manipulation of plants will be abandoned altogether so the key will be to ensure these technologies are applied in a way that is safe, sustainable and ethical. Would it be better to avoid genetically modified crops and wide-spread use of glyphosate herbicides entirely? In an ideal world, probably. In higher income countries there is likely to be a continued shift towards organic and sustainably-farmed produce in any case. But to feed and clothe a global population of eleven billion people, with increasing demands for a richer diet (GMO soy and corn are mostly used as animal feed), it is likely these products and processes, or more evolved versions thereof, will continue.
In short, Bayer's business is one that we typically like. The markets it competes in are large with a favorable long-term outlook, it has a leading position in the areas it chooses to compete with strong competitive advantages.
Bayer’s share price has been crushed due to the US$63bn acquisition of Monsanto in 2018, necessitating an increase in net debt to around EUR 40bn (including debt acquired and net pension liabilities), and exposure to litigation risk surrounding Monsanto’s leading weed-killer product RoundUp. In three California court cases since the acquisition juries have found RoundUp was a substantial factor in causing the plaintiff’s non-Hodgkin’s Lymphoma and have leveled enormous financial penalties. The latest jury verdict in May awarded punitive damages of over US$2bn. There are around 14,000 similar cases filed in the US alone. Bayer will eventually have to negotiate a sizeable class action settlement.
Using a combination of peer multiples and discounted cash flows for each segment, we estimate the underlying business is worth around EUR 140bn. After net debt and pension liabilities of EUR 46bn, the intrinsic value of the equity should be worth around EUR 94bn or EUR 96 per share (although roughly in a range of fair value between EUR 90 to 110 per share).
By our math any RoundUp litigation settlement of EUR 10bn or greater would result in an annualized return below 15% over the next three years. We estimate a 1-in-2 chance of a settlement below that figure. That makes this a borderline investment case, but applying a range of probabilities and outcomes, we also see a nearly 1-in-3 chance of an annualized return of 18% or more.
Under a really bad litigation settlement outcome the downside appears fairly limited from the current share price of EUR 53. We estimate, that all else being equal, a settlement of EUR 40bn, would generate a negative total return of -12% (excluding dividends, which at the current EUR 2.8 per share and assuming no dividend cut would offset the loss over 2.5 years). We expect that a settlement of that size is only a one-in-twenty probability.
This analysis suggests a pretty reasonable trade-off: limited downside under a low-probability adverse scenario, and strong up-side under a reasonable probability mid-case scenario. With even more up-side if things really go their way.
What Are We Missing?
The market appears to be pricing in something much worse, so what are we missing? Or is there really a good opportunity?
Assuming we are wrong and the stock goes to 35 (as Carl Jacobi says: "invert, always invert") what was likely to send it there? These are our best guesses:
1. our estimate of the RoundUp settlement liability is too optimistic.
2. lawsuits with regard to other Crop Science products are yet to emerge.
3. regulators ban or limit the use of glyphosate and related GMO crops.
4. the pharma division should be valued using biotech multiples, i.e. 9-10x EBITDA
5. major agricultural downturn and trade war leads to massive decline in volumes.
6. Bayer’s debt rating is downgraded and interest expenses rise significantly.
Probably the biggest risk from the above is (3). Driven by media headlines, a consumer outcry or activist pressure, regulators could limit or ban the use of glyphosate herbicides or linked GMOs. Our valuation of Bayer assumes stable conditions for the underlying Crop Science division. At our central estimate of litigation liabilities of EUR 11.8bn, the current share price appears to assume a 40% decline in the value of the Crop Science division. There is likely to be some pressure, but an impact of this size seems unlikely as we explain below.
While each of thes above factors alone is not material to the investment case, a combination could be. A larger-than-expected settlement, higher decline in earnings from RoundUp and related seeds and a multiple contraction in the pharma business could increase the down-side risk to 50% or more. Again, we think this unlikely, but it is possible.
