Owain Bennallack and his fellow Fools Nathan Parmelee and Nate Weisshaar explore the mega-merger mania that has gripped the pharmaceutical sector. Do these big deals make sense for shareholders, and what should you be doing? They also bash bankers’ outrageous bonuses and weigh up the pros and cons of AIM shares, before concluding as usual with three shares worth watching: Hargreaves Lansdown (LSE: HL), Elementis (LSE: ELM) and BHP Billiton (LSE: BLT) (NYSE: BBL.US).
The following is an unedited transcript of this podcast
Owain Bennallack: Hello and welcome to Money Talk, the investing roundtable from The Motley Fool. I’m Owain Bennallack, and with me today is Nate Weisshaar, in his last recording from our London office. We also have Nathan Parmelee calling in from Boston, to prove that there will be life for Nate on this podcast, after he returns home to the U.S.
Both Nate and Nathan, of course, work on our Champion Shares Pro and Share Advisor services. Hello, chaps.
Nate Weisshaar: Hello.
Nathan Parmelee: Hello, Owain.
Bennallack: Hi, Nathan. Nathan, I’m going to concentrate on Nate, I’m afraid, even though it is a delight to have you on the line today.
But Nate, this is it! I’m not sure I’m going to be able to make it through the next 20 to 70 minutes — depending on how much we have to edit out — I’m not sure I’ll be able to get through it all without welling up and starting to cry.
Weisshaar: I’ve stocked up on Kleenex over here, so I’m ready to go.
Bennallack: Have you seen the film, “Superbad,” where they try and score with some, quote from the film, “hot chicks” — that’s a quote; that’s not me being pejorative — and they end up having a last sleepover at his house, and it’s a drunken scene of … I don’t want to see anything like that happening here. I don’t want any declarations of …
Weisshaar: We’ll make sure that we stay away from the sleeping bags.
Bennallack: … undying kinship. For that reason, in fact, I’m not going to drink for the entire podcast, because I don’t want to get maudlin.
Parmelee: It’s a shame.
Bennallack: It is a shame. You’re free to drink, Nathan, because obviously you’re getting Nate, so you could be having a drink of celebration.
Parmelee: I’m still just trying to get through my morning coffee, at the moment.
Bennallack: OK, well, feel free to top it up with a bit of Irish whiskey or whatnot. Okay, let’s try and get through this without tears, from Nathan, of boredom.
First of all, we’ll talk about the mega merger mania in the pharma sector. Nathan actually knows a thing or two about the drugs makers, so it’s convenient that he’s on the line, and we’ll be picking his brains.
Then I want to talk about banker bonuses. It seems like the megabanks — RBS, Barclays, Lloyds, these big fellas — they are set on getting around new legislation from Brussels that’s meant to cap big bonuses to bankers. As shareholders, should we wish that they weren’t doing this? We’ll discuss that.
Then we’ll talk about AIM shares. From this week — or, in fact, from last week, by the time you guys hear this — it will be cheaper to invest in these smaller and less well-regulated companies, but is that a reason to do so?
Then we’ll conclude, as usual, with three companies that we’ve been looking at in recent days. Does that sound good to you guys?
Weisshaar: Let’s get started.
Parmelee: Sounds great.
Bennallack: Is that something in your eye there, Nate?
Weisshaar: Yeah, just a little dust.
Bennallack: Yeah, you wipe that out.
Let’s start with the pharmaceutical sector. In just the past few weeks, we’ve seen U.K. giant GlaxoSmithKline swap its oncology business with rival Novartis. It’s picked up a vaccine division from Novartis, plus a wodge of cash.
We’ve seen American company Zimmer, of the eponymous Zimmer Frame fame, bid $13 billion for rival Biomet, and we’ve seen deal addict Valeant team up with a hedge fund to acquire Allergen, the maker of Botox.
As if all that wasn’t enough, the biggest news of all really, perhaps, is that the U.K.’s other pharma giant, AstraZeneca, has been soaring on news that it’s still in the sights of the biggest beast of the sector, Pfizer. It rebuffed a £60 billion deal, apparently, from Pfizer — or takeover offer.
