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In 1997, Joel Greenblatt published You Can Be A Stock Market Genius. Despite the title — which admittedly sounds like a ghost-written tome by some third-rate CNBC anchor trying to capitalize on the bull market of the time — it’s a highly respectable, and highly respected, book.

Genius is probably best remembered for Greenblatt’s discussion of spin-offs, in which a company carves out a portion of its business into a new independent company, and distributes ownership in that company to existing shareholders. Greenblatt pointed to a study from Penn State University in 1988 which showed long-term outperformance for spin-offs over time, and highlighted a number of reasons for the consistent record of excess returns.

Two appear most important: first, that spin-offs often see indiscriminate selling, as existing shareholders don’t necessarily want the spun business; and second, that management incentives in the new company improve sharply. Indeed, Greenblatt pointed to post-spin stock option pricing as something investors should watch closely, citing the example of a complex spin by John Malone’s Liberty Media (it’s nice to know that some things never change.)

As recently as 2017, a S&P Global study noted that long-term returns for spin-offs continued to beat the market. Short-term underperformance does occur, but that seems to match well with Greenblatt’s theory about indiscriminate selling. Many other great investors too have touted the value of spin-offs, though the group did perform poorly last year.

Haleon is the market’s biggest spin-off this year, with a market cap of $27 billion. Like many of Greenblatt’s examples, it has fallen sharply since the spin. Unlike other spin-offs, however, there’s a more concrete reason why.

But the catalyst for the selling in recent weeks looks potentially overblown. As a result, investors have an opportunity to own an attractive franchise at an even more attractive valuation.

person holding brown and black round ornament — Photo by Kateryna Hliznitsova on Unsplash

Introducing Haleon

In mid-2019, Pfizer (PFE) and GlaxoSmithKline (now known as simply GSK plc) closed on a joint venture of the companies’ respective consumer health businesses. (GSK’s business itself had been buttressed by a joint venture with Novartis (NVS) that was established in 2015; GSK then bought out Novartis for $13 billion in 2018.) Two years later, after divesting roughly 50 brands during the interim, GSK officially announced that it would spin off the JV. The spin-off, named Haleon, closed on July 18 of this year.

Simply put, Haleon is a powerhouse. With sales in over 170 countries, it is the world’s largest over-the-counter business, with top market share in the U.S. and a second-place ranking in China. As of Q1 2022, trailing twelve-month revenue was just shy of £10 billion (nearly $12 billion US).

In the 20-F filing ahead of the spin (see p.73), Haleon delineated its nine “power brands: Panadol (acetaminophen), Voltaren (arthritis relief), Advil (ibuprofen), Otrivin (nasal spray), Theraflu (influenza treatment), Sensodyne (toothpaste), Polident (denture care), paradontax (toothpaste), and Centrum (vitamins).

Those brands drove 58% of sales in 2021, and Haleon’s portfolio includes other well-known products:

source: Haleon 20-F

Trailing twelve-month revenue (as of Q1 2022) is reasonably diversified across five major categories (percentages don’t foot due to rounding):

Oral Health: 28%
Pain Relief: 24%
Digestive Health: 20%
Vitamins, Minerals and Supplements (VMS): 16%
Respiratory Health: 13%

Pfizer owns about 32% of Haleon; GSK another 13%-plus (6% at the corporate level, 7.5% in a pair of partnerships), with the remaining ~54% being distributed to GSK shareholders. Haleon shares were listed on the London Stock Exchange; the NYSE-listed HLN is an ADR (American Depositary Receipt) which represents two ordinary shares.

The Case For The Haleon Business

That brief description hints at the argument that Haleon is a truly attractive business. The fundamentals confirm that thesis.

In 2021, Haleon posted adjusted gross margins of 63%. Adjusted operating margins were 22.8%. Those two metrics alone show the brand strength and pricing power inherent in the portfolio.

Revenue growth of late perhaps doesn’t look terribly impressive. Organic growth was 2.8% in 2020 and 3.8% in 2021. But the novel coronavirus pandemic has provided a headwind to growth. In the first quarter of 2022, for instance, organic growth in Respiratory Health was 53 (fifty-three) percent, due to a historically soft cold & flu season in the winter of 2020-2021. (Consumers avoiding the coronavirus of course avoided many other viruses as well.) On an organic basis, Haleon actually outgrew the consumer health of Johnson & Johnson (JNJ) over the two-year period, even with the cold & flu headwind.

Looking forward, Haleon management has said it expects revenue growth to accelerate to 4% to 6% over the mid-term, along with “moderate expansion” of its operating profit margins. That revenue target (and by extension the margin outlook) assumes the business can modestly outgrow an overall end market that should, on average, increase 3% to 4% annually.

There are reasons to see that prediction coming to pass. Again, a return to normalcy alone provides the potential for acceleration from a 3%-plus CAGR over the past two years. Haleon plans to increase advertising and promotion spend at a rate modestly above that of revenue growth, with higher gross margins allowing the company to drive operating leverage regardless.

