High Consolidation in Agricultural Input: Creating Value for Investors

The Agriculture value chain is an interesting space (Figure 1). While much of it, like the natural resources space, is highly consolidated and controlled by large corporations or governments, billions of farmers around the world still form one key part of the chain. These farmers are individuals or families that are dependent on production improvements and increases in crop yields for their success and, in some cases, survival. As a result, they are extremely reliant on the firms from which they buy seeds, agrochemicals[i],

Figure 1 : Agriculture Value Chain

blog07_image1fertilizers, agricultural machinery and farmland (agricultural input companies). These firms are generally extremely large and powerful, often with oligopolies in their respective space, and this gives them huge market power. Their dominance is best illustrated by the fact that these firms have historically had the highest margins in the entire value chain and agriculture industry[ii].

The concentration in the agricultural input segment provides incumbents with strong market power in this strategic sector. The top 6 players in the agrochemical industry currently control 63% of the global commercial seed market and 75% of the global pesticide market[iii], both of which are R&D-intensive industries. For example, the development of new genetic traits in seeds requires, on average, R&D investment of $150 million and 10 years of development[iv]. With these top 6 companies currently contributing nearly 75% of total private sector spending in global seeds and agrochemical R&D[v], their dominance is driven by the long-term success of their investments. Even more surprising are the global oligopolies in relatively low-R&D businesses such in the agricultural input segment such as farm machinery and fertilizers. The top 3 players in farm machinery currently have a market share of 49%, while the top 5 players in the potassium market (a key ingredient in fertilizers) account for nearly 70% of global market share[vi].

Despite this consolidation and the market power it provides, the operating environment for the agricultural input segment has been difficult over the last few years. Over the last 2 years, the US has experienced a farm income recession which is expected to continue in 2016. After reaching recent highs in 2013, net cash incomes are expected to decline for the third consecutive year in 2016 (by 2.5%), while net farm incomes are forecast to decline for the fourth consecutive year from their 2012 highs (by 3%). However, income seems to be beginning to stabilize, indicated by the fact that these declines are moderate compared to the 27% and 38% reductions in net cash and net farm income, respectively, that occurred in 2015[vii]. Moreover, the US dollar has depreciated by 3.45% YTD after a nearly 20% appreciation from 2013-2015 (which negatively impacted farm exports) [viii]. On a global basis, farm incomes are also expected to improve in 2016. India, which suffered two consecutive years of drought in 2014 and 2015 which resulted in a crippling agrarian crisis, is expected to see above-average rainfall in 2016[ix].

With farmers, the primary customer base for the agriculture input segment, experiencing these headwinds, the firms that operate in the space have also had difficulties. That said, the long-term story for the segment’s success and growth remains intact, and the relatively low valuations at the moment seem to have created an opportunity for companies to go through one more round of consolidation and restructuring. This should not only lead to increased valuations in the short-term, but also create sustainable long-term value for investors.

Seeds & Agrochemical Sector Consolidation

The latest round of consolidation began with M&A activities in the seeds and agrochemical sector. In December 2015, Dow Chemicals (DOW: NYSE) and DuPont (DD: NYSE) announced a merger of equals in a deal worth $130 billion. According to the plan provided in an investor presentation, the merged entity would be unbundled into three entities including one with a pure-play agriculture focus with revenues of $19 billion[x]. This entity would have a nearly 16% share in the global agrochemical and a 25% share in the global seeds market[xi] and should lead to it having significant market power over buyers. According to a different estimate, the merger would create the first integrated seeds and agrochemical leader in the industry, displacing Monsanto and Syngenta as the top two players in the industry, and also create strong value for investors. A study showed that over 12, 24, and 36-month periods, investors should generate excess returns of 19.4%, 24.4%, and 26.3%, respectively, by investing in the new subsidiaries of the parent company[xii].

Deal volume has remained strong in 2016, with two large acquisition deals announced recently involving Syngenta (SYNEF: OTC), Monsanto (MON: NYSE) and Bayer AG (BAYRY: OTC). Syngenta has accepted an acquisition offer from ChemChina in a deal valued at $43.80 billion, which amounts to a nearly 22% premium on the day of the announcement (February 2nd) and a deal multiple of 17x to trailing 12-month income[xiii]. This offer followed the rejection of $47 billion offer from Monsanto in January 2016. In what can be termed as reaction to deals in the space, Bayer made a $62 billion offer for Monsanto in May. The all-cash deal, which values Monsanto’s outstanding shares — without accounting for debt — at about $53 billion, represents a 44% premium to the May 9th closing price. The deal has already been rejected by the management of Monsanto and, according to analysts, an EBITDA multiple similar to the Syngenta-ChemChina deal would translate into an additional 20% over the offer price for Monsanto shareholders[xiv].