Bayer’s pharmaceutical business is among the leading franchises, competing with the likes of Sanofi, Lilly, Roche, Merck and others. The business generated EUR 16.7bn in revenue in 2018, and generated EUR 5.6bn in EBITDA before one-off items, a 33.4% EBITDA margin and EUR 3.5bn in free cash flow after all capital expenditure. Revenues have grown at 8.4% CAGR over the past five years, largely as a result of Xarelto (31% CAGR) and Eylea (46% CAGR), and which have now come to represent 35% of the pharmaceutical portfolio.
Xarelto is an oral anticoagulant (blood-thinner), co-developed with Janssen that is a competitor to Warfarin. Warfarin was first developed as rat poison in 1948 and was only later approved as a therapeutic human anticoagulant in 1954. It is speculated that Warfarin was used to poison Stalin. Getting Warfarin dosage correct is the key issue as the most common side effect is bleeding, and problematically, bleeding in the brain. While Xarelto is still under patent protection and therefore much more expensive, and it can also cause bleeding in the gastro-intestinal tract, but the chances of cerebral hemorrhage are much lower. You also don’t need blood tests to check levels, it has fewer interactions with other medications and you only need to take it once a day. Xarelto represented EUR 3.6bn in revenue in 2018, up 10% y/y.
Eylea is an anti-VEGF drug developed by Regeneron and approved by the FDA for central retinal vein occlusion (CRVO)-associated macular edema (blindness). Anti-VEGF drugs make the injured blood vessels less leaky, thereby decreasing macular edema. The problem is treatment with Eylea requires monthly injections in the eye and you can imagine how you look forward to a trip to the hospital for that. There is an off-patent, and therefore much cheaper, biologic called Avastin that is approved for use in colo-rectal cancer but is often used off-label to treat eye conditions like CRVO. Avastin costs $60 per dose vs $1,850 for Eylea, but Eylea is still the preferred treatment by physicians given the labeling and it is covered by most insurance plans.
The problem Bayer’s pharmaceutical business faces is that both Xarelto and Eylea lose patent protection in 2024 (and 2027 for Eylea formulation) so roughly EUR 7bn in sales, or around 35-40% of the pharma portfolio will see generic competition starting in roughly five to seven years and those revenues will decline. Bayer needs to refill its pipeline. The problem is that a number of promising drug candidates did not make it through clinical trials in 2018, so the pipeline now looks fairly thin.
The one rising star in the portfolio is Vitrakvi, which Bayer acquired from Loxo Oncology last year just before Loxo was acquired by Eli-Lilly. The FDA granted accelerated approval for the drug last November given its response rate and duration in cancer patients. Vitrakvi is one of a new class of biologics that target tumors by gene expression, regardless of where the cancer is found in the body (tissue agnostic). In this case Vitrakvi targets solid tumors that have a neurotrophic receptor tyrosine kinase (NTRK) gene fusion and is approved for use in adult and pediatric patients where the cancer is metastatic or where surgical resection isn’t likely to work. It is incredibly expensive, around US$400,000 per year before discounts, but that’s because cases of NTRK gene expression cancers are quite rare, with only 2,500-3,000 per year in the US, and identifying them requires the doctor to sequence the DNA of the tumor, a step that is expensive and may not occur that often.
Worldwide Bayer has estimated Vitrakvi to generate around EUR 750mm in peak sales, so it’s not a solution to the patent-cliff problem on its own. Bayer will likely have to acquire other late stage targets, but those deals will be expensive given similar patent cliff issues at other large pharma players and Bayer’s balance sheet is no longer in the best shape to do those deals given the Monsanto acquisition and litigation issues.
We estimate the pharma business worth EUR 74bn, based on 13x FY19 EBITDA of EUR 5.6bn or 4.2x sales, the median of peers. A discounted cash flow valuation results in a higher figure of EUR 84bn, but doesn’t explicitly capture the revenue risk after five years.
Consumer Healthcare Business
Bayer’s consumer healthcare business includes household over-the-counter brands like Aspirin, Claritin, Alka-Seltzer, Canesten and Elevit. It is a tier one player, but at the lower end with sales of EUR 5.3bn in 2018, putting it around #5 in terms of consumer health sales. The really big players like Johnson & Johnson and GlaxoSmithKline do around $11-14bn in revenue. The business generates around EUR 1bn in EBITDA, at roughly a 20% margin and should generate around EUR 500m in free cash flow.
