Important disclosures appear on the last page of this report. The Henry Fund Henry B. Tippie School of Management Aric Jensen [[email protected]] Baxter International Inc. (BAX) April 19, 2017 Health Care – Equipment & Supplies Stock Rating Sell Investment Thesis Target Price $46-49 We give a Sell recommendation for Baxter International. Baxter’s stock price has been on a tear the past 12 months – up over 24% and overvalued by all of our estimates. The market has been generous due to Baxter’s ability to beat earnings throughout the separation of Baxalta and their pending acquisition of Claris Injectables. However, we feel the recent run in price has left Baxter overvalued with low levels of growth going forward. Investment Positives • Baxter is a stable contract-heavy company with a history of beating earnings – you generally know what to expect. • Baxter will continue to be a global leader in injectables, especially within renal therapies, and look to expand further by adding Claris Injectables. We forecast the acquisition to generate sales of $125M in 2018 and increase at a 10% CAGR through 2021. • Baxter has recently strengthened their balance sheet, exemplified by their current ratio of 2.40 and debt to equity ratio of 0.34. • Baxter has made apparent their desire to increase operational efficiencies and margins. Our model predicts their profit margin to increase from 10.45% in 2017 to 11.94% in 2021. Investment Negatives • Sales within existing segments have only increased at 2.59% CAGR since 2013 and we forecast revenue growth at a 3.66% CAGR. This pales in comparison to Baxter’s competitors, such as Medtronic (21.2%) and Abbott Labs (8.92%). • They are competing in a diversified industry where market share is hard to come by via unprotected generic drugs. • Pricing pressure for the past two decades has left the industry with margins below other industries within health care, evidenced by Baxter’s 2016 adjusted profit margin of 5.7%. Henry Fund DCF $48.36 Henry Fund DDM $45.54 Relative Multiple $33.97 Price Data Current Price $52.73 52wk Range $42.22-53.54 Consensus 1yr Target $52.91 Key Statistics Market Cap (B) $28.58 Shares Outstanding (M) 541.96 Institutional Ownership 77.03% Three Year Beta 0.81 Dividend Yield 0.98% Est. 5yr Growth 14.43% Price/Earnings (TTM) 5.85 Price/Earnings (FY1) 21.52 Price/Sales (TTM) 2.81 Price/Book (mrq) 3.43 Profitability Operating Margin 12.00% Profit Margin 48.85% Return on Assets (TTM) 4.18% Return on Equity (TTM) 57.93% Earnings Estimates Year 2014 2015 2016 2017E 2018E 2019E EPS $4.61 $1.78 $9.09 $2.00 $2.20 $2.35 growth 24.6% -61.4% 410.7% -78.0% 10.0% 6.8% 12 Month Performance Company Description Baxter International is a Medical Equipment and Supply company that specializes in products related to intravenous (IV) therapies, such as pumps and administration sets, and products related to treating end-stage renal disease. In June 2015, Baxter officially separated their biopharmaceutical business as Baxalta, later bought out by Shire PLC, to focus on their Hospital Products and Renal segments. The pending acquisition of Claris Injectables Limited will help them with their goal of global generic expansion. 5.8 57.9 14.3 28.4 11.0 16.3 19.8 18.6 13.0 0 20 40 60 80 P/E ROE EV/EBITDA Data Source: FactSet BAX Industry Sector -5% 0% 5% 10% 15% 20% 25% A M J J A S O N D J F M Data Source: FactSet BAX S&P 500
Transcript
Important disclosures appear on the last page of this report.
Health Care – Equipment & Supplies Stock Rating Sell
Investment Thesis Target Price $46-49 We give a Sell recommendation for Baxter International. Baxter’s stock price has been on a tear the past 12 months – up over 24% and overvalued by all of our estimates. The market has been generous due to Baxter’s ability to beat earnings throughout the separation of Baxalta and their pending acquisition of Claris Injectables. However, we feel the recent run in price has left Baxter overvalued with low levels of growth going forward.
Investment Positives • Baxter is a stable contract-heavy company with a history of beating
earnings – you generally know what to expect. • Baxter will continue to be a global leader in injectables, especially within
renal therapies, and look to expand further by adding Claris Injectables. We forecast the acquisition to generate sales of $125M in 2018 and increase at a 10% CAGR through 2021.
• Baxter has recently strengthened their balance sheet, exemplified by their current ratio of 2.40 and debt to equity ratio of 0.34.
