Research

Industrial Gas Pricing – Talking a Good Game

Written March 3rd, 2015 by

Our recent thoughts on Industrial Gas companies have focused on their ability to pull pricing and cost levers to grow top and bottom lines. We have been particularly focused on APD and what it will need to deliver to justify further share price appreciation from here. Today, Air Products announced another round of price increases in the merchant business, as they have done in the past, but we think that the focus on achieving increases this time will be greater. The company is increasing prices for its North American merchant gas customers effective March 15, 2015 or as contracts expire. Monthly service charges will also be impacted.

As we wrote in the past, we believe that if Air Products is to beat its ambitious targets for 2017, the company will have to place an emphasis on cost and price that it has not in the past. So far, both imperatives have been given their due with the company announcing 500 job cuts in its most recent update. Still, we suspect that even if some 2500 more jobs are cut in the next 1 ½ to 2 years, expectations for APD may be difficult to manage.

With APD now pushing another round of price hikes, we expect that competitors will likely follow suit rather than use this as an opportunity to gain share.  These price increases come on the back of similar increases announced six months ago and more modest increases pushed by Praxair at the end of 2014. APD states that this round of hikes is to pass through higher metals costs for bulk tanks, using similar reasoning to PX in its December announcement. We believe that the more likely motivation is margin expansion given our understanding of recent iron and steel price moves. In either case, the question is still how far can pricing be pushed before customers defect.  Lack of volume growth in the business generally increases the focus on price as a way to grow top and bottom lines.
If the industry moves pricing more meaningfully than in recent years, then the optimistic top line estimates for APD shown below may be attainable.  At the same time the estimates for PX and others will likely be too low. The valuation opportunity is in PX in the US, and possibly Air Liquide in Europe.

Industrial Gases Blog

WBA, CVS, RAD: There Are Simply Too Many Pharmacies & Now it Starts to Matter

Written February 25th, 2015 by

Retail prescription margin growth has outpaced CPI since 1990, drug pricing since at least 2001, and any other major US retail setting’s gross margin growth since at least 2004

It’s not because we lack enough pharmacies, it’s because traditional drug benefit plans (which cover 92% of Rx’s) mean customers face the same Rx costs no matter which store they choose. Under narrow (or preferred) networks this all changes – pharmacies willing to dispense at lower margins can, for the first time, gain traffic

Now that retail dispensing margins are real money, engineering drug benefits to reduce dispensing margins makes great sense. We believe narrow retail networks can save +/-7% over all-inclusive networks. If this doesn’t sound like a lot, bear in mind that all the effort PBMs and HMOs put into managing formularies and negotiating drug rebates yields an average savings of about 8%

Using the federal standards for pharmacy proximity (90% of beneficiaries within 2 miles of a pharmacy for urban, within 5 miles for suburban, and within 15 miles for rural), we estimate that 34% of US retail pharmacies could be closed before these proximity standards are no longer met

As retail networks narrow, chains (WBA, CVS, RAD) can profitably dispense at lower margins than independents, so the long trend of independent closures is likely to continue. However mass merchants and supermarkets presumably are willing to dispense at even lower margins than the chains. Chains get 63-69% of sales from prescriptions, mass merchants and supermarkets get only 6-10% – meaning mass merchants and supermarkets can cut dispensing costs and make it up on front store traffic, but the pharmacy chains cannot

The average distance from a WBA pharmacy to a mass merchant or supermarket with a licensed pharmacy is only 1.3 miles; for CVS it’s 1.9 miles, and for RAD 2.5 miles. Within the applicable minimum proximity radius (2 mi urban, 5 mi suburban, 15 mi rural) the average WBA and/or CVS pharmacy will find 9.2 mass merchants and/or supermarkets with pharmacies; the average RAD pharmacy will find 7.9

RAD’s earnings are most reactive to falling dispensing margins; a 1 percent change in pharmacy gross margin percentage would, all else equal, have lowered RAD’s 2014 OPEX by 24.1%. For WBA the fall in OPEX would have been 11.5%, for CVS 5.3%

Consensus expectations for near term (2015/16) gross margins fell in the wake of late-summer warnings by WBA and RAD about the effects of generic acquisition costs and narrowing networks. However consensus now expects gross margins to be stable over the mid- to longer-term, which fails to account for the likelihood that narrow retail pharmacy networks will gather more beneficiaries with each passing year, creating a steady source of mounting gross margin pressure

