AMM Dividend Letter Issue 21: Envy & Baxter International
This is from the AMM Dividend Letter released July 2, 2015. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
With everything else being equal would you rather:
A) live in a town where the median salary was $25,000 and you earned $50,000?
B) live in a town with a median salary of $200,000 but you earned $100,000?
This should be an easy answer. You would want to live in a town were you earned $100,000. Everything besides the salary is the same: job title, work environment, living environment, costs, etc., but in one scenario you are earning double the money. The median salary info is superfluous. It has no real bearing on your well being. Yet, for some reason it does.
Harvard researchers asked subjects this exact same question. 50% of the subjects preferred scenario A. The test subjects choosing scenario A are willing to earn much less money on an absolute basis in order to rank higher on a relative social basis to their peers. The researchers called this “positional externalities” or “positional concerns”, also known as envy.
The test subjects choosing scenario A want their peers to be envious of them. Envious of the extra money they have and the extra stuff it can buy. The test subjects avoid scenario B because they know they will be envious of their peers. A survey by Money magazine in 2002 provided further evidence of this when 63% of the respondents agreed with the statement “It’s harder for me to be friends with people who have a lot more money than I do”.
Even family members have a tough time with envy. A recent study of women showed that they are much more satisfied with their household income when their husbands earn more than their sisters’ husbands.
Social comparisons and envy worked well for our early hunter-gatherer ancestors. By watching, comparing, and learning from those who had more resources our ancestors could learn to obtain more for themselves. Securing more resources for themselves insured our ancestors could live long enough to reproduce. The more surviving individuals a small familial group had, the better chances the group as a whole had to survive.
For the great majority of people today in modern civilization, life is no longer a daily struggle to find food and survive. Envy has transformed from a beneficial factor for our ancestors into a tool for personal unhappiness in the modern world.
It is far too easy to compare ourselves to others when money is involved. The problem is there will always be someone who is richer or makes more money than you. Measuring yourself to others on a relative basis is a recipe for unhappiness and harming your financial future. When you measure yourself on a relative basis to your peers you run the risk of spending unnecessarily on improving the outward appearance of your social status, at the detriment to your long-run financial security.
Instead measure yourself on an absolute basis. More than likely you’ll find you have all of your “needs” covered and plenty left over for your “wants” too. Indulging your “wants” is important, as it wouldn’t be healthy to live like a miser either. However, being cognizant of the “envy affect” can help you focus on spending your hard earned money on what matters most to you and your family.
“I’ve heard Warren [Buffett] say a half dozen times, ‘It’s not greed that drives the world, but envy.’” – Charlie Munger
Your Portfolio Management Team
Dividend Stock in Focus
Baxter International (BAX): $38.30*
Baxalta (BXLT): $31.03*
*price as of the close July 2, 2015
We’ve stated before that we build the dividend portfolio around three types of dividend payers.
1) Dividend Stalwarts: Companies that have strong dependable market positions, that pay a reasonable dividend (~2-3%), and have shown an ability to grow their dividends over a long period of time at a pace far faster than inflation.
2) New Dividend Payers: Companies that have recently initiated a dividend policy. While these companies do not have the long history of paying and growing their dividend like the stalwarts, they do have a strong market position and the cash flow to become a stalwart in the future.
3) Restructuring/Special Situations: Companies undergoing a restructuring, spin-off, or other special situation. If we see value in the restructuring and the parent company pays a reasonable dividend we will invest. Our initial time frame for these investments is one year but if, after the restructuring, one of the companies’ appears to offer good odds of becoming a dividend stalwart we may hold our investment for a longer time frame.
Quite often a position in our dividend strategy starts in one category and then switches into another. Baxter International is an example.
Baxter International looks like a dividend stalwart. The company has a reasonable dividend yield and has grown its dividend at a double digit rate for the last 10+ years. However, we did not invest in Baxter International as a dividend paying stalwart. We initiated a position in Baxter International because it is now undergoing a corporate restructuring by becoming two separate companies.
Baxter International is spinning-off its biotech/drug business as a new stand alone company, Baxalta, while the new Baxter International will retain its industry leading medical products business.
Both companies will pay a dividend after the restructuring and we think both of them have the ability to become dividend stalwarts just like the old Baxter International.
Over the last ten years Baxter International, before the spin-off, grew their annual dividend at a compound annual growth rate of 13.45%. Before the spin-off, Baxter’s dividend yield was 3.00% with a payout ratio of 48%.
The dividend history above belongs to the old Baxter International. Post restructuring the new Baxter international will target a dividend payout ratio of 35% and Baxalta will target a 15% payout ratio. The new Baxter will continue to return capital to shareholders like the old Baxter through dividend increases and opportunistic share repurchases. Baxalta will focus more on reinvesting capital back into the business and using excess capital for potential acquisitions to fuel further growth. We expect Baxalta it to increase its dividend too in order to maintain a 15% payout ratio as its earnings grow.
Catalysts for Dividend Growth and Price Appreciation:
Baxalta (BXLT) Spin-Off
Baxter International officially became two separate companies on July 1st. Baxter International spun-off its higher-growth biosciences division in a tax-free distribution to shareholders, naming the new company Baxalta. Baxter will retain the medical products division and a 20% stake in Baxalta.
The biosciences division, now Baxalta, was responsible for about 40% of Baxter’s total revenues but contributed 60% to its pre-tax profits. The biosciences division is also the faster growing division with revenue compound annual growth expectations of 6-8% for the next 5 years.