Farm Machinery and Fertilizer Opportunities

Based on the M&A activity in the space in recent months, the seeds and agrochemical sector may go from 6 major players to just 3 in a short time. Although other sectors in the agriculture input segment have not seen similar consolidation, declining valuations here may be creating M&A opportunities for incumbents. For example, the fertilizer sector had some deal volume in 2015, with an offer of nearly $8 billion by Potash Corp (POT: NYSE) for K+S (SDF: ETR), reflecting a 41% premium on the last traded price and a 43% premium over the six-month average on the day of the offer (June 25, 2015)[xv]. Similarly, CF Industries (CF: NYSE) offered to buy the North American and European assets of OCI (OCINY: OTC) for $8 billion in 2015 with the aim of creating the world’s largest nitrogen fertilizer company[xvi].

blog07_image02

As can be observed from Figure 2, most of the major fertilizer companies are trading at significant discounts (20%-30%) from the end of 2014. Despite these lower valuations and an adverse business climate, these companies have maintained a strong ROIC in the range of 7%-12%. There are a few exceptions in the industry, such as CF Industries, which has different dynamics due to its ambitious expansion plan over the last 12 months including a failed acquisition attempt with OCI. According to FactSet, the largest four firms in the industry have net debt to equity in the range of 20%-80% while net debt to EBITDA ranges from 0.25x to 2.30x. These numbers suggest that, overall, the balance sheets for the industry are not overleveraged and there is a scope for industry consolidation via M&A.

In contrast, instead of consolidation, farm machinery companies are looking at M&A to help them gain insights into software, robotics, GPS, satellite monitoring, climate data, and even drones. While this might seem strange, it is meant to give them the skills and insights they need in order to move into precision farming[xvii]. For example, Deere & Co (DE: NYSE), the market leader in the farm equipment industry, has entered into a definitive agreement with Monsanto to acquire its Precision Planting equipment business and enable exclusive near real-time data connectivity between certain John Deere farm equipment and the Climate FieldView™ platform. The agreement represents the industry’s first and only near real-time in-cab wireless connection to John Deere equipment by a third party, and could be the start of a trend of similar deals.

Accessing the Opportunity

With the world’s population projected to increase from 7.3 billion people in 2015 to 9.8 billion in 2050 (UN Projections, 2015) and rising standards of living, feeding the human race over the next few decades, and beyond, is expected to be a significant challenge. From 2005-2050, global demand for calories and proteins derived from crops is expected to increase by 100% and 110%[xviii], respectively. Considering the fact that technologies and resources indispensable to global food security are controlled by just 15-20 corporations and, based on the trends mentioned above, an investment in the agricultural input segment could generate strong returns for investors.

The First Trust Indxx Global Agriculture Index ETF (NASDAQ: FTAG) is the only fund in the market that provides exposure to the agricultural input segment. The ETF seeks to track the Indxx Global Agriculture Index, a market capitalization weighted index designed to measure the performance of companies which are directly or indirectly engaged in improving agricultural yields and production. The index is comprised of farmland companies and firms involved in chemicals & fertilizers, seeds, irrigation equipment, and farm machinery. As of June 30, 2016, the index consists of 46 constituents, with a weighted average market cap of $35.67 billion.

For more information on the index, please visit http://www.indxx.com/globalagriculture.php

 

[i] Agrochemical refers to chemicals used for crop protection practices. Agrochemicals cover the all ranges of herbicide, fungicide, pesticides and insecticides.

[ii] https://www.kpmg.com/UA/en/IssuesAndInsights/ArticlesPublications/Documents/KPMG_The_Agricultural_and_food_value_chain%20(May_2013).pdf

[iii] http://www.etcgroup.org/sites/www.etcgroup.org/files/files/etc_breakbad_final_dec_15_15_0.pdf

[iv] http://fininfohub.com/2014/09/15/farm_seeds/

[v] http://www.seedsavers.org/site/pdf/HeritageFarmCompanion_BigSix.pdf

[vi] http://www.livemint.com/Companies/rZqZPYXyCs1SwYxatT1OtO/Potash-market-in-shock-after-Uralkali-halts-Belarus-venture.html

[vii] http://www.ers.usda.gov/topics/farm-economy/farm-sector-income-finances/2016-farm-sector-income-forecast.aspx

[viii] http://www.bloomberg.com/quote/DXY:CUR as of 5/27/2016

[ix] http://www.thehindubusinessline.com/economy/agri-business/monsoon-rains-seen-above-average-in-2016-imd/article8466501.ece

[x] http://money.usnews.com/investing/articles/2015-12-22/dow-dupont-merger-could-create-opportunities-for-investors

[xi] http://www.counterpunch.org/2016/01/08/monsanto-syngenta-agribusiness-giants-get-even-bigger/

[xii] http://www2.owen.vanderbilt.edu/alexeiovtchinnikov/Predictability%20of%20long-term%20spinoff%20returns.pdf

[xiii] http://www.bsic.it/merger-king-chemchina-going-west-time-syngenta/

[xiv] http://www.bloomberg.com/news/articles/2016-05-23/germany-s-bayer-offers-62-billion-cash-to-acquire-monsanto

[xv] http://www.reuters.com/article/us-k-s-m-a-potashcorp-idUSKBN0P52L420150626

[xvi]http://www.oci.nl/media/cms_page_media/63/OCI%20N%20V%20%20Investor%20Presentation%20March%202016%20FINAL.pdf

[xvii] Precision farming is a concept that allows the user a way to deal with every field and field section variations. Soil texture, composition, organic matter and pH levels all effect how soil uses and retains nutrients. Nutrient levels fluctuate because of factors like drainage, field work practices, cover crops, weeds and previous year’s yields.