• Baxter has made apparent their desire to increase operational efficiencies and margins. Our model predicts their profit margin to increase from 10.45% in 2017 to 11.94% in 2021.
Investment Negatives • Sales within existing segments have only increased at 2.59% CAGR since
2013 and we forecast revenue growth at a 3.66% CAGR. This pales in comparison to Baxter’s competitors, such as Medtronic (21.2%) and Abbott Labs (8.92%).
• They are competing in a diversified industry where market share is hard to come by via unprotected generic drugs.
• Pricing pressure for the past two decades has left the industry with margins below other industries within health care, evidenced by Baxter’s 2016 adjusted profit margin of 5.7%.
Henry Fund DCF $48.36 Henry Fund DDM $45.54 Relative Multiple $33.97 Price Data Current Price $52.73 52wk Range $42.22-53.54 Consensus 1yr Target $52.91 Key Statistics Market Cap (B) $28.58 Shares Outstanding (M) 541.96 Institutional Ownership 77.03% Three Year Beta 0.81 Dividend Yield 0.98% Est. 5yr Growth 14.43% Price/Earnings (TTM) 5.85 Price/Earnings (FY1) 21.52 Price/Sales (TTM) 2.81 Price/Book (mrq) 3.43 Profitability Operating Margin 12.00% Profit Margin 48.85% Return on Assets (TTM) 4.18% Return on Equity (TTM) 57.93%
Earnings Estimates Year 2014 2015 2016 2017E 2018E 2019E
EPS $4.61 $1.78 $9.09 $2.00 $2.20 $2.35
growth 24.6% -61.4% 410.7% -78.0% 10.0% 6.8%
12 Month Performance Company Description
Baxter International is a Medical Equipment and Supply company that specializes in products related to intravenous (IV) therapies, such as pumps and administration sets, and products related to treating end-stage renal disease. In June 2015, Baxter officially separated their biopharmaceutical business as Baxalta, later bought out by Shire PLC, to focus on their Hospital Products and Renal segments. The pending acquisition of Claris Injectables Limited will help them with their goal of global generic expansion.
5.8
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11.0 16.319.8 18.6
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20
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80
P/E ROE EV/EBITDA
Data Source: FactSet
BAX Industry Sector
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A M J J A S O N D J F M
Data Source: FactSet
BAX S&P 500
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EXECUTIVE SUMMARY
We give a Sell recommendation for Baxter International. Baxter stock price has outpaced the S&P 500 over the past year despite going through the separation of Baxalta and their pending acquisition of Claris Injectables. While they are consistent in beating earnings estimates, they have not adequately grown their existing segments enough – nor is the pending acquisition grand enough – to warrant their current price.
Baxter’s new acquisition will help them achieve their strategy of global growth in generic injectables, but we do not envision the new injectables beating our lofty forecast of 10% growth after 2018. The medical equipment and supply industry is extremely diversified, which makes generic sales very competitive. Becton, Dickinson and Company has doubled U.S. sales and nearly doubled medical device sales since 2014 and Abbott Laboratories has grown international generic drug sales at a 11.25% CAGR since 2014. If they can carry forward that momentum into Baxter’s path, it would slow growth even further moving forward.
COMPANY DESCRIPTION
Baxter International, incorporated in 1931, has a long history in medical equipment and supplies. Based out of Deerfield, IL, Baxter manufactures in over 20 countries and sells their products and services in over 100 countries. Baxter’s customers are mainly hospitals, kidney dialysis centers, nursing homes, rehabilitation centers, doctors’ offices, and individual patients. Baxter operates in two main segments, Hospital Products and Renal.1
Data Source: BAX 2016 10-K
Hospital Products
Hospital Products is the highest sales segment, with $6.3B in sales in 2016. This was an increase of 2.09% from 2015 after experiencing a decrease in sales of 5.62% from the previous year. This segment is further split into four sub-segments.1
Fluid Systems
Products within Fluid Systems consist of intravenous (IV) therapies, infusion pumps, and administration sets. Fluid Systems sales increased 9.21% to $2.3B in 2016. This was driven by a sales increase of their SIGMA SPECTRUM pump and IV solutions.1 Our forecast expects the greatest growth going forward in the Fluid Systems sub-segment. For the five-year forecast period, we estimate sales to grow at 4.01% CAGR. This is due to their focus on operational efficiency and synergies from the acquisition of Claris Injectables, which is discussed in the next section.
