You might have noticed on Twitter that I’m getting tired of the news around Bayer. This time Bayer gave a trading update in which it mentioned a revised outlook including a heads-up on an incoming 1.5 billion impairment charge. I also think that the current level of Bayer dividend is at risk.

How did the stock market respond to the news? Well, see below picture and I’ll rest my case.

As you can notice, my first response is a bit emotional, so let’s start having a rational view on it.

In this post I will try to digest the messaging from Bayer and what it means for the dividend safety. I will also give some insights into the financial reporting practice which might mislead you as a novel investor.

Company Profile

Bayer AG is a life science company and one of the world’s leaders in designing, producing, and marketing pharmaceutical products and agrochemicals. Sales are distributed by product family as follows:

• Crop Science (45.5%): herbicides, fungicides, insecticides, etc.
• Pharmaceuticals (41.2%) : intended for the prevention and treatment of cardiovascular and respiratory diseases, diabetes, nervous system disorders, etc.
• Consumer Health (12.6%)
• Other (0.7%)

What did Bayer actually report on in their press release?

Let’s get straight into it. I guess the following quote is what really triggered the price decline in its share price:

Adjusted outlook for 2020 confirmed / 2021 sales expected at approximately 2020 levels despite significant headwinds from COVID-19 pandemic; 2021 core earnings per share expected to be slightly below 2020 levels at constant exchange rates / Lower than expected outlook in the agricultural market likely to lead to mid-to-high single-digit billion-euro non-cash impairment charges in the Crop Science business / Strengthening margin profile and funding of additional investments in innovation and growth through additional operational savings, targeted at more than 1.5 billion euros annually as of 2024 / Dividend policy to remain unchanged, payout ratio planned at lower end of 30-to-40 percent range of core earnings per share in the coming years

…Payouts in the coming years are expected at the lower end of this corridor rather than at the upper end in previous years….

OK, I think I’ve learnt over time how to read such kind of annual report texts. Hence, this is how I’m summing it up in numbers:

• Estimated 2020 sales (page 27) of 43 to 44 Billion Euro
• Estimated 2020 core EPS of 6.70 to 6.90 Euro will be now slightly lower: Let’s assume 6.40 Euro.
• Mid-to-High single digit billion Euro non-cash Impairment. Let’s assume 8 Billion Euro.
• 30-40 percent range of Dividend Payout from Core Earnings per Share. Current Bayer dividend: 2.80 Euro. 30% from 6.40 = 1.92 Euro.

Before I start drawing conclusions, let me first explain the difference between IFRS EPS and Core EPS

IFRS EPS or Core EPS?

IFRS is the International Financial Reporting Standard. It sets common rules so that financial statements can be consistent, transparent, and comparable around the world. This is interesting, because Pharma Companies prefer to use their own version of EPS called Core EPS. Bayer gives the following reason for using it:

Core earnings per share are not defined in the International Financial Reporting Standards. The company considers that this indicator gives readers a clearer picture of the results of operations and ensures greater comparability of data over time.

Right, who to believe now? An independent organization or a Board of Directors? I let you judge yourself 😉

Having said that, in my opinion Bayer’s Core EPS numbers will still look good, because Bayer has a tendency to move all one-time recurring events (sarcasm) that they are required to report in their IFRS EPS out of their Core EPS. This is actually not something particular to Bayer, because it applies to most of the Pharma and Life Science companies.

If you thought that General Electric and IBM were masters in financial engineering, then you haven’t looked enough yet into Pharma industry income statements 😉. As an example, just have a look at the last 10 years of Bayer earnings:

Bayer had only one time a higher IFRS EPS over the last 10 years. The total sum of IFRS EPS between 2010 and 2019 was ~40 Euro per share which is a large deviation compared to the total sum of ~53 Euro Core EPS.

What are the reasons given by Bayer?

Mostly these are impairments of Intangible assets. Intangible assets typically show up on the balance sheet after a Pharma company acquires a drug from another company and it must be written off when a drug trial fails -> hence impairments.

Some will argue that this is OK, because they are considered non-cash, but aren’t we then just creating another hybrid form of a cash flow statement? Hence, in my opinion we don’t need a Core EPS number at all!

In Bayer’s case this is the explanation for ~80% of the difference between IFRS EPS and Core EPS. This is about ~12 Bln Euro over the last decade and in the next year we’ll get another 8 Bln Euro on top of that do to the Monsanto misjudgments.

The other 20% is typically due to restructuring costs and legal expenses.

Again, reporting every year restructuring charges as a one-off event is not an one-off event anymore. The same regarding legal expenses. I would rather argue that these are operational costs as they show up every year in the annual report.

To me, this is financial engineering at it’s finest and it happens all across the Pharma industry. All 3 types of costs are in my opinion results of past (sometimes dubious) management decisions:

• overpaying for acquiring drug development projects
• misjudging the potential success of an acquired drug
• continuously restructuring your company – when will it finally be done in the right way if it’s supposed to be a one-off?
• lack of due diligence and illegal practices which require legal support

Hence, in my analysis I’m typically ignoring Core EPS, except when it’s used in their dividend policy as is the case for Bayer.

