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Turnaround Letter
Out-of-Favor Stocks with Real Value

March 7, 2023

Following Organon’s (OGN) complicated fourth-quarter earnings report, we are moving the shares from Buy to Sell.

We had expected that Organon would produce at least stable and large free cash flows supported by at least modest revenue growth. It had the traits of a modern era “cigar butt” – a dull but undervalued asset worthy of a higher share price. However, the management is morphing Organon into a company with more expensive growth aspirations that are weighing on free cash flow.

Revenue growth for Organon is elusive even excluding currency changes. We see little likelihood of enduring growth from organic sources due to chronic competitive headwinds and regulatory-driven pricing pressure in nearly all of its geographic markets. Management’s expectations for the biosimilars portfolio continue to weaken, including for the upcoming U.S. launch of the Humira biosimilar product.

Related to difficult revenue growth is ongoing pressure on Organon’s gross margin. While the company met its guidance for 2022 gross margins of mid-60%, forward guidance for 2023 is for about 63%. The pricing pressure isn’t likely to be alleviated in future years.

Management is spending more on R&D and selling/promotions to generate growth. But this is adding further pressure to the EBITDA margin. Operating costs rose by nearly a percentage point in the fourth quarter and by over three percentage points for the full year. These costs are likely to continue to tick upward, leaving Organon structurally less profitable. And, management has great confidence that its R&D capabilities can create impressive new products and identify/acquire others at bargain prices. We don’t share this confidence.

With limited prospects for organic growth, the company is reverting to buying revenues in the form of acquisitions and other revenue deals. But these are likely to be recurring costs (in essence, R&D by another name). And, Organon’s balance sheet is fully levered already, leaving little room for sizeable acquisitions unless it issues shares, which would be heavily dilutive at the current stock price.

Further draining its free cash flow is dilution from stock awards. To prevent dilution, the company will need to spend around $60 million a year on buybacks, equivalent to reducing the EBITDA margin by nearly a full percentage point.

Like many spin-offs, Organon’s separation from its parent hasn’t been cheap, given its ongoing transition costs, hobbled R&D effort and elevated debt burden. This unfortunate legacy is weighing on the company.

With the dour outlook, is there a contrarian play here? Possibly, but we believe that it isn’t worth the risk. Organon could turn itself around, but the upside in our view is that this might yield a 30 stock in perhaps a few years. The implied 20% upside potential, even with a 4.5% dividend yield, isn’t worth the risk of chronic disappointments that would continue to chip away at Organon’s core earnings power. And, if Organon’s earnings weaken, the yield will provide little support: a 6% yield on the $1.12/share annual dividend implies an 18.67 stock price, down 24% from here. On a valuation basis, the stock currently trades at a 7.3x estimated 2023 EBITDA – hardly a bargain given the company’s chronic issues. And, this multiple is higher than the 7.2x on forward EBITDA at our recommendation date, illustrating the value trap nature of Organon.

Organon highlights the risks of investing in spin-offs of healthcare companies. Large pharmaceutical and equipment companies are broadly struggling to generate growth, so they logically offload their growth laggards. But the spun-off companies often are larded with weak products that are well past their prime and already losing revenues, with numerous and highly capable competitors who are also scrounging for growth and may be happy to find some by cutting prices. Pricing pressure from government regulators only adds to the problems.

Another burden is that these spun-off businesses often have nothing in the way of independent back-office technology and staffing. These have to be rented under transition support agreements (TSAs) for two or more years while the new company builds its own from scratch. This creates duplicative costs even as the new management (usually with no public company leadership experience) undergoes on-the-job training to build a coherent entity.

Adding to the difficulty of healthcare spin-offs is the debt burden they are often yoked to, created to fund a large cash dividend back to their former parent. Organon paid a $9 billion dividend to Merck, a huge sum that unfortunately was one-third funded with floating-rate debt. While this debt was cheap at the mid-2021 spin-off date, today it carries interest at a staggering 8.5% rate (priced at Libor +300). Corporate parents size the debt based on scenarios that may seem reasonable at the spin-off date but which seem overly optimistic only a few years later.

A large proportion of spin-offs are not successful. Most investors know this but make the mistake of avoiding all spin-offs. This dichotomy creates the contrarian opportunity that we look for. While Organon was an unsuccessful investment, we escaped with a reasonably small negative (14%) total return loss, including dividends, from our initial recommendation in the July 2021 Cabot Turnaround Letter at $30.19.

The widely respected Dr. Kerr L White once said, “good judgment comes from experience, and experience comes from bad judgment.” The Organon recommendation seemed like good judgment at the time and now adds to our experience base.

Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company.