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Raman Minhas
Raman Minhas
Articles (7)  | Author's Website |

Is Baxalta a Good Spin-Off Opportunity?

The biotech pure play spin-off may enable value release from medical technology parent, Baxter

October 15, 2015 | About:

A number of well-known guru investors hold Baxalta (NYSE:BXLT), the biopharmaceutical pure-play spin-off from medtech parent Baxter. These include Tweedy Browne (Trades, Portfolio), Daniel Loeb (Trades, Portfolio) and Richard Pzena (Trades, Portfolio). Is it a good buy for investors at a current price of $33?

In this stock note, I consider historical performance, upside, risks, valuation and a suggested buy price.

Baxalta Inc. (NYSE: BXLT) - Stock Note

Buy price: $28.00

Current Price: $33.08

Market Cap.=$22.39 billion

Enterprise Value = $25.55 billion

PE(ttm)=22x

Sector: Biotechnology

Summary:

  • Spin off from Baxter medtech business allows management to focus on biopharmaceutical (biotech) pure-play, with its own operational, regulatory, competitive and commercial requirements
  • Niche focus in selected areas: haematology, immunology, oncology and biosimilars
  • Steady revenue growth (CAGR 5%) when considered as stand-alone business unit
  • Diversified portfolio of 29 marketed products, with rich portfolio of development stage products
  • High ROE greater than 30%, and net margins greater than 18%
  • Good long-term potential, but investors should wait until it reaches buy price of $28

Chart since IPO

LbnnrrHHeoQmUuwyWO0NHhpCrCee-iQSc1q6hemb

Financials (from listing filings):

Year

2010

2011

2012

2013

2014

2014 PF*

Revenue (£M)

4831

5218

5310

5555

5952

6109

Gross Profit

-

-

3070

3226

3509

3519

Gross Margin %

-

-

57.8

58.1

60.0

57.6

Operating Income

-

-

1561

1613

1532

1405

Operating Margin %

-

-

29.4

29.0

25.7

23.0

Net Income

1225

1344

1205

1288

1186

1114

Net Margin %

25.4

25.8

22.7

23.2

19.9

18.2

Shares Outstanding (M)

-

-

-

-

-

681

PE ratio

-

-

-

-

-

20x

Debt: Equity**

-

-

-

-

-

1.65

ROE %

-

-

-

-

-

37%

*ProForma adjustments for 2014

**NetDebt: Equity = 1.05x; NetDebt/EBIT = 2.15x

Main difference in pro forma drop in net profit margin is due to interest expense, so use 20% going forward (range in last five years is 18% to 23%  if adjusted for interest expense following split).

Description

Baxalta was spun out from Baxter (NYSE:BAX) in July as a stand-alone biopharmaceutical business. It sells products in over 100 countries, and sales for 2014 were $5.95 billion (pro forma $6.1 billion), with $2.9 billion of sales outside the U.S.

It manufactures and markets leading treatments for haematology, immunology and oncology. Specifically, this includes haemophilia and other bleeding disorders, immune deficiencies, alpha-1 anti-tripsin deficiency (a genetic disorder which affects lungs and can reduce lifespan), burns and shock, and other chronic and acute medical conditions.

Its portfolio includes intravenous solutions and nutritional therapies, drug delivery and administration systems, injectable drugs, inhalation anesthetics and biosurgery products.

Baxalta’s renal business offers a comprehensive portfolio of products for end-stage renal disease patients, complemented by its recent acquisition of Gambro AB.

The company is also investing into new disease areas, including oncology, and technology platforms including gene therapy and biosimilars.

Baxalta has an active R&D pipeline, and new products are obtained through in-house research, targeted acquisitions, licensing and scientific collaborations. Last year's R&D expense was $820 million, around 13% of revenue.

Revenue and earnings growth

Full year revenue for 2014 was $6.1 billion (pro forma adjusted), which has grown at a CAGR of 5% over the last four years. These figures are based on “carve out” of Baxalta business from Baxter parent; earlier figures are unavailable.

Since 2010, net margins have steadily fallen from 25% to 20%. Adjusted to pro forma equivalent, this ranges from 23% to 18%. The 2% reduction is largely due to the interest expense of the new debt load for BXLT. Gross margins are just below 60%, and operating margins over 25% (with proforma operating margin of 23%).