The power brands account for almost 60% of revenue — but 80% of growth. And some of those brands offer room for penetration in new markets, with developing markets a particular focus. The 20-F notes that per capita spending on OTC and VMS in the US in 2021 was £110 per person — yet £29 in Central and Eastern Europe, £22 in China and, incredibly, only £2 in India (where Haleon has ~4 million points of distribution and impressive growth of late).

A pivot into “natural” products targets millennials. E-commerce is another driver. And it’s possible that, as Greenblatt argued 25 years ago, the separation will provide a boost, given that a consumer-facing business is now removed from a pharmaceutical industry management structure.

To be sure, those factors alone don’t mean the 4% to 6% bogey will be hit. Wall Street analysts clearly have at least some skepticism, given how often the target was raised during the Q&A period of GSK’s Consumer Health Capital Markets Day at the end of February.

But the broad point here holds: this is an attractive business. It’s defensive, highly profitable, and growing at a reasonable clip even amid recent headwinds. It’s a business that in theory investors should want to pay up to own.

The Case For Haleon Stock

But investors aren’t paying up right now. At Friday’s close just below $6, HLN trades at 14.4x TTM adjusted pro forma1 net income, ~13x 2021 Adjusted EBITDA2 and 17x the average free cash flow for 2020-2021 (as with net income, pro forma for added interest expense).

Relative valuation here is difficult, because there isn’t a logical direct peer. The other two major, global, consumer health businesses are part of larger companies: J&J (which is planning its own spin-off) and Reckitt Benckiser (RKT.L) (RBGLY).

But the valuation assigned to J&J as a whole implies a high valuation for its consumer health business, given that JNJ merits a sharp premium to pharmaceutical peers and a higher multiple than the likes of medical device rivals like Medtronic (MDT). And there’s one intriguing comparison which suggests that HLN is sharply, and maybe, ridiculously undervalued.

In its fiscal 2022 (ending June), Procter & Gamble (PG) generated an adjusted operating margin of 23.6%. For the year, P&G drove organic sales growth of 7%.

The midpoint of Haleon’s target revenue growth range is two points below P&G’s FY22 performance. Its operating margin is ~100 basis points lower. On a TTM basis, PG trades at 21x EV/EBIT. HLN is now below 14x.

To be clear, PG merits a premium. Its growth is better, and its market positioning likely more dominant. And we were also skeptical toward PG’s valuation in April (though that stock is probably ~two turns lower on an EV/EBIT basis at this point).

Still, the gap between the two stocks’ valuations is enormous. The gap between the two businesses is nowhere near as large.

There’s another key data point here as well. In January, Unilever offered £50 billion for the assets that would become Haleon. GSK turned down the bid, saying it undervalued the business. Haleon now has an enterprise value under £32 billion.

To be fair, Unilever shareholders hated that offer, but they no doubt would have felt differently at a price one-third lower. That aside, absolute valuation works as well. Assume 5% annual free cash growth (once again, from a base that accounts for interest expense going forward), 2% terminal rate, and an 8% discount rate and HLN is worth $7.22, 21% upside from here.

Obviously, any DCF is only as good as its inputs, and the leveraged balance sheet (~4x EBITDA on a net basis) might argue for a higher discount rate. But the fundamentals here are telling us one thing with almost absolute certainty: the market is pricing in not only that Haleon will miss its targets, but that the business will not be nearly as impressive going forward as it has been looking backward.

The Zantac Problem

The question, of course, is why.

The bullish interpretation is that HLN is being sold off due to short-term factors — among them post-spin dynamics like those discussed in the introduction to this piece.

Certainly, HLN has absolutely collapsed since the spin took place just five weeks ago:

source: finviz.com

But, as the chart shows, the selling didn’t start immediately. In fact, at its Aug. 8 close, HLN had gained a bit over 3% from its opening price.

What’s happened since then is, to be honest, a bit confusing. A wave of selling has hit a number of stocks, including both HLN and GSK, over concerns about exposure to a number of lawsuits over the antacid Zantac (ranitidine). Like HLN, GSK has dropped over 20%. Sanofi SA (SNY) has sold off as well; the total hit from what appears to be a Zantac-driven sell-off across several stocks now exceeds $40 billion.

Perhaps the most confusing aspect is the timing. In the 20-F, Haleon disclosed potential liabilities from lawsuits that claim Zantac caused cancer, following decisions in the EU and US to pull the product from shelves. GSK did the same before the spin. The London Sunday Times posited this weekend that UK analysts were late in coming to awareness of the first trial in the US, which was due to take place later this month. The Times noted that the issue had merited relatively little commentary from analysts in the months leading up to the spin.

Yet that initial lawsuit was dropped this week amid conflicting reports over whether the plaintiff had settled with other companies. That news did nothing for HLN, GSK, or SNY, which suggests either that a) something else is at play and/or b) investors are simply selling first and asking questions later.

The core reason to believe explanation b) is the fact that no one knows at all how this will play out. J&J has dealt with lawsuits over asbestos in its talcum powder that the company argued were baseless; that company booked nearly $6 billion in related expenses across 2020 and 2021. The plantiffs’ cases related to Zantac appear (from this legal tourist’s perspective) to be relatively thin, but that alone doesn’t mean the defendants will win.