The problem for Bayer and the other branded consumer health companies, is that growth is challenged amid a changing retail landscape and shifting consumer preferences. Volumes have been declining for the past few years. Key among those changes has been the rise of private label products, which are increasingly attractive to younger, more cash-strapped consumers. They tend to be less swayed by brand loyalty especially when they are aware that the active ingredients across products are the same. Moreover, the specialty retailers like Boots, CVS and Walgreens have upped their game with regard to branding, packaging and marketing so that consumers place as much trust and value in the retailer brand as in the manufacturer brand. The same things is occurring in groceries, where brands like Campbells Soup and Kraft-Heinz are losing to brands like Kirkland from Costco. Even Warren Buffet admits to getting this wrong with his purchase of Kraft.
That said, even with weak growth, the business should continue to generate at least EUR 500m in free cash flow and based on peer multiples of 13.5x EV/EBITDA and 3.2x sales should be worth approximately EUR 15bn.
Bayer’s animal health business consists primarily of flea, tick and worm treatments for pets but also antibiotics and other treatments for farm animals. The business generates around EUR 1.5bn in sales and EUR 350m in EBITDA, with around 2/3rds coming from the US and Europe. The business has been relatively stable and is expected to be sold in 2019, with lots of private equity bidders going over the data and preparing bids. Based on a discounted cash flow approach this business is worth roughly EUR 5.4bn, although the press is reporting private equity interest up to the EUR 7-8bn mark. The PE guys are flush with cash, have access to lots of cheap debt and need to put money to work (although unbelievably, they get to charge fees on uncalled money, so what’s the rush?). In any case, with a healthy private equity appetite for debt a higher price wouldn’t be a surprise.
Crop Science Business
That leaves the agricultural science business. Bayer was already among a handful of large, leading crop science companies producing new seed varietals, herbicides and pesticides, with EUR 9.6bn in sales and around EUR 2bn in EBITDA and EUR 1.2b in free cash flow as of 2017. The industry underwent major consolidation between 2015 and 2018. In 2017 Swiss firm Syngenta was acquired by the Chinese. Dow Chemical and DuPont then merged, with their respective ag science businesses placing them as a firm #2 with USD 14bn in sales. Bayer was at risk of becoming an also ran in a very attractive industry segment in terms of economics. So in 2016, under the leadership of a new CEO, Bayer launched a $63bn bid for the leading player in the industry, Monsanto. Their combined Crop Science business would be the clear market leader, with close to EUR 20bn in revenues in after some lines were sold to BASF for anti-trust reasons, a much more even split between North America and Europe and a business geared more toward genetically engineered seeds for corn and soy, as well as leading herbicides such as RoundUp.
Bayer went "all in" so to speak, despite Monsanto's controversial reputation. After nearly two years of regulatory reviews in the US and Europe and other key markets, the transaction closed in mid-2018. Pro-Forma financials for 2018 show a business with EUR 19.3bn in revenue, EUR 2.7bn in adjusted EBITDA. Management has guided for an EBITDA margin of 24% in 2019 before one-offs related to the transaction, restructuring and litigation, which would be closer to EUR 4.6-4.8bn and could be as high as EUR 5bn going forward as synergies between the two businesses emerge. Bayer is looking to cut 12,000 staff over the coming two years, or roughly 10% of its global workforce.
We think the combined Crop Science business should be worth around EUR 70bn, based on a discounted cash flow model assuming 25% EBITDA margins and capital expenditure of a little over 7% of revenues and 2% long-term growth.
There aren't many listed peers to compare with. Corteva recently spun off from DowDupont and also appears to be undervalued as a result of the transaction on around 11x EV/EBITDA and 1.4x sales, although given all the restructuring charges during the integration of Dow and DuPont and then subsequent separation, the numbers are a mess.