Nathan, is this just like when you’re waiting for a bus, and then three buses come along at once? Why is all this action happening in pharma right now?
Parmelee: It is kind of that way, but they’re all different buses, I would say — or different sizes and colours. Each deal has a unique twist to it.
If you look at the AstraZeneca deal and Pfizer, Pfizer seems a little bit focused on product, but more focused on how they can wring out cost savings from the deal and lower their tax bill.
Whereas, if you look at the Novartis and GlaxoSmithKline deal, it’s much more about how they can reshape and refocus their product portfolios and be stronger businesses going forward — but independent, on their own.
Bennallack: If there are all these deals happening, even if they are kind of diverse deals, does that suggest that there’s value here, that the big companies want to unlock?
We’ve discussed, internally in The Motley Fool, how Valeant for instance has grown incredibly quickly. It remains to be seen whether it’s sustainably, but it has grown very quickly by picking up seemingly undervalued drugs from the big rivals, then wringing a higher profit out of them.
Is this effectively what the companies are now trying to do for themselves?
Parmelee: It really is, more than anything, wringing out costs in a lot of these deals and getting more efficient. Plus, I just feel when you get a few years into a bull market everybody starts to put the fear of the last recession or financial crisis behind them and feel stronger and more secure.
Then they’re out there looking, “OK, what can we do strategically to buy some growth and reshape the business?” and they feel more confident about putting money to work, so I think that’s definitely a big part of what’s going on, too.
Bennallack: If you were a U.K. investor, and specifically looking at AstraZeneca and GlaxoSmithKline, would you say that there’s more to go for those shares? Do they still look undervalued in any way?
Parmelee: At this point I would say not so much for AstraZeneca, just because at this point I think Pfizer is going to try to do the minimum to get the deal done, so maybe you squeeze out a few more per cent here — and if for some reason the deal falls through, I wouldn’t be surprised if AstraZeneca shares took a hit, because I think the value that’s in there right now can’t be realised unless AstraZeneca is combined with another company and you can take costs out.
Glaxo, on the other hand, is interesting. It’s kind of unknown at this point, but you have a more-focussed business with a more-focussed product portfolio. Historically, companies do well when they focus on fewer things, and do them well, as opposed to spreading themselves too thin.
So, of the two, Glaxo interests me more right now.
Bennallack: Nate, we’ve also seen, in this mega merger mania, we’ve seen Reckitt Benckiser, a U.K. company, in the hunt for the consumer division of the German pharma company, Merck. And in fact, the Glaxo/Novartis deal also included a consumer division element, which I didn’t mention, just for succinctness purposes — which I’m obviously now jettisoning, by going into it in detail!
Why is this happening? Why are they now deciding, these big pharma companies, that they don’t seem to want the consumer divisions? Weren’t they meant to add some stability to the businesses?
Weisshaar: Yes, they do. I think it’s really got to be a strategic choice on the company’s part. To be clear, the Glaxo deal, they are combining their consumer division with Novartis’, and taking a 65% stake in this new entity — so they’re not exactly abandoning the consumer, because it is a bit of a cash cow for them.
It’s stable, but it’s also lower growth, so in the case of Merck, if they’re looking for a bit more of a potential upside, then they’re going to want to focus their energies on drug discovery, as opposed to over-the-counter or consumer goods.
I think that’s what you’re seeing here. As Nathan said, these companies are trying to focus their portfolios a little bit more.
Bennallack: Do you think they’re doing that because returns have been pretty flat for the last decade or so?
Weisshaar: I think that is part of it. I think research, drug discovery, and bringing drugs to market, is becoming much more expensive and in order to better-utilise the assets, they need to focus on a few specific areas.
Astra has laid out four specific areas they’re looking to develop drugs. Glaxo has done something similar, vaccines being one of them, which is why the Novartis deal makes sense for them.
