You may have heard the phrase: “The Future is Female.” This may be true, but cash flow has no gender. Organon, an under the radar spinoff from pharma giant Merck, specializes in women’s health on the international stage. The company is a cash printing machine that should sail through economically turbulent times.
By The Sick Economist
According to bestdegrees.com, in the 2019 academic year, 57% of bachelor’s degrees were earned by women. You may have noticed from press coverage of the Russia/Ukraine war, that many of the top leaders in the region are women. The leader of Taiwan is currently a woman. All across the globe, women are taking the vanguard in the 21st century. Female empowerment means that women are more vocal in advocating for their needs, and increasingly have the economic power to make sure that those needs are met. Organon & Co ($OGN) is a new company created specifically to benefit from this trend.
Another constituency that Organon was built to address is shareholders who seek steady and growing dividends. The company currently boasts a 3% dividend, and only pays out roughly 25% of its profit, meaning that brisk dividend growth is almost guaranteed for the foreseeable future. Currently trading at just 7 times earnings, the shares may be a steal for investors who are willing to embrace a company that Wall Street has ignored.
How does Organon generate its current payout? What growth prospects might exist? And if the company can provide ample and growing dividends, why has Wall Street shunned it?
Current Cash Flow – The Three Pillars
What do you do if your company is not growing fast enough? The hard solution is to continue to innovate or acquire new products that sell briskly. The easy solution is to just lop off the parts of the company that aren’t growing fast, combine them into a new entity, and pitch the entire affair as a spinoff to create a more “lean, focused” organization.
In reality, you will wind up shrinking your company, instead of growing it. But the entity that is left over after the spinoff will be growing faster, from a smaller base of revenue, and the Wall Street analysts will soon just focus on your old company’s new growth number. If you are very lucky, this new and improved growth number, expressed as an annual percentage, will vault you into an elite category that Wall Street considers to be “growth stocks.” Growth stocks are typically valued at a higher multiple than lowly dividend paying cash cow stocks. So, your newly shrunken company, which now produces less free cash flow, will be perceived as growing more quickly, and the shares will thus be valued more highly relative to slower growing peers. Welcome to the perverse logic of Wall Street Analysts and the CEOs who love them.
This is exactly what happened with Merck and Organon. Merck was a vast and ancient pharmaceutical enterprise, selling just about every kind of medicine in every country for more than a century. Some of its divisions boasted fast growing, revolutionary cancer products like Keytruda, while other divisions sold more niche, patented products, or even generic, over the counter products that had been grinding out profit for decades. As some products grew quickly, and other products had reached a more mature stage in their life cycle, this left Merck with a middling growth rate.
As described above, it was decided that the easiest way to turn Merck into a lean, mean, revenue growth machine was to clip off the more mature divisions, and the divisions addressing niche products, merge them together, and send them out into the cold, cruel commercial world to fend for themselves. The new entity of shunned divisions was named Organon, and made its debut as an independent, publicly traded company in June of 2021. The new entity was largely spun off to existing Merck shareholders; for many small Merck shareholders, Organon simply “appeared” one day in their brokerage account along with a brief email explaining that they now owned two separate companies, instead of just one. Slow growing companies weren’t considered sexy by the Wall Street elite; Organon came into the world not with fanfare and breathless cable TV interviews, but with a measly email and a poorly circulated press release.
It should be noted that, although Merck decided to ditch its slow growing divisions, these divisions were still profitable. Very profitable. For some odd reason, in Wall Street’s obsession with growth, they often forget to care about the inherent profitability of a product or business. Organon started its life as a corporate entity with a collection of slow growing, but very lucrative products.
The company’s gross margins regularly exceed 60%. EBITDA is close to 40%. The company gushes so much cash, that its current quarterly dividend yield (a healthy 3%) represents less than 25% of its profit. The suits at Merck were so obsessed with hitting growth numbers that they essentially took an ATM machine and threw it out into the street. Bad for them, good for the astute dividend investor.
Organon is starting independent life with three different divisions which generate cash in different ways. The organization’s highest profile division is its women’s health division. This division includes 11 different products, and is aiming to establish itself as a comprehensive “one stop shop” for women’s health prescription products across the globe. Organon offers birth control, fertility medication, and is working on projects for a variety of female ailments.
The second division is “established brands,” which is code word for an assortment of well known medications that have gone generic. This is currently the largest division in terms of revenue and includes such well known brands as Propecia and Nasonex.
The last division is just a young baby division within a young baby corporation. This is the biosimilar division. The entire business of biosimilars did not exist just ten years ago. As more and more ground breaking medications fall into the biologic category, this division will find more and more opportunities to copy those medications and churn out steady cash flow.
As we discussed above, the boys at Merck did a pretty good job of setting up Organon to print cash for the near future. Even with little current growth, the dividend payout ratio is so low that they can continue to grow their dividend for quite some time, regardless of a slowing economy or an inflation problem.
But eventually, even slow growing companies must grow if they are to meet their investors’ dividend expectations. There are a few signs that Orgnanon is well equipped to meet these future growth needs.