Bayer’s stand-alone crop science business was probably worth EUR 25bn prior to the deal based on 12x EBITDA multiple or 2.5x sales. Considering Bayer paid US$63bn including debt, or roughly EUR 56bn at current exchange rates, and assuming a very rough 25% control premium, the underlying Monsanto business could be said to be worth around EUR 45bn. Combined this comes close to the estimated EUR 70bn for the combined business.
Other and Corporate
On a discounted cash flow basis our estimates for “Other” segments and corporate costs and capex represents around EUR -29bn in total value. There is around EUR 400m in net EBITDA losses based on the 2018 financials between the two segments and another EUR 400m in capex, which is assumed to grow 1.5% indefinitely.
Just weeks after the Bayer’s acquisition of Monsanto closed, Monsanto lost its first lawsuit claiming that its key product, RoundUp, causes cancer. The jury in the California court awarded the plaintiff US$278m in damages, later reduced to $78m by the judge.
Bayer/Monsanto also lost the subsequent two cases, making it three-for-three against the company. In the case just concluded in May, the jury awarded the two plaintiffs $2bn in punitive damages.
Five more trials will take place by the end of the year, and the number of cases has now increased to around 14,000. Bayer’s share price is now 60% below its peak of $137 in 2015 and the whole company is now worth only EUR 50bn, less than the price it paid for Monsanto.
So what is RoundUp, does it cause cancer, and what is it going to cost them?
RoundUp is based on Glyphosate, the most heavily used herbicide in the world, particularly on soybean and corn crops. Around 50% of its use in the US is on soybeans and it is also used heavily in Brazil and Argentina, the other two large global exporters of soybeans.
Glyphosate was originally developed in the 1950’s, but was introduced to the market in 1974 by Monsanto under the brand RoundUp. Glyphosate works by targeting a key enzyme required for plant growth, but which isn’t found in animals, so it’s considered to be one of the least chronically toxic herbicides for mammals. The EPA considers a chronic dose to be 1.75 mg per kg of bodyweight per day, while the EU limits a chronic does to 0.5mg/kg/day. It metabolizes as aminomethylphosphonic acid.
RoundUp usage grew steadily from its introduction in 1974, but usage really exploded from around 1996 when Monsanto introduced RoundUp Ready seeds, that were genetically modified to be resistant to Glyphosate. This was as a response to the original patents on Glyphosate expiring and Monsanto needing to find a way to protect its lucractive market position. RoundUp Ready allowed farmers to spray their entire crop with RoundUp, saving time and cost, and only the weeds were affected. Of the 1.6 billion kgs of RoundUp that have been applied in the US since 1974, 2/3rds was in the past ten years. In fact around 1kg of RoundUp is used for every hectare of cultivated crop land in the US. Of course, sustained exposure has allowed different varieties of weeds to develop resistance, but so far that has just led to farmers applying more RoundUp, with each crop now getting around 1.6 treatments, up from less than 1 a decade ago.
This is a very polarizing issue. On the one hand the use of the relatively safe Glyphosate has been a tremendous boon for agricultural productivity. But there are questions around its long-term health consequences (more on that in a minute), farmer dependency on a single supplier of seed and herbicide, a reduction in crop genetic diversity and ultimately weeds that have developed resistance requiring newer and potentially even more toxic herbicides (if you have an issue with Glyphosate, you will like the alternatives from Bayer's competitors even less. 2, 4-6 or Dicamba contains both glyphosate and some of the stuff from Agent Orange and it spreads more easily when applied).
There have long been claims that Glyphosate and the RoundUp formulation (including the surfactants) in particular can cause tumors in rats, that it causes mutations in cells in the lab, and that its use is associated with a higher risk of non-Hodgkins lymphoma (“NHL”) in humans.
There doesn’t appear to be a clear answer, especially to the non-scientist. For example, we can quickly pull up two seemingly reputable papers from the website of the National Institute of Health that give two completely contradictory results. One finds that Glyphosate use by farmers in Canada is associated with a doubling of the risk of developing NHL with strong statistical significance. Another epidemiological study called the Agricultural Health Study (AHS), conducted by the NIH itself, across more than 50,000 people over a very long period of time up to 2018 finds no link at all. This AHS is considered one of the best studies into the issue and is completely independent of Monsanto or the industry.
