Markets Now - Monday 8th June 2020

AstraZenGilead? AsGileadeca? AstraGilZelda? AGilZedead? AlanGilzean? Whichever way, it was the big talking point of Sunday (after wet statues and whatever the hell this was) because Bloomberg said . . . 

AstraZeneca Plc has made a preliminary approach to rival drugmaker Gilead Sciences Inc. about a potential merger, according to people familiar with the matter, in what would be the biggest health-care deal on record.

The U.K.-based firm informally contacted Gilead last month to gauge its interest in a possible tie-up, the people said, asking not to be identified because the details are private. AstraZeneca didn’t specify terms for any transaction, they said. While Gilead has discussed the idea with advisers, no decisions have been made on how to proceed and the companies aren’t in formal talks, the people added.

The first thing to note is AstraZeneca’s response: there isn’t one. No RNS, no on-the-record comment and (aside from people close to things) no nothing. That’s important. If there were any current talks between the companies, silence from an offeror would demand some very creative interpretation of Takeover Code Rule 2.2 (which, to be fair, sometimes happens!). Absent more information we are probably safe to assume that talks have indeed ceased and Bloomberg’s heavy use of the past tense was a necessary precaution.

The next thing to do is to sense check what “a preliminary approach . . . about a potential merger” might mean. For that, we need to chew a little at the scenery.

Pascal Soriot has been CEO of AstraZeneca since 2012, which when the average tenure of a FTSE 100 boss is five and a half years feels like an eternity. In that time AstraZeneca’s gone up 187 per cent and is the FTSE 100’s biggest company. Mr Soriot hasn’t been shy in the past about suggesting he’s underpaid, though shareholders tend to disagree.

AstraZeneca remains a quite small company in an international context though, with future performance reliant on half a dozen drugs. It’s also a bit stretched in the balance sheet and rather weak on free cashflow line. Current management guidance is for AstraZeneca to hit net cash positive by 2024, by which time the peripatetic Mr Soriot will be 161 in CEO years. It wouldn’t be wholly surprising if he had one eye on a bigger pay packet but was keen to secure his legacy with some bulk buying.

Using AstraZeneca’s puffy share price as acquisition currency, where the deal brings in actual cash rather than a pipeline of hope, makes a crude sort of sense. AstraZeneca’s M&A team probably has an entire alphabet of deal codenames on the go at the moment.

In that context, was serious contact made to Gilead? Yeah, probably. But Gilead would be a very big, politically complicated and slightly flavour-of-the-month target, particularly as there are plenty of peers with potentially surplus divisions on both sides of the Atlantic. Here’s Barclays:

The central thread to the [Bloomberg] article is the COVID-19 related overlap (i.e. GILD’s remdesivir, AZN’s vaccine etc), albeit it is not clear whether this hypothetical rationale emanates from the same source as the alleged deal proposal or elsewhere.

From our perspective the strategic rationale of the deal would be limited: GILD’s is currently a similarly sized pharma business to AZN (2020E $25bn on our US colleague’s estimates vs. $26bn on ours for AZN) but headed in the opposite direction, with a well-known mid-term growth deficit (absent remdesivir) just as AZN has entered a sustained period of double-digit revenue growth. Therapeutically, whilst it’s a category we like, a major diversification into HIV (c70% of GILD’s business) would be regarded as perplexing for AZN; moreover, there is some pipeline merit (filgotinib, some CAR-T assets) but the therapeutic synergy is again either not immediately obvious or somewhat tenuous. We note management teams are well acquainted from Roche and financial synergies from such a transaction would be potentially significant, even despite the lack of therapeutic synergy, assuming significant rationalisation of the combined cost base (e.g. GILD’s c$15bn cost base vs $11bn core op.income, of which c$5bn lies in R&D/SG&A), but also require very significant job cuts at a time of global economic hardship. Unless AZN management have a particularly high conviction view of the future evolution of the SarsCov2 pandemic, we think that would unlikely offer sufficient rationale.