[xviii]  “Global food demand and the sustainable intensification of agriculture” by Tilman, Balzer, Hill and Befort (October 12, 2011)

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Biosimilars: A New Wave of Generic Drugs

Thus far in the 21st century, the rise of biologic drugs[i] has been a major theme in the global pharmaceutical industry. According to IMS Health, global biologic sales increased from nearly $46 billion in 2002 to $160 billion in 2012 with expected sales in 2017 of $221 billion (20% of total global pharmaceuticals sales)[ii]. The rise of biologics has coincided with increasing healthcare costs on governments worldwide. On average, biologic drugs are 22 times more expensive than traditional drugs, and it is expected that biologics will account for 50% of US prescription drug expenditures[iii] by 2018. As a result, regulatory authorities are focused on contain spiraling healthcare costs and capturing a “generic drug” savings premium, and have started laying the groundwork for generic biologics, generally called biosimilars. Unlike Europe and Japan, the US only adopted universal healthcare (via the Affordable Care Act, also known as Obamacare) in 2010, which explains the delay in establishing a regulatory pathway for approvals of biosimilars in the US. With the major US presidential candidates of both political parties publicly calling for controlling spiraling drug prices, biosimilar cost savings represents a very simple way to cut costs. According to various estimates, healthcare savings from the use of biosimilars range from $25 billion to $250 billion over the period 2014-2024[iv].

fig1

 

As a result, biosimilars have become one of the fastest-growing segments of the global pharmaceutical sector. According to allied research projections, global sales of biosimilars are conservatively expected to rise from $2.5 billion in 2014 to $26.5 billion by 2020 reflecting an annualized growth rate of over 48%[v]. A key trigger for the growth biosimilars is expected to come from the expiration of patent protection for blockbuster biologic drugs. According to estimates by EvaluatePharma, biologics with aggregate US sales of $79 billion will lose patent protection between 2013 and 2018[vi].

Fig 2 and 3

The European Experience

Although a significant majority of EU members do not allow for the interchangeability of biosimilars with original biologics, biosimilars have still experienced reasonable success in Europe. If one categorizes biologics into broad categories, biosimilars have remained limited to EPO[vii] and GSCF[viii] products, but have still managed to capture nearly 25% of the EPO and 50% of GCSF markets, by monthly volume, within the first seven years of launch[ix]. Overall, the adoption of biosimilars has been much slower than generics, which typically capture 90% of volumes with a few months of introduction. This can be attributed to the fact that biosimilars are typically sold at discounts of 15%-25% vs. biologics, compared to an average discount of 40% for traditional generics vs. their brand-name competition, as well as restrictions in the EU regarding the use of biosimilars as direct replacements for the original biologics.

blog04image5

 There does seem to be direct relationship between biosimilar adoption rates and pricing, as evidenced by the success of the biosimilar drug Remsina in the EU. At a global level Remsina, developed by Celltrion (068270: KOSDAQ), became the first approved biosimilar MAB[x] when it was approved by the European Medicines Agency (the EU equivalent of the FDA in the US) for sale in the EU. Remsina currently sells at nearly a 45% discount (70% in the case of some Nordic countries) to its brand-name biologic competitor, Remicade, which has allowed it to capture big hospital drug mandates in Europe[xi]. Many European governments have commissioned studies focused on promoting the biosimilar replacement of Remicade among physicians, payers and patients. In fact, the impact of discounted pricing can be gauged by the fact that according to Merck & Co. (MRK: NYSE), which has international marketing rights for Remicade, international sales for Remicade dropped by nearly 25% in 2015 on a YoY basis. According to analyst estimates, Remicade sales should keep dropping, and could drop 50% below 2014 levels by the end of 2017 (Source: Bloomberg).

Biosimilars in the US

The approval of biosimilars in the US could have a significant impact on industry dynamics as, unlike in the EU, US guidelines allow for the interchangeability of biosimilars with the original biologic. In addition, as the US currently accounts for more than 50% of biologic usage, large numbers of biosimilar approvals in the US is expected to create strong opportunities over the next 5 years. As an example of this, Zarxio, launched by Novartis (NVS: NYSE) in September 2015, became the first ever biosimilar to be launched in the US, and is selling at a 15% discount to its biologic competitor, Neupogen. Together with Granix (sold by Teva (TEVA: NYSE) as a biosimilar to Neupogen), these two biosimilars had already taken 25% of Neupogen’s market share in terms of volume by the end of 2015[xii].

There also appears to be strong interest in the adoption of low-cost biosimilars by a key group in the US: doctors. In a recent survey of 150 doctors by InCrowd, 83% indicated a preference for a biosimilar in the event of a 25% discount to the biologic, and 33% indicated a preference for a biosimilar even if the discount was just 5%[xiii].

Despite strong interest and favorable political support in the US from presidential candidates, regulatory guidelines still lack clarity in terms of the biosimilar approval process. For example, Zarxio was approved by the FDA, but is still not interchangeable with its biologic reference drug. That said, it is expected that the biosimilar Remicade will be approved by the FDA this year and that the process will become clearer. If the FDA goes along these expectations, it would not only make biosimilars more mainstream and bring clarity to regulatory guidelines, but could also be extremely favorable to the biosimilar drug market due to the sheer size of the US drug market.

How to Invest in Biosimilars

The biosimilar drug segment is still growing and evolving, and there is no investable product that currently provides pure-play exposure to the space. That said, leveraging its extensive research into the space, Indxx has developed the Indxx Global Generics & New Pharma Index to provide access to the companies in this industry. The index includes exchange-listed companies, on a global basis, that derive a significant proportion of their revenues (or that have the potential to derive a significant proportion of their revenues) from the generic drug industry, or that have a primary business focus on the generic drug industry. The products of these companies are pharmaceuticals that are identical, or bioequivalent in the dosage form, safety, strength, quality and intended usage to brand name pharmaceuticals.