Earnings growth over the last four years have remained fairly flat, due to a fall in the net margin from 25% to 20%. The drop in 2014 was due to special items, including R&D charges of $214 million for upfront and milestone payments relating to collaborative agreements.

Business optimization charges of $22 million, $45 million and $51 million in 2014, 2013 and 2012 reduced the net margin, as did a legal charge of $84 million payable for class action suit for pricing of plasma-based therapies ($10 million of which was reversed).

Of the three charges, R&D charges for collaborations and legal charges are routine. R&D collaboration charges are lumpy, though $214 million is higher than usual. This amount is included in the $820 million total R&D charge. If using a normalised annual charge of $100 million, this brings the pro forma net margin up to 20%. Legal challenges are a matter of course in the biopharma industry.

The median net margin for mid-large biotechs is 25%. As a focused, stand-alone entity, Baxalta should be able to maintain a 20% net margin (versus 18-23% range with pro forma adjustment).

Buy price

When calculating buy price, I use conservative numbers (reducing downside risk) to project out revenue and earnings figures for three years and look for a 15% CAGR in stock price. Why three years and 15%? Three years is close enough to the historical trend data while allowing value to out. We use 15% because it’s a moderate hurdle but doesn’t require the optimistic scenarios of more aggressive hurdles.

Baxalta is a steady grower, with diverse products sold internationally and in growing demand. For three-year forward growth projections, I have used a current pro forma sales base of $6.1 billion, revenue growth rate of 5% pa, and net margin of 20%.

In July, management approved a $1 billion share repurchase program (time frame not defined). This is nearly 5% of the outstanding shares. Using this I have assumed an annual buy back rate of 1% from the current 681 million fully diluted shares in issue.

PE based valuation vs. reverse DCF

The PE ratio for mid-large cap pure play biotechs (i.e. market cap > $10 billion) ranges from 12x to over 80x, with a median PE of 30x. Baxalta’s PE ratio (trailing 12 months) at 22x is in the lowest quartile.

As a pure play biotech company with acquisition potential, I’ve used a PE multiple of 20x to calculate the buy price. Generally, I stick to 15x, but on occasion will go as high as 20x; biotech purists and M&A advisors may argue as high as 30x but I’d rather use a little conservatism.

Using these figures gives a forward three-year fair price of just under $43. To achieve a 15% CAGR, this gives a buy price today of $28, against a current price of $33.

As a sanity check, I also performed a reverse DCF valuation. Assuming a growth rate of 5% can be maintained, using a 10% discount rate, and assuming the net debt of $3.1 billion can be paid off from cash-flow (over the 10+ years DCF), this gives a value of $29. Lower growth rates and retaining net debt gives a value of around $23 per share.

By doing a reverse DCF, I’m not trying to obtain an exact valuation. Rather, it’s to see what assumptions are needed to achieve the same value by DCF. It’s also to make sure the two valuation approaches are at least in the same ball park. In a real world scenario, I would expect a small premium due to the acquisition potential within the active biotech sector.

Risks and opportunities

In addition to industry pressures faced by all biotech companies, (i.e. regulatory, R&D cost, clinical trials, manufacturing, competitive, reimbursement, intellectual property and legal), the following points are worth mentioning:

Spin-off value release

Spin-offs, where resulting businesses can focus more on their core offerings, and develop manufacturing, operating and commercial efficiencies have become a popular corporate method to release value. A particular case is where value is hidden in a parent group with lower profitability.

In Baxalta’s case, this is useful since it operates as a biopharmaceutical company, versus it’s medtech parent Baxter. Large profitable medtech companies generally have a lower profit margin than the equivalent biotech companies. Stripping out 2014 results for Baxalta, Baxter has a net margin of 12%, while the high range figure achieved by large medtechs is around 15% excluding outliers. As noted earlier, Baxalta’s net margin is around 20%.

Biotech and medtech, though both serving patients and in the healthcare sector, have very different R&D, regulatory, manufacturing, operational, human resource and commercial requirements. The separation allows Baxalta to focus fully on its biopharmaceutical business, and also allows an upward revision in valuation multiple.