But even with the AHS, another seemingly reputable paper calls the AHS result into question, with a highly technical criticism of the way in which the AHS adjusted for non-responses in the follow up – a discussion that is way beyond our statistical competency to assess. This is a scientifically and statistically complex subject.
The Environmental Protection Agency (EPA) has always maintained that its own studies and assessment show that glyphosate is safe at exposure levels humans are likely to experience and the other regulators at the US National Toxicology Program and environmental regulators in Europe, Canada and Australia have concurred. Unless one is of a highly conspiratorial frame of mind, one assumes these agencies are competent and honest.
However, despite forty years of approval by the EPA and others, in 2015 a WHO body called the International Agency for Research on Cancer (“IARC”), did its own review of the scientific literature and came to the conclusion that glyphosate was a “probable human carcinogen”. This was the first time a regulatory body had labelled the product as possibly carcinogenic, and that finding is a large part of the reason Bayer finds itself in this position today. It opened the door to a flood of lawsuits. The IARC also found that red meat and hot drinks (the temperature, not the drinks themselves) were in the same category 2A, “probably human carcinogen”, as well as as the exposure from being a hairdresser, so this is the neighborhood that RoundUp finds itself in. Can you now sue McDonalds for not labeling Big Macs as carcinogenic? I'm sure it's only a matter of time given the vegan activism we are now seeing.
Yet even after this development, the EPA concluded another review of the literature in 2017 and after a lengthy period of public comment, published its recommendations in April of this year, finding once again that glyphosate is NOT likely to be carcinogenic to humans.
Monsanto’s stance was always that the overwhelming body of scientific evidence, based on thousands of studies, does not support a conclusion that RoundUp causes cancer. That seems like a fair representation of the facts.
But here’s the problem, a few of those thousands of studies have shown that it can be carcinogenic. Whether these studies were based on quality science (some certainly weren’t, such as the 2014 Seralini study with only a couple of dozen rats that tend to develop tumors 70% of the time – a recipe for background noise and low statistical significance), and even if later, more comprehensive epidemiological studies do not show any link, it is not possible to say that there is absolutely no evidence of a link. One study showing a link, however good or bad the science, and you have “some” evidence, as the plaintiff’s attorney points out. And as one scientist at the EPA noted during their recent review, given the thousands of studies done on Glyphosate over the past four decades, it would be unusual if some didn’t find a link just on the basis of probability.
Unfortunately for Bayer, Monsanto has long been considered Amercia’s most hated company, and so there is little sympathy for nuanced scientific debate from the media or a jury. It is hard to imagine Apple being found liable for enormous damages, despite the US National Toxicology Program finding that cell phone radiation caused tumors of the heart, brain and adrenal glands of male rats. Where is the warning label? Instead you get “Designed in California”, which sounds way cooler than actually manufactured in California. That would, you know, involve pollution and stuff.
In court this spells disaster for Bayer. Internal emails by Monsanto scientists attacking the science of a study that shows a link to cancer, no matter how justified given the quality of the study (Seralini again), appear as corporate skullduggery. A good California lawyer can turn this stuff into Oscar material and so far three juries in three separate cases have found that RoundUp was a “substantial contributor” to the plaintiff’s NHL - despite those plaintiffs being former smokers, overweight, with previous cancers and at an advanced age (all significantly higher risk factors for NHL than Glyphosate). Juries have found that given there was “some” evidence of a link to cancer, Monsanto had a duty to label RoundUp as carcinogenic.
Further, Monsanto’s failure to warn consumers was malicious and fraudulent. In the last trial the plaintiff’s attorney signed off his closing argument with “Go get em!” and the jury came back with $2bn in punitive damages.