Baxalta’s growth will come from the following three divisions.
Hemophilia is Baxalta’s largest drug division and is lead by the Hemophilia A drug Advate. Hemophilia A is a genetic disorder mostly found in boys because of a defective gene found on the X chromosome. Hemophilia A sufferers lack clotting factor VIII and it is difficult for them to stop even minor bleeding.
It is estimated that 1 in 5,000 boys globally are born with hemophilia A. For the most part hemophilia sufferers in the U.S. are readily diagnosed and treated but it is much different for the rest of the world, especially in developing countries. It is estimated that over 75% of the global sufferers go undiagnosed or receive inadequate to no treatment. Baxalta and their leading drug Advate have large potential worldwide growth as diagnosis and treatments increase around the world.
Baxalta’s immunology division recently received approval for HYQVIA, a treatment for primary immunodeficiency (weak immune system). It is a once a month subcutaneous dose that greatly improves upon current treatments. Current subcutaneous immunodeficiency treatments are once a week with multiple injections leading to 8-26 needle sticks per month. The high volume of needle sticks means the patient has to inject themselves in many different parts of the body. HYQVIA is one needle stick every 3-4 weeks. A large improvement on a patient’s quality of life.
The third leg to Baxalta’s growth is its new oncology division which was added through the purchase of ONCASPAR. One of its early promising drugs is nal-IRI (MM-398). The drug focuses on people suffering from metastic pancreatic cancer. The rest of Baxalta’s oncology pipeline has potential too and the company expects drug launches in the U.S. and the EU to pick up over the next few years.
Margin Expansion and Free Cash Flow Growth
Compared to other companies engaged in bio-pharmaceuticals, Baxalta’s free cash flow generation is low in part because of below average margins. Spin-offs are attractive value investments because as a new stand alone company all efforts will be focused on growing and increasing profitability for the new company. Management has said they are targeting operating margins of 30-31% and EBITDA margins of 35-36%. These targets will bring Baxalta in line with other bio-pharmaceutical companies like current holding AbbVie (ABBV). 6-8% compound annual sales growth with improving margins should produce tremendous free cash flow growth for Baxalta.
The new Baxter will retain the medical devices division. It is the slower growing and lower margin business when compared to biosciences/Baxalta. However, Baxter is an industry leader in IV Solutions, injectables, infusion pumps, anesthesia gases and greatly benefits from its economies of scale. Management has outlined its goal for new product launches and cost reductions in each of its medical products divisions which should boost margins and increase cash flow that can be returned to shareholders.
Baxter’s largest opportunity is in renal care. The aging global population combined with rising global rates of diabetes, hypertension, and obesity is increasing the need for renal care for chronic and acute sufferers. The need for renal care is growing the fastest in emerging countries as their rates of diabetes and obesity are increasing.
Baxter purchased Swedish Dialysis company Gambro to solidify and expand its renal care offerings. The purchase also improves Baxter’s competitive position with Fresenius, the world’s leading renal care and dialysis company. The Gambro purchase increased renal care as a percentage of Baxter’s revenue from 20% to 27%, and better positions them to gain share in emerging markets. Before the Gambro purchase renal care was Baxter’s least profitable medical products division but it now offers the best potential for margin expansion, increased profitability, and revenue growth.
Pre-Mortem (Potential Risks to our Thesis):
Advate is the leading hemophilia A large molecule drug on the market. Its profitability has attracted competition. Biogen Idec launched Eloctate, a longer acting molecule. Advate is currently a 3-day dosing schedule and Eloctate can support a 5-day dosing cycle. Novo Nordisk and Bayer could also add Advate competitors. The me-too Advate drugs have the potential to take market share away from Advate.
The good news is that so far patients have not been switching from 11 year old Advate to the newer Eloctate. One reason is when a doctor and their patient find a drug that is working they tend to stay on that drug. Especially, if the newer drug doesn’t offer any real material improvement. The second reason for poor switching is the payer landscape. UnitedHealth came out and said that Eloctate is “not medically necessary” which means they will not pay for it.
Baxalta as a stand alone bio-pharmaceutical company is attractive because of its pipeline’s potential. If the pipeline fails to materialize or if the drugs fail to generate high enough sales then Baxalta’s post spin-off value will be impacted.
New Baxter Missed Execution
The key to the new Baxter’s success is the effective implementation of improving cost structures, new product launches, and margin improvement. If management can not reach the margin expansion targets it has stated then the value proposition of the new Baxter is weaker. It will be tough to unseat Baxter’s leading position in the medical products industry, but as an investment, missed operational execution means less cash flow and capital that can be returned to shareholders.
Usually the announcement of an upcoming spin-off causes a stock to move higher on the news. Baxter’s share price was punished. Many shareholders likely owned Baxter as a dividend growth stalwart. The spin-off announcement and the future capital return plans of the two new companies meant this was no longer the case in the short-term. The existing dividend growth focused shareholders sold, and subsequently drove Baxter’s share price down to $64 per share. We made our first purchases at the end of May around $66 per share.
We had a pre-spin value of $79 per share for old Baxter based on a sum of the parts (i.e. the total of the two separate businesses). The selling pressure created an opportunity to buy a high quality company, soon to be two, at a large discount to its intrinsic value with upcoming catalysts that will help unlock its hidden value. Since we are new shareholders we are not experiencing a change in dividend payments. We are investing in two new dividend payers that have publicly stated that they are committed to growing their dividends and returning capital to shareholders.
All previous letters are archived here.