Tuesday, January 3, 2017

Valuation and investment analysis

I just had a chat with someone who wondered why I did not have a valuation for everything in my portfolio - a buy and a sell price.

My reaction: such (false) precision was silly and ultimately counter-productive.

To demonstrate I will give you a set of accounts for a consumer staples company.

Annual Standardised in Millions of U.S. Dollars
Net Sales7,6586,9777,212
Total Revenue7,6586,9777,212
Cost of Revenue, Total3,6333,4543,860
Cost of Revenue3,6333,4543,860
Gross Profit4,0253,5233,352
Selling/General/Admin. Expenses, Total2,6652,4462,368
Selling/General/Administrative Expense2,6652,4462,368
Labor & Related Expense------
Advertising Expense------
Interest/Investment Income - Operating------
Investment Income - Operating------
Interest Exp.(Inc.),Net-Operating, Total------
Unusual Expense (Income)36(195)0
Restructuring Charge361800
Impairment-Assets Held for Use------
Loss(Gain) on Sale of Assets - Operating0(375)0
Other Unusual Expense (Income)------
Other Operating Expenses, Total------
Other Operating Expense------
Other, Net------
Total Operating Expense6,3345,7056,228
Operating Income1,3241,272984
Interest Expense, Net Non-Operating(297)(208)(168)
Interest Expense - Non-Operating(297)(208)(168)
Interest Capitalized - Non-Operating------
Interest/Invest Income - Non-Operating336306151
Interest Income - Non-Operating232154151
Investment Income - Non-Operating1041520
Interest Inc.(Exp.),Net-Non-Op., Total3998(17)
Gain (Loss) on Sale of Assets------
Other, Net13597
Other Non-Operating Income (Expense)13597
Net Income Before Taxes1,3641,4051,064
Provision for Income Taxes496471386
Net Income After Taxes868934678

As you can see - it has net income after taxes of just under $900 million.

I am not even going to bother inserting a balance sheet. The company has some debt (as seen by the interest expense) but there is little doubt the debt can be paid - and you can give me a valuation before debt if you want.

There are some substantial (foreign) cash balances as well as well as some investments. The debt and the cash balances and investments are roughly a wash - so you can safely ignore them.

The company has a long record of slow but steady growth - but it has grown a bit faster than that for the past few years. The CEO has been a vast improvement on other CEOs and has done some optimisation.

There is no doubt about the validity of the business. I guarantee you that you have consumed the product.

Also it is a highly stable product and hence should be very amenable to valuation. Volume growth is unlikely to exceed 5% in any year. A volume decline of 5% would be an unlikely disaster. However the last year did have volume growth above 5%.

Before you read any further I want you to write down a range of valuations. Just a lower bound (where on this information you would be falling over yourself to buy it) and an upper bound (where you would be falling over yourself to sell it).

Go on - write it down.

The trick is 40 lines further down - so write down your numbers before you scroll further...

Yes further down.

Further down still.

A little further down.

Okay - I have changed the dates. The real dates for this are 1987, 1986, and 1985 respectively.

And the company in question is Coca Cola.

These are the accounts Warren Buffett bought his stake on.

The market cap is now $178 billion.

I do not think any of you would have come up with a number anywhere near that high. Even if you had bought the stock at the high range for plausible values (say 30 times earnings) the return from then to now was (highly) acceptable. The stock was trading at about 12 times earnings then.

Net income is now over $7 billion and the multiple has expanded a lot.


I do not need to say it - but a valuation was not important in the buy case and would have detracted from the buy case a great deal.

The valuation as such was pretty trivial. Was it realistic to assume that the company over a reasonable time frame could return $12-15 billion to shareholders. The answer to that was a resounding yes.

Was there a margin of safety around that?

Again a resounding yes.

So the stock was easily able to be owned.


The questions that mattered (and still matter) is "can the product be taken to the world", and will the next generation think of it in the positive light the last generation thought of it.

The answers are less obvious now than they were then. Young people it seems drink Red Bull rather than Coke in surprising numbers. They are your future.


This is a general quality of investment analysis. Proper valuations are far more art than science. DCF valuations - especially of something growing near or above the discount rate are famously sensitive to assumptions. The right comparison is to the Hubble Telescope: move direction a fraction of a degree and you wind up in another galaxy.


By contrast there are some things for which a proper valuation should be done and can be done.

If you own a regulated utility what you really own is a regulated series of cash flows with regulatory risk around them.

An accurate valuation is part-and-parcel of the analysis - because it delineates what you own.