Morgan Stanley (AstraZeneca’s joint house broker) agrees:

There is little-to-no overlap with the core businesses of each company. If a transaction were to be confirmed, Gilead could benefit from AstraZeneca as it tries to expand its oncology and inflammation businesses, while AstraZeneca could increase its near-term cash generation from Gilead’s HIV/HCV businesses. AstraZeneca’s strength in emerging markets would extend the geographical diversification of the Gilead business and there are potentially complementary pipeline assets and platform technologies in oncology and inflammation. In terms of possible rationale, a June 8 Bloomberg article notes that AstraZeneca’s balance sheet is relatively weak, whereas Gilead has a strong balance sheet and steady cashflows from the HIV/HCV franchises despite the LOE for Truvada, Descovy and Odefsey (~25% of 2020 revenues and ~14% of 2024 revenues) over the next 5 years. As such, it suggests that AstraZeneca could use its relatively highly rated stock (21x 2021 earnings versus 12x for GILD) to acquire greater cash generation to accelerate the acquisition of external innovation. Hypothetically, we calculate that financing a tie-up 50% equity / 50% debt with target company synergies in a historical range of 8-12%, a deal could be potentially £6-9/share accretive to AstraZeneca shareholders all else equal.

UBS takes the cynical line and runs with it:

At first sight that seems somewhat strange given there is hardly any therapeutic (Gilead is mainly antivirals) and strategic overlap between the companies. However, Gilead has what AZN doesn’t - a lot of cash ($24bn as of Q1). We have written about AZN’s poor cash conversion/CFROI repeatedly and after last year’s equity raise and the Daiichi deal for Enhertu (which pretty much precludes any further cash deals), could using AZN equity as currency be a driver? Gilead needs a pipeline (which AZN has) and AZN could be looking for cash, not least to cover its dividend. So whilst there may not be obvious strategic sense (outside cell therapies), we believe dismissing this too quickly may be rash.

AZN doesn’t have any cash resources of note and the equity raise last year would suggest (AZN couldn’t roll debt) tapping the bond market is an unlikely option now. So in the case of a deal, assuming 100% equity would seem most likely to us. In a scenario of a 30% premium on Friday’s close and assuming the target SG&A offers c20% synergy potential would lead to >20% EPS accretion in 2021 and >10% in 2022. However, the 2020-25e pro-forma sales, EBIT and EPS CAGR would be diluted into sector average territory (mid-single digit) and the EPS dilution in the outer years would be high single digit. For a stock that is meant to be a growth stock, that would probably be a bitter pill to swallow for growth investors.

There could be some strategic sense: Gilead amongst others has struggled with cell therapy Yescarta and one could argue that’s an area where AZN has expertise. However we think that could never be a large enough contributor to total NPV. Aside from that, one could maybe argue that after the Daiichi deal AZN is a better allocator of capital but it seems tough to get away from the current cash need as first motivation.

And Jefferies kicks the tyres some more:

The idea of doing mega-deals arguably remains on the table in biopharma given ongoing changes to healthcare systems and cost-savings benefits, as demonstrated by two such last year: BMY/CELG and ABBV/AGN. Both were surprising at the time and both targets were cheap. GILD is also cheap at 12x P/E. However, the acquirers were both suffering from challenged stock prices and likely looked at the mega-mergers as the only way out.

AZN is at an all-time high stock price and might see this as a valuable currency. AZN could be attracted to: 1) GILD’s significant FCF (due to durable HIV), which could help the balance sheet (i.e., buying GILD for the durable cash flows and using it to fund more pipeline) and; 2) some opportunity to cut costs, although GILD already runs at very high 45% operating margins and 35% net margins.

From the GILD point of view, we think this is unlikely because: 1) Dan O’Day arrived as chairman and CEO only 15 mos ago, so this would be very early and quick; 2) GILD thinks its P/E is far too low, which is why he’s in place to turn it around via a strategy of partnerships and bolt-on acquisitions such as the recent deals with Forty-Seven and Arcus; 3) GILD has not had an opportunity to execute on the pipeline, go out and do deals, maximize the value of Remdesivir, and derive full value on HIV durability (including capsid, long-acting bictegravir, etc).

From a scenario perspective: GILD stock is at $77 but our Long View valuation analysis has GILD at a base case value of $97 (HIV has erosion after 2022) with an upside value of $110 if HIV is flat to growing after 2022-27 due to long-acting HIV capsid and other pipeline value that has not played out yet. The $110 does not take into account further potential upside if there was significant cost-cutting given SG&A is currently $4.5B at GILD and R&D is another $4.5B. We estimate that cutting costs by half would drive at least another $20/sh of upside in our DCF models, though we do not include this in our upside case.

At pixel time no other media has matched Bloomberg’s punchy treatment of the story using their own sources, with only The Times reporting this morning that AstraZeneca had “abandoned a tentative interest”. A rational person might therefore conclude that Gilead had just become less likely to be bought by AstraZeneca and expect to see the shares fall. And, needless to say, Gilead is marked about 4 per cent higher in (notoriously thin) US pre-market trading.