There’s a major distinction here, however. At the least, investors knew that J&J was responsible for liabilities related to its talcum powder. In the case of Zantac, ultimate responsibility itself may well be a source of litigation.

The Haleon 20-F traces the history of Zantac, which provides a microcosm of the wheeling and dealing across the pharmaceutical industry over the past two decades. Zantac’s OTC rights began in 1993 with a joint venture between Warner Lambert and GSK; that JV was terminated in 1998 with rights going to Warner Lambert.

Pfizer bought Warner Lambert in 2000; J&J acquired Pfizer’s OTC business six years later, then sold it on to Boehringer Ingelheim. Sanofi then bought Boehringer’s consumer health business in 2017.

In other words, Haleon hasn’t controlled the product since 1998; its 32% owner, Pfizer, divested Zantac in 2006. As Haleon noted in a press release this month, the company does have a potential indemnification requirement to both Pfizer and GSK, but only if other third parties with their own requirements don’t pay up and only if Haleon is determined to be liable. Notably, Haleon is “not a party to any of the Zantac claims,” and never marketed Zantac in the US.

And yet Haleon has lost more than $7 billion in market capitalization over the past few weeks.

What Else Can Go Wrong

That seems like an enormous overreaction. It’s possible that some liability trickles down to Haleon via a convoluted legal process, certainly. But that liability is years away, and there seems minimal chance that Haleon must bear the burden alone. (To be clear, this is not legal advice.)

Even the example of J&J is instructive. JNJ stock plunged more than 10% in December 2018 after a Reuters report highlighted its talc liabilities; five days later, the company lost a motion to overturn a $4.7 billion verdict. Since the beginning of 2019, JNJ has returned (including dividends) a bit over 10% annualized3.

Yet HLN seems to be pricing in pretty substantial liability. Again, mid-single-digit EPS/FCF growth suggests a price above $7 — and a market cap more than $5 billion higher. If we knew that Haleon was going to have to pay $5 billion over time, the stock would look attractive here. The expected value of potential outcomes, on a present value, seems like it comes in well below that figure. (To repeat, not legal advice.)

The question then becomes: what else can go wrong? In this environment there are plenty of catalysts, to be sure.

The macroeconomic environments in the U.K. and Europe are a clear risk. The EMEA (Europe, Middle East, and Africa) region drove 40.6% of 2021 revenue, at higher operating margins (24.8% vs 23.5% in North America and 21.5% in Latin America and Asia-Pacific). Higher energy costs and inflation more generally might raise the risk of consumers trading down, either hitting revenue and/or reducing margins through price competition.

Haleon management has been constructive on this point so far. Competitors are facing similar challenges, albeit without the benefits of scale. The weaker pound provides a potential margin benefit as well: currency was a modest headwind to margins in 2020 and 2021, but the British pound has reversed sharply so far this year. Direct commodity costs, meanwhile, are less than 10% of revenue, and Haleon has costs locked in through this year and in some cases beyond.

From a near-term perspective, there is the possibility of more post-spin selling, given the weak performance. Pfizer’s ownership provides an overhang, as the company has said it will sell its stake, albeit in “a disciplined manner.” Filings show that as of Aug. 9, Pfizer had not yet sold any shares. It’s possible the company has done so since, but given the industry’s apparent surprise at the nature of the broader Zantac-driven sell-off, it seems unlikely.

A Long-Term Buy

Between the macro picture and the legal uncertainty, there are risks here. But they seems like risks worth taking. Below $6, HLN is pricing in both substantial liability related to Zantac and a notable deceleration in its top- and bottom-line growth.

It’s possible one or both occurs. But even with the leverage on the balance sheet, the risk/reward here seems skewed to the upside. 2024 Adjusted EBITDA of $3 billion (an ~8% compound annualized growth rate), 3x net leverage (in line with the expressed target), and a 15x EV/EBITDA multiple suggests total returns in the range of 20% over the next two years. (Haleon plans to start a dividend next year with a payout ratio of 30%, building over time.)

Similar downside here requires a massive legal liability (think $10 billion-plus), significant compression in margins, or a big contraction in already-reasonable valuation multiples.

Again, it’s possible one of those occurs. All three would be a stunning surprise. This looks like an overreaction, one perhaps amplified by post-spin dynamics. And it thus looks like a buying opportunity.

As of this writing, Vince Martin has no positions in any securities mentioned. He may initiate a position in HLN this week.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

1

This accounts for interest rates from new borrowings totaling £317 million ($395 million). That calculation includes a 5% placeholder for planned borrowings required to fund a dividend to GSK and for floating rate bonds whose interest rate was not disclosed in the 20-F. Those borrowings total less than 20% of total post-spin debt, so if the 5% figure is off it should be manageably so.

2

Haleon hasn’t disclosed Adjusted EBITDA for Q1.

3

The company’s COVID vaccine probably isn’t a factor in the gains, given that J&J has sold the vaccine at cost. It’s changing that policy, but now demand appears to be drying up.

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