Estimating the RoundUp Litigation Liability
Firstly, how many claims could there be? There are 700,000 cases of non-hodgkins lymphoma in the US at a prevalence of around 0.2% of the population. But how many would have had sustained exposure to RoundUp? There are around 3.3 million Americans working in agriculture, on farms or in grounds maintenance according to the Bureau of Labor Statistics. Assuming all these workers had sustained exposure to RoundUp (although it is unlikely every single one of them did), and if the prevalence of NHL among these occupations could be up to double the national average, or 0.2%-0.4% (if you accept the findings of the "bad" study from Canada), that gives a range of between 6,600 to 13,200 cases. There are already more than that number of cases filed.
The question is probably more around the number of consumer RoundUp cases that come forward and that is much harder to estimate. How many would have had demonstrable long-term exposure significant enough to convince a jury that RoundUp was a significant contributor? Well, logically very few. Of the 125m kg of glyphosate herbicide used in 2014, non agricultural usage of 12m kg was less than 10% of the total. That works out to be 39mg of glyphosate per person per year given a non-agriculturally employed population of approximately 316m, or 0.1mg/day.
A 24oz bottle or RoundUp weedkiller from Home Depot that covers an average yard, contains 2% by weight of glyphosate or just 13.6mg per bottle. You'd need to use 73 bottles bottles per year to get through 1kg of glyphosate, which is still only 2.7mg per day, even if you ingested the whole lot. The EPA limit is 2mg per kg of bodyweight per day, so if you're 80kg that 160mgs per day. Logically there is no-one with anywhere near enough exposure from residential usage to have a case. You would have to be bathing in the stuff. Clearly logic doesn't have much to do with it and so we can only guess at the number or residential claims.
Our very rough guess is 50,000 claims in total including the 6,600-13,200 ag-worker claims.
What could be the ultimate damages per claim?
There are a few analogs although every situation and case is unique:
1. In 2012 Bayer faced 12,000 claims related to blood clot injuries from its oral contraceptive Yaz. By 2016 it had settled 10,300 of those for $2.04bn and another $80m for smaller claims. The larger settlement worked out to US$200,000 per claim.
In 2015 unsealed court records from Illinois show that 850 asbestos victims across the country had been awarded $335,000 from the court system and $182,000 from bankruptcy trusts. James Hardie’s latest results show that ongoing asbestos-related settlements averaged $250,000 in 2018, with $300,000 for mesothelioma and $120,000 for lung cancer cases.
A settlement for 9/11 victims included a $300,000 award specifically for a sufferer of non-Hodgkins Lymphoma.
In the 1994 settlement Engle vs R. J. Reynolds the jury awarded punitive damages of $144.8bn across 500,000 Florida plaintiffs or US$290,000 per claim. But the legality of awarding punitive damages to members of a class unrelated to their individual assessment of compensatory damages caused the class to be decertified and 8,000 or so individual cases have subsequently proceeded and are still ongoing 25 years later!
These are a small sample to be sure, but they do point to a number of around US$200,000 to US$300,000 per case.
For additional context, the largest class action settlements in history came from BP in the Gulf of Mexico (US$ 20bn), and the Volkswagen emissions scandal (US$ 15bn). The VW settlement involved 475,000 plaintiffs, but only for vehicle buy-backs and $5,000 to $10,000 in cash. Cancer is a little more serious.
Our mid-case above of US$15bn implies less than EUR 12bn in present value terms assuming 2yrs to payment and doesn't account for insurance recoveries and is pre-tax.
While the 14,000 pending cases sound like a very scary number, many of these cases will be marginal and not attract the same penalties from the earliest cases. Each has its merits or not, and lawyers likely have brought their strongest cases first. The damages awarded in these initial cases make for good headlines, but tend to be revised lower and could even be overturned by the judge on appeal. Punitive damages, for example, are supposed to have a statutory cap of 3-to-1 versus compensatory damages, although this can be flexed under certain circumstances, but a single digit multiplier is more likely.