1.00pm - Plus500’s getting tonked on what looks like an okay trading update from the financial bookmaker. The problem is firstly that client bets have been on the right side of the flight-to-s***te rally over the last few weeks, and secondly that the stock was up nearly 40 per cent in the year to date, which even in the current perfet market conditions is a bit rich for a company with zero visibility. Here’s Peel Hunt:

Another very strong update regarding customer numbers and activity. New customers in Q2’20 to date is already an impressive 110,574, following on from 82,951 in Q1. Customer income also very strong at $249m; however, customers are winning of late and total revenue therefore said to be £102.5m. High levels of customer deposits ($488m) bode well for the near term and company cash of $474m is very strong. Plus is clearly trading extremely strongly at the moment and arguably conditions will never be better given market volatility. We recommend taking advantage of any further strength.

And the perpetual Plus500 Stans at Liberum:

The continued market volatility seen during May is likely to result in the group delivering yet another quarter of record underlying performance in 2Q20. This performance reflects the benefits of the group’s best-in-class platform, which has enabled it to continue to achieve exceptional user growth, and undoubtedly take share. This dynamic, combined with the quality of these users, bodes extremely well for the medium-term, as demonstrated by the tripling in net client deposits since year-end. This outlook leaves us remaining confident in our FY20 estimates despite the negative move in customer trading income seen in recent weeks as markets have rallied. With the shares trading on just 9.9x CY21 earnings we believe the long-term merits of the model remain underappreciated and reiterate our BUY rating and 1680p TP.

In sellside, Bernstein likes Campari. Sector note.

We are upgrading Campari to Outperform, as we take all our target prices up ~15% to reflect the combination of the recent market rally, the fall in consensus earnings for the market (which has significantly increased the implied market multiple) and the rally on EM FX.

On average, YTD the Euro Bevs names have modestly underperformed the market by -3% (down 14% for Large Cap Bevs vs 11% for the MSCI Europe), with ABI a massive under-performer (-33% absolute, -24% relative to the MSCI) and Rémy Cointreau a significant outperformer (+14% absolute, +28% relative). Compared to broader Staples, Euro Bevs have underperformed 7%. Looking at performance in 2Q so far, Large Cap Euro Bevs are up 15% on average (broadly in-line with the MSCI Europe up 14%) but have outperformed Staples by 8%. However, there are massive variations within the group. Rémy Cointreau is up 25% in absolute terms since the end of March (outperforming its large cap peers by 10%) and ABI is up 20%.

Much of the relative under-performance in 1Q can be explained by the combination of the significant drag that beverage alcohol companies face due to the lockdowns that have been in place around the world plus the weakness of many emerging market currencies. Likewise, the recovery in the last three weeks is largely due to relief that the hit might not be as bad as feared (e.g. China's rapid recovery and US Off Trade strength), as well as a broad-based rally for nearly all emerging market currencies. It remains to be seen what the medium-term damage from On Trade closures will be and to what extent consumer purchasing power will be impaired. However, over the longer term, we expect that consumers' desire to socialize using alcohol as a lubricant will not change, even if we may possibly see some changes in how consumers socialize. And the sector will recover, as it has after previous big downturns such as 1990/91, 2001 and 2008/09.

The challenge for valuation remains estimating market earnings expectations. We like to think we have largely kitchen-sinked our models. Until recently, consensus estimates appeared to be massively out of date. However, in the last two months, estimates have fallen 28% for F20 and 14% for F21. Furthermore, the market has rallied 15% in the last three weeks. This puts the sector on a relative P/E premium of 29% on NTM+1 (Apr 21-Mar 22), 18.5x for Beverages vs 14.3x for the Market. We think this 29% is too low compared to our belief that 50% is warranted in the long-term.

... Campari had strongly re-rated over 2018 and 1H19 but is now well off its €9.20 peak. Campari will be hard hit by COVID-19 due to high On Trade exposure, especially in core markets of Italy and the USA. However, in our view, Campari is now trading at a close-to-fair 35% premium to peers on our NTM+1 earnings (off its peak of over 60%.) in a sector that is under-valued.

Morgan Stanley likes Hays:

We think consensus is too pessimistic. While the shape of recovery is debatable, consensus is already pricing in worst case fee declines and/or limited cost savings. Our new FY20/21e EBITA is 20/10% above consensus. We also raise our FY22e EBITA by 40%. Our PT moves to 145p; Overweight.