Integrated Pharmacy Solutions
This sub-segment consists of premixed and oncology drugs, nutrition products, and pharmacy compounding services. Revenue has experienced decreases in each of the past two years, totaling -9.06% in 2015 and -2.26% to $2.2B in 2016. Most of these decreases are attributed to lower U.S. sales of their generic oncology drug cyclophosphamide due to a competitor entering the market in 2014. Cyclophosphamide sales were $450M in 2014, $270M in 2015, and $210M in 2016. We expect sales to decline again in 2017 before stabilizing in 2018.
The drops in cyclophosphamide sales were partially offset by increased revenue from pharmacy compounding services and nutritional therapies in each of the last two years. Revenue in 2015 was also aided by government orders of poison/overdose antidote PROTOPAM, however these orders did not reoccur in 2016.1 Overall, we expect sales growth at a 3.37% CAGR through 2021.
Surgical Care
The Surgical Care sub-segment consists of inhaled anesthesia products and biological products and medical devices that are used in surgery related to hemostasis, tissue sealing, and adhesion prevention. Sales within Surgical Care have been relatively flat near $1.3B since 2013, seeing growth at a low 0.36% CAGR.1 We expect
62%
38%
2016 Sales by Segment (Total $10.2B)
Hospital Products
Renal
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sales within this segment to increase to a CAGR of 1.6% due to Baxter’s global expansion efforts.
Other
The Other sub-segment consists of revenue related to products that Baxter manufactures for its pharmaceutical partners. Other revenue has been slowly slipping since 2013 as Baxter has experienced reduced demand for these services and one partner electing to self-manufacture products previously contracted to Baxter. From 2013 to 2016, other revenue decreased to $442M at 4.72% CAGR.1 We have forecasted other revenue to increase at a 2.5% CAGR for the next five years.
Data Source: BAX 2016 10-K
Renal
The Renal segment consists of products that treat end-stage renal disease, including peritoneal dialysis (PD), hemodialysis (HD), and continuous renal replacement therapy (CRRT). It is estimated that 10% of people worldwide suffer from chronic kidney disease (CKD) and that over 1 million people die annually from untreated kidney failure. In the U.S. alone, spending on renal treatment could exceed $48B.2
Baxter experienced Renal sales of $3.86B in 2016, up 1.74% from $3.79B in 2015. The increase is attributed to growth within the PD and CRRT businesses.1 Our model forecasts Renal to attain a sales growth rate of 3.69% CAGR. This is due to their dedication towards reaching a greater number of patients globally.
Company Analysis
Baxter is amid a transition period that started with the separation of their biopharmaceutical business, Baxalta, in 2015. They view the separation as a vital step towards
optimizing the Hospital Products and Renal segments. Baxter aims to further solidify these segments with the potential launch of more than 100 products by 2020.1 They brought to market 20 such launches in 2016. This included the introduction of Numeta G13E, which is “the only triple-chamber commercially prepared parenteral nutrition system approved for vulnerable neonatal patients.”3 It should be noted that this includes new products, enhancing current products, and expansion into new geographical markets.1
RECENT DEVELOPMENTS
Earnings
In 2016, Baxter came in above estimates all four quarters with average earnings surprise percentage of 18.3%.4 This is greatly tied to much of Baxter’s revenues stemming from contracts with their customers and keeping guidance achievable. The 2017 EPS estimate from our model is $2.00, which is below guidance of $2.10-$2.18 for adjusted EPS and above GAAP EPS of $1.52-$1.67.2 They are due to release Q1 earnings on April 26 with an EPS estimate of $0.52.
Agreement to Acquire Claris Injectables
In December 2016, Baxter agreed to purchase Claris Injectables Limited for $625M in cash. This deal is expected to close in the second half of 2017. Currently, Claris Injectables is a wholly owned subsidiary of Claris Lifesciences Limited, which is based out of India. The newly acquired business was expected to generate over $100M in revenue in 2016 and is viewed as a strategic acquisition to enhance Baxter’s generic injectable portfolio as it looks to expand globally in emerging markets. Since the deal is supposed to be finalized in late 2017, we forecasted $125M in sales for 2018 and growth at a 10% CAGR through 2021.5
Separation of Baxalta
In July 2015, Baxter leadership decided it would be better for the distinctly different businesses to forge their own respective paths. Immediately upon separation, Baxalta entered the S&P 500 and Baxter dropped out.6 This was a good opportunity to separate the slow stable contract-growth side of Baxter from the risk-reward biopharma side of Baxalta.
