I decided I needed a soundtrack for this week’s article. The theme is regret – the feeling that you wish you could change something that’s already happened. Edith Piaf laid the mark down. She had no regrets at all. Defiantly, she announced:
Je repars á zéro. Non, rien de rien. Non, je ne regrette rien!
Non, je ne regrette rien (No, I Regret Nothing) topped French charts for seven weeks in 1960 and became more famous for its use in countless movies since. Edith is musical tonic for the gin of regret. Still feeling guilty about that nice guy you ghosted after you found out he owned six cats? Edith at full blast will fix that.
Need a song that shows a little remorse, but still basically says “f*ck ’em”? Leave it to Ol’ Blue Eyes. In 1969, Frank Sinatra crooned with feigned modesty:
Regrets, I’ve had a few. But then again, too few to mention… And more, much more than this, I did it my way.
Artists were more introspective in the post-Vietnam era. Regret began to fill the airwaves. Take the easy-going beach classic Margaritaville by Jimmy Buffett. The 1977 ballad seems innocuous on the surface. Tequila, salt, sand and sun. But don’t let those steel drums fool you. Margaritaville, the anthem for an entire cult following, is all about regret. Jimmy Buffett is basically drowning his sorrows because he knows he blew his chance at true love.
I know it’s my own damn fault.
By the 1990’s, Regret was on full display. All Apologies by Nirvana immediately comes to mind, but I prefer Pearl Jam’s Black for its gut-wrenching agony.
I know someday you’ll have a beautiful life. I know you’ll be a star in somebody else’s sky. But why, why can’t it be. Oh, can’t it be mine?
Need more? Johnny Cash covered Trent Reznor’s Hurt:
If I could start again. A million miles away. I would keep myself. I would find a way.
That’s some painful regret right there. If you’re reaching for the tissues, let’s close our little musical journey on a lighter note. Taylor Swift’s, Back to December:
It turns out freedom ain’t nothing but missing you.
Ah, that’s better.
Regret is a dish served cold in Leverkusen, Germany. If you call Bayer headquarters and get placed on hold, you probably have to listen to Radiohead. The regret of which I speak is the 2018 purchase of Monsanto for $63 billion. It has been nothing short of a disaster for the venerable aspirin-maker which dates its founding to 1863.
Bayer operates in three segments: Crop Science (2024 revenues, €22.3 billion), Pharmaceuticals (€18.1 billion), and Consumer Health (€5.9 billion). Crop Science features the RoundUp herbicide franchise and DeKalb seeds. Pharmaceuticals offer a wide range of treatments with success in cardiology and women’s health. Consumer Health includes the famous Aspirin brand as well as Aleve, Claritin, MiraLax, and AlkaSeltzer.
The Crop Science business presents the largest challenge. Between 2019 and 2024, Bayer has taken over $13 billion in goodwill impairment charges. The company has accumulated over $19 billion for litigation expenses. The problem has been claims that RoundUp, the indispensable weed-killer, causes cancer. Monsanto has reached settlement agreements on nearly 100,000 lawsuits for approximately $11 billion and estimates that 58,000 cases remain. However, Bayer won a significant victory last August when the US Circuit Court of Appeals ruled that Federal law shields the company from claims at the state level. The court rejected a plaintiff’s claim that Monsanto placed farmers in danger by failing to place a cancer warning label on the product. The ruling conflicts with other decisions and leads to a belief that the commerce-friendly US Supreme Court could soon weigh in and reduce Bayer’s liabilities.
The Pharmaceutical division faces an urgent need to replenish its drug pipeline. Xarelto is Bayer’s bestselling drug, but its patent expired in 2024. Generics have started to cut into sales of the anti-coagulant. Xarelto sales topped $4 billion in 2023 and declined to $3.5 billion in 2024. The top 15 medicines accounted for $15.3 billion of sales, or 85% of the pharmaceutical segment. The next best performer is Eylea at $3.3 billion and 1% annual growth, and Nubeqa at $1.5 billion and 73% annual growth. The drugs are for retinal diseases and cancer treatment, respectively. Only a German company could withstand the irony of producing medicines to cure cancer while simultaneously making a herbicide that is a carcinogen. Somewhere, Friedrich Nietzsche is having a laugh.