For our full research notes, please visit our published research site

February 23, 2015 – TMT Model Portfolio Update: Escaping the Death Watch

Written February 23rd, 2015 by

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We assessed the valuations of 187 US traded large cap TMT stocks, separating their EV into near-term and long-term components and graphing them on these axes. In the framework, the names fall into quadrants that have interesting implications for trading. This quarter, we are looking more closely at the “Death Watch” – i.e. stocks with below average 5-yr cash flow growth expectations and where the implicit 5th year terminal value represents less than 75% of the total EV. Amongst these 47 names are a motley crew of old IT suppliers and fallen internet stars who’s best days are likely behind them, but also several post-peak cyclicals, industry vertical suppliers, and a few surprises. We see particular opportunity in MSFT, QCOM, STX and WDC, where we feel management has navigated past obvious dangers and where their positions for the future are poorly appreciated. We also note that AAPL has fallen from the skepticism quadrant into the death watch – its recent cash flow performance has been so strong, that analysts and investors no longer project significant growth, perhaps also discounting its overseas cash assets as well. We are sympathetic to this perspective, although we are keeping AAPL in our Large Cap Model portfolio, which outperformed its benchmark in the quarter by 40bp, up 950bp. We are swapping STX for WDC, and PAY for AMZN. Our Small Cap Model Portfolio underperformed dramatically, up just 110bp, on very poor performance from OPWR, MRIN, RKUS and WWWW. We are removing JDSU, WWWW and MRIN, along with CNVR, which was acquired. We are adding HUBS, RENT, QLYS and SMCI in their place.

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SSR Health New Product Approval Portfolios & Supporting Data Update

Written February 17th, 2015 by

Drug, biotech, and research-based spec pharma stocks tend to outperform their peers in the year or so before and after regulatory actions (‘PDUFA’ dates) on major new products, with a large portion of total risks being concentrated in the days immediately preceding and following the PDUFA date

Since November of 2011 we’ve run model portfolios consisting solely of names with pending (i.e. ‘pre-PDUFA’) or recent (i.e. ‘post-PDUFA) major-product regulatory actions, respectively. Within each broader ‘pre-‘ and ‘post-PDUFA’ portfolio are three sub-portfolios that differ only in terms of how large the new product is as a percentage of the company’s total sales forecast. E.g. the ‘1% pre-PDUFA’ portfolio consists of all names with pending regulatory decisions on products that account for at least 1% of the company’s total sales forecast, and so on for the ‘5%’ and ‘20%’ pre- and post-PDUFA portfolios. To moderate risks, all portfolios follow rules to limit long positions in the days immediately before and after regulatory actions

Since inception the 1% pre-PDUFA portfolio has produced greater annualized returns (75% v. 37%) with comparable standard deviation of annual returns (17% v. 15%) to an ‘innovator index’ of nearly the entire universe of biopharmaceutical stocks. The 5% and 20% pre-PDUFA portfolios have outperformed by even greater margins as compared to the innovator index (98% and 119% v. 37%), though at higher s.d. of returns (34% and 53% v. 15%)

We expect US real pricing power for pharmaceuticals to fade, increasing the importance of new product flow to relative performance. Thus screening for names with attractively priced new product flow is an appropriate first step to stock selection across the drug, biotech, and spec pharma sub-sectors. We offer two related tools, the first being these portfolios of names with major pending or recent regulatory actions (published monthly); the second being our Hidden Pipeline series of reports that identify undervalued phase 2 and earlier pipelines (published quarterly)

For our full research notes, please visit our published research site

Net Neutrality: Reining in the Dumb Pipe Oligopoly

Written February 10th, 2015 by

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The Title II reclassification of broadband reflects a sea change in policy and is a substantial threat to the long term growth and profitability assumptions at the core of cable and telco valuations. The overwhelming public support for restraints on wireline and wireless carriers trumps the aggressive industry political spending, and even without explicit price controls, the proposed action would create an empowered FCC clearly aligned to act on the interests of consumers. We do not expect legal or legislative challenges to bear fruit, given the firm FCC mandate in law, the weight of public opinion, and the growing ability of the internet community to drive political action. We also believe that the perspective reflected by this proposal makes it unlikely that the FCC will approve the pending CMCSA/TWC merger.

