Stronger Than Ever? Ha!

It was just over a year ago that Erez Vigodman, President and CEO of Teva Pharmaceutical Industries proclaimed in a press release: “The acquisition of Actavis Generics comes at a time when Teva is stronger than ever—in both our generics and specialty businesses.” What a difference a year can make!

Of course, we have the advantage of hindsight over Mr. Vigodman. So, instead of dwelling on Teva, the purpose of our writing is to ask which companies today look “stronger than ever” but may actually turn out to be quite fragile down the road?

A few come to our mind immediately (in alphabetical order):

  1. Apple: Hard to argue with the products or the current cash flow. However, what is the investor’s risk-reward? To double one’s money from here, Apple needs to create an additional $800+ billion of market value. Possible, but highly unlikely. Yet, losing 50% of its market value would still leave Apple with a market value of $400+ billion. Possible, and quite likely. Not a good risk-reward.*
  2. Boeing: How long will the Airbus-Boeing duopoly remain, especially as much of the aircraft industry growth is in Asia? What will be the impact of Chinese efforts to break the duopoly? How high can defense spending go in the U.S. and how high can Boeing’s profit margins go? What risks am I taking on as an equityholder by paying a high multiple on high (accounting) profits? Where are we in the aerospace and defense industry cycle?
  3. Royal Caribbean Cruises: Ever heard of cyclical risk? What about capital intensity?
  4. UnitedHealth Group: The absolute market value of the company is $185+ billion (about $570 for every person living in the United States)! Based on book value, UnitedHealth trades at over 4x – hard to believe this could be possible in what is essentially a commodity business in what should be a regulated, low-growth industry. How can UnitedHealth be “stronger than ever” when the U.S. health care system seems weaker than ever? What’s sustainable here and what’s not?
  5. Verizon (or AT&T): Acquisitions seem to be the path of glory for both of these behemoths…we are skeptical. Hint: look at the debt, management incentives and history.

The list could go on and on to include the companies we mentioned in an earlier post, as well as many others. Of course, the distinction always needs to be made between the investment case for the equity and the prospects for the underlying business. In the case of Teva, investors who agreed with Mr. Vigodman a year ago and owned the shares until now, were hit by a double-whammy: not only did the prospects for the business prove to be too optimistic, but there was also little room for error on the valuation side.

With central bankers being so pro-cyclical**, it’s hard for investors to resist the temptation to pay record multiples for record earnings. However, in our view, that is one of the biggest mistakes investors can make.

* And what about the cash? Well. it is $262 billion as of the latest balance sheet date. But there is also debt of $108 billion. Net cash has been around $150 billion for years now. Will share buybacks ultimately prove value-creating for long-term shareholders? Only time will tell…
** In our view, central bank policies are facilitating, if not actively promoting, bad capital allocation decisions throughout the world economy. However, this should ultimately be the downfall of these policies, as well as the inflated stock prices that they bring about. The latter are in many cases inflated exactly because of the potential for M&A, courtesy of low rates and ample liquidity for corporate actors. Absent low interest rates, it is unlikely that a Valeant or a Teva would have happened in the way that they happened. Instead of stimulating such capital misallocation, central banks should act counter-cyclically to rein it in. The prospects for the latter course of action, of course, remain wishful thinking as central bankers know best and they too are stronger than ever: Ha!