Bayer has two missions: clean up the Monsanto litigation and create a more robust pipeline of pharmaceuticals. Bill Anderson, a native Texan, was hired in 2023 to lead Bayer. Anderson is a drug industry veteran, having previously run Genentech’s oncology, immunology and opthamology divisions. He later served as CEO of Genentech, a subsidiary of the Swiss drug-giant Roche, and ultimately ran Roche’s entire pharmaceuticals division. Given Anderson’s background expertise, there is speculation that once the RoundUp litigation has been arrested, the crop sciences business could be sold.
What we need to know is whether or not Bayer has the makings of a good value investment. For all of Bayer’s problems, this is still a multinational company that generated $4.5 billion of free cash flow in 2024. If you can handle the rocky ride ahead, Bayer could prove to be a very lucrative investment with a great deal of upside.
Shares trade on the DAX for about €23, giving the company a market capitalization of €22.6 billion, or $24.5 billion. American investors can buy ADRs with the BAYRY ticker for about $6.30 apiece. The company recently closed the books for 2024 and posted €46.6 billion of revenues, a decline of 9% from 2023. Operating income was €3.5 billion, with operating margins collapsing from 17.2% in 2023 to just below 7.5% in 2024. Mr. Anderson faces a stiff test.
Leverage is a concern. Over €40.8 billion of debt and leases weigh heavily. The board responded to the threat of losing Bayer’s BBB rating by eliminating the company’s hefty dividend which preserved about $2.4 billion last year. Debt was reduced from 2023’s level of $45 billion and is now on par with 2018 levels. Management is keen to reduce the debt further.
I decided to value Bayer using the preferred tool in Bruce Greenwald’s kit – a calculation of earnings power value (EPV) by taking normalized and unlevered free cash flow and dividing it by a percentage rate which reflects the company’s cost of capital. Using 2024 numbers, I calculated Bayer’s intrinsic value to be approximately €68 per share, or nearly three times its current trading price.
There are three items of note: First, I capitalized Bayer’s annual R&D spending which has hovered between €5 and €7 billion per year. The adjustment adds about €250 million to the annual income. Second, I made the computation of the weighted average cost of capital with a sledgehammer rather than a scalpel. Debt is fairly straightforward. As a BBB rated company, Bayer can borrow at 5.7% in the US market. I chose the US risk-free rate rather than the German bund rate that is about 150 basis points lower. For the equity (35% weight), I employed a 10% risk premium over our 10-Year rate, for 14.3%. The WACC, therefore, computes to 7.55%. Third, I deducted €8 billion from the value as a litigation reserve for future RoundUp claims.
Unlevered free cash flow of €8.7 billion is thus capitalized to €115 billion. Subtract net debt of €36.6 billion, pension obligations of €3.3 billion and the aforementioned litigation reserve, and the net value sums to €66.9 billion after a small adjustment for noncontrolling interests. The resulting share price of €68 gives an investor a very wide margin of safety.
Next, I made an assumption that Anderson and Co. can improve margins. Even if they rise to just 12%, still well below the recent past, it produces an additional €2.2 billion of operating cash. This boosts the share price above €96. One may quickly rebut my thesis by pointing out that the company very well may need every scrap of operating leverage if the Xarelto decline is more precipitous than expected, or the drug pipeline runneth dry.
The next exercise is to break down what a split-up Bayer might look like. Here’s a preview: The Crop Science business had an adjusted EBITDA of $4.3 billion in 2024. Corteva, spun off from DuPont in 2019 has a market cap of $41.5 billion and an EV/EBITDA multiple of 15. Even a 12 multiple would value Bayer’s agriculture division at €51.6 billion. Something to ponder.
Litigation is no way to run a business. If an investment thesis relies on a favorable ruling from the Supreme Court, you’re already on shaky ground. But Monsanto’s RoundUp isn’t like tobacco. It’s not a leisure product. RoundUp is an essential tool for the farming industry. Glyphosate is so effective, many farmers fear that it may disappear from the market and lead to replacement by cheap knock-offs from China which are likely to be unregulated and riskier to one’s health. RoundUp is not going away.