While Bayer is portrayed in the media as a staid, conservative German company naïve to aggressive US litigation, the reality is Bayer is no stranger to US courts and is a tough litigant. Moreover the dynamics of the settlement negotiation process typically favor the defendant and the plaintiff’s counsel is incentivized to settle sooner rather than later. They often don’t get paid until a settlement is reached, while defendants like Bayer have deep pockets to drag the fight out case by case, going through multiple rounds of appeal and hoping that either cases don’t make it to court or that weaker cases arise that they are able to win. That stops the avalanche of new cases and brings the expectations of litigants toward a lower and more realistic settlement sum. Any settlement could therefore be years away. In the Yaz case above settlement was only reached in 2015 after the first cases were lodged in 2009.
Risks to the Investment Case
It is always wise to assume that you may be wrong. Assuming this analysis is wrong, where is it likely to be wrong and what is the impact on the investment case if it is wrong?
1. The estimate of the RoundUp settlement liability is too optimistic.
Anything above US$15bn makes the investment unattractive, all else being equal.
2. Lawsuits with regard to other Crop Science products are yet to emerge.
While this is a possibility (including California’s lawsuit over Monsanto’s historical BPA production) it is almost impossible to predict or quantify.
3. Regulators ban or limit the use of glyphosate and related GMO crops.
Pushed by jury verdicts, media headlines and public pressure, regulators reassess prior views and implement stricter measures on the use of Glyphosate, other herbicides or GMOs in general. This risk is potentially higher in Europe where regulators are more circumspect and France has already de-registered some Bayer products. The overall financial impact is difficult to assess. Assuming a 30% reduction in the value of the Crop Science division it would be worth closer to EUR 45bn. Mitigating this risk, farmers in the US are likely to resist restrictions as it would reduce profitability and US farmers are already under enormous pressure from lower crop prices, wet weather and Chinese tariffs on US agricultural products. Glyphosate is almost universally applied to soybean production in the US and would require a massive change in systems, processes and supply chains to remove.
The farm lobby is quite powerful. Alternative products either contain Glyphosate or other substances that are potentially even more harmful. Regulators that have studied and approved Glyphosate are likely to resist pressure to change their assessments based on inconclusive science.
4. The pharma division is worth only ex-growth biotech multiples, i.e. 9-10x EBITDA
Pure biotech companies that have significant portions of revenue subject to near term patent expiry and generic competition are valued on much lower multiples:
- Amgen: 9.5x EV/EBITDA and 4.5x sales
- Gilead:7.7x EV/EBITDA and 3.7x sales
- Biogen: 6.5x EV/EBITDA and 3.2x sales
Using these peers and applying 10x EBITDA and 3.2x sales, Bayer’s Pharma business would be worth closer to EUR 60bn (EUR -14bn vs base case). Mitigating this risk, it is possible to use the valuation of Regeneron (REGN) for an appropriate multiple for Bayer’s Eylea business, its #2 product with 15% of Pharma revenue. Regeneron is valued on 12x EV/EBITDA and 4.8x revenues.
5. Major agricultural downturn and trade war leads to massive decline in Crop Science volumes.
Likely in North America in the near-term, but should not have a significant impact on the long term valuation of the business. Bayer’s Crop Science business has significant geographic diversification: tariffs on US soy are likely to result in increasing exports from Brazil and Argentina, which are also significant markets for the company.
6. Bayer’s debt rating is downgraded and interest expenses rise significantly.
Possible if the final settlement pushes debt metrics below current Moody’s Baa1 rating levels. Underlying ND/EBITDA, adjusted for pensions, is currently 3.8x. With a sizeable settlement this could very quickly become 4-5x, offset slightly depending on sale of the Animal Health business (EUR 5bn vs EUR 350m in EBITDA). However, with gov bond yields at record lows, even a small increase in spread is unlikely to be a major concern. Dividends of EUR 2.7bn a year could be reduced if necessary.
Individually each of these risks is manageable. A combination of (3) and (4) could reduce the value of the business to EUR 87bn, or just EUR 42 per share for the equity (-22%), even before a significant RoundUp settlement. Those should be independent probabilities. A more likely down-side scenario is the combined probability of a larger settlement and reduced earnings in Crop Science, but even here we think the stock price has over-reacted. Headlines aside, it will take dramatic shifts move US farmers away from RoundUp Ready soybean and corn.