A spoonful of sugar - To what extent should businesses try to sweeten the pill of tough decisions?
Regular visitors to The Value Perspective will be well aware it is all part of the value investor’s job description to take uncomfortable decisions, ignore consensus and generally swim against the tide of received opinion – in short, to be contrarian – and thus the views expressed on this site are very much those of the team and the team alone. For those who do not swing by so often, however, it is worth pointing out these views will not necessarily always chime with those expressed or reflected in other Schroders' communications, strategies or funds.
Investors are forever losing faith in companies and their management teams but the opposite can and does also occur. Indeed, here on The Value Perspective, we would argue a certain lack of confidence in the market is currently informing some of the decision-making at one of our biggest positions – the British pharmaceuticals giant AstraZeneca.
Having pulled out all the stops two years ago in its successful fight to ward off the unwelcome advances of US rival Pfizer – a situation we considered at the time in pieces such as Astra projections and Pipe dreams – Astra is now going through what might reasonably be described as a period of transition.
Drugs manufacturing is a ‘lumpy’ endeavour – after all, it is not as if any business in the sector can just roll out a new blockbuster treatment every six months – and the stark reality is that, in common with plenty of other large pharmaceutical companies, Astra has not, in the past, invested enough in the right sort of research and development (R&D).
At the same time, patents for existing drugs have been expiring – cholesterol pill Crestor, the last of Astra’s own blockbusters, comes off-patent later this year – and, as a result, sales and earnings have been dropping. This is a fact of pharmaceutical life – but then so is the prospect that, all things being equal, Astra’s sales and earnings will pick up again at some point in the future.
Here on The Value Perspective, as long-term investors, we understand this profile and, to be fair, so should the broader market. It is after all a discounting mechanism – in other words, if it believes in the long-term future of a business, it should to some extent be able to look through any shorter-term periods of difficulty and price the shares accordingly.
Two courses of action
That the powers that be at Astra are not entirely convinced the market will do this – and, given the history of investment, you cannot entirely blame them – is suggested by a couple of courses of action they are taking to improve the profile of the business. One is something we fully support. The other – not so much.
On the plus side, then, Astra is investing heavily in its business – not only by increasing its spending on R&D but also by looking to improve the productivity of investment in new science. There are no guarantees this strategy will return the business to growth although obviously the management team believes it will. Equally obviously, as it will take time to bring any new drugs on-stream, this spending could impact profits in the short term.
To offset this possibility, therefore, Astra has also revisited the way it presents elements of its accounting – in effect, working to scale back the price/earnings ratio of the underlying business to a multiple that is rather less likely to scare investors as the company gets back on its feet. This is the course of action about which we are less sure.
Astra has introduced two new ideas, the first of which is something called ‘externalisation revenues’. Whether or not ‘externalisation’ is a word – and, to be fair, our spellchecker seems not to have a problem with it – simply put, this involves Astra selling some of the future upside in some of its drugs, with the one-off payments the company receives helping to boost its sales figures.
Since there are no costs associated with this strategy, it is extremely profitable although the ‘one-off’ aspect of the whole approach is somewhat neutralised if a business starts doing it every year. And, because it helps to smooth out earnings in the short term, externalising revenues is something Astra has started doing every year.
Gains on disposal
What Astra has also started doing is selling parts of, and generally tidying up, its portfolio of businesses. This commendable practice is something we see a lot – but what we have never seen is these ‘gains on disposal’ appearing in a company’s accounts under ‘core underlying earnings’. Again this is extremely profitable and again it is positive in the short term but again …
Look, we understand Astra’s thinking here – it is hoping that, a couple of years from now, the business will reap the rewards of all its hard work and investment and, as this comes through in sales and earnings, the company’s numbers will no longer need to feature lines for externalisation revenues and other one-off gains.
In the meantime, though, investors do need to bear in mind that, last year, those externalisation revenues and other one-off gains accounted for some $2.5bn (£1.75bn) of Astra’s $5.5bn of operating profits. Whatever may happen in the future, whether you choose to look at the business with or without that number makes an enormous difference in the here and now.
Think of it this way – if you are valuing Astra today and choose to include that $2.5bn in your profit number, you are effectively already giving the business credit for lots of its investments coming through to replace those externalisation revenues and one-off gains. That may well prove to be right but equally it may not and so investors ought to take an interest in the difference between the two numbers.
Here on The Value Perspective, that interest is largely academic – after all, we are long-term investors and this really should prove to be a short-term phenomenon. Nevertheless, we cannot help but be struck by the way that, while making some very tough long-term decisions, Astra’s management seems to feel it must sugar the pill of significant short-term profit reductions for fear of how the market will react.
Fund Manager, Equity Value
I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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