Things are looking better in Leverkusen. Even their fußball team, Bayer Leverkusen won the Bundesliga in 2024. It’s the first time a team other than Bayern Munich or Dortmund won since 2008. So, they’ve got that going for them, which is nice.
Hat tip to my friend Guillermo who hails from Vigo, Spain and put me onto the Bayer value story. Until next time.
DISCLAIMER
The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.
Boston real estate was feeling pretty sore in the early 1990’s. Many state-chartered banks in New England had collapsed under the weight of so many bad commercial real estate loans, just like their savings and loan brethren throughout the southwest. I first stepped into this troubled market by briefly working for a small real estate brokerage office in Boston.
We got a call from a man who was interested in selling his retail condominium. Wearing my coat and tie, I went with Peter, whom I considered a grizzled veteran even though he was probably only around 35. I didn’t even know about the existence of commercial condominiums. It was a first-floor space in a 1920’s brick building with large glass display windows. Despite the architectural charms, we didn’t think there was much of a market for a 2,500 square foot storefront with on-street parking.
The door opened with a jingle. Wood floors, high tin ceilings, and old brass lamp fixtures illuminated the room. The smell hit you right away. A sharp odor. Turpentine. Acetone. Oil. But it slowly faded into warm woodiness. Like an old church reassuringly scrubbed by parish ladies bearing buckets of Murphy’s oil soap and tins of carnuba wax.
We were met by the owner – a man who was probably in his early fifties, slim and athletic. He had wiry gray hair, sharp blue eyes and the kind of wrinkles you see on runners who have spent a lot of time in the sun. We reached out to shake hands and were clumsily met by his left which he cupped around the knuckles of our outstretched rights. I tried not to look too closely, but his right hand hung limply at his side.
After the awkward introduction, we soon realized we had entered the man’s cathedral. Before us stood row after row of heavy wooden desks – maybe 20 in all. Each one was a masterpiece of carved rosettes, scrolls, leaves, vines and columns. Mahogany pantheons stood among castles of walnut and majestic oak temples. Weighing hundreds of pounds, and much more expensive than any commission check that we stood to earn from a sale, these furnishings were destined for Back Bay mansions and State Street banks.
We learned the owner had suffered an accident on his bike that caused paralysis in his right arm. His career as a carpenter and craftsman was over. He had no partner or apprentice, and his children had moved on. He answered our real estate questions with grim stoicism, but his eyes sparkled once we asked him to show us his inventory. Was he at peace with his tragic misfortune? We took down his information, made some measurements and told him we would call with a proposal to list the space for sale.
I remember buckling the seatbelt when we got in Peter’s car. A small voice inside of me told me to go back and ask the man to teach me to continue his business. I could be his apprentice. This urge came despite my entire woodworking experience consisting of a single semester of shop class in seventh grade. He may have been flattered by my offer, but he would surely know his craft was more than a skill to be taught. It was art. Was I an artist?
As you grow older, you begin to wonder how different your life might have been if you had chosen different forks in the road. The furniture would have been magnificent. The finished product something to behold. Maybe I’d be the one looking for a woodworking apprentice today. Someone to carry on my craft.
Then you realize that every path is painful. How many desks could I have sold, really? All those hours sanding, carving, chiseling, and finishing. The dust, fumes, and bloodied fingers. The greedy lumber mill, the client’s bounced check, the revival of midcentury modern and Restoration Hardware. There’s no easy path, as fanciful as it may seem. Yet it was art. Something tangible. Not just numbers on a spreadsheet.
Ah well, off to the spreadsheets we go.
Elliott Management has received much notoriety for its activist shareholder campaigns. In recent weeks Paul Singer’s fund has taken large stakes in BP, Phillips 66, Honeywell, and Southwest Airlines (LUV). Although the firm chalked up a big win at Starbucks last year, two campaigns were less successful: A 2023 shake-up at Goodyear yielded no investment gains. Meanwhile, shares of Sensata (ST) have fallen 12% after an initial surge during May 2024’s announcement of a cooperation agreement between management and the fearsome investment firm. Elliott gained a board seat and pressed for the replacement of the CEO after a series of acquisitions that failed to deliver positive results.
