Background
U.K. based Reckitt Benckiser (RB.) was formed from the merger of British company Reckitt and Colman and Dutch Benckiser in December 1999. Bart Becht became CEO of this new company and has been credited for its transformation, focusing on core brands and margin enhancement. He adopted a consumer marketing mindset and increased spend in advertising, focused investment on 17 global power brands (e.g. Finish, Airwick, Nurofen, Gaviscon) and product innovation. 40% of Reckitt Benckiser's 2007 revenues came from products launched within the previous three years. Although traditionally known as a household products company because of brands like dishwasher detergent, Finish, the company now has a relatively large over-the-counter (OTC) medicines business (including brands such as Lemsip, Gaviscon and Senokot) as well as a small, but profitable prescription pharmaceutical division.
In October 2005, Reckitt’s bought the OTC business of Boots Healthcare International (part of the Boots Group), for close to £2 billion, beating of competition from other companies such as GlaxoSmithkline and Novartis. Boots Healthcare International’s portfolio included some strong brands, notably the pain killer Nurofen, Strepsils sore throat lozenges; and the anti-acne brand Clearasil. In January 2008, the company acquired Adams Respiratory Therapeutics, Inc., a U.S. company, for $2.3bn: predominantly for its Mucinex cough business which the company now plans to expand beyond the U.S. where it has a significant share of the market.
Results
Since the formation of Reckitt Benckiser, the financial results delivered have been tremendous. Reckitt’s share’s have risen consistently since 1999 from around £4 to close to £34. Becht’s focus on delivering strong share holder returns have made him one of the best paid CEO’s in the World. The Boots OTC acquisition in 2005 proved to be a master stroke since the company has managed to drive significant growth in the core brands such as Nurofen through innovation e.g. Nurofen Express, cost cutting and a focus on superior marketing.
Reckitt Benckiser continued to deliver strong results last year with underlying sales for 2009 rising 8% year on year. Operating margins rose 1% point to 24.4%. However, the European business only delivered 1% growth to £867 million whilst emerging markets grew 19% to £388 million. The company has set targets in 2010 for net revenue growth of 5% and for operating profit growth of 10%. The company had net cash of £220 million.
Bear Points
Generic competition for Suboxone
In 2009, Reckitt Benckiser's pharmaceutical business grew 66% to £194 million but Becht declined to give 2010 guidance for the division at last week's results due to the uncertain timing of generic competition for its high growth Suboxone (buprenorphine and naloxone) heroin substitute in the US. The product lost “orphan drug” protection in the U.S. in October 2009, although it has recently gained protection in Europe for another 6 years.. In Europe sales are driven by Subutex (buprenorphine) a similar product but lacking the overdose protection of Suboxone. Suboxone in the US now accounts for 18% of group operating profits and around 10 percent of group profits. In the U.S. the drug accounts for half of the pharmaceutical divisions earnings and the North American operation represents two-thirds of total pharma sales.
If a generic version of Suboxone launches in the U.S. sales are expected to decline 80-90% as pricing pressure intensifies. A generic version of Subutex was launched in October 2009 in the U.S. by Roxane (part of Boehringer pharmaceuticals) but this has had relatively limited impact because Suboxone constitutes the majority of U.S. sales currently. The threat of generic Subuxone remains a significant driver of Reckitt’s earnings uncertainty in 2010. To date there has been no application to the Food and Drug Administration (FDA) for a generic copy and the indication for the drug is relatively niche for many generics companies to get involved with. In addition, Reckitt’s may decide to strike a deal with a generic manufacturer to exclusively licence the drug,keeping others competitors at bay for up to a year and holding up prices. The if and when of generic competition remain the $64,000 questions for the company. If generics can be held off then the highly profitable Suboxone business can be kept afloat. The fact that pharmaceuticals account for 10% of group earnings should not be underestimated if generic Suboxone becomes an unwelcome reality for Reckitt Benckiser. It should be noted that other similar companies in the consumer good sector do not have this uncertainty to contend with since they do not have this prescription market exposure.
Retail environment and private label
The global recession of the last 18 months has tempted consumers to buy cheaper private or own label products as finances have been stretched in many households. Up to this recession there was an intrinsic fear for many shoppers of being seen with cheaper “copies” in their shopping trolleys but the allure of expensive retail brands seem to have diminished and it is not expected that this trend will reverse as private label has shown strong growth. Supermarkets such as Tesco in the U.K. and Walmart in the U.S. have worked hard to improve the quality of their own offerings. A trend in consumers trading down to cheaper products is likely to curtail the growth of Reckitt’s products and this was certainly seen in Europe in 2009 where growth was limited despite significant product innovation.
Pressure from retailers to increase their margins is also intensifying. Large mass market retailers are "encouraging" further investment in in-store brand support or squeezing additional trade margin out of suppliers. Although Reckitt's has strong brands and the customer infrastructure to resist these pressures, maintaining margin is increasingly difficult if the competition decide to capitulate to these demands.
Reducing scope for cost cutting
Reckitt’s “Project Squeeze” to drive gross margin on its product has been effective in driving profitability over the last decade. However the scope for further margin improvement seems unlikely given pressures on raw material costs and the evaporation of further savings from the integration of both Adams and Boots Healthcare International.
Likelihood of acquisition
Reckitt’s healthy cash position and decelerating growth in developed markets makes an acqisition for the company more likely than ever. The company has publicly stated it has an appetite to build its presence in healthcare. However, obvious candidates apart from UK based SSL International (owners of Scholl and Durex) are thin on the ground, particularly in the over-the-counter market. An acquisition of SSL is likely to be expensive and therefore it is felt unlikely to be a target, especially as it has a fragmented portfolio of many brands acquired during the 1990’s. Other targets in the healthcare space are owned by multinationals such as Novartis, J&J and GSK who have not announced intentions to divest assets. A consumer products or household company may be an easier buy but again assets for sale will be premium priced. Given the growth outlook, it seems likely that Reckitt’s will acquire but perhaps at an unpalatable price for investors.
Bull points
Reckitt Benckiser remains a well run company with senior management objectives aligned behind investor’s objectives – namely strong earnings per share growth over the short and long term. Its focus on investing heavily behind their core brands have paid dividends and the emerging markets remain a significant target for future growth. It has a culture of innovation and differentiation and this remains core to the company’s future momentum. The company has a strong balance sheet, cash flow generation and has yield of around 3% which is likely to increase.
The forward price/earnings of Reckitt’s is undemanding at around 16 times 2010 earnings. This is in line with competitors like Procter and Gamble and Unilever.
Summary
Following the 2009 results, several analysts upgraded Reckitt Benckiser and the consensus amongst brokers is either buy or strong buy. Thus expectations are high for continued delivery of strong growth. For Contrarian Investor this gives an opportunity since when expectations are so consistently high, any slip up at all by the company will hit the shares hard. The entry of a generic competitor to Subuxone in the U.S. potentially gives the catalyst for a downward re-rating of this share. At £33.13, there may be still some upward momentum to go if the markets continue to rally especially given the undemanding rating assuming that generic Suboxone competition does not hit in 2010 . However, a short position looks tempting if the shares move beyond £35 in the near future. Watching and waiting for an opportunity to take advantage of a fall. Reckitt Benckiser is an extremely well run business but the environment in which it is operating is getting tougher and the company's healthcare exposure gives it access to a high margin market but with it regulatory and generic risks.