Value emerging: Previously we argued that Hays is fairly valued even assuming worst case fee declines, leaving scope for upside when visibility improves. Since then, various lead indicators - while still pointing to a weaker trading environment - are not as bad as we and consensus originally feared. We raise our organic growth assumptions by 600-1000bps. Risk-reward skew remains favorable with limited downside even in our bear case - move to Overweight.

Upside to consensus: Hays cons appears to price in c.65% fee growth decline in Q4 and limited or no cost savings. This, in part, is driven by Hays indicating 70% fee decline as its stress case scenario, which consensus (including us) had discounted as the base case; this is wrong. We now view c.-45% as more realistic in a base case. Also, for cons FY20e EBITA estimates to be true, Hays should generate a loss of c. £55m in Q4, which we view as highly unlikely (MSe £40m).

Time for a recovery multiple: Hays is trading on 1.8x FY22 EV/GP, which is a 20% discount to the mid-cycle average of 2.2x. Between 2009-10, Hays traded at an average 2 year forward multiple EV/GP multiple of 2.2x. We apply 2.2x to normalised FY22 estimates along with a DCF to derive our new PT of 145p. Note that our new FY22 EBITA estimates are still 40% below the peak in FY19 and we assume profits reach prior peak only by 2025.

Best placed if the recovery is W shaped: Hays' average cons FY20/21e EPS are cut by c.70% YTD vs. 35-60% downgrades for others. We see limited downside even if the recovery is W shaped. The equity raise leaves it best placed to capture the recovery or weather further uncertainty. Although the shares are up c.20% in the last month, in line with other staffer, they have still underperformed the sector since trough in March. We expected generalist staffers to outperform in the early part of a cyclical recovery and preferred Adecco as a play (+55% from trough). However, we now see better risk-reward for Hays, which is our new top pick among staffers. Even in our bear case we see only 25% downside compared with 50% for peers and the balance sheet remains cash positive.

RBC doesn’t like JD Sports:

JD Sports has a strong track record and management team. However we think its longer term margin recovery prospects may be compromised by a shift in customer shopping patterns and to online. We think valuation already largely reflects a strong v-shaped recovery and so we adopt a more cautious stance on the shares.

Sales densities likely to be lower in high traffic locations. We have seen some encouraging signs in terms of customer willingness to return to stores, with conversion up and likely some pent up demand to come through in the UK. In the UK JD has a roughly 50:50 split between malls and high streets so is well hedged for customers choosing to shop locally. However we do expect pressure on sales densities for stores in more urban, touristy locations, which rely more on public transport, and a structural shift online, which we see as a potential constraint to margin recovery.

Longer term online shift a threat to margins. JD is a fairly store heavy retailer, reflecting its younger more cash based consumer, with c.17% of sales coming from online pre COVID. Our survey suggests some more price and promo competition from major third party brands clearing excess inventory. Our basket, including delivery, was 19% more expensive at JD online, compared to brands’ own websites, or 7% more expensive excluding a recent Nike promotion. Longer term we think a shift to online will make it harder for JD to get back to historic margins, given the ease of switching to branded websites and the higher fixed cost base of JD’s stores.

Prospects for young fashion sector mixed. On the one hand fashion is a high priority purchase for many younger customers and we expect the strong casual/athleisure trend to continue. However we also expect more employment pressures from later this year to affect the earning power of younger shoppers.

Valuation pricing in a V-shaped recovery. We think the JD share price was clearly oversold during the COVID crisis, falling around two thirds from highs reached earlier this year. However the shares are up c.30% in the last month and have rerated by c.15pp compared to our FY22 PBT estimate. JD trades at c.25x our FY22 EPS forecast which we think is fairly full given its less certain growth prospects. As such we move to a more cautious stance on the shares.