Bennallack: Well, keep an eye on that sector, everyone, because I think there’s probably a bit more to come. But as Nathan says, possibly not in Astra, which is already now £60 billion. It will be the biggest takeover in U.K. history, if that goes through.
On to the poor old bankers, and their brave attempt to keep several roofs over their heads, Ferraris in the garage, eight figures on their paycheques. RBS is reportedly set to pay multi-million pound “allowances” to its top staff, which are not really linked to the performance of RBS, which — let’s face it — has been terrible, if you’ve been a shareholder.
This is all an attempt to get around new European rules that limit big bonuses. The U.K. government is actually taking legal action against the European Commission on those new rules, whilst also saying it doesn’t want RBS to go round the rules with the bonuses.
It’s all a bit of a mess, isn’t it, Nate?
Weisshaar: Well, what’s new in this sector?
Yes, it’s quite interesting that the European Commission wants to prevent a re-enactment of the global financial crisis, which everyone …
Bennallack: Those killjoys!
Weisshaar: I know! Well, some people have their own priorities.
But one of the symptoms, apparently — or one of the areas being blamed for the financial crisis — was poor incentives, and overly large pay packages was a big part of that. So, the European Commission is looking to cap banker bonuses at 100% of base pay and, in case that’s not enough, if the shareholders say yes, it can go up to 200% of base pay.
Obviously, London bankers don’t think that’s enough, so they’re trying to get around that by creating a whole new pay “division.” It’s not basic salary, it’s not a bonus, it’s now an allowance, which harkens back to my childhood, when I received an allowance for setting the table.
Bennallack: Yes. Probably about as hard to achieve, I would have thought. So, basically, they’ve just put a new column in their spread sheet and they’ve called it “allowance,” so therefore it isn’t salary, so it doesn’t …
Weisshaar: It’s a nice little loop-hole.
Bennallack: You can see why these people have made it to the top, can’t you, with this financial acumen?
Weisshaar: Yes, it’s very savvy.
Bennallack: I think the shareholders are in a bit of a bind here because, to me it seem to stink, but equally, the banks themselves — Barclays, for instance — recently said it had to pay bigger bonuses to its New York staff, just to keep hold of them.
So, Barclays shares have gone down, paying out more money to its investment bankers. It doesn’t really seem fair, but what is a bank, if it isn’t human capital? I guess it is some money that you lend out — that would be the other thing — and a few branches.
Clearly, the people are the main fuel of the engine of growth, so, “If they come to us and say, ‘Well, we have to pay this money,’ who are we to say no?” would be the counter-argument.
Weisshaar: It’s a tough situation for shareholders. On one hand, if you want your bank to recover, then it’s going to require a certain level of skill, a certain level of competitive advantage, and usually that means you’re going to have to pay up for the best people in the market.
Shareholders of Barclays have obviously not had a great run, and it’s hard to swallow the argument that we need to pay these bankers this, despite the fact that profits are falling, share prices are falling.
But if you look at the numbers, last year Barclays Investment Bank Division saw profits fall 37%, and Barclays is still arguing that they need to pay people more.
Bennallack: Essentially they’re saying they need to pay people more because someone else will pay them more, otherwise.
Weisshaar: And you have to wonder, if a 37% drop in profits is what they’re delivering, why would somebody do that? But then you look at the bigger picture, and you see that the investment banking division is still providing almost half of Barclays profits. So, this is truly the profit driver of the company.
Bennallack: It pains me to say this, as a capitalist — I admit it — but I’m starting to wish the U.K. government, the Europeans, maybe the U.S. and the Asians, had all got in a room and they had actually agreed to cap bonuses. At the time, I thought this was a bit communist, I admit.
Perhaps it would have been impossible, but at least it would have got away from this ridiculous situation where most of the Wall Street banks have reported dodgy results in this last quarter, and yet you know that every investment banker is going in there and saying, “Well, I’m going to go from Barclays to Goldman Sachs if you don’t pay me more.” The Goldman Sachs guys are going, “I’m going to go to Barclays if you don’t pay me more.”
