A major beer merger, cautious investors in China, and promising data on a new diabetes drug are among the factors driving ratings changes at quarter-end, says Morningstar's Matt Coffina.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Matt Coffina, who's the editor of Morningstar StockInvestor newsletter. We're going to take a look at some recent ratings changes across our equity-research universe. Matt, thanks for joining me.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: So, certainly one of the big headlines over the past couple of months has been a slowing China. What impact has this had on our equity research, and have we made any changes to our fair value estimates because of this slowdown?
Coffina: It's a very important area. It's certainly something that investors are paying a lot of attention to, and a lot of companies are exposed in varying ways. There are some companies that sell directly into China--multinational kinds of companies. But in those cases, I'd say their exposure is pretty limited. It's hard to see a material impact on fair value estimates. Maybe it lowers the growth rate for a company like Unilever (UN) or another multinational consumer-products company. It can lower the growth rate by a point or two here or there, but there are other factors going on in the fair value estimate that usually renders that immaterial.
The biggest impact you're going to see is on companies that are in China, and wholly focused on the Chinese consumer. An especially prominent impact recently was Alibaba (BABA). We lowered our fair value estimate to $76 per share from $84. This really started with some comments by management that indicated that the consumer is more cautious than they used to be, and that's really hurting their e-commerce sales. So, it looks like e-commerce sales growth for Alibaba is going to slow to maybe the mid-20% range this year, versus the 40% range just a couple of quarters ago. So, it's a really dramatic slowdown. I think there could be some other factors at play here as well.
For one thing, Alibaba is a very large part of the Chinese e-commerce market. They have something like 85% market share, and e-commerce penetration in China is also much higher than it is even in the U.S. Something like 10% of retail sales are already going through e-commerce, so there could be some aspect of them just sort of having tapped out the opportunity. Now, I wouldn't want to say a 20% growth rate is anything to [turn your nose up at]; it's still pretty good in an absolute sense. But it's possible that a lot of the categories that were going to transition to e-commerce--things like maybe food or auto sales--are less conducive to e-commerce. Those categories that were easy to move to e-commerce have already done so at this point, and it's likely that they're going to see slower growth going forward.
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Glaser: We recently lowered our fair value estimates on the potash producers. Why are we concerned about these fertilizer companies?
Coffina: We just cut our fair value estimate for Potash Corp (POT) to $33 a share from $40. We had similar reductions for other companies that are involved in potash, really depending on the extent to which they're exposed to this commodity. And the story is similar--as with any other commodity right now--there's just too much supply and not enough demand. What happened was that potash really had a big runup in its price. Maybe seven or eight years ago, potash prices spiked, and a lot of companies started to work on some potash expansion projects. As it happens, it takes about seven or eight years to get those projects from starting to build out the mine to first production. And that's an advantage in some ways for potash producers because it creates this barrier to entry. But it also means that you might be making decisions about your future production many years before that production is actually going to come online.
So, potash prices spiked, but it was very temporary; they came back down. And unfortunately, here we are, seven or eight years later, and a lot of capacity is coming online exactly when demand seems to be about as weak as it's been in a number of years. That's partly attributable to China and other emerging markets. It's partly attributable to crop prices, which have been down, and that's hurting farmers' income. Usually, we think fertilizer is one of the last things you cut if you're a farmer; but that said, if your income is lower, you might start to apply less fertilizer. Potash, in particular, you can often delay a year or two because it stays in the soil; you don't necessarily have to apply as much every year. So, demand is weak; there's a lot of supply potentially coming online over the next several years. And, perhaps, the most important part is that the oligopoly has started to break down a bit.
So, I think we talked a few years ago about how the Eastern European oligopoly had broken up; Russia and Belarus are no longer cooperating with each other in the potash market. But now there's concern that Canpotex--that's the combination of the big three Canadian producers--might not be able to hold the ranks, so to speak, and continue to hold back production in order to support prices, in which case, they have a lot of excess production capacity that they're not using right now. And if they don't have that cooperation, you could get a situation where the market just becomes flooded in potash, and the price falls dramatically. That would have a significant impact on fair value estimates across the space. We don't think that's the most likely scenario right now, but we do think potash prices are likely to be weaker over the next few years than we thought they would be previously, and that's what's weighing on our fair value estimates.
