value and opportunity

Company description:

Egis Pharamaceuticals is a Hungarian based producer of Generic pharmaceuticals. Interestingly, according to their homepage, the company was founded in 1913 as a Swiss company. In 1993 it was privatised, in 1995 the majority was taken over by a French company Servier.

Valuation
Valuation based on traditional metrics looks cheap at a current price of ~ 20.000 HUfs

Market Cap ~540 mn EUR
P/B 0.8
P/E 7.5
P/S 1.0
Div. Yield: 1.3%

Taking into account ~5500 HUF net cash per share (~25% of market cap), the stock is ridiculously cheap:

EV/EBITDA: 3.0
EV/EBIT: 4.6
adj. P/E (trail 12 m): 5.5

Profitablity

On top of the cheap valuation, the company is consistently profitable, with double-digit margins:

	NI margin	ROE	ROE cash adj
31.12.2002	9.2%	11.6%	12.7%
31.12.2003	7.0%	8.5%	8.7%
31.12.2004	8.1%	9.9%	10.2%
30.12.2005	11.9%	14.0%	14.0%
29.12.2006	15.2%	18.1%	18.5%
31.12.2007	6.5%	7.3%	7.9%
31.12.2008	11.0%	10.6%	11.6%
31.12.2009	11.8%	10.9%	12.2%
31.12.2010	14.1%	11.9%	12.5%
30.12.2011	10.5%	8.7%	9.7%
31.12.2012	14.0%	10.9%	13.6%
Avg	10.8%	11.1%	12.0%

Why is it so cheap ?

If a company looks so cheap, especially in today’s market environment, the first question is: Why ? So lets look at some obvious potential problems:

“Dictator discount”:
As a Hungarian company, one might think that a lot of investors are shunning Hungary because of the dictator like current government. In my portfolio, I experienced the unpredictability already once with Magyar Telekom. Although I managed to get out with a small profit, it was quite sobering to see how the company got punished by the Government via extra taxes, additional licences etc.

For Egis, this is clearly an issue. On top of price controls they are also subject to special taxes like Magyar Telekom. On the other hand they seem to be able to set off those special taxes against R&D expenses. This is from the last report:

Semi-annual drug price reductions, triggered by the price and reimbursement system that has been effective since October 2011 (the so-called blind bidding), strongly affected also this quarter, despite the fact that there was no further round at the beginning of the quarter. In addition to the blind bidding process, also the quarterly adjustment of reimbursement keys of medicines falling into the same INN category (so-called fixing) prevailed. However, price cuts focused on the blind bidding processes, consequently, the rate of price reductions effected on January 1, 2013 by Egis was negligible.
Payment obligation of drug producers on grounds of the reimbursements allocated to their drugs was raised to 20% from 12% as from July 1, 2011. In the second quarter, the total amount payable by the Company according to the turnover came to HUF 562mn. As from July 1, 2011 the rate of registration fee on medical representatives has been HUF 10mn/medrep/annum instead of HUF 5mn. On such grounds HUF 250mn payment obligation was accounted over the quarter.
In December 2012, the Parliament confirmed the R&D cost related deductibility option of payment obligations for an indefinite period of time. Accordingly, 90% of the payment obligations debiting the calendar year preceding the given year may be deducted, provided that the Company’s R&D expenses exceed 25% of reimbursement (proportionate to manufacturer’s price) paid on their products and that, within R&D spending, personnel
expenses remain above 3% of the same reimbursement amount. Pursuant to the rules of law lower rates of R&D expenses trigger lower deductions.
Entitlement to the deductibility option for the Company for the present financial year is judged on the basis of the R&D spending in the 2012/2013 financial year, consequently, the deduction allowance is accounted in the given business year while the financial settlement can be performed in the subsequent year. Taking into account the R&D expenses incurred in the second quarter of 2012/2013, 90% of the payment obligation, including also registration fee of medical representatives and surtax proportionate to reimbursement, occurring in the second quarter of the calendar year 2012, HUF 727mn were accounted as allowance.

That sounds complicated, but in the end, EGIS only paid an effective rate of 6% in the first 6 months. I am not sure how sustainable this is, the normal corporate tax rate in hungary would be 19%.