Nathan, you tend to not like big banks, I’ve noticed, over our years of working together. I guess this is just another reason. Well, you don’t have to own the shares, do you? You can just not buy the shares if you don’t like this.
Parmelee: Right, exactly. My argument is more towards the risks that these businesses take to get their profits, and how it’s opaque and you can’t really see what they’re doing, and the risk that they’re taking to get there.
But when it comes to pay, I actually am in favour of leaving pay alone, and not regulating it. I would rather see the Europeans, the Americans, the Asians, everybody, get in a room and agree that we’re going to treat banks — traditional retail and commercial banking — differently, and separate it from investment banking and the risk-taking activities.
Just have them be distinct entities that can’t be together, kind of like the U.S. had with Glass-Steagall, and control the risk that way. Allow them to have separate balance sheets, and pursue whatever they want to pursue, and pay accordingly, and manage it that way.
Bennallack: Then if you were an investor and you wanted to invest in swashbuckling investment bankers, you could take your risks and hopefully get your rewards, and then if you wanted to buy a boring bank, you could buy Lloyds, essentially.
Bennallack: That would be the argument. Why do you think that didn’t happen?
Parmelee: I think part of it is, nobody wants to be the first to do it, because they fear that the remaining continents or countries where people don’t have to separate have an unfair advantage, because they have access to cheap funds through deposits, and the ability to take more risks than they can.
Part of it also is just the lobbying strength of the industry is tremendous, so they’re able to sneak in, “You’ll damage the economy by doing different things to the industry and limiting risk-taking. This is what makes the economy dynamic and grow.”
And, in a sense, I agree. It does make the economy dynamic and grow, and I just think you should separate those activities from the more mundane home mortgages and business loans, and things like that.
Bennallack: We could talk about this for hours, but it seems to me if they were ever going to separate it, this was the time, because firstly there was the political will, and the public would have been with it.
And secondly, those riskier operations probably would have got capital to go about their … debt is cheap at the moment, so it’s not like that money would have been drained from the system, I don’t think.
Parmelee: I tend to agree with you. I think they let an opportunity pass.
Bennallack: One option to buying shares in big, bloated banks staffed by overpaid managers could be to buy into small, hungry firms, run by entrepreneurs, and that has just got cheaper in the U.K., with stamp duty of 0.5% no longer being charged when you buy shares listed on AIM — that’s the Alternative Investment Market.
Now, companies on AIM are more lightly regulated than on the main market, and that hasn’t stopped people recently. They’ve been on a bit of a tear, because last year you were allowed to put them into ISAs for the first time.
I think they’ve gone up about 17%, when I last looked, since that change, versus about 10% for similarly small companies that are listed on the London Stock Exchange as a whole.
Over the long-term, though, the AIM market has done pretty poorly. It’s down about 20% from where it was in the late 1990s, and an awful lot of AIM companies have literally gone bust — and those that haven’t, an awful lot of them are about one pence, or strange shell companies. So, you’ve got to keep your wits about you.
Nate, does this stamp duty change — it’s only half a per cent, at the end of the day — does that make AIM shares worth a closer look?
Weisshaar: Well, lower trading costs are always an attractive prospect for investors, but I think you can’t let the tail wag the dog in this. You still need to be conscious of what it is you’re investing in. You’re investing in companies — you’re not investing in electronic blips on a chart.
As you say, there have been plenty of companies listed on the AIM that have gone bust. A lot of the resource-focussed companies have been of questionable nature.
Bennallack: Strange Chinese companies as well.
Bennallack: Why would a Chinese company come and list in London on the AIM market? What would they see in that?
Weisshaar: Just the wise British investors, that’s what it is!
Anyone looking at the AIM has to recognise that it is more lightly regulated, and as it’s generally made up of relatively small companies, it’s also going to be more volatile. These are definitely things you want to pay attention to, much more so than just the stamp duty.
