Dividend
Taxation, The Stock Market, and the Economy
When the after-tax return of any asset class increases compared to that of other asset classes, money flows in that direction. The dividend tax exemption proposed by the Bush administration thereby increases the intrinsic value of U.S. equities by nearly 10%. This will cause strength in the stock market, stimulating investor’s appetite for stock offerings that allow companies to raise cash by selling stock. This provides liquidity to revitalize capital spending in weak industries such as telecommunications, in turn creating jobs, reviving growth in the economy, and generally making people feel a whole lot more optimistic. The time is right to end the double taxation of dividends.
Monsanto (MON 19) is cheap. Free cash flow generation (after capital expenditures) was about $1.50 in 2002 and should be about $1.90 this year. Were the company to pay out all 2003 free cash flow as a dividend, the yield would be 10%. And, both earnings and cash generation should grow at low double-digit rates over the next several years. Intrinsic value calculated by discounting back the future cash flow stream exceeds $30 per share.
Monsanto is the leading global provider of technology-based agricultural products to farmers. The company consists of two segments. 67% of revenues come from “Agricultural Productivity,” consisting mostly of the production of RoundUp herbicide. RoundUp dominates the selective herbicides market and provides the cash flow that Monsanto reinvested to become the world leader in biotechnology crops. 33% comes from the “Seeds and Genomics” segment, which produces seeds with value-adding bioengineered traits. The company’s business model integrates Roundup herbicide with seeds and biotechnology traits to offer total productivity solutions to the farmer. Monsanto accounted for more than 90 percent of the acres planted worldwide with herbicide-tolerant or insect-resistant seeds in 2002. Monsanto has received over half of all US Department of Agriculture approvals for biotech products.
RoundUp’s operating earnings growth has stalled due to generic competition, although volume continues to grow. Meanwhile, seeds are growing at a rapid rate, as the controversy over GMO’s (genetically modified organisms) recedes. Comments from Brazil's new agriculture minister support the legalization of GMO crops. The EU Agriculture and Environmental Councils recently approved the GMO Labeling and Traceability Rule, opening the GMO approval process in Europe. I do not know why one would get more upset about seeds modified by genetic engineering than by radiation, as hybrid seeds have been made for years, especially when seeds infused with resistance to insect pests dramatically reduce insecticide usage.
Management expects new seed approvals to provide incremental EPS growth of $.90. They include Roundup Ready Soybeans in Brazil, Yieldgard Rootworm Corn in the US, Bollgard Cotton in India, Bollgard Cotton II in the US, and Roundup Ready Corn in Europe. In several years, soybeans engineered to provide higher levels of protein and Omega III oils will be introduced. Drought-resistance is a trait under development that will not just improve farm economics, but will combat starvation in arid parts of the world. “Trait stacking”, in which one seed possesses multiple traits, increases value to farmers and consumers, while compounding profitability.
2002 was a very disappointing year for the company. Currency implosions in South America caused accounts receivable losses, driving the company to permanently change operations in weak currency economies. The company has transitioned to requiring cash payment or exceptional credit from cash-strapped farmers and that policy has hurt revenues. Combining that with poor weather in the US caused the company to produce 2002 operating earnings per share of about $1.10 compared to management’s expectation a year ago of $2.25 - $2.40. Weather and foreign economies are ongoing risks to Monsanto and its shareholders. With a permanently changed business plan in foreign markets, it could take five years to attain the previously hoped for level of earnings.
Trait approvals listed above will drive the growth. The stock declined from the high $30’s as 2002’s events played out, creating the present bargain. Monsanto’s similarities to a pharmaceutical company are obvious, but the price to earnings ratio is half to a third that of a good research-based drug company. The stock is cheap.
Cardinal Health (CAH 60) is a leading provider of products and services for the healthcare industry. Positioned between pharmaceutical manufacturers and drug sellers and users, Cardinal delivers productivity, cost savings and patient safety to its hospital and pharmacy customers. In the US, half of all surgeries performed use Cardinal products and 25% of all prescriptions pass through Cardinal’s distribution network.
Tremendous scale and deep management has built a track record of consistently increasing profit margins and return on capital, as earnings growth has compounded at 20% over the past 15 years.
But Cardinal has an issue to deal with. Recently, an industry observer reduced its projection of revenue growth for the pharmaceutical distribution industry, from which Cardinal derives 67% of its revenues. A decline in industry revenue growth from 16% to 12% is entirely possible, not that 12% is all that bad. It’s just not 16%. This is occurring largely because of the proliferation of generic drugs, as drug patents expire. Generic drugs are a lot cheaper, so even if the number of pills sold increases, the total revenues generated decline. As awareness of this seeped its way through Wall Street, Cardinal stock declined 15%, while other pharmaceutical distributors declined 20-25%.
Fortunately for the pharmaceutical distribution companies, the actual profit per pill is higher for a generic, because the generic manufacturers compete against each other for help selling their non-name brand products by giving distributors a bigger piece of the profit pie. So the damage should be completed over the next two weeks or so as these companies announce their December quarter earnings.
Cardinal, being the awesome company that it is, was able to offset most of this year’s damage by winning a large contract worth $1.8 billion per year from Express Scripts. Revenue guidance for the June 2003 fiscal year will probably be achieved, but guidance for 2004 will likely be lowered. More visibility into pharmaceutical distribution revenue growth will be needed before the stock starts climbing again. I am most certainly looking for the opportunity to buy it, since I believe it will be much higher in future years. I was targeting $55 before the Express Scripts news; now I’m on thin ice. I estimate intrinsic value is about $70.
All of Cardinal’s four
divisions, including Pharmaceutical Distribution discussed above, are leaders
in their fields. The Medical Products
and Services Division composes a quarter of Cardinal’s revenues and is growing
revenues and earnings at about 14%. It
generates 40% of Cardinal’s total cash flow.
Pharmacy Technology and Services is about 15% of sales and is growing operating earnings in excess of 20%. This division does contract drug manufacturing and packaging for pharmaceutical and biotech companies. Services provided include discovery, development, commercial manufacturing and packaging, sales and marketing, product launching, and distribution for generic and patent drugs. It is under contract to manufacture and/or package Advil, Claritin, Bextra, Kaletra, Zyprexa, Celebrex, Maxalt, etc. Phase 1/Phase 2 biotech drug development capability is domiciled in San Diego. The recent acquisition of Syncor makes this Cardinal division the leading nuclear pharmacy service in US, providing products for chemotherapy.
Automation and Information Services is the fastest growing division of Cardinal. With revenue and operating earnings growth in the 20-25% range, it’s 10% share of Cardinal’s total business is expanding. This division offers hospitals the Pyxis point-of-use medicine cabinets that control drug administration to patients, prevent shrinkage, and guard patient safety.
Management is guiding 2003 growth as follows: revenues 14-16%, operating earnings 18-20%, net earnings 20-22%, diluted EPS 20-22%. EPS should be about $3.20 in the June ‘03 fiscal year, giving the stock a P/E of 19.
Steven L. Ré, CFA January 17, 2003
The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets don’t always go up. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.