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Motive & Opportunity: The Convoluted Tale of Generic Price Inflation

Written February 9th, 2015 by

Since early 2013, prices for generics sold in the US at retail have risen more than 40% on a sales weighted basis

Three-quarters of this inflation was driven by straightforward median reversion: a host of products with very low prices simply raised their prices to within range of the broader market’s median. Before pricing actions these products had a median price of $0.29 as compared to $0.77 for products whose prices did not inflate; after the pricing actions these products’ median price rose to $0.72

Other than their very low starting prices, there is nothing remarkable about the median-reverting products – there are just as many manufacturers per median-reverting product as there are for products whose prices did not inflate; and the median-reverting products were no more likely to have experienced supply disruptions

The remaining one-quarter of inflation was driven by very large price increases on products that had average prices to begin with, but that also had very low average sales per product, and fewer manufacturers per product, as compared to products whose prices did not inflate

We believe the surge of inflation occurred for two simple reasons: generic manufacturers, under pressure from stalling sales growth and stagnant ROA’s, very badly needed it; and, the generic manufacturers’ main customers – drug wholesalers – chose to go along

The generic companies’ sales growth is at its lowest level in 14 years; ROA’s have been below 3 percent since before the financial crisis and have stayed there, despite a recovery in SP500 ROA’s to nearly 5 percent

From drug wholesalers’ perspective, their margins expanded on the products whose prices median-reverted. On the subset of products where sufficient data are available (representing about 75% of the median reverting products’ sales) wholesalers’ costs grew 25% but their selling prices grew 39%

Growth in prices paid to generic manufacturers is likely to stall once the industry’s aggregate fundamentals improve. There’s already evidence this is occurring, as pricing gains have substantially expanded both gross and operating margins, pointing to a corresponding recovery in ROA’s. Major pending US generic launches (e.g. Nexium, Abilify) may accelerate a fundamental recovery

Wholesalers’ margin gains are likely to be fleeting, as excess buying margin is passed along to retail clients in the form of lower prices

The ongoing shift to National Average Drug Acquisition Cost (NADAC) is a wildcard – very low cost generics could be highly profitable to wholesalers under the outgoing Average Wholesale Price (AWP) benchmark; under NADAC very low priced generics are likely to be money losers. It follows that drug wholesalers may welcome continued price inflation of very low cost generics, regardless of whether generic manufacturers remain as desperately in need of price gains as they have been recently

For our full research notes, please visit our published research site

Quick Thoughts: TWTR – BOOM! There’s MAUs in Them Thar Tweets

Written February 5th, 2015 by

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-     TWTR doesn’t have a user problem – it has a registration problem, and it’s taking steps to fix it. Meanwhile, it has the most easily monetized platform this side of GOOG search.

-     Adjusted for change in the integration of iPhone users, MAUs accelerated to 21.7% YoY growth, with initiatives now rolling to improve onboarding of 500M monthly anonymous visitors

-     Attractive demographics, unique interest graph, powerful native formats, off site reach, multi-media integration very attractive to advertisers. Ad density and pricing have LONG runways.

-     Our model still shows upside to $70+ on strong revenue growth and margin expansion going forward. Resolution of MAU controversy can catalyze a significant rerating.

4Q14 was a lot like most other recent Twitter quarters in many respects. Revenues were up 97% YoY against a tough compare and smashed consensus expectations. EPS, setting aside the big chunk of employee stock compensation, was a solid $0.12, doubling consensus on strong 30% EBITDA margins. Reported monthly active users (MAU) was seemingly disappointing at just 288M, up only 4M from the 284 reported the previous quarter. In the past, this was enough to crush the stock.

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Why ABBV is Still a Value

Written February 5th, 2015 by

GILD’s disclosure of an expected 46% average Harvoni discount for 2015 reduces our net pricing expectations for ABBV’s Viekira Pak to roughly $42,000 per regimen, down from roughly $60,000

Despite this, we still see ABBV as a value, simply because it’s capable of substantially exceeding EPS expectations, even at lower Viekira Pak net pricing

An obvious point worth emphasizing is the obvious relationship between price and volume – which very much applies to the HCV market, given the fact that payors have restricted access to sicker patients. ESRX removed any restrictions beyond having to be RNA positive, significantly expanding the potential patient pool; given ESRX’s share of commercial patients we believe this pressures other payors to act similarly. Viekira Pak is exclusive to ESRX