The index currently provides significant exposure to the biosimilar space, and pure-play biosimilar drug companies are nearly 15% of the total index weight. In addition, most generic drug companies (which are also included in the index) are focused on biosimilars as their next growth opportunity. The index is fairly representative of the global biosimilar opportunity, with nearly 10% of the index weight allocated to biosimilar companies based in South Korea, Japan, Taiwan and India. 14 of the 20 biosimilar companies in the index belong to these countries.

As of December 31, 2015, the index included 78 securities of companies with a minimum market capitalization of $1 billion and a weighted average market capitalization of nearly $14 billion.

Indxx has licensed the index to noted New York-based asset manager and ETF sponsor Van Eck Associates Corporation for their exclusive use, and Van Eck has launched an ETF tracking the index – the Market Vectors Generic Drug ETF – under the symbol GNRX.

[i] A biologic is a substance that is made from a living organism, or its products, and is used in the prevention, diagnosis, or treatment of cancer and other diseases. Biological drugs include antibodies, interleukins, and vaccines. Also called a biologic agent or a biological agent. [ii]https://www.imshealth.com/files/web/IMSH%20Institute/Reports/The_Global_Use_of_Medicines_2017/global%20use%20of%20med%202017%20right6%20Biologics_Market.pdf
[iii]https://www.ftc.gov/system/files/documents/public_events/Follow-On%20Biologics%20Workshop%3A%20Impact%20of%20Recent%20Legislative%20and%20Regulatory%20Naming%20Proposals%20on%20Competition/purvis.pdf
[iv]http://www.americanactionforum.org/wp-content/uploads/files/research/2015-09-04_Biosimilars_FINAL_formatted.pdf
[v]https://www.alliedmarketresearch.com/global-biosimilars-market-market
[vi] Generating value in generics: Finding the next 5 years of growth by McKinsey
[vii] Erythropoietin, also known as EPO, hematopoietin, or hemopoietin, is a glycoprotein hormone that controls erythropoiesis, or red blood cell production.
[viii] Granulocyte-colony stimulating factor (G-CSF or GCSF), also known as colony-stimulating factor 3 (CSF 3), is a glycoprotein that stimulates the bone marrow to produce granulocytes and stem cells and release them into the bloodstream.
[ix]https://www.ftc.gov/system/files/documents/public_events/Follow-On%20Biologics%20Workshop%3A%20Impact%20of%20Recent%20Legislative%20and%20Regulatory%20Naming%20Proposals%20on%20Competition/ramachandra.pdf
[x] Monoclonal Anti Body. Antibodies that are produced by identical immune cells.
[xi]http://pharmaceuticalcommerce.com/business_finance?articleid=27680
[xii]http://www.biopharma-reporter.com/Markets-Regulations/Sandoz-s-biosimilar-Zarxio-gradually-eroding-Amgen-s-Neupogen-sales
[xiii]http://www.biopharma-reporter.com/Markets-Regulations/Bigger-discounts-will-boost-biosimilar-prescribing-say-US-physicians?nocount
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Crop Biotech: A Wealth Creation Opportunity

In 1996, the application of biotechnology in agricultural production became a reality with the launch of genetically-modified (GM) crops. GM crops became an instant success, reflected in the fact that nearly 148 million hectares of GM crops were planted in 2010, a nearly 87-fold increase over the 1.7 million hectares planted in 1996. Although the use of GM crops has remained concentrated mostly in the US, nearly 29 countries used GM crops by 2010, including 19 developing countries. An impact assessment of GM crops indicates that GM crops have increased both crop yields and profitability. For example, since the commercialization of GM crops started in 1996, economic gains of $51.9 billion have been achieved (through 2008). 50.6% of these gains are accounted for via a reduction in production costs and 49.6% via substantial yield gains.[i] With the improvement in yields expected to fulfill 90% of crop demand growth by 2050, the success and growth of crop biotech is critical to achieving food security for future generations.

Crop biotech is highly concentrated field with only three companies – Dupont (DD: NYSE), Monsanto (MON: NYSE) and Syngenta (SYT: NYSE) – having rights to produce and distribute GM seeds. Crop biotech is also used extensively in crop protection (insecticides and pesticides). The top 6 crop biotech companies in the world control nearly 74% of the global crop protection market ($57 billion) and 62% of the global seed market ($40 billion), shown in Figures 1 and 2.

Figure 1: Market Share in Global Crop Protection Market                       Figure 2: Market Share in Global Seed Market
Agri Fig 1 and 2

With the proposed merger of Dupont (DD: NYSE) and Dow Chemical (DOW: US), which would create a crop biotech firm with a 25% share of the global seed and 16% share of the global crop protection markets, the crop biotech space is on track to become even more concentrated.

The strong market positions of these types of companies can be attributed to significant R&D investments made over the last 10 years. For example, over this period Monsanto (MON: NYSE) invested nearly 10% of its sales in R&D on a consistent basis, with its R&D investments totaling $13 billion over the same period (Figure 3).