Glaser: Turning to health care, Eli Lilly (LLY) had some promising data on a new diabetes drug. How do you see that impacting fair values across that space?
Coffina: So, Lilly has this SGLT-2 drug, it's called, under development, and it actually showed in a clinical trial a 38% reduction in cardiac death. So, it's a really great cardiovascular advantage over existing standard of care. We think the primary impact is that this is going to benefit the SGLT-2 class. So, we think this is probably a class effect, even though it's only Lilly's drug that has reported this favorable data so far. So, that's going to benefit Lilly's drug, but Johnson & Johnson (JNJ), AstraZeneca (AZN), and Merck (MRK) all have drugs within this class. Unfortunately for Merck, we think that this class is probably also going to start to steal market share from DPP-4s. DPP-4 drugs like Merck's Januvia, are currently pretty much the second line of treatment.
You start with metformin if you have diabetes, and then the next thing you take is an oral DPP-4 inhibitor. We think that patients might increasingly start to use these SGLT-2s first, instead of the DPP-4s--and that could hurt Merck. So, we brought down Merck's fair value a bit, and we increased Lilly's fair value estimate. And then another interesting effect that we're not as clear on what the impact is going to be is whether this could delay patients taking other kinds of diabetes medications like insulin. We haven't changed our fair value estimates for the major insulin manufacturers because of this data yet; but as we get more and more treatment options, that could certainly weigh on the need for these more complicated injectable therapies.
Glaser: Finally, there's been talk of a merger between Anheuser-Busch InBev (BUD) and SABMiller (SBMRY). If this were to go through, how would that change the competitive dynamics in the beer industry? Would you see moat ratings change because of this?
Coffina: It's a deal that's been rumored for a long time. I think a lot of people have been expecting Anheuser-Busch InBev to make a play for SABMiller. And Miller's stock actually declined pretty precipitously over a short period of time, and I think AB InBev saw this as an opportunity to jump in and finally acquire the company. For AB InBev, the main impact is that it would give them greater exposure to Africa and a few other emerging markets. They have very little exposure to Africa today, and this is already a huge company in the markets that they're already operating in. So, really, the next and final frontier for them is a handful of emerging markets where they don't have as strong of a presence.
The exact terms haven't been announced yet, so we don't have the exact prices and things like that which will certainly affect fair value estimates. We don't think it's likely there will be a significant impact on AB InBev's fair value--or Miller's fair value for that matter. We thought that SABMiller was undervalued before the deal, so the deal sort of served as a catalyst for Miller's stock to appreciate to what we thought it was worth anyway. But we don't think there'll be as big of cost savings as there have been in AB InBev's past deals. For example, when they acquired Anheuser-Busch, that was a company that had very lavish corporate spending; there were a lot of costs to be cut. We think SABMiller is run a little leaner than that. So, we see some incremental growth opportunities and some cost-cutting potential, but probably just enough to offset the premium they're paying. It doesn't really create any value for either of those two companies.
Interestingly, the biggest winner from this deal is probably Molson Coors (TAP). Molson Coors has a joint venture with SABMiller--the Miller-Coors joint venture in the U.S. And AB InBev is almost certainly going to have to divest its stake in this, because otherwise it would just have too much market share in the U.S. And Molson Coors is the only logical buyer. They already owned the other half of the joint venture, and they also have certain rights of first refusal and last refusal. It's relatively unlikely that someone else is going to come in and be a viable bidder. We saw a similar situation with Constellation Brands (STZ) a few years back.
AB InBev did a deal, and they had to divest some brands. Constellation was able to pick them up at a very good price. We don't necessarily expect such a good price from Molson Coors. It's certainly possible, but we haven't seen the terms yet. But even if they pay a fair price, we think there are going to be significant cost synergies--stuff like distribution, marketing. This is going to add significantly to Molson Coors' fair value estimates. So, we already increased our fair value, and there could be even more upside depending on the price they pay for the other half of the joint venture.
Glaser: Matt, thanks for the update on what's going on in our equity research.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