36%
36%
21%
7%
2016 Sales in Hospital Products ($6.3B)
Fluid Systems
Integrated PharmacySolutionsSurgical Care
Other
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Baxter retained a 19.5% stake in Baxalta into 2016. They disposed of the stake through a combination of debt-for-equity and equity-for-equity exchanges and by contributing to their U.S. pension plan. Baxter openly recognizes a possible tax liability due to the shares transaction.1
INDUSTRY TRENDS
Growth Amid Diversification
Among the global medical device market, the top 15 companies owned roughly 43.5% of the market share as of 2014. The biggest was Johnson & Johnson, with a 7.3% market share.
While the expected market growth through 2020 is a 4.1% CAGR, Baxter’s estimated growth, per Evaluate Group, from 2014-2020 is a 2.7% CAGR. Our model optimistically forecasts a 3.66% CAGR in sales through 2021.
Pricing Pressure
For nearly two decades, the medical device market has experienced unrelenting pressure on their prices. The main way for hospitals to controls prices is to spend less on capital expenditures. Baxter and their competitors are greatly dependent on capital expenditure budgets of hospitals and reimbursement from programs such as Medicare.
This was further enforced from 2013 to 2015 by the Patient Protection and Affordable Care Act (ACA). Within the first year, the 2.3% excise tax levied on medical devices was estimated to cause a loss of 165,000 jobs directly and indirectly. As well, 30.6% of respondents in a survey administered by AdvaMed reported a decrease in R&D spending due to the tax and almost 10% percent reported moving jobs abroad.7
Enduring controversy, a two-year moratorium on the excise tax went into effect for calendar years 2016 and 2017. While this did not cause U.S. medical devices companies to instantly hyperinflate their prices, it has allowed them the freedom to spend more on R&D and global expansion. We have not included any excise tax effects into our model because we see the moratorium being extended or repeal of this tax as highly likely.
Increase in M&A Activity
The pricing pressures have led bigger medical device companies to look towards economies of scale and attempt to offer comprehensive solutions to patients. This has led to an explosion of M&A activity since the middle of 2013.
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The largest acquisition from July 2015 to June 2016 was that of Abbott Laboratories purchasing St. Jude Medical for $25B. In total, a record 213 deals happened in that year, with an aggregate deal value of nearly $80B.8 With their previously discussed acquisition of Claris Injectables, Baxter aims to grow via the same method and have stated that they will continue to monitor for accretive acquisitions going forward.
MARKETS AND COMPETITION
There are two forces that exert power on the Equipment & Supplies Industry. Due to the diversification, rivalry within the industry is extremely high. This is partially mitigated by the patents and niches that are observed, but exists nonetheless. The second force that impacts pricing within the industry is that of buyer power. This has to do with the industry being dependent on hospital capital expenditures and the pressure from government and insurance companies for the industry to keep prices at an affordable level.
Peer Comparisons
Becton, Dickinson and Company (BDX)
Based out of New Jersey with over 100 years in medical equipment, BDX is arguably Baxter’s most direct competitor. BDX has two business segments: BD Medical and BD Life Sciences.
The Medical segment, with 2016 sales of $8.7B, offers products related to intravenous medication delivery. These products include syringes, needles, and infusion pumps focusing on the treatment of diabetes.
BDX has experienced sales growth at 21.6% CAGR since 2014. This has been driven by U.S. sales within their Medical segment.9
BDX has performed well in the market over the last year, posting returns only beaten by Baxter among the peers. BDX would appear overvalued when looking at their P/B ratio of 5.17, which is highest of the group. When comparing BDX to BAX, it seems BDX has spent less on R&D and SG&A in exchange for a higher profit margin.
Abbott Laboratories (ABT)
Abbott Labs, based out of Illinois, is yet another player with over 100 years in medical equipment. With the separation of their major pharmaceutical business as AbbVie in 2013, they have since postured as a dominant force in nutritional and medical devices. Abbott’s products exist within four segments: Established Pharmaceuticals, Nutritionals, Diagnostics, and Vascular.
The Established Pharmaceuticals segment consists of generic drugs sold outside the U.S. in the areas of gastroenterology, women’s health, cardiovascular and metabolic products, pain and central nervous system products, and respiratory drugs and vaccines. This segment has been the highest growth segment for Abbott since 2014 with a CAGR of 11.25%.
