Wednesday, July 15, 2009

High margin, low or reasonable capex businesses (part 2)

Continuation from the previous post.

Business : Eli Lilly is a pharmaceutical company which discover, develop, manufacture and sell drug products. It also has an animal health business segment, whose operations are not significant to its financial earnings.

Competition : Eli Lilly competes with products manufactured by many other companies in highly competitive markets worldwide. Important competitive factors include product efficacy, safety, ease of use, price, demonstrated cost-effectiveness, marketing effectiveness, service and research and development of new products and processes. If new products or delivery systems with therapeutic or cost advantages are introduce by competitors, Lilly's products can be subject to progressive price reductions, decreased sales volume, or both. Most of its products must compete with other products already on the market or products that are later developed by competitors.

Financials (in $'000,000) :

Net profit-2079.929532662.71979.61810.1
Profit margin as a % of revenue-10.21%15.85%16.97%13.52%13.06%
Total asset29212.626874.822042.424667.824954
Return on asset-7.12%10.99%12.08%8.03%7.25%
Net cash provided by operating activities7295.65154.53975.91913.62869.5
Capital expenditures-947.2-1082.4-1077.8-1298.1-1898.1
Free cash flow6348.44072.12898.1615.5971.4
Diluted no. of shares1094.51090.751087.491092.151088.94

The market capitalization is about $36 billion.

Comments : Eli Lilly, like most other big pharmas, is facing slow growth and challenges ahead to replace oncoming expiry to their blockbuster drugs. Its top three drugs make up almost 45% of its business. Furthermore, all are facing impending expiration to their patents either in 2011 (no.1 drug) or 2013 (no.2 and 3 drugs). To be successful in the highly competitive pharmaceutical industry, the company must commit substantial resources each year to research and development in order to develop new products to take the place of products facing expiration of patent and regulatory data exclusivity. Historically, Eli Lilly commits between 18 to 20% of sales to R&D. However, this does not guarantee success as there are many risks involve in development on drugs from research risk to regulatory risk to commercial risk. In recent years, the regulatory environment has gotten increasingly challenging for the industry. The industry worldwide faces a changing regulatory environment and heightened public scrutiny, which require greater assurances than ever to the safety and efficacy of drugs, as well as effectively providing reduced incentives for innovative pharmaceutical research. These requirements have resulted in the reduced number of new products that get approved. However, with the acquisition of ImClone, its drug Erbitux ought to boost Lilly's sales. The drug, a key component of Lilly's acquisition of ImClone, has been approved to treat head and neck cancer in the E.U. and should be approved in the U.S. next year. The company's once-a-week diabetes control drug, Byetta is an important long-term growth opportunity. Byetta currently has annual sales of about $700 million (or 2% of the oral diabetes market). It stimulates the release of insulin only when bloody sugar levels are high, but must be injected twice daily. A fruitful pipeline is necessary to sustain growth to 2012-2014 with the impending expiration of patent to its top-performing drugs, creating the need for a strong crop of treatments to replace them. While growth from Cialis and Alimta should offset some of the lost sales, other clinical molecules will need to be successfully promoted to grow the bottom line over the long term. Lilly, with its excellence financials, makes it an appealing long-term investment. While patent expirations are a concern, the company's has an almost-pristine balance sheet and puts it in a position to acquire small tug-in companies with close-to-market drugs who are financially strapped, should the 20 or so products under development in its pipeline fail to make an impact by 2012-2014.

Business : Moody's Corporation is a provider of credit ratings, research, and analysis covering debt instruments and securities in the global capital markets. It also provides quantitative credit assessment services, credit training services, and credit process software to banks and other financial institutions. Berkshire Hathaway is a major shareholder with 20.4% of the common stock.

Competition : Moody's credit rating division competes with other Credit Rating Agencies and with investment banks and brokerage firms that offer credit opinions and research. Many of Moody's customers also have in-house credit research capabilities. Its largest competitor in the global credit rating business is Standard & Poor's Rating Services, a division of The McGraw-Hill Companies. In addition to S&P, Moody's other competitors include, Fitch, a subsidiary of Fimalac S.A., Dominion Bond Rating Service Ltd. of Canada, A.M. Best Company Inc., Japan Credit Rating Agency, Rating and Investing Information Inc. of Japan, and Egan-Jones Rating Company. In 2008, two more firms were granted the Nationally Recognized Statistical Rating Organizations Status (NRSROs): LACE Financial Corp., and Realpoint LLC. SEC continues to expand the number of NRSROs. Moody's Analytics competes broadly in the financial information space with diversified competitors such as Thomson-Reuters, Bloomberg, RiskMetrics, Dun & Bradstreet, S&P, Fitch, and Markit Group, among others.