I enjoyed some investment success several years ago when Elliott pressured Cabela’s to sell to Bass Pro Shops, so I am always tempted to follow Singer’s moves. Sensata trades 32% below its 52-week high, and it caught my eye. Goodyear turned out to be a rare blemish for the Elliott team. The tire business is plagued by shrinking margins and brutal competition from Asian manufacturers. Sensata is different. Sensata produces sensors and electrical protection components that have unique technological sophistication. Moreover, the adoption of hybrid and electric vehicles has increased demand for Sensata’s products.
How will Elliott’s scheme play out? For my valuation exercise, I’m purely focused on the possibility of improved operating margins. This is Elliott’s playbook for Southwest. Last week, Southwest announced that they would conduct the first major layoff in the company’s history. They expect to cut salaries, primarily in the corporate offices, by 15%. This is part of an effort to save $500 million annually by 2027. Comparing salary margins at Southwest versus Delta Airlines, it’s not hard to see where value can be created.
Looking back to the peak of Southwest’s market capitalization in 2018, salaries accounted for 37% of passenger revenues. Meanwhile, salaries at Delta amounted to 27% of passenger revenues. Six years later, Delta’s wage bill has risen to 32% and Southwest’s surged to 49%. There’s no argument to be made that Southwest can match Delta. But can they cut salaries back to 46% of passenger revenues? That seems very likely. Such a reduction would boost profits at Southwest by $625 million. Assuming a post-tax multiple of 7.9x translates into $5 billion of market capitalization for LUV, or just about 27% above current levels.
How about Sensata? What kind of value creation can margin improvement deliver?
Revenue for the Attleboro, Massachusetts firm has plateaued at $4 billion over the past three years. Operating margins have declined from 17-18% levels prior to Covid, to around 13% today. Tracking the trailing twelve-month period ending in September of 2024, unlevered free cash flow at Sensata was about $500 million. Using a weighted average cost of capital of 7.69% for the business leads to an earnings power value of $3.95 billion after accounting for about $2.6 billion of net debt. On a per share basis, this is around $26, or slightly below last week’s $29 level.
If Sensata can just lift margins by a couple of percentage points (easier said than done) from 12.25% to 14%, free cash flow would increase to $573 million, and translate into over $900 million of shareholder value. This puts the stock in the $32 range. That’s only about 7% above the current price, but the exercise shows the direction management may be headed. Others have noted that some business lines may be sold.
There’s danger in blindly following a fund manager’s latest 13D or 13F filings. People tend to focus on one or two names rather than seeing the big picture. Elliott’s latest filings include a diverse array of holdings. They also disclose many hedges – put options on many sector ETF’s rank among the firm’s many positions. Filings are historical. Elliott could have sold Sensata shares last week. We won’t know for a couple of months.
I will say that in a market that continues to trade on price-to-sales hopium, it is refreshing to actually find a US company selling near it’s intrinsic value using the straightforward earnings power value methodology. Sensata is reasonably priced. The downside appears to be protected. In the case of both Southwest and Sensata, Elliott’s investment thesis of operating margin improvements will translate into tangible business performance and shareholder value.
Until next time.
DISCLAIMER
The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.
Many years ago, when I was in high school, my Dad gave me some scholarly advice that paid dividends in subsequent years. He said that if I was stumped on an essay question, then the best thing to do was to “show what I know”. I may not have all the facts about the Battle of Antietam, but I might be able to muster some pretty decent paragrpahs about why Abraham Lincoln demoted General George McClellan. “Show what you know” snatched mediocrity from the flames of academic despair on several occasions.
That’s where I’m at this week. I don’t have any new conclusions, but I can tell you a few of my thoughts and observations. Here’s to showing what (little) I know…
Peakstone Realty Trust (PKST)
Oh Peakstone, you broke my heart. Last fall, I thought I found the ideal REIT trading at an enormous discount. Peakstone was priced in the $14 range and had a market cap of $480 million. The office and industrial REIT owns some prime property like the Freeport McMoRan tower in downtown Phoenix, Amazon distribution centers, and the McKesson office complex in Scottsdale.
I threw a ludicrous cap rate at the office space and figured the real estate was still worth about $1.7 billion. After subtracting net debt of $936 million, I thought the stock was worth $18. Plus it had a 6% yield.