Figure 3: Annual R&D Expenditure as % of Sales                           Figure 4: Crop Yields, Dec. 2015 (MT/Hectare)

Agri Fig 3 and 4

The success of the R&D efforts of crop biotech companies can be gauged by the fact that yields for corn and soybean in the US have remained nearly double that of China (Figure 4). It is also worth noting that the gap between yields for these two countries expanded significantly in the last 10 years, which can be attributed to the high level of penetration of GM seeds in the US. At present, more than 80% of corn and soybean in the US is produced through GM seeds.[i]

Due to their success and dominance, some crop biotech companies are now acquisition targets as the industry attempts to consolidate and create synergies. In addition to the proposed DuPont-Dow Chemical merger, which would create an entity with more than $100 billion in annual revenues, ChemChina has offered to buy Syngenta (SYT: NYSE) at a lofty valuation of 16.7x EBITDA, compared to the crop chemicals average of just 8.6x.

Due to the fundamentals of the space, crop biotech has become an interesting potential opportunity for investors. Ownership of critical technical know-how, which is pivotal to global food security, has remained with a few listed private corporations, and these companies, which may be attractive acquisition targets, could represent a lucrative investment proposition for investors.

How to Invest

While there are a number of funds available to investors interested in the Agriculture sector in general, the First Trust Indxx Global Agriculture Index ETF (FTAG: NASDAQ) is the only fund in market that provides suitable exposure to the crop biotech opportunity. As of January 31, 2016, the top five companies in crop biotech, including GM seeds and crop protection firms, have nearly a 41% weight in the fund. The ETF seeks to track the Indxx Global Agriculture Index (IGAI), a market capitalization weighted index designed to measure the performance of companies which are directly or indirectly engaged in improving agricultural yields. The index is comprised of farmland companies and firms involved in chemicals & fertilizers, seeds, irrigation equipment, and farm machinery.

For more information on the index, please visit http://www.indxx.com/globalagriculture.php

[i] http://www.ers.usda.gov/amber-waves/2014-march/adoption-of-genetically-engineered-crops-by-us-farmers-has-increased-steadily-for-over-15-years.aspx#.Vtbri_l97IV

 

 

 

 

 

 

[i] http://www.sciencedirect.com/science/article/pii/S1687157X11000266

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Natural Resources Dividend Companies: A Contrarian Investment Opportunity?

Over the last 3 years, there has been a general decline in the valuation levels of companies in the natural resources sector. This decline is reflected in the fact that the P/B (price/book) ratio for the S&P Global Natural Resources Index dropped from nearly 2x in 2009 to nearly 1x by the end of 2015. As the S&P Natural Resources Index has a history of less than 10 years, skeptics could argue that these low valuations may not be sufficiently low, as fundamentals have deteriorated significantly since 2010 due to the end of the last commodity boom cycle (2000-2011). Therefore, we will compare the present valuation levels of top natural resource companies with their levels during the last commodity bear cycle (1997-1999).

Figure 1: P/B Comparison for Top Natural Resources Companies: 1997-1999 vs. 2015

NR Fig 1

To make it a more conservative comparison, present valuation levels have been compared to the minimum levels achieved from 1997-1999 (Figure 1). One can observe that natural resource companies are trading at a significant discount (from 20%-70%) compared to their lowest valuation levels during the last bear cycle. For example, BHP Billiton (BHP: NYSE), Rio Tinto (RIO: NYSE) and Exxon Mobil (XOM: NYSE) are trading at discounts of 41%, 25% and 42%, respectively. This indicates that, in terms of valuation multiples, companies in the natural resources sector may currently be oversold.

Dividends: Adding Depth to the Value Proposition

To evaluate the potential opportunity offered by high dividend-yielding natural resource companies, we have examined the constituents of the Indxx Global Natural Resources Income Index (IGNRI). An analysis of valuation levels reveals that 19 of 30 companies in the index that are dedicated to the upstream energy and mining segment are trading below their book values. These sub-book value companies form between 40%-50% of the overall index weight. As a whole, this group of 30 companies is trading at an average P/B ratio of only 1.02x at present, compared to a 5-year average of 2.13x and a 10-year average of 2.55x. Moreover, 14 out of 30 companies actually increased their dividend payouts in 2015. In comparison, only two of these 30 companies made significant dividend cuts or abolished their dividend policy in 2015, despite a difficult operating environment.

Figure 2: Leverage Ratio for Top 10 Holdings

NR Fig 2.png

As shown in Figure 2, net debt to equity ratios for the top 10 holdings in the Indxx Global Natural Resources Income Index are well below 50% for 8 companies and below 75% for all 10 companies. Also, net debt to EBITDA ratios are below 1.5x for 8 companies, which indicates strong balance sheets and cash position for these companies even during this bear cycle. In fact, the top 3 holdings (accounting for nearly 30% of the weight of the index) are trading at market cap to cash ratios of less than 2x.

Investment Opportunity

Strong short-term cash flows, combined with dividend yields of nearly 7%-8% and strong fundamentals make a potential strong case for natural resource dividend-paying companies to be considered as a contrarian investment strategy. A product that could provide access to this opportunity for investors is the First Trust Indxx Global Natural Resource Income ETF (FTRI: NASDAQ), which tracks the Indxx Global Natural Resources Income Index (IGNRI). The Indxx Global Natural Resources Income Index is a 50-stock free float adjusted market capitalization weighted index designed to measure the market performance of the 50 highest dividend-yielding companies involved in the upstream segment of the natural resources sector. The index provides highly diversified exposure to global natural resources, including energy, materials, timber, water and agriculture, with screens for companies that have maintained consistent, growing dividend payments and profitability over the last 12-24 months.