Otherwise I don’t even look at it, because in that case Free Cash Flow is a much more reliable source of information as it can’t be manipulated that easily.

Free Cash Flow and LT Debt

So let’s have a look at more reliable numbers then. As you can see, in most of the years IFRS EPS and FCF went pretty much in lockstep with each other. The dividend was handsomely covered and it typically hovered in a band between 40% and 60% payout ratio. This is very healthy and something that most of us as dividend investors appreciate.

There was a small uptick in the payout ratio last year, because earnings started to lag. Actually, earnings are at the same level as they were in 2014.

In 2018 Bayer purchased Monsanto and we can see no noticeable impact to the earnings, this while it added ~20% in sales due to the acquisition.

This is where you can see the shareholder value being destroyed by the current board of directors, because this has been the development in long term debt:

The company really leveraged up with the Monsanto acquisition, because their debt ballooned twofold!

At the same time their Goodwill also moved up from 15 Bln Euro to a whopping 38 Bln. Remember, goodwill is an account on the balance sheet which really means “we overpaid for an acquisition for the underlying assets and we need to put is somewhere on the balance sheet. Hopefully the asset growths in value over time so that it offsets goodwill”.

Effectively Bayer went largely into debt to fund goodwill. Isn’t it irony?

Goodwill paid for Monsanto is exactly where I expect the 8 Bln impairment to come from in the next quarter. Bayer calls it the crop science business, but I expect that they really mean Monsanto with this.

What to make from this?

We just looked into their numbers and we can just say that Monsanto was a horrible acquisition. I didn’t even mention the ~10% share dilution that came with it and the 10 bln+ RoundUp litigation case.

I would even argue that it’s the worst acquisition in Europe from at least the last 2 decades.

This is the reason why Bayer is trading at a forward Core EPS P/E of ~7. As you know by now, I don’t like to look at Core EPS, so from an average FCF per share we are more likely talking about a multiple of 8.

This is an extremely low valuation knowing that FCF has been flat over the last 5 years, not declining.

Fortunately the debt is still manageable and there seems to be some light in the end of the tunnel regarding the RoundUp lawsuits.

Bayer is trading currently around 46 Euro per share. I am sure that it would trade around a multiple of 20 (thus 110 Euro) without those lawsuits and some uptick in earnings after COVID-19.

This is why I believe that their management needs to be replaced ASAP by a strong outsider CEO with a strong track record of fixing troubled companies.

Back to Bayer Dividend safety

Let’s get back to the following quote from the introduction of this post:

Payouts in the coming years are expected at the lower end of this corridor rather than at the upper end in previous years..

I calculated earlier that this would mean a dividend of 1.92 Euro. Therefore I assume next year’s Bayer dividend will be somewhere between 1.92 and 2.20 Euro.

This would literally mean a dividend cut of ~25%.

I know that many investors in the accumulation phase typically step over this fact and think: ah, no worries, let’s keep it, it’s not that big and it might continue growing again in the near future.

I personally don’t think like that and I take a dividend cut very seriously. If companies in my portfolio would start having a habit of cutting dividends once in a while then that could really get me into trouble once I’m living of those dividends. Therefore I will always consider selling my position after a dividend cut.

So, to sum it up:

I think that there is a very high likelihood that we will get a 25% dividend cut announced early in Q1 2021.

I consider the Bayer dividend as not safe.

Next Steps

I don’t see Bayer as a dividend growth company anymore so I will replace it in my allocation strategy with another stock.

In my opinion Bayer is now a turnaround play. If you are a contrarian investor then I would highly recommend you to study Bayer further. It might just be a deeply undervalued company with strong earnings potential if it fixes its issues (settle RoundUp case, use cash flow to payoff debt rapidly and get the earnings to grow again).

I strongly believe that it has the potential to become a 3-bagger within the next 5 years purely due to multiple expansion and some earnings growth.

This is why I will keep the 100 shares for now, but I intend to sell them as soon as it gets to fair value again. I can’t trust on the company from a dividend cash flow point of view, hence why it doesn’t fit anymore in my dividend growth portfolio.

Technically it means that Bayer moves to my 10% section in the portfolio which is reserved for Growth stocks (i.e. Google and Facebook) and turnaround plays.

Last but not least, Morningstar reduced their fair value estimate to 75 Euro last week.

Disclaimer

I own 100 shares of Bayer ($ETR:BAYN) and I don’t intend to sell them in the short term based on the current information at my disposal. I will consider selling them if the share price recovers to 100 Euro and above.

Last but not least, I urge you to do your own homework. I am not a professional or licensed investor. I neither have the best track record in investing. All the information shared in this blog post merely serves as entertainment, not as investing advice.

Thanks for reading this far 🙏

What are your thoughts about Bayer AG? Let me know in the comments, I’m very curious!

Yours Truly

European Dividend Growth Investor