In January 2017, Abbott completed the acquisition of St. Jude Medical for $25B in cash and common shares. This will considerably enhance the heart and medical device sales for Abbott.10,11 Abbott’s P/E ratio (46.78) suggests that the market is excited about the growth opportunities this could bring. However, they seem adequately priced when viewing P/S and P/B. One statistic to note is their low profit margin relative to the peers of 5.1%. Abbott has also shown the most volatility and least return in stock price among the peers over the past year.
Revenue ($M) R&D/Sales SG&A/Sales Profit Margin
JNJ 71,890 12.7% 27.7% 23.0%
MDT* 28,833 7.7% 32.8% 12.3%
ABT 20,853 6.8% 32.0% 5.1%
BDX 12,483 6.6% 24.1% 7.8%
BAX 10,163 6.4% 27.0% 5.7%
*FYE 29 Apr 16 Data Source: FactSet
Revenue (millions) 2014 2015 2016 CAGR
Medical 4,573 6,460 8,654 37.6%
U.S. Total Sales 3,417 5,069 6,893 42.0%
Data Source: BDX 2016 10-K
Revenue (millions) 2014 2015 2016 CAGR
Established Pharmaceuticals 3,118 3,720 3,859 11.25%
Nutritionals 6,953 6,975 6,899 -0.39%
Diagnostics 4,721 4,646 4,813 0.97%
Vascular 2,986 2,792 2,896 -1.52%
Other 2,469 2,272 2,386 -1.70%
Total 20,247 20,405 20,853 1.49%
Data Source: ABT 2016 10-K
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Data Source: FactSet
Medtronic (MDT)
Based out of Ireland, Medtronic had sales of $28.8B for fiscal year ending April 29, 2016. This was a 42.3% increase from the previous fiscal year, due mostly to the acquisition of Covidien in January 2015. The 2015 revenue from Covidien was reported separately from pre-existing operations, but serves to boost their Minimally Invasive Therapies segment. Medtronic’s business consists of three other segments: Cardiac and Vascular, Restorative Therapies, and Diabetes.
Medtronic boasts the second largest market cap among the peers and the price-to-book ratio points towards them being undervalued. The P/E and P/S ratios are in line with the peers outside that of Baxter’s. Medtronic achieved a profit margin much higher than the pure-play peers at 12.3%, while spending the most on SG&A at 32.8% and most on R&D among pure-play peers at 7.7%.
Within the Diabetes segment, which is the smallest revenue generating segment, Medtronic develops and manufactures products related to insulin pump therapy, glucose monitoring, and software for therapy management. Given the nature of Medtronic’s other segments and Diabetes achieving the slowest sales growth of the segments at 6%, do not be surprised to see a possible divestiture of this segment in the future. This would effectively remove Medtronic as a pure competitor of Baxter, as Baxter has shifted their focus to international injectable sales.12
Johnson & Johnson (JNJ)
Based out of New Jersey, JNJ is easily the goliath of the medical device industry, with a market cap of over $203B and 2016 sales of $71.9B. JNJ does business in three segments: Consumer, Pharmaceutical, and Medical Devices.
Revenue within the Medical Devices segment totaled $25.1B in 2016.13 JNJ also boasts the highest price-to-book and price-to-sales ratios, and profit margin among the peers at 4.59, 4.68, and 23.0%. JNJ’s profit margin is an outlier that can be attributed to their Pharmaceutical segment that consists of premium-priced patented drugs. Their P/S ratio is most likely a reflection of their commitment to R&D spending and delivering results.
ECONOMIC OUTLOOK
Health Expenditures and GDP
Medical equipment and supplies sales is directly tied to health care spending. All estimates lead to this spending to keep increasing, at minimum, the same rate as GDP in the future.
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A M J J A S O N D J F M
BAX ABT PFE BDX MDT Market Cap ($B) P/E P/S P/B
PFE 203.07 29.07 3.84 3.48
MDT 110.02 28.37 3.75 2.23
ABT 75.74 46.78 3.63 3.14
BDX 39.18 30.64 3.16 5.17
BAX 28.61 5.86 2.82 3.44
Data Source: Yahoo Finance
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This is a good sign for stable long-term growth within this industry and part of the reason we have forecasted a CV growth rate of 2.5% for Baxter.
The correlation of health care spending to GDP looks good for Baxter considering their ongoing efforts to expand globally, as emerging markets and developing economies are forecasted to see 4.6% GDP growth in 2017.