The battle here is to work out what the salient details are. Sometimes they are whether young people will continue drinking Red Bull. Sometimes they are working out a technological change.

In rare cases they are working out valuation.

Mostly valuation is simply about bounding a margin of safety. And most of that involves understanding the business anyway.


PS. If you work for a shop that requires a valuation for everything quit now. The pretence will either kill you or your performance.

PPS. I do not think there is a margin of safety around Coca Cola any more. Not enough to make me interested anyway.


Later post-script:
This is in the comments so frequently that if  you look at Coke's appreciation (and compare to the S&P) Buffett has not done that well. Some even say "if you ignore dividends". But that misses the point.

Here is an extract from Berkshire's last annual report:

 Berkshire has a round 400 million Coke shares at a cost base of $1299 million. The dividend is $1.40 per share - or $560 million per year.

That is a 43 percent yield in dividends on his cost base.

If you wish to ignore the dividends (as my commentators do) may you please give them to me.


Wednesday, December 28, 2016

Did Mike Tyson ring a bell?

They say nobody rings a bell at the top. But this is pretty good...

It's Mike Tyson promoting online trading platform Trade12.

What can you say? I wouldn't like to step anywhere near a ring with Iron Mike - but I would love him as a counter-party.


Trade12 is a bit of a black box. It is - and I am not exaggerating, owned and operated by an Estonian subsidiary of a Marshall Island company and regulated by a private company in Vanuatu.

And according to its literature it does not solicit and accept clients from USA and France.


Which brings me back to Iron Mike Tyson.

He is - I gather - a US citizen.

Either he trades with Trade12 (which would be illegal) or Trade12 is not "the strong choice of a champion".

I suspect the latter - in which case my fantasy of trading against Mike Tyson is - well - just a fantasy.


Friday, December 16, 2016

UCB: Lower standards in Belgium

The last two posts on this blog detail how - for all practical purposes - UCB (the large Belgian pharmaceutical company) has lost the patent to one of its main drugs (Vimpat) and not told the market. See here and here

EBIT is likely to fall 30-40 percent eventually. The company might dain one day to fill shareholders in on the details. The numbers are really not pretty but without proper company disclosure it is impossible to make an accurate estimate. 

For almost two weeks I have expected the UCB to make a statement. But they have kept silent failing to disclose key information to the market.

The patent's death certificate was only sent by the United States Patent and Trademark office last Monday and there are different time-zones and languages to deal with. So I drafted the blog-posts gently, expecting a confirming press release along with accurate statement of prognosis from the company.

The patents death certificate is however almost certainly final. This is a clear statement of fact by the Patent Office against the patent. Appeals against patents are almost always on matters of law - and courts are reluctant to overturn fact-finders. All previous actions against this patent have been on law. A finding of fact against UCB is devastating. 

This is not ordinary course of business patent litigation. In the ordinary course of business UCB has wound up in patent disputes with other companies (eg Mylan, Argentum). And those disputes have been where the assumption is that UCB has a valid patent.

This time it is in dispute with the US Government. And the US Government is stating there is no valid patent. 

Ask other European companies how disputes with the US Government pan out.

Moreover the burden of proof has changed. UCB now has to get its patent approved under de-novo standards when the Patent Office has already rejected the patent. 

Of course none of this seems to warrant any statement from UCB.

Lower standards

I am going to be blunt. Withholding a piece of information this significant from the market in the US would result in a fairly nasty SEC inquiry complete with subpoenas to determine who knew what and when. I have made relatively few investments in Belgium so I can't tell whether the Belgian regulatory standards are lower or the standards are just lower at UCB.

But standards are very low here.

In the US if a single insider has sold whilst in possession of this information (which was unreleased to the market) they could expect close investigation by Preet Bharara. I don't know what standards apply in Belgium.

As stated in previous postsI found the IR officers we met of very high integrity. But this has to extend higher than this. I think it has to rise to the level of Jean-Christophe Tellier - the well regarded CEO.

The Jean-Christophe Tellier was described in the press release announcing his appointment as playing "a key role in driving the growth of UCB’s three core medicines, Cimzia®, Vimpat® and Neupro®."

Presumably he knows that his strategy surrounding those drugs is dead. Presumably he is part of withholding that information from the market.

In the US his days as CEO would be numbered.

I can only presume that standards are lower in Belgium. But if UCB claims to have high standards Mr Tellier should be fired.


Monday, December 12, 2016

UCB's lack of candour

This is a follow up to last Friday's post about UCB - the large Belgian pharmaceuticals company. It probably helps if you read that post first.