First, the company starts life with the right management team. Orgnanon’s CEO, Kevin Ali, is a pharmaceutical executive with extensive international leadership experience. In particular, he has a long track record of success growing pharmaceutical businesses in the developing world. This is key to Organon’s women’s health division and established brands division. Although access to birth control and women’s health medicine may be taken for granted in the Western World, millions upon millions of women in Africa, India and other places are becoming empowered to seek this kind of care for the first time in history. Africa and India alone is home to a rapidly growing population of more than 1 billion women; many are the first generation to receive any women’s healthcare at all. The developing world is also key to growing cash flow for the established brands division. In the United States most patients may see little difference between generic medications and the more expensive branded equivalent, but in many countries with less established regulatory frameworks, these long established international brands are seen as a mark of quality and efficacy. Many patients in the developing world simply don’t trust generic medications. A CEO with decades of experience in these markets is well positioned to manage this portfolio for growth.
Second, Orgnanon’s financial strength and massive cash flow puts the company in a good position to find and acquire promising growth medications in the field of women’s health. Just in the last year since it became an independent company, Organon has already engaged in five transactions to establish growing revenue sources for its complete women’s health portfolio.
Lastly, although the company’s biosimilar portfolio is starting from a very low revenue base, this division has already experienced 25% growth in the last year. The world of biotech is experiencing an explosion of new launches in the biologic space, which means that, with time, the business of biosimilars will only grow. Although biosimilars are essentially generic versions of biologic drugs, since these drugs are made with a complicated process involving living bacteria, not just anyone can set up shop and crank out these medicines. There is room for profitable growth here with subdued competition.
Even though Organon is not currently expanding at the rate that excites Wall Street analysts, the company’s future growth prospects are real and substantial.
Why so cheap?
So far we have established that the company boasts well respected and experienced management, copious current cash flow, and real growth prospects. So this leaves us with the obvious question: why is this thing selling so cheap? Organon currently trades at just 7 times earnings. Most Big Pharma companies trade between 20 and 40 times earnings, even after the S&P 500’s recent plunge. Why does Wall Street have so little respect for this major new player on the scene?
This first reason could be the company’s debt. In addition to using the spinoff as a way to shed Merck’s low growth assets, the suits at Merck also found a sneaky way to reduce their debt. Because the new collection of assets created steady cash flow, Merck felt free to load the new company with debt. In this way, Merck could improve its balance sheet with no work, and no risk, and Organon’s robust cash flow could service an abnormally large debt. Today Orgnanon carries about $9 Billion in debt, which could seem concerning to some, since the entire stock market capitalization of the company is just $9 billion. To the careless eye, it seems like the young business is in excessive debt that will hamper its ability to grow.
Despite the large debt load, Merck actually didn’t leave its new spinoff in a terrible position. Organon has “good” debt. That means that, ⅔ of the debt is locked in at very low interest rates over a long period of time. Even though we are in a rapidly rising interest rate environment, the organization’s debt service costs will remain low and predictable. Additionally, the debt does not have to be paid off until at least 2028.
Organon’s interest payment for the whole year of 2022 is $400 million. That sounds like a lot of money, but is actually modest considering that company cranked out $1 billion in gross profit in just the first quarter of the year. And, in just one year of existence, the management team has already started paying down the debt, reducing it from $9.35 billion to $9.09 billion in the company’s first year of existence. Although this debt load looks burdensome at first glance, the company should easily be able to pay it down while still churning out dividends and investing in growth.
The second reason why Organon could be undervalued is that, sadly, Wall Street is still mostly run by men. Although more and more women are in positions of leadership every year, men still predominate. Therefore, they may not really understand Organon’s substantial growth prospects. For example, two of the company’s top growth prospects are treatments for bacterial vaginosis and endometriosis. These are two conditions that rarely kill women, but may cause embarrassment, discomfort, or even extreme pain. Until now, millions upon millions of women across the globe just lived with these conditions the best they could. Wall Street analysts, who are primarily men from the developed world, may not quite appreciate the revenue growth potential of these kinds of products.
Lastly, Organon may be undervalued because it is primarily an income stock. As we discussed earlier, since 2010 and our nation’s recovery from the Great Financial Crisis, most financial media and well known analysts have been fascinated by growth stocks. Stocks with little or no profit routinely doubled, tripled or quadrupled in price! Profit seemed irrelevant, let alone dividends. A whole generation of young analysts was trained to think this way.
It seems however, that the party is now over. The Nasdaq index has tumbled 30% from its high; many unprofitable growth companies have been slaughtered without mercy, shriveling in value by 50, 60 or 70%. Rising interest rates and slowing economic conditions suggest more storm clouds on the horizon.
Suddenly, a recession proof stock that can grow dividends in any economic environment may seem a lot more appealing. Organon sells many basic products that would be the last item to go when household budgets are stressed. It carries manageable and long term debt with fixed interest rates. And shareholders can count on these quarterly payments even when their tech portfolio is a smoldering wreck.
Organon’s current under valuation may simply be an indicator that it belongs to a category that has been “out of style” for a long time; value stocks. That whole category might seem a lot sexier when formerly high flying growth stocks have crashed and burned.
If you seek a company whose share price will triple or quadruple over the next ten years, Organon is probably not for you. If you seek a company whose dividend payment can triple or quadruple, then you might just give this new business a chance. It came into the world with little hype or fanfare, but its dividend growth potential just may make it a star.
Disclosure: The Sick Economist owns shares in $OGN