OGN - Organon: What Is The Recipe?

Summary

• Organon has seen a real struggle in its first year on its own as a publicly listed business.
• Lack of growth was anticipated, yet the extent of margin pressure has been unexpected.
• With net debt flattish, leverage ratios have only increased, creating few triggers in the near-term horizon.

A year ago, I concluded that there were fertile grounds for shares of Organon & Co. ( OGN ) in this premium article. The spinoff from Merck & Co., Inc. ( MRK ) has seen some volatile trading after its separation, and with shares lagging a bit, that looked rather interesting.

Since shares started trading on their own early last summer, shares showed some volatility in a $28-$38 trading range in the first months after trading, and trading towards the lower end of that range at the time, I found the valuation enticing.

A Recap

The spinoff of Organon within Merck has been well-prepared as the spinoff procedure started early in 2020, allowing the company to operate separately under the ownership of Merck ahead of the official spinoff. Organon generated $6.6 billion in sales in 2020 from women's health, including unintended pregnancies, treatment of women with peri- and postmenopausal symptoms, uterine fibroid, etc.

The business is organized out of two segments of which "established brands" is the largest segment with 49 products together being responsible for $4.5 billion in sales. The women's health business generated $1.6 billion in sales from 10 products, including some biosimilars.

The business is a truly international, or better said, global cash cow. Some 80% of sales are generated abroad, as the company reports adjusted EBITDA of $2.8 billion, translating into very fat margins. While there are some exclusivity issues and concerns, the counterargument is that the line-up of products is quite broad, with real diversification seen as no individual product is responsible for more than 10% of sales. Nonetheless, not all was great as the company guided for 2021 sales to fall from $6.6 billion in 2020 to $6.1-$6.4 billion in 2021.

Based on $2.8 billion in EBITDA, I pegged after-tax cash flows around $1.6 billion after deducting $200-$300 million in capital investments, $400 million in interest costs and a 25% tax rate. Such a number would work down to earnings of $6.50 per share based on roughly a quarter of a billion shares outstanding.

With shares trading at $33, that worked down to just 5 times earnings, albeit that the fall in sales and leverage were the counterarguments. Leverage was a real big argument, with net debt posted at $8.6 billion at the time, actually exceeding its $8.3 billion equity valuation at the time, albeit that leverage was manageable at 3.1 times EBITDA, albeit that EBITDA was likely seen around $2.5 billion in 2021, increasing leverage ratios to 3.5 times.

Weighing it all together, I thought that the value argument was prevailing as I have initiated a position, and after shares have hit a high around $40 earlier this year, shares are now back to $28 per share and change.

What Happened?

In November of last year, the company announced a deal to acquire Forendo Pharma in a deal valued at just $75 million upfront, albeit that regulatory and commercial achievements could drive up the value of the deal to nearly a billion. In February, full year sales were reported at $6.3 billion and while sales were down just 3%, adjusted EBITDA margins fell 10 percentage points to 38%, coming in just below $2.4 billion. This translates into adjusted earnings of $6.54 per share and GAAP earnings of $5.31 per share, with many reconciliation items looking quite fair, as net debt was quite stable at $8.4 billion.

The company guided for flattish sales at $6.1-$6.4 billion in 2022, pretty flat year-over-year, yet adjusted EBITDA margins are seen around 35%, as this reveals further margin pressure and EBITDA to come in just below $2.2 billion. This results in a pre-tax earnings headwind of around $0.80 per share, but earnings should still come in around $6 per share on an adjusted basis, all while leverage ratio increases on a relative basis.

The company cut the full year sales guidance to $6.1-$6.3 billion alongside the release of the second quarter results, driven by the stronger dollar. The issue is that the midpoint of the EBITDA guidance is cut to 33%, implying that EBITDA is rapidly falling towards the $2 billion mark. With net debt flattish around $8.4 billion, leverage ratios have risen from 3 to 4 times on the back of a decline in adjusted EBITDA.

Concluding Remark

Truth is that I understand the cautious stake of the business over the past year. While the sales are holding up nicely, we have seen EBITDA fall from $2.8 billion to $20 billion in the meantime amidst a strong dollar, but notably softer pricing.

With net debt flattish over the past year, amidst poor cash flow conversion, absolute debt is flattish and relative leverage ratios are increasing, making investors cautious amidst the dynamic of higher relative leverage and rapid increased pressure on margins.

Amidst all of this, there are few green shoots in the near term of the stock as the long-term valuation argument remains and is actually really attractive as it was last year, yet some real execution is needed at some point.

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