In Friday's post I outlined the state of play regarding UCB's important Vimpat patent. Disputes about that patent have been background for the stock for some time. When I went to visit UCB in Belgium (1 December 2015) the IR officers 
were straightforward about this. Third party patent challenges were the bear story on the stock

But UCB has since then touted victories in their patent disputes and regularly touted extensions of the Vimpat franchise.

UCB has made many press releases detailing just how important the Vimpat franchise is to them. 
  • When the CEO (Jean-Christophe Tellier) was appointed the press release stated: "Jean-Christophe Tellier joined the company in 2011 and was instrumental in establishing the company’s current strategy; he has played a key role in driving the growth of UCB’s three core medicines, Cimzia®, Vimpat® and Neupro®."
  • UCB has been active in touting Vimpat both in the EU and the US as a monotherapy for epilepsy. (See here and here.)
  • UCB has been extremely active extending labels for Vimpat in Japan. (See here for an example.)

Indeed extensions of the Vimpat franchise have been important in UCB's growth strategy.

So it was deeply surprising to us when UCB neglected to tell the market that US Patent Office had reviewed the patent (an ex-parte review) and had decided to withdraw the patent entirely. [You can find the letter that the Patent Office sent here.]

This is an unusual move. Since the ex parte examination system was introduced (35 years ago) about 13,500 ex parte requests for examination has been made just over a thousand of them have had all claims rejected. You can find statistics here. Rejected here is a term of art. A claim is "objected" for all sorts of formal reasons like the claims not being properly grouped. A "rejection" is a determination that the claim is not patentable - and is appellable to the Patent Trial and Appeal Board (a court) and then to the court system. 

This is altogether a different type of threat to UCB. Past patent disputes have been with other companies wanting to release a generic - and thus far UCB has either had the case thrown out or got a significant delay. These are standard commercial disputes with commercial parties. And in every one of these disputes the court has worked on the assumption that UCB has a valid patent and the question is whether the other party is infringing on this patent. 

This dispute is with the US Government. The US Government has reviewed past decisions and decided that Vimpat is simply non-patentable. That is the US Government has determined that UCB does not own a valid patent. Sure UCB has two months to try and convince a (well informed) patent examiner otherwise - but their chances of this are low. The patent examiner will be experienced in this area and it is not as if the bureaucrat was uninformed that this was a controversial and important case.

After the two months has elapsed UCB could appeal to the 
Patent Trial and Appeal Board. However the standard here is the de-novo patent standard. The situation is as if Vimpat had its original patent comprehensively rejected and it has to appeal to a court against the scientist/reviewers at the Patent Office. The courts are usually pretty deferential to the examiners at the Patent Office on the basis that they have the disinterested expertise to assess patents. 

In this case Johnny Railey was the examiner and he is amongst the most experienced biotech patent examiners in the US. You can find his linked in CV here. You can find a very extensive list of patents in which he was the examiner here

Appeals of this kind almost always fail. As Johnny Railey is amongst the most experienced patent examiners the chance of an appeal succeeding is even lower.

For practical purposes the Vimpat patent is almost certainly dead - and UCB's much ballyhooed growth strategy will die with it.

I am surprised at the lack of a management press release.

Disputes with the US Government

UCB has press released interim victories in District Court against commercial claimants on the Vimpat patent.

Their IR officers have been willing to give up-to-date reports of the (mostly) favourable commercial disputes they have.

But there is not a word here that their (new) dispute is with the US Government and the default position from here (statistically likely to be upheld) is that they will lose their patent in its entirety.

Not disclosing a business-critical dispute with the US Government is strange.

Whatever: shareholders should ask themselves how other European companies have prevailed in dispute with the US Government.


Friday, December 9, 2016

UCB's Vimpat patent

UCB is a Belgium-based biopharmaceutical and specialty chemical company that specialises in two therapeutic areas: diseases of the central nervous system and immunology. The main central nervous system speciality is epilepsy and the main drug in this area is Vimpat. (UCB revenue mostly comes from four drugs of which Vimpat is one.)

We went to visit UCB once, a cold and wet wintery day where we got modestly lost in Belgium.

The investor relations people were straightforward. We were new to the story and our notes state clearly that generic challenges to the Vimpat patent were the main bear story for the stock. Our notes also talk about Keppra - another epilepsy drug. When it went off patent revenues dropped substantially. Keppra was an famous "patent cliff" drug.