As of December 31, 2015, the index has 48 constituents with a weighted average market capitalization of $42.24 billion and a trailing 12-month dividend yield of 7.24%.

For more information on the index and its methodology, please visit http://www.indxx.com/globalnatural.php

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India’s Generic Drug Manufacturers: Poised for Continued Growth

Over the last 10 years, the export prowess of India’s generic pharmaceutical industry has reshaped the global pharmaceutical business. Since the 1970s, helped by the abolition of patent protection rights, India’s pharmaceutical industry has been dominated by home-grown generic drugmakers. Once known as exporters of bulk APIs , Indian generic drugmakers have moved upwards on the global value chain and managed to gain a foothold in regulated markets such as the US and Europe. For example, in the US, Indian generic drugmakers account for 40% of generic and 10% of finished dosages by volume. Total sales for Indian generic drug companies grew from nearly $4 billion in 2004 to $17 billion in 2014 (an annualized growth rate of 16%), while foreign sales for Indian Companies grew even faster at 22% per year, from nearly $1.7 billion to $12 billion (Figure 1). This augurs well for Indian companies, which are also experiencing growth momentum in their domestic market.

fig1

Strong US Growth

fig2

Indian generic drugmakers have gained a significant to ehold in the US, with a dominant share in ANDA-drugiv approvals. In fact, Indian companies are second only to US-based companies in ANDA approvals, maintaining a total share of nearly 30%-40% on a consistent basis (Figure 2).

In addition, Indian firms have accounted for 20-25% of the first ANDA-approvals for a specific drug over the last few years, which may serve as evidence of their strong R&D capabilities. This is a key statistic, as first ANDA-approval is considered a major reward in the generic drug industry and comes with the exclusive right to sell the generic version of a drug for the first 180 days after patent expiry. With a current backlog of 3,000 pending ANDA applications and the FDA indicating its goal to clear 90% of these in the next 3 years, India’s generic players may see strong topline growth in the next few years.

 Investment in Research & Development

R&D is a major focus for Indian generic drug companies as they continue to move further up the value chain and become more competitive on a global basis. For the top Indian generic companies that publish their R&D investment numbers, total R&D investment expanded from 3.88% of sales in

fig3

2010 to more than 6% by 2015, while total R&D investment more than tripled from $252 million in 2010 to $833 million by 2015 (Figure 3). Considering that India’s currency depreciated by nearly 50% during this same period, the R&D growth numbers quoted are significantly understated.

India’s generic drug companies have also made significant headway in the manufacturing of APIs. A recent FDA report indicates that of the 3,652v facilities worldwide approved for the production of APIs (and finished dosages), India accounts for nearly 23.7% (the largest share outside the US) and is the largest exporter to the US (double the exports by China).

Strong Balance Sheets Could Lead to M&A Activity

fig4

Another key growth trigger is expected to come from the strong balance sheets of the largest Indian generic pharmaceutical companies, which should allow them to pursue inorganic growth through M&A. Over the last 15 years, the top US generic drug players such as Teva Pharmaceutical Industries (TEVA: NYSE), Mylan Inc. (MYL: NASDAQ) and Allergan (AGN: NYSE) have

grown in size on the strength of successful M&A, which indicates the importance of scale and size in the industry.

At the moment, top Indian Companies such as Lupin (LPC: NSEINDIA), Dr. Reddy’s Laboratories (DRRD: NSEINDIA) and Sun Pharmaceuticals (SUNP: NSEINDIA) have low debt-to-equity ratios (<15%) as well as low total-debt-to-EBITDA ratios (<1.25) (Figure 4). This indicates that they may be in strong positions to take on additional debt to merge with or acquire other firms in the industry, as well as service that debt going forward.

Growth through M&A is not something new for Indian companies. For example, over the last 5 years, Sun Pharmaceuticals (SUNP: NSEINDIA) has become one of the top 5 generic companies in the world, capitalizing on the acquisitions of Taro Pharmaceutical (an Israel-based pharmaceutical company) and former Indian generics leader Ranbaxy Laboratories.

Potential Headwinds

As Indian drugmakers are selling products in the US market, local manufacturing facilities have to follow manufacturing standards and quality controls set up by the US FDA, which can expose Indian drugmakers to high levels of regulatory risks. Ranbaxy Laboratories, one of the largest Indian generic companies a year ago, is a case in point. Despite having a strong ANDA pipeline, the company lost out on competition due to 3 FDA warning letters in 2008 and 2013 restricting their exports to the US. In the past 2 years, large Indian drugmakers such as Dr. Reddy’s Laboratories (DRRD: NSEINDIA), Sun Pharmaceuticals (SUNP: NSEINDIA) and Cipla (CIPLA: NSEINDIA) have received FDA warning letters for different facilities. Though Indian companies have asserted their commitment towards FDA compliance, these actions could lead to short-term investment losses for investors.

Conclusions

Backed by the success of Indian companies in tapping the US generic drug market, a largely underpenetrated but fast-growing local healthcare market and strong fundamentals, Indian generic drug firms may be a compelling investment case for investors.