We’re now 40% lower, and that stings. A lot. All management really had to do was buy back stock, sell assets and pay down debt. When your dividend is yielding 6%, it’s a no-brainer. Instead, deal junkies do what deal junkies gotta do. Deals, y’all. In November, they went out and re-levered the balance sheet in to buy a $490 million portfolio of outdoor storage real estate at a cap rate of… 5.2%.
I did not have buying B industrial assets with negative leverage on my bingo card, but there you go. The website photos on Peakstone’s portfolio page now look like the opening credits from Sopranos.
Barry-Callebaut (BRRLY)
The Zurich-based refiner and seller of chocolate has taken an absolute beating as the price of cocoa has skyrocketed. Shares are down 50% over the past year. I’ve never seen anything quite like the price chart for cocoa. Parabolic is an understatement. It’s actually mind-boggling.
Crop failures in Ivory Coast and Ghana have led to a shortage. But is it really that bad? There’s got to be an opportunity here somewhere. Surely futures markets are way over their skis?
Barry-Callebaut is one of the leading suppliers to confectioners, and they have a dynamic new CEO who has begun an efficiency drive. The problem is that Barry-Callebaut had to purchase inventories of cocoa at massive discounts to the contracted sales prices to their customers.
Working capital looks like an absolute trainwreck. The company spent over 2.6 billion CHF on cococa inventory over the past year. In order to cover the loss, BRRLY turned to the debt markets and raised about 3 billion CHF. Eventually, the cocoa market’s gotta rebalance, right?
Digital Realty Trust (DLR)
The sector is so hot right now. An Australian fund manager, Nate Koppikar, is shorting data centers in the belief that supply of will outstrip demand as this whole AI-thing bursts its bubble. I have looked at Digital Realty in some depth. I don’t have much of a smoking gun here, but I do agree that the market is way ahead of itself.
Digital Realty trades at 24 times projected funds from operations and carries an enterprise value of $70.4 billion. I produced a cocktail napkin set of numbers and my conclusion is that the stock trades at a 40% premium to its intrinsic value.
I took the most recent unlevered free cash flow of $1.9 billion and applied a cap rate of 5.5%. This results in an asset value of $35 billion. I subtracted debt, redeemable noncontrolling interests, preferred stock and added joint venture investments at 2 times book value. Next, I ran a very basic discounted cash flow on a future investment pipeline that essentially doubles the company’s real estate footprint in five years. I assumed 25% leverage for the new properties. The present value of future development amounts to $17.4 billion. The sum of these pieces is an estimate of net asset value of $39.7 billion.
Obviously, this is a work in progress, but here are my general observations thus far: REITs must distribute 90% of their taxable income. Therefore, it is very difficult to achieve growth through the reinvestment of profits. DLR pays a dividend yield near 3%, and this leaves virtually zero cash to deploy into new data centers. DLR must, therefore, raise external capital in order to grow. I assumed that they continue to borrow 25% of their future investment requirements. The rest needs to come from the issuance of new stock. Indeed, during the first three quarters of 2024, Digital Realty raised $2.7 billion by issuing new shares.
Raising cash through the sale of stock to deploy into profitable real estate developments works just fine as long as the return on capital exceeds the cost of capital. In this regard, DLR’s recent track record has been unexceptional. Returns on capital have hovered near 6.5%. In my future development scenario, I assumed returns of 10%. This is what their major competitor Equinix has been able to achieve. DLR has been able to produce shareholder value despite unremarkable asset performance because they loaded up with debt at the absolute bottom of the COVID-era interest rate bonanza. The weighted average cost of the $17.1 billion of loans outstanding is a puny 2.9%. Unfortunately, the incremental debt for the development program will have an interest rate in the 5% range.
At this point, I don’t have a strong conviction about the value of Digital Realty. My projections are too simplistic to be relied upon. But I do believe that the stock reflects a future development pipeline that must be executed flawlessly and at returns much higher than the company has a achieved in recent years. REITs that can issue stock, and deploy the cash at returns in excess of the cost of capital work very well. When they don’t deliver those returns, they become shareholder dilution machines. I’m going to leave it here for now.
Until next time.
DISCLAIMER
The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.