Bennallack: Nathan, we’ve looked and we will continue to look, I hope, at lots of companies including AIM companies. Nate’s point is definitely right; there are companies that we, in our services, have liked and continue to like that are listed on AIM, are there not?
Parmelee: Yes, and they either tend to be small businesses in small industries — small niches, you might say — where they have a strong position, but they’re still just small businesses because the industry is small.
Then the other type tend to be young, dynamic, fast-growing companies. But it really comes back to what Nate said. It’s focussed on the companies, what they’re doing, how well they’re doing it, and less so on the stock price and the story and the excitement behind certain sectors.
Bennallack: Are there any companies which you think are particularly noteworthy?
Parmelee: ASOS stands out, Majestic Wine … there have been other companies that started out on the AIM and graduated to the LSE, like Monitise is hoping to do right now. But yes, there are a number of interesting businesses on the AIM. You just have to pick and choose.
Bennallack: Let’s talk about a few shares that have certainly caught our eye recently, on AIM or elsewhere. Nate, what’s on your radar right now?
Weisshaar: One I’ve been watching is Hargreaves Lansdown (LSE: HL). I’ve actually been watching them for years, but the shares have been sliding recently, and the company has been reporting very strong growth in customers and customer assets under management, mostly through ISAs.
I think the changes in the new ISA regulation bode well for the future of Hargreaves, but the market doesn’t seem to be revelling in these changes quite as much as investors might be, so it’s one I’m watching. It’s getting interesting.
Bennallack: The essential problem with Hargreaves was it’s always been doing very well, but it became pretty expensive to buy. It seems that the shares have come down because investors are worried that maybe Hargreaves isn’t going to get through this RDR process with its fat margins intact.
If it can only earn some percentage lower than it used to earn from inflated assets, doesn’t that mean that it should be worth less?
Weisshaar: It definitely does, but the great thing about Hargreaves is that it is the market leader in an industry where there are definite benefits to being the biggest player. They have scale benefits.
It doesn’t cost them very much to manage the account of another person, once they’ve set up their infrastructure, and as that person invests more money with them, it doesn’t cost them hardly anything more to manage that. So, as they grow bigger, their costs should stay relatively stable.
And, yes, the fees that they can charge are under pressure from RDR, and really the big question when looking at them is, can they grow customers and assets under management fast enough to offset declining margins?
Bennallack: If you were modelling this, you’d essentially have one line going up, saying “This is the assets under management, going up,” and another line going down, showing, “This is the margins,” and you would want the two, multiplied together, to keep going up overall.
Weisshaar: Hopefully that would be the case if you’re a bull investor here.
Bennallack: Okay, that sounds interesting.
Nathan, can you give us a share that you think is worth keeping an eye on?
Parmelee: Yes. I’m going to look at a company that actually just recently reported, that I think investors should keep an eye on. That’s chemical manufacturer Elementis (LSE: ELM). I’ll admit, it looks slightly expensive on the surface, but they’re moving more and more into serving the personal care industry, and they have some dominant positions in other parts of their business in the industries they’re in.
It’s becoming a less-cyclical business, and in a way almost more like a consumer staple, with a lot of repeat purchase sales going out the door. So, the quality of the earnings there are just improving tremendously, even though the growth is more in the, say, low to mid single-digit range on revenues.
To me, it’s actually a business that looks a little bit cheap, even though on the surface it appears expensive.
Weisshaar: To that point, Nathan, with a P/E of 20 and what is — you’ve got to say — a bit of a mixed recent update, the company is in the chemical industry, and that generally boils down to commodities, really.
If it’s growing mid single-digits in what might be a commodity business, is the valuation really justified?
Parmelee: In this case, I think it is. I wouldn’t call the shares a screaming bargain here, but I do think they’re ones that will do well for investors, over time.
I think, when you look at the most recent report, the parts of the business that did poorly were the cyclical parts of the business. They serve the energy industry, and I think in that part of the business the sales were down 20%. But the overall business still eked out growth, particularly that sector of the chemicals business I think still had 4-5% growth because their sales into the personal care industry were up 50%.