Health Care Reform
At this point it seems likely that the 2.3% medical device excise tax will be either repealed or have the moratorium extended beyond 2017, therefore we have not modeled the excise tax into our forecast. The American Health Care Act of 2017 (AHCA) that was proposed by President Trump set out to permanently repeal the excise tax. The failure of the AHCA to get passed has led some to question the future of the moratorium. Scott Whitaker, CEO of AdvaMed, noted that repeal continues to have “broad partisan support.” With Republicans controlling both the House and the Senate and set on tax reform, there is a
good chance this tax is not a factor through President Trump’s term.14
Population Demographics
Population growth may be not be as rapid as it once was, but advances in health care have increased expected lifespans. This has led to a shift in the age demographic of the population.
In 1980, less than 12% of the U.S. population was above 65. That number is expected to be 16% by 2020. As this percentage increases, health care spending will increase and lead to more capital spending on medical devices and injectables.
Emerging Market Standards of Care
Another trend that favors the medical device industry is emerging markets’ access to advanced health care. Baxter aims to take advantage of this increase in spending through its acquisition of Claris Injectables and its existing presence in India and easier access to the rest of Asia.
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Data Source: Siemens Healthcare
CATALYSTS FOR GROWTH
Aging Population
As described in the previous section, the U.S. population is aging. As emerging markets continue to gain access to improved health care, the global population will follow this trend. This bodes well for the medical device industry as the number of chronic conditions and health care spending increases the older a person gets.
Data Source: CMS Chronic Conditions Among Medicare
Beneficiaries Chartbook 2012 Edition
Worldwide, it is estimated that one out of five men and one out of four women aged 65-74 have chronic kidney disease (CKD).3 This bodes well for Baxter’s Renal segment moving forward.
Access to Health Insurance
While the ACA has slowed per capita health care spending growth, the increase in percentage of people insured will
keep spending closely tied to GDP. This should help hospitals to budget capital expenditures and possibly help companies like Baxter secure more contracts.
INVESTMENT POSITIVES
• Baxter is a stable contract-heavy company with a history of beating earnings – you generally know what to expect.
• Baxter will continue to be a global leader in injectables, especially within renal therapies, and look to expand further by adding Claris Injectables.
• Baxter has a strong balance sheet, exemplified by their current ratio of 2.40 and debt to equity ratio of 0.34.
• Baxter has made apparent their desire to increase operational efficiencies and margins as they transition to a value stock.
INVESTMENT NEGATIVES
• Baxter is forecasted to lose market share to competitors through 2020.
• They are competing in a diversified industry where market share is hard to come by via generic drugs.
• Pricing pressure for the past two decades has left the industry with margins below other industries within health care.
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VALUATION
In the valuation model, we used a 3-year raw Beta of 0.81. Using a Henry Fund consensus equity risk premium of 4.80% and a risk-free rate of 2.84% (30-year treasury yield), a cost of equity of 6.73% was calculated. Then, using a pre-tax cost debt of 4.32%, which correlates to their existing 30-year senior notes, a WACC of 6.39% was calculated.
Revenue Growth
We have forecasted overall revenue growth at 3.66% CAGR with a continuing growth value of 2.5%.
Data Source: BAX 2016 10-K and Henry Fund Estimates
Baxter’s portfolio growth going forward is forecasted to be balanced with Fluid Systems, Renal, and Integrated Pharmacy Solutions leading the growth with respective 5-year CAGRs of 4.01%, 3.69%, and 3.37%. These projections are attributed to Baxter’s international growth strategy with added growth to the Fluid Systems due to the synergies from the acquisition of Claris Injectables.
Operating Expenses Assumptions
Baxter has stated operational efficiency as a top priority. We have forecasted cost of goods sold to decrease and amortization to decrease in line with guidance from Baxter through the forecast period. Baxter has been employing accelerated depreciation and added business optimization expenses since the separation of Baxalta. Therefore, we have also forecasted capital expenditures to decrease from the previous five-year average of 11.7% to 7% in 2017 and 3% by 2021. This also effectively causes depreciation to decrease from 4.20% to 3.94% during that same time. We are holding SG&A and R&D expenses constant as a percentage of sales at 25% and 6%, respectively. These are
below historical averages to further reflect their intent to increase margins. We feel it is unrealistic to decrease these further considering their objective to innovate and focus on global expansion. The 2017 estimates for these two expenses are slightly above analyst estimates of $574M (5.6%) for R&D and $2,432M (23.8%) for SG&A.10
Data Source: BAX 2016 10-K and Henry Fund Estimates
Margin Forecasts
Baxter’s focus on decreasing operating expenses will serve to slightly increase their margins going forward. When viewing the chart below, the spike in profit margin is due to the net realized gains on the retained shares transaction. These gains were disbursed to shareholders, which deems the spike as non-consequential. When adjusted by removing the retained shares gain, a profit margin of 5.7% is calculated.
Data Source: BAX 2016 10-K and Henry Fund Estimates
Per the results of our DCF model ($48.36), Baxter is overvalued considering the current stock price of $52.79. This would become further overvalued if we were to adjust our estimates for short-term and long-term growth down towards analysts’ estimates. Our 5-year sales CAGR of 3.66% is optimistic relative to analysts’ consensus of 2.87% CAGR.10 As well, the Henry Fund model accounts for CV NOPLAT growth of 2.5%.
Baxter has had trouble paying stable dividends since the separation of Baxalta. If the DDM were to be used with 10% yearly dividend growth, Baxter would be overvalued compared to the DDM price of $45.54. Given the Relative P/E model price of $33.97, Baxter would appear to be even further overvalued. The relative model can be further discounted when considering that Baxter reported an inflated 2016 EPS of $9.09. This was caused by the retained shares transaction from the sale of Baxalta. When removing this transaction from the income statement, it leaves an adjusted EPS of $1.06.
Forecast Versus Consensus
Due to our model being optimistic for both short-term and long-term growth, a lot of the assumptions can be detached from the sensitivity of our Sell rating. However, there is one assumption that our model is sensitive to, which is the tax rate. This has a lot to do with the fact that over 58% of their sales are international. Upon performing sensitivity analysis, decreasing our assumed marginal tax rate of 19% to 15% would indicate a DCF price of $52.05 – meaning fair value and possibly a hold rating.
Consensus for a total of 16 analysts has a Hold rating and a target price of $52.91.10 This comes in above our target price of $46-49 and DCF value of $48.36. However, this should come as no surprise considering the historic tendency of analysts to either be optimistic about the covered company or quit covering the company. The most important factors are the analysts’ Hold rating in combination with a forecasted price within 1% of the current price and the fact that the price is up nearly 25% in the past 12 months. However, due to Baxter’s consistency in beatings earnings estimates, it is probably best to hold until after the next earnings release at the end of April 2017.
KEYS TO MONITOR
• Due to 58% of Baxter’s revenue coming from international sales, currency exchange rates can easily erase a 2% gain in those sales.
• Investors will also want to keep an eye out for first quarter earnings and revised guidance being released at the end of April 2017. Their consistency in beating earnings could worry investors if missing earnings is in combination with lowered guidance for the rest of the year. This could drop the market price of Baxter below the Henry Fund target price.
• Currently, the medical device excise tax is set to go back into effect on January 1, 2018. This would lead to the forecast being revised and lowering the target price.
• As stated, the most difficult assumption in our model was the forecasted tax rate. While it is unlikely for Baxter to have a long-term tax rate below 15% going forward, keep an eye out.
IMPORTANT DISCLAIMER
Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa’s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report.
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REFERENCES
1 BAX 2016 10-K 2 "Global Facts: About Kidney Disease." The National Kidney
Foundation. N.p., 11 Mar. 2015. Web. 19 Apr. 2017. 3 "Baxter Reports 2016 Fourth-Quarter and Full-Year Results."
Total Payout Ratio (Dividends Paid + Repurchases)/Net Income 65.88% 94.01% 11.28% 86.76% 84.28% 84.09% 81.46% 80.49%
Present Value of Operating Lease Obligations (2016) Present Value of Operating Lease Obligations (2015) Present Value of Operating Lease Obligations (2014)
Operating Operating Operating
Fiscal Years Ending Dec. 31 Leases Fiscal Years Ending Dec. 31 Leases Fiscal Years Ending Dec. 31 Leases
2017 129 2016 149 2015 222
2018 108 2017 125 2016 187
2019 85 2018 106 2017 163
2020 67 2019 86 2018 130
2021 58 2020 72 2019 113
Thereafter 216 Thereafter 176 Thereafter 232
Total Minimum Payments 663 Total Minimum Payments 714 Total Minimum Payments 1047