The risk to Vimpat has been reflected in the press too. Fierce Pharma - an industry rag - reports that August 15 this year was the best day for UCB in years as a Delaware District Court had rejected challenges to the Vimpat patent. Notwithstanding this, Fierce Pharma noted that the patent still faced challenges. To quote:

UCB isn’t totally out of the woods, though. In late May, New York-based generics maker Argentum Pharmaceuticals won an inter partes review of Vimpat’s patent protection by the U.S. Patent & Trademark Office (PTO)’s Patent Trial & Appeal Board (PTAB). And that decision may not be handed down until next May. 
Still, court’s decision is a “long-awaited sentiment boost” for UCB, whose shares had fallen by about 17% so far this year, Citigroup analysts wrote in a Monday note seen by Bloomberg. Despite the lingering risk of patent invalidation, they wrote, “we expect market confidence to improve.”

As noted Argentum Pharmaceuticals won an inter-parties review of Vimpat's patent. Argentum's press release however noted an even more aggressive request. To quote:
Argentum also filed an ex parte reexamination request against this same patent that raises additional grounds of unpatentability than those in the IPR.  A decision by the PTO on Argentum's reexamination request is due no later than July 29, 2016.
This is mentioned as afterthought in the press release because it is a really aggressive claim. Argentum asked the Patent Office itself to review the patent it previously granted and presumably throw out the original patent.

Given the afterthought nature of that request I suspect even Argentum will be surprised that the ex-parte review rejected all thirteen claims of the Vimpat patent.

In other words the Patent Office has thrown out the patent.

This is all in a letter dated 5 December 2016 (that is just a few days ago). You can find that letter here. And according to that letter UCB has only two months to dispute the total rejection of the patent by the patent office.

This rejection will of course be followed by Argentum and Mylan (and probably other companies) commencing distribution of a generic for Vimpat. Mylan were behind the above-mentioned court challenge.


It is - given the significance of this to the business - perhaps a little unusual that UCB has made no press release.


Is this the beginning of a new, more aggressive patent office?

The political pressure in the US to do something to reduce drug prices is large. In the past election this was one area of near universal agreement.

I am wondering whether we are going to see this sort of action by the Patent Office more widely.

If the trend is more widespread it could be bad news for pharma investors generally.


Thursday, December 8, 2016

In praise of Donald Trump's conflicts of interest

There is an obsession in the liberal press about Donald Trump's opaque personal finances and the repeated appearance that he has a conflict of interest.

I am obsessed too. But I want him to have more conflicts.

I want a Trump Tower paying royalties to the Donald in every country that matters, indeed in most cities. I want them in countries that do not matter. Frankly I would love them all over China, India and Pakistan.

If the Donald leaves office safely with 100 billion dollar net worth it would be just fine with me.


You see if the Donald has economic interests in some country he will not wind up on any ill-advised military adventures there. Indeed he would tend to prefer open economic relations, as much as anything so he can get his cash out.

Trump corruption is wonderful then because it preserves the open and (relatively) peaceful world I like.

So please Donald - more conflicts of interest - big international conflicts of interest. I want them yuuuge.

Make me happy.


Flotek: some new research

Flotek should be familiar to readers of this blog.

In plain english Flotek makes a chemical mix which makes sand-water mixes slippery so you can get more sand into fractures when you fracture an oil and gas reservoir. Their chemical mix is a surfactant.

There are many suppliers of surfactants. The product is a commodity.

However Flotek sell their product as somehow special. The claim: their surfactant is a "complex nano-fluid", but it is really a mix of d-limonene (the oil from orange peel) and isopropyl alcohol.


This blog once showed that data Flotek provided for pitching their complex nano-fluid was either (a) made up or (b) did not support the idea that their fluid was particularly effective.

We were right. Flotek put out a press release effectively admitting all of our allegations.

In other words their key claims were BS.

At the time Flotek claimed they had a software sales tool (that ran on an iPad) called FracMax which was critical to demonstrating their fluid effective - but we could not find a working copy of FracMax and could not find anyone who had ever seen one.

This was problematic. Flotek told the market that FracMax was their main selling tool.

Whatever FracMax has disappeared from Flotek's literature.

So their main selling tool was also BS.


All this should have been the death-knell for the stock. But it wasn't. Sure the stock is lower but not much (given the decline in oil and gas volumes) and somehow people still believe the "complex nano-fluid" story. I have never met a serious Flotek owner - so the stock price remains a mystery to me.


Today FourWorld Capital Management (an outfit I had never heard of) put out an updated and more thorough analysis of Flotek.

Its darn good - so go read it.

Why this stock trades above pennies I do not understand.

It will trade at pennies one day. I remain short.

John Hempton

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.