Stifel doesn’t like Melrose:

Melrose has rallied further and faster than we dared imagine when we reset our expectations at the heart of this crisis. That is welcome, and the shares did come from a sharply oversold position in our view. But now we think they have run far enough, and we are becoming rather more cautious on the near term outlook. Valuations now look full (18X 2021E, even assuming quite strong margin recovery from 2020 levels), 1H results are likely to be horrible, and the group's success to date in preventing any rise in debt levels may be challenged when it starts to implement what is likely to be a substantial and expensive restructuring (details likely with IH results in August; we outline our expectations in this note). We have edged up our 2021 numbers to reflect a slightly bigger bounce in Auto volumes than earlier assumed (in line with industry projections from our colleagues at Mainfirst), and pushed our TP up to 150p (from 125p) to reflect both these forecast increases and the expansion of peer multiples. But with the stock already close to these levels, and short term risks still elevated we are cutting our rating from Buy to Hold. In the longer term (2-3 years) we still see plenty of scope for upside, but we think that the shares have run far enough for now, and that there are some risks of a pullback through 1H results.

And Berenberg doesn’t like Polypipe. Sector thing, 107 pages:

The UK construction sector has been in the eye of the storm – from being considered “essential”, to shutdowns through the supply chain to the gradual re-openings we are seeing at present. As a result, the sector has been volatile, with shares -25% since the February high. However, the recent rally leaves the sector trading on c19x 2021 P/E. Although not cheap, there remain opportunities in UK construction and thus stock picking is crucial. To aid this, we assess how the recovery (or not) could take shape in each end-market, drawing comparisons to the global financial crisis (GFC). Accordingly, we shake up our preferences on both end-markets and stocks.

● Changing our preferences: After the initial re-opening bounce, the recovery in each end-market will take different shapes. In that regard, we are most positive about infrastructure followed by repair, maintenance and improvements (RMI). We are now wary again about non-residential activity while we would be cautious about the pace of recovery in new-build housing.

● Infrastructure – fiscal stimulus to drive an outperformance: We take lessons from 2008-09 when public sector gross investment increased by 52%. In fact, 2009 was the only year over the past two decades when actual spend significantly exceeded Budget forecasts. As the economy slows again, we would expect fiscal stimulus to be key to supporting the economy. Although COVID-19 has meant spend has been focused elsewhere, recent commentary has been positive, with some schemes being accelerated while phase 1 of HS2 is also due to begin construction by 2021.

● Residential RMI – maintenance spend likely to prove resilient, but more cautious about improvement: In the GFC, RMI spend was more resilient than the decline in housing transactions, suggesting that homeowners stayed put and instead renovated their existing dwelling. We expect this to repeat and be further aided by the time consumers have had to spend at home as well as a lack of alternative discretionary spend. Our Google Trends analysis supports this. We remain cautious, however, about big-ticket improvement projects, leaning our preference to DIY and DIFM. Although early days, the Green Deal could be a catalyst in the mid-term.

● New-build non-residential – likely to see a reversion back to the trends of 2018-19: Given the late-cycle nature of non-resi construction, we expect it to recover in H2 as ongoing projects get completed before slowing again. However, prior to now, the UK had seen spend weak for 17 months, thus we believe any slowdown will be less severe than in 2008-09. We expect trends will revert back to 2018-19 when we saw declines in more cyclical and structurally challenged end-markets, such as offices and retail, and growth in structural themes, such as warehousing.

● New-build residential – tightening mortgage market and social distancing likely to be a headwind: Housing has historically been a key pillar to our preferences, but we are now less optimistic. Mortgage availability at higher LTVs has fallen by c85% while with more than 8m workers furloughed, we are cautious about incremental demand. We expect completions to initially increase as housebuilders fulfil their orderbooks, but expect the recovery in starts to be slow, unaided by social-distancing measures. However, given the presence of Help to Buy as well as a lower proportion of SME builders, the sector should be more resilient than in 2008-09.

● Balance sheets in good shape, but keep an eye on costs: With operations now beginning to re-open, liquidity concerns have fallen while balance sheets are generally in good shape (and, if not, covenants have been amended). Importantly now, cost management will be crucial as the sector gradually comes off the furlough scheme, restructures and manages social distancing on site. This will weigh on margins. Although raw materials are a tailwind, for the majority of our coverage hedging strategies mean they are unlikely to benefit until 2021.

● Top picks: Our preferences lie with those where we see more of a fiscal opportunity via infrastructure, such as Breedon (Buy) or regulatory tailwinds, or those names that have underperformed, but where we believe end-markets will be relatively more resilient, such as Volution (Buy) and Travis Perkins (Buy).

● Least preferred: Our least preferred names are those where valuation remains elevated despite cyclical risks and a lack of geographic diversity, such as Marshalls (Hold) and Howden (Hold). We also downgrade Polypipe to Hold for these reasons. While we remain wary about Forterra (Hold) given the fall in FCF as the group builds new capacity.

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