Leveraging its extensive research into the space, Indxx has developed the Indxx Global Generics & New Pharma Index to provide access to the companies in this industry. The index includes exchange-listed companies, on a global basis, that derive a significant proportion of their revenues (or that have the potential to derive a significant proportion of their revenues) from the generic drug industry, or that have a primary business focus on the generic drug industry. The products of these companies are pharmaceuticals that are identical, or bioequivalent in the dosage form, safety, strength, quality and intended usage to brand name pharmaceuticals. As of December 31, 2015, the index included 83 securities of companies with a minimum market capitalization of $1 billion and a weighted average market capitalization of nearly $35 billion.

Indxx has licensed the index to noted New York-based asset manager and ETF sponsor Van Eck Associates Corporation for their exclusive use, and Van Eck has launched an ETF tracking the index – the Market Vectors Generic Drug ETF – under the symbol GNRX.


i API stands for Active Pharmaceutical Ingredient which is chemical molecule in the medicine that lends the medicine desired therapeutic impact
ii http://www.careratings.com/upload/NewsFiles/SplAnalysis/Patent%20Cliff%20in%20US%20-%20CARE%20Ratings%20report.pdf
iii It include 12 largest listed Indian Generic firms which are covered by Bloomberg Industries. These firms have bene considered as proxy for Indian Generic Pharma industry throughout the article. Fiscal year for Indian companies end at March every year which has been adjusted to make it comparable to US counterparts. For example, Annual sales declared as of March 2015 has been used a data for Fiscal year 2014.
iv ANDA stands for Abbreviated New Drug Application. This application is filed for approval of generic drugs.
vhttp://www.gmp-compliance.org/enews_03940_FDA-publishes-List-of-GMP-facilities-producing-for-the-US-market–generic-drug-products-and-APIs-.html
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Natural Resources: Dividends Makes the Difference

The recent global commodity slowdown has resulted in a challenging environment for the natural resources sector. From 2010-2015, the 25 largest natural resource companies generated an average total price return of -34%, with only two companies generating positive returns for investors. However, a closer look at the business models of natural resource companies indicates the futility of expecting significant price returns. The main reason for this is that these companies are fundamentally real estate companies, owning land and property with vast (and valuable) amounts of natural resources buried underneath. Therefore, the market value of these companies is critically dependent on the price of natural resources, which have failed to produce any meaningful returns over the last 30 years (gold and oil had compound annual growth rates of just 4% and 1.14%, respectively, from 1985-2015). As a result, these companies have largely mirrored these disappointing results.

Fig12

That said, natural resource companies may still represent a lucrative investment opportunity due to their income potential, which could be very appealing to some investors.

Dividends: A Silver Lining

Typically, natural resource companies sell their assets in the market and generate cash for shareholders. Whenever assets are sold in the market, a part of company is essentially divested and, as in case of a divestiture, results in cash payouts (after servicing debt obligations).

fig34

As shown in Figure 3, companies that have returned dividends worth more than 20% of a 2010 investment over the next five years have generated overall positive (or low negative) returns for investors, despite a sharp fall in natural resource prices. It is worth noting that the worst performing investments during this period were British Gas (BG: LSE) and PetroChina (857: HK), which returned just 6% and 17%, respectively. Exxon Mobil (XOM: NYSE) is an exception to this rule, which is largely explained by its superior price performance vs. its peers. However, even in the case of Exxon Mobil, dividends represent more than 75% of returns for investors over this time period.

In addition, valuations for natural resource companies look fairly attractive at the moment, with 6 of the top 10 companies in the world trading at a discount to their book values. Compared to 2010, nearly every company is trading at significant discount of 25%-50%. For example, the average Price to Book ratio for the top 10 companies is currently 1.09x, compared to 1.64x in 2010, and the group is trading at average discount of 32% vs. 2010. With their track record of returning cash to investors and current attractive valuations, now could be an attractive time for investors to enter the sector.

So, rather than being a simple proxy for commodities, natural resource companies may be better explained as firms that consistently distribute high levels of cash to investors every year. Companies that return higher cash as percentage of assets can not only generate higher new present value for investors, but also protect against commodity market uncertainty.  Therefore, a product focused exclusively on the highest dividend-yielding companies could capture the essence of natural resource investing.

Investment Opportunity

The Indxx Global Natural Resources Income Index (IGNRI) is a 50-stock free float adjusted market capitalization weighted index designed to measure the market performance of the 50 highest dividend yielding companies involved in the upstream segment of the natural resources sector. The index provides highly diversified exposure to global natural resources, including energy, materials, timber, water and agriculture, and also screens for companies that have maintained consistent, growing dividend payments and profitability over the last 12-24 months.

Since June 2006, the Index has returned 49% of an initial investment in terms of dividends, and also returned more than 3.5% of the initial investment each year (Figures 5 and 6). The impact of dividends is clearly visible when we compare the total return and price return versions of the index, in that the total return index generated an additional return of nearly 5% every year. In fact, from June 2006-December 2015, the total return index returned an annualized gain of 0.32%, vs. an annualized loss of 4.72% for the price return version of the index.

Fig56

On December 21, 2015, the First Trust Indxx Global Agriculture Index ETF (FTAG: NASDAQ) was launched, which tracks the Indxx Global Natural Resources Index (IGNRI). As of December 31, 2015, the index has 48 constituents with a weighted average market capitalization of $42.24 billion and a trailing 12-month dividend yield of 7.24%.

For more information on the index and its methodology, please visit http://www.indxx.com/globalnatural.php.