Going forward, I think here, with the shares where they are, you get the stability of those personal care sales, and then a potential for recovery down the road in the part of the business that serves the energy sector. Really, it’s that combination that makes it interesting to me here.
Bennallack: You could say that the P/E is high because the market anticipates a recovery in the cyclical elements, I guess.
Parmelee: Yes, I think that’s fair. The market’s looking through and seeing the stable part of the business and the potential for growth in the rest of the business.
Bennallack: Let’s move on, last and least, to my share. I’m thinking, again, about BHP Billiton (LSE: BLT), which I think I’ve mentioned on this podcast before. It’s a massive diversified miner, operations everywhere.
But the reason it’s come back onto my radar again, like some huge elephant running through the living room, is because Mick Davis, who quit last year from the merged Xstrata Glencore, he has put together a fund — a war chest — to go out and look for undervalued mining assets, because so many of these big companies have been knocked down, as China has stopped building a new city every other day, I think is the official statistic.
He’s amassed nearly $4 billion. He is understood to have the potential to raise another $8 billion in debt, and according to reports in The Sunday Times, he is looking specifically at BHP Billiton’s legacy assets — thermal coal, that kind of thing. Interestingly, it’s stuff that he knows quite well from when he was at BHP, before the merger that created BHP Billiton.
It’s a little bit counter-intuitive, because I think one of the reasons people like to own BHP Billiton is because it’s so big and diversified. Would they really want to start hiving parts of it off?
But, equally, you might have to wait a long time for the mining super cycle to get everyone excited again by proving it’s back on. Whereas, Mick Davis, if he comes in and he sees a way to wring some value out of those assets that perhaps BHP can’t wring out, potentially you might get a bit of earlier excitement — akin, maybe, to what we’re seeing in the pharma sector — in the shares of BHP Billiton. That’s my theory, anyway.
Parmelee: Yes, it sounds like you’re looking at a business that would become more focussed. But if you could, would you rather buy the Mick Davis business? Buy into that, instead, for the dynamicism and the growth?
Bennallack: I think it’s unlisted, so that’s sadly not an option, but I think possibly you would. I think probably there’s a couple more years of … well, you can’t really tell, but there could easily be a couple more years of plodding around in the commodities space.
They’ve all said they’ve got to stop wasting money, so they’ve all stopped building millions of mines — or most of them have. They’re looking at allocating the capital more efficiently, blah, blah, blah. But if you could come in with the dynamic change agent — maybe come in with the cheetah, instead of the limping gazelle — it might be better to own the cheetah!
There are a couple of littler, smaller companies listed on the market, if you want to do your homework, that are trying to do something similar to this. But, then again, if you buy BHP, you’re going to have the upside of not having to take the risk on an execution from buying and wringing costs out of those assets.
So, I think it’s an interesting place to look at the moment, the commodities sector. I think there’s time, though, to figure out your strategy.
Parmelee: Fair enough.
Bennallack: That about wraps it up for this week. If you’d like to hear more Motley Fool wisdom, head to our free site, which is www.fool.co.uk, or you can download our free report on becoming a millionaire … the slow and Foolish way. You can get that at fool.co.uk/millionaire.
Nate, I won’t keep you from that plane any longer.
Weisshaar: I’ve got my bags all ready to go.
Bennallack: You have literally got your bags in the office. Are you going to the airport after this?
Weisshaar: Shortly. Very shortly.
Bennallack: This is incredible scenes. I can see you are crying, now.
Weisshaar: Just a bit. Just a bit. It’s dusty in here.
Bennallack: It is dusty in here. Well, we’ll be speaking to you very shortly via the same wondrous technology that’s brought Nathan online today, so Nathan, thanks for dialling in.
Parmelee: It was great, thanks for having me, Owain.
Bennallack: Next time, we’ll have Nate on the ISDN as well.
Weisshaar: It’ll be a great experiment.
Bennallack: Okay, thanks everyone!
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The Motley Fool owns shares in Elementis.