



Buffett Buys Pharma: Two Out Of Four Seem CompellingBuffett Buys Pharma: Two Out Of Four Seem CompellingSummary Berkshire's latest filing revealed the Oracle of Omaha and his team opening new positions in four pharma giants as of late. From a quality standpoint, all companies seem like a natural fit considering Buffett's reported preference for widemoat businesses. Two of the four companies do seem to offer a compelling entry opportunity with doubledigit total returns likely in the cards going forward. Written by the FALCON Team IntroductionFollowing the recent news of Warren Buffett's Berkshire Hathaway (BRK.B) (BRK.A) initiating positions worth more than $1.8 billion in each of AbbVie (ABBV), BristolMyers Squibb (BMY), and Merck (MRK), as well as $136 million in Pfizer (PFE), we believe it is worthwhile to give our take on the purchases through the established EVA framework. Simply put, EVA (Economic Value Added) is an estimate of a firm's true economic profit, that is computed as net operating profit after taxes (NOPAT) less a charge for tying up balance sheet capital. While mindlessly mimicking legendary investors' moves could lead to sobering results in general, they could certainly serve as sources of interesting investment ideas. As Berkshire's recent pharma purchase spree most certainly represents a sector bet (analog to taking stakes in four major airlines previously, which were sold eventually), it makes sense to take a look at the stocks individually. For a deepdive analysis, you can browse through our previous articles on Pfizer and BristolMyers, whereas today we rather focus on the valuation aspect and expected total return profile of each pharma giant. Quality SnapshotValue Creation: Is a widemoat rating warranted? We tend to prefer companies whose businesses are protected by large and enduring economic moats, as buying those companies at the right price generally leads to outperformance, as outlined in our research article. The existence of a moat around a business reportedly plays a key role among Buffett's investment principles as well, citing that "the most important factor to pick a successful investment is judging the durability of a company's competitive advantage". From a qualitative standpoint, "big pharma" seems like a natural fit, since a diversified portfolio of patentprotected drugs bears strong pricingpower, enabling these businesses to generate returns on invested capital in excess of their cost of capital. The lengthy patent cycles also allow for sufficient time to bring the next generation of pharmaceuticals to the market, while the established product lines produce a sufficient amount of cash flow to fund the immense costs of drug development (averaging ~$1B per new medicine). Additionally, the sheer size of these companies enables an efficient distribution channel and massive economies of scale in drug manufacturing, underpinning the widemoat qualitative thesis by allowing these businesses to retain their competitive position and outearn their WACC for decades to come. Judging from the quantitative perspective, in the EVA framework, the EVA Margin (EVA/Sales) serves as our ratio to define a company's moat. A 5% EVA Margin can be used as an indicator for a "good" company, whereas the persistence of a 5%+ EVA Margin for 10 years makes a company great and thus "moaty". Just by taking a glimpse at the chart, it becomes readily apparent that all of the four companies have produced meaningfully positive EVA over the past decade, with AbbVie and BristolMyers standing out from the crowd, sporting EVA Margins consistently in the double digits. Merck's lengthy development cycle of blockbusters like Keytruda has also started to bear fruit, resulting in a meaningful EVA Margin expansion as of late. Pfizer's recent divestiture of its lowmargin offpatent drug portfolio is also expected to provide an upside effect on its EVAbased profitability. As a conclusion, for this select group of pharma companies, a widemoat rating seems warranted from a quantitative standpoint as well. ValuationDiscounted EVA Model Although definitely a far cry from a precise tool, a discounted EVA model can be useful as a "vaguely right" (rather than a "precisely wrong") indicator of the fair value of a company. It is especially effective in extreme cases when the share price and the fundamental performance of the underlying business are largely disconnected from each other. The reason why we use EVA instead of free cash flow in our valuation model is because EVA better matches costs and benefits, making it a superior measure of corporate performance. It spreads the charge for using capital over the time periods when the investments are expected to contribute to profit and add to the value, instead of concentrating the charge for capital in the one period that the investment is made, as cash flow does. In other words, free cash flow can be negative (caused by large CapEx figures) even if a firm is creating shareholder value, but EVA shows the underlying truth. That being said, the present value of a forecast for EVA is always mathematically identical to the net present value of discounted cash flow. Note that we are not trying to calculate precise values, as that is an almost impossible endeavor, given the model's pronounced sensitivity to a plethora of assumptions. Total Return Forecast When calculating a total return potential for a stock from any given price, we employ the 5year explicit EVA forecast, our assumptions regarding the dividend and share buybacks, as well as a reasonable premium reflecting the growth characteristics of the underlying business. For the latter, our prime indicator in the EVA world is the Future Growth Reliance (FGR), which is the percent proportion of the firm's market value that is derived from, and depends on, growth in EVA. For example, an FGR ratio of 20% says that the firm's market value would tumble 20% if investors became convinced that it would never be able to increase EVA above its current level. A negative FGR ratio signals that the market is pricing in a decline from the current level of EVA generation, indicating an expectation for future headwinds. To sum up, a higher FGR ratio indicates higher expectations for future growth, whereas in case of significant discrepancies, the sooner the FGR ratio returns to a reasonable range, the higher the annualized total return of an investment. AbbVieIn the table below, you can see the historical EVA performance following AbbVie's spinoff from Abbott Laboratories (ABT), along with the consensus EVA estimates through 2025. Source: Author's calculation based on data from evaexpress.com In our discounted EVA valuation model, we use the 5year consensus EVA CAGR estimate of 6.7%, extrapolating the same value for the period of 20262030. We assume a terminal growth rate of 0% since no company can forever increase its EVA, as opposed to free cash flow, EBITDA, earnings, or any other conventional accounting measure. That is because the number of additional projects where a firm can outearn its true cost of capital (hence increase EVA) is always finite. As a discount rate, we use AbbVie's 5year weighted average cost of capital of 7.9%. The resulting fair value estimate arrives at $101. Source: Author's calculation based on data from evaexpress.com Turning to our total return forecast, we are factoring in a rather conservative 6% dividend growth rate along with no share repurchases. We are using the consensus EVA estimates (as presented above) as a measure of fundamental performance. Based on these assumptions, our realistic 5year annualized total return falls in the ballpark of a middling ~6% from the current price of $105 (with the shaded band representing an FGR range of 520% around the midpoint value, derived from historical averages). Source: Author's illustration based on data from evaexpress.com BristolMyers SquibbIn the table below, you can see the EVA performance of BristolMyers over the past decade, along with the consensus EVA estimates through 2025. Source: Author's calculation based on data from evaexpress.com In our discounted EVA valuation model, we use a more conservative scenario than the 5year consensus EVA CAGR estimate of 23.9%, factoring in a 12% annualized growth rate in 20212025, tapering off to 6% in the period of 20262030. We assume a terminal growth rate of 0%, and as a discount rate, we use BristolMyers' 5year weighted average cost of capital of 5.9%. The resulting fair value estimate arrives at $116. Source: Author's calculation based on data from evaexpress.com Turning to our total return forecast, we are factoring in a more conservative (yet still stellar) 15% EVA Margin going forward, as we believe the consensus EVA forecast is overly optimistic in this regard. We also consider a 3% dividend growth rate for the period, along with no share repurchases. Based on these assumptions, our realistic 5year annualized total return estimate falls in the range of a respectable ~12% from the current price of $63 (with the shaded band representing an FGR range of 10% to 10% around the midpoint value, derived from historical averages). 
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