Large biotechs currently trade at PE multiples of around 20x to 70x (excluding outliers and non-recurring). Clearly, the high end of this range is very rich, but even at current PE of 22x, Baxalta is in the bottom quartile of valuation multiples for large biotechs.

Acquisition potential

Shire PLC (SHPG), an highly acquisitive, Irish domiciled, biotech with international operations and $6 billion of sales including rare diseases, made an offer to buy Baxalta for $30.6 billion just five weeks after the spin-off. Benefits to Shire include growing product portfolio in rare diseases, and a tax benefit. Shire’s corporate tax rate is around 16% to 17%, whereas Baxalta’s is 22%. Just by acquiring the business, and without any economies from operating improvements, this would improve the combined results by hundreds of millions.

Baxalta’s board rejected the offer as undervalued. A sweetened offer was made in mid-September and again rejected. It’s not unreasonable that a higher offer will be made, or other buyers may compete with operational or financial strategic rationales.

Acquisition is a quicker way for the value to out, though it means current Baxalta shareholders may lose out on future growth. Even in the absence of an acquisition (it’s not done until it’s done), Baxalta has a credible growth story at a reasonable valuation.

Debt and balance sheet

As part of the spin-out, Baxalta has added nearly $5 billion in debt to its balance sheet, $4 billion of cash which was paid to Baxter as a partial consideration for the asset transfer to create Baxalta. The net debt after accounting for cash reserves is around $3.15 billion. While this is not a small amount, it is less than 2.2x operating income (my cut off is 3x) and should be safely manageable within current cash flow ($1.4 billion operating cash flow in 2014).

Baxter ownership

Immediately after the spin-off, Baxter will hold approximately 19.5% of shares in Baxalta. While Baxter’s filings have stated this will be used to pay down some of its own debt and fund pension liabilities, it is still in Baxter’s reputational and financial interest to have set up the spin-off to succeed.

Baxter plans to dispose of this shareholding within 18 months, but has allowed itself up to five years, citing “business reasons for the retention.” This could create downward pressure on the share price. However, the five-year timeframe should reduce the risk of overhang if conducted in an orderly way.

Anti-takeover provision

Baxalta has included an anti-takeover or “poison pill” provision preventing an unfriendly takeover. This involves a shareholder being “interested” by owning at least 15% of the equity and have such holding for at least three years before any acquisition can occur.

One way companies can bypass such provisions is by changing sufficient members of the board. However, even this is prevented as Baxalta has three-year staggered contracts, meaning a “clean sweep” of the board could not be forced.

The anti-takeover provisions do not prevent an acquisition before the three years, but means it has to be friendly and approved by the board. While this could go against shareholders interest (e.g. directors preventing acquisition to maintain roles themselves), strong incentive payments to top management suggest a favourable deal could work. It’s also a way the board can extract better value to ensure a friendly deal.

Product sales

For large biotechs, a diversified product portfolio, along with a track record of developing new products and obtaining regulatory approvals is important to ensure long-term sustainability. This can counter the sometimes binary effect of new therapeutic approvals in smaller companies when there is too much reliance on one or two lead products.

The model is similar to established pharmaceutical companies where new products come from internal R&D, collaborations and acquisitions. A diversified pipeline, not overly reliant on a few products, and a history of new product approvals and layering sales is essential for investors.

Baxalta remains active as an acquirer to bolster its portfolio. In July, it bought Oncospar for $900 million, a leaukaemia treatment from Sigma-Tau Finanziaria.

Sales are diversified with haematology products accounting for around 50% sales for 2012 to 2014, Inhibitor Therapies (haematology related) at 12% to 13%, Immunoglobulin Therapies at 28% to 30%, and Biotherapeutics at 9% over the same period.

In total, Baxalta markets over 29 biotherapeutic products. This is backed up by a development pipeline where over seven new product launches are planned by 2018, and multiple earlier stage pipeline products across all therapeutic franchises. While one could model risk scenarios for each product approval and impact it would have, having a track record of successive approvals and multiple products in development is probably more useful and reliable.

Disclosure

I do not own BXLT at the time of writing, but may go long if my buy price is reached.

This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice.This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities. Any investors reading this material agree to rely on their own research.

Raman Minhas writes about investing using Growth At Reasonable Price to find interesting and profitable opportunities. If you enjoyed this article,join his free GARP newsletter.

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