Setting aside the price / volume argument, we would stress that consensus underestimates the mid- to longer-term EPS potential of Viekira Pak, and that the share price reflects skepticism that even these low estimates will be met

Consensus – before being lowered to reflect GILD’s news –  implied Viekira Pak would add +/- $0.50 EPS annually over the 2015 – 2018 period, for a cumulative EPS contribution of $1.85 across this period

With this $1.85, four-year EPS gain as a back drop, we believe Viekira Pak sales to US patients who are already diagnosed will drive EPS gains of $1.60 and $2.28, and that US patients who are currently actively infected (aka RNA positive) but undiagnosed will contribute further EPS gains of $0.78 to $1.04, for cumulative EPS from US demand of $2.38 to $3.32 – well above the $1.85 implied by consensus, before even considering ex-US demand

The most recent major generation of HCV therapy (pegylated interferons) generated fully 74% of global sales in markets outside the US. For various reasons we expect US demand for the current generation agents to be more on the order of a third of worldwide demand, but the basic point is still obvious – US demand alone is more than sufficient to exceed consensus expectations, and US demand is but a third of global demand

Despite the exceedingly conservative nature of consensus, the market views the marginal EPS from Viekira Pak with great skepticism – ABBV trades at a 25% discount to peers on out-year EPS estimates, the same discount the shares carried before Viekira Pak estimates had made any contribution to overall ABBV consensus

On a positive note unrelated to pricing, MRK announced on Wednesday that the FDA would rescind the breakthrough therapy designation for its HCV regimen. At a minimum this pushes the MRK approval to 2016, and raises the question of whether the MRK regimen compares favorably to either Harvoni or Viekira Pak – both of which received breakthrough designations

For our full research notes, please visit our published research site

February 3, 2015 – Advertising: The “Golden Age” of TV Enters its Golden Years

Written February 3rd, 2015 by

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US TV advertising has crested and is beginning its inevitable decline. In an era of rising transmission fees and a vigorous market for content licensing, media companies have been reporting disappointing revenues for their TV network units – the result of poor ad sales. The networks drove through rate increases during last May’s Upfronts at the cost of reduced volume, a strategy that appears to be backfiring after poor ratings during the Fall season and a correspondingly weak scatter market. Meanwhile, Nielsen, whose methodology we believe is significantly biased toward over counting, acknowledges declining viewership for channelized TV, while advertisers decry the accompanying deterioration in the attentiveness of that audience toward their commercials. These viewers are migrating to streaming video, in their living rooms as well as on their mobile devices, and advertisers are shifting their attention to digital as well. The extraordinary trajectory of online advertising, reflected in the double and triple digit ongoing growth in ad revenues at GOOG, FB, and TWTR, has begun to eat into TV’s piece of the pie. Big advertisers, in traditional categories like autos, consumer products, telecommunications and financial services, are explicitly stating their intention to shift budget dollars from TV to digital, while broader surveys of marketers suggest the same thing.

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Quick Thoughts: AMZN and GOOG – Looking for Some Investor Love

Written January 29th, 2015 by

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-       AMZN jumped nearly 9% after hours after turning in a surprise $0.45/share profit, while GOOG held serve on a nominal miss caused by a 4% YoY FX hit and a few one-time items.

-       AMZN was typically cryptic, but highlighted strong growth in Prime and its recent price increase as drivers of the EPS upside.

-       GOOG’s sales and earnings would have topped consensus w/o FX effects, and cost-per-click would have been up slightly YoY. Management highlighted investments in ad tech that are driving sales

-       AMZN may be out of the woods with investors for the time being and GOOG may be ready to take the next step with its big initiatives in ad tech, e-commerce, and the digital home

TMT heavyweights AMZN and GOOG capped off a busy week in earnings with topline misses, while the former delivered an unusually high earnings beat sending shares of AMZN as high as 13% in the after hours session. GOOG dipped a couple points on the earnings release but reversed course after the call with the stock up 1.4% as a messy quarter was brought into context. Like their tech peers that reported earlier in the week, both AMZN and GOOG also reported FX issues, with impacts of -4% to their toplines. Both would have easily topped consensus revenue otherwise. For AMZN, the earnings surprise shows Bezos is answering the bell, not because of Wall Street, but to avert retention issues when it comes to his employees. For GOOG, the second straight miss taken in context of a quarter with unusual FX headwinds and large one-time real estate investments shows the business is otherwise continuing the course dominating digital advertising.

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