Financials ($'000,000) :

Net profit457.6701.5753.9560.8425.1
Profit margin as a % of revenue26.07%31.05%37.01%32.39%29.56%
Total asset1773.41714.61497.71457.21389.3
Return on asset25.80%40.91%50.34%38.48%30.60%
Net cash provided by operating activities534.7984752.5707.9526.2
Capital expenditures-84.4-181.8-31.1-31.3-21.3
Free cash flow450.3802.2721.4676.6504.9
Diluted no. of shares245.3272.2291.9305.6304.7

The company's market capitalization is about $7.1 billion.

Comments : The credit rating business continues to be challenging with regulatory risk and new competitors. The big three may have permanently caused some damage to its reputation for impression of being a "rubber-stamper." In first quarter, Moody's continues to struggle, having recently reported its seventh consecutive quarterly earnings decline, with earnings sliding 15% year on year. The biggest declines were witnessed in the structured finance and financial institutions segments, where revenues fell 29% and 16% respectively. The decline in these two segments more than offset improved results from corporate finance segment which business was up by 15%. A few factors work against the company this quarter, including depressed credit market and the strengthening of the U.S. dollar. The latter will cut into full year earnings, as nearly 50% of Moody's ratings business comes from outside the U.S. Also, the company's expenses are expected to rise because of the need to increase its compliance operations in anticipation of some new regulations on credit rating agencies, beginning in 2010. The credit rating business faces increased scrutiny going forward, as the European Union approved new oversight for the $5 billion industry. This comes following public outcries that credit raters failed to give investors adequate warnings of risks in subprime mortgage securities. Under the proposed rules, agencies face would be liable for their opinions and could face E.U. sanctions if found guilty of professional misconduct. Although the new proposal would not force Moody's to alter its business model, the rules would increase compliance expenses. With all these, though, a top and bottom line rebound is probable as credit issuance picks up when the economy starts to recover - sometime in 2010. Moody's share has been on a roll since March. Investors with a long-term perspective should achieve decent returns at today's price.

Business : The Dun & Bradstreet Corp. is a worldwide provider of business information and related decision support services.

Financials ($'000,000) :

Net profit310.6298.1240.7221.2211.8
Profit margin as a % of revenue17.99%18.64%16.32%16.03%15.46%
Total asset15861658.81360.11613.41635.5
Return on asset19.58%17.97%17.70%13.71%12.95%
Net cash provided by operating activities436.5393.9304.9261.5267.6
Capital expenditures-11.8-13.7-11.6-5.7-12.1
Free cash flow424.7380.2293.3255.8255.5
Diluted no. of shares55.559.865.169.473.1

The market capitalization of Dun & Bradstreet is about $4.4 billion.

Comments : The company has done well in cutting operating cost. Although revenue declined by 1.8% during the first quarter year on year, the operating income increased by 14%, more than offset by a 7% reduction in operating expenses. DNB faces a stagnant domestic U.S. business, but its international segment is still growing though the growth has slowed considerably during the first quarter year on year. Price has come under some pressure, in particular the Sales & Marketing Solutions division. The S&M division has come under fire as demand for its customer information and marketing services waned. With many clients operating in the beaten down retail sector, the lack of a proprietary product in this arena has forced DNB to compete on price. The core division, Risk Management Solutions, has by and large helped protect top line results because of the larger prevalence of subscription-type products, though business declined by 1%. The company is also an avid stock repurchaser, even during the first quarter.


Daniel M. Ryan said...

Regarding Moody's: the ball game would change considerably if someone [or the SEC] successfully sues the company on a negligence basis for some of the products it put its AAA rating on. [I'm sure everyone knows what products I mean.]

Only a cloud on the horizon, but similar circumstances killed at least one old-line acccounting firm after the Enron et. al. scandals. Before then, it was almost inconceivable that an accounting firm would be held liable in that way.

Berkshire said...

Hi Daniel,

I do not admire the way the credit ratings conduct their business in general. The business model they have is something that is like asking Apple to pay CNet to rate MacBook as outstanding. That is something fundamentally wrong.

But overall, credit raters are not the most evil, though they deserve a share of the blame for participating in it. I wouldn't classify them in the same breadth as Arthur Anderson though.

I'm sure what you anticipate would become reality that more regulation is on the horizon. Already Mary Shapiro is calling for it today.

But overall, given the rundown in price, I think there's value to it, though as an individual, I do not rely on any ratings or analyst opinion to value my investments. But no doubt, the credit rating business will still be around though, there are just too many people who need an opinion to protect their "asses" so to speak in order to invest in a security. For sure, institutions need ratings.

Penny Stocks said...

Look beyond the mega cap stocks for value.