However, as a percentage of sales, Hungary doesn’t play such a big role anymore. In the current 6 month period, Sales in Hungary are 20% of total sales. In contrast, sales into Russia are now 1/3 of total sales and growing.

So to summarize the “dictator” discount theory: I don’t think this is justified. Rather it looks like that EGIS is benefiting from a very good treatment with regard to taxes at the moment, compared to companies like Magyar Telekom.

Cyclical business / easy to spot problems ahead:

For most pharmaceutical companies, patent expiry is the most obvious problems. If blockbusters expire their patents, then often profits fall off a cliff. With EGIS, this seems not a problem. As far as I understand, EGIS is mostly producing generics and not doing any R&D on own developments.

The majority share holders, Servier Group in France itself is a pharmaceutical company which does the original research. EGIS is then licensing some of their products.

So in the case of EGIS, I don’t see patent expiries as a big problem, nor is the generic business very cyclical.

Nevertheless, we do see some volatility in margins, especially in 2007 and 2011. What happened there ?

2011: If we look at 2011 vs. 2010, we can see that 2 factors contributed to the significantly lower margins:

– losses in associated companies (~-1.5% net margin)
– contribution to the National Hungarian National health fund (~3% of net margin)

So without those non-operative charges, EGIS would have shown solid ~14% net margins for 2011 as well

2007:
This looks a little bit strange. from 2006 to 2007, “material type costs” jumped significantly. According to their 2007 investor presentation, this was a result of unfavourable exchange rates (the Forint gained significantly in that period), price cuts in Hungary and a different product mix.

The USD/HUF FX effect might have been the strongest effect and this most likely explains the improving margins once the Forint became weaker again. Today, EGIS hedges ~70% of their USD exposure which should prevent most of that volatility.

So in both cases I think the problem was not a underlying cyclicality of the business model but rather a result of unfavourable exchange rates and regulation.

Dependence from major shareholders – related company transactions

The majority shareholder with around a 51% stake is Servier Group, a privately owned french pharmaceutical group with around 4 bn EUR turnover.

If we look into the last annual report unde point 24. related party transactions, we can see that between 15.20% of sales go to other Servier companies. This is not insignificant, but so far I don’t see an indication that this is not done at arm’s length.

In contrary, having a subsidiary with only a tax rate of 2% or so, if there were no minorities, I would let this company earn as much as possible in intra group transactions.

Balance sheet quality (operating leases, pensions, guarantees)

No problems here. I didn’t find any disclosure of leases and they only have a tiny pension liability. Nothing about guarantees either.

Free Cashflow conversion / low dividend / acquisition

Over the last 10 years, EGIS only showed Free Cashflow of around 400 HUF per share on average, only in the last 2 years, this went up to around 1400 HUF per share. Historically, EGIS paid only a mini dividend of 120 HUFs, so less than 0.5% dividend yield. One factor for the low free cash flow has been the fact that in the past EGIS booked purchases of fixed income securities as “investments” even if they were actually short term cash like securities. They changed that in 2011.

This year at least, sitting on 5500 HUFs net cash per share they doubled their dividend, nevertheless the 1.20% dividend yield looks small compared to for instance Magyars 14% plus dividend yield.

I am sure that the historically low dividend yield is one of the reasons why many investors avoid that stock. However if we look into the past, the money that EGIS reinvested actually led to decent growth. Over 15 years, sales in local currency more than quadrupled in line with profit. ROEs and ROIC always remained around 10-12% which is not fantastic but very solid.

Personally, I can live very well with a company which reinvests at 10-12% ROCE and not paying dividends, especially when it is so cheap as EGIS. I think such low dividend paying solid stocks are in fact one of the few “pockets” in the market where the valuations are OK because the “yield hogs” are not interested in them.

In the last few months, EGIS announced several times that they plan to use their cash on an acquisition in Russia. This is of course a risk factor, but I I understand correctly, they are going for manufacturing capacity and not for expensive goodwill type acquisitions. This is clearly a risk, on the other hand, the company is already very active in Russia for a long time and should know the market quite well.

From a free cash flow reporting perspective, acquisitions of course look a lot nicer than building you own, although the result is the same.

Preliminary summary:

So far, one can see that there are some factors why the stock trades at such low multiples. Most of those factors however are not a problem for me, so it definitely makes sense to take an even closer look in a coming post.