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Generic Drugs: Revolutionary Change in the Global Pharmaceutical Industry

Over the last few years, generic drugs – low-cost copies of branded drugs – have been gaining in volumei and market shareii. Typically priced at significant discounts (50%-70%) to their branded counterparts, health plans and governments around the world, which are dealing with rapidly increasing costs and aging populations, have actively encouraged and promoted their use. Today in the US, generic drugs account for 88% of all prescriptions filled and according to latest IMS report, generics may account for 91%-92% of prescription volumes by 2020.

According to a report by IMS Health, from 2013-2018 generic drugs are expected to account for 52% of global pharmaceutical spending growth, compared to 35% for branded drugs. Overall, sales of generic drugs are forecast to increase from $267 billion in 2013 to $442 billion in 2018, an annualized growth rate of 10.6%. Major factors driving this growth include popular branded drugs losing their patent protection (known as a “patent cliff”), support for generics from governments, new complex generics coming into the market, and industry consolidation.

Imaag11

The Patent Cliff: $200 Billion in Branded Drugs Sales, Now Open to Generics

Traditionally, pharmaceutical companies develop new branded drugs by investing huge amounts of money (often more than $1 billion) into research and development over 10-15 yearsiii. This is the amount of time and money required to not only develop a number of potential new drugs, but go through the long, expensive and arduous approval process required by the US Food and Drug Administration (FDA) to prove a drug is safe and effective, and then market the drug to consumers. Since this model is so expensive and time consuming, the FDA typically gives drug companies 12 years of patent protection and a total monopoly on sales during that period. This allows the drugs companies to recoup their costs, earn a profit, and start the process anew for the next wave of new and innovative drugs.

In contrast, generic drug companies operate very differently. The amount of money they need to invest to produce a generic is many orders of magnitude less than the traditional branded drug companies, since the drug has already been formulated and approved. In order to protect the traditional branded drug companies and allow them to earn back the amount of money invested, generic drugs can only be introduced after the 12 years of patent protection has expired. And even then, FDA-approved copies of branded drugs are only given a short 180-day exclusivity period if their generic is the first to market. Once generic drugs are introduced to the market, they are typically sold at steep discounts (50%-70%) compared to the branded alternative and, as a result, branded drugs typically lose 90% or more of their market share to generics in a short amount of time.

For example, Lipitor, an anti-cholesterol drug owned by Pfizer with annual sales of more than $10 billion, lost its patent protection in November 2011. Generic versions of the drug quickly entered the market and, by 2014, more than 97% of sales were from generic copies (Figure 2).

Image23

 

The patent cliff is a trend that is expected to continue. From 2011-2020, drugs with annual sales of $200 billion will be losing their patent protection (Figure 3).  This may lead not only to revenue losses for the traditional branded drug companies, but also the potential for significant new revenues for generic drug manufacturers. In fact, the patent cliff has generated enough financial resources and market clout for the generic manufacturers to help them transition from fringe players into what can be called the “New Big Pharma” industry, and move into new and exciting area and products.

Higher Complexity, Better Margins

Over the last few years, generic drug manufacturers have significantly increased their research & development spending as a percentage of their cash flows from operations (Figure 4). This is because they are starting to move into new, more complex products that will allow them to charge higher prices, boost their margins and protect themselves against the intense competition in the generic drug sector. Some of these new products are Biosimilars, Biobettersiv and SuperGenerics,v and will be powerful trends in the coming years.

R&amp;DCFO

 

Biosimilars are generic copies of a class of drugs called Biologics. However, Biologic drugs are much more complex than traditional branded drugs, not only in terms of their molecular structure but also in terms of their production (and are therefore much harder to copy). Biosimilars therefore require significantly more R&D investment and time to produce ($100 million-$200 million and 6 years) than typical generic drugs ($1 million-$5 million and 2 years).

In March 2015, Zarxio, a biosimilar to Amgen’s Neupogen, was the first biosimilar approved in the US, opening a nearly $67 billion opportunity (the annual global sales of biologics losing patent protection between now through 2019) up to generic drug manufacturers. In Europe, the same biosimilar took 66%vi of the overall market share within 5 years of its launch. In the nearly 7 years following the introduction of the first biosimilar, only 3 biosimilars are in the market, with each having a market share of more than 10%. These high barriers to entry allow generic drug players to earn much higher margins and increase their profitabilityvii.

Accessing the Generic Drug & New Big Pharma Opportunity

Due to the growth of the space, generic drug manufacturers are a compelling investment theme for investors. There are also a number of other trends in the industry, from aging populations and higher healthcare spending to mergers and acquisitions that could make it even more attractive. These will be discussed by our research team in the coming weeks and months.

As a result of our extensive research into the space, Indxx has developed the Indxx Global Generics & New Pharma Index to provide access to the companies in this industry. The index includes exchange-listed companies, on a global basis, that derive a significant proportion of their revenues (or that have the potential to derive a significant proportion of their revenues) from the generic drug industry, or that have a primary business focus on the generic drug industry. The products of these companies are pharmaceuticals that are identical, or bioequivalent in the dosage form, safety, strength, quality and intended usage to brand name pharmaceuticals. As of December 31, 2015, the Index included 83 securities of companies with a minimum market capitalization of $1 billion and a weighted average market capitalization of nearly $35 billion.

Indxx has licensed the index to noted New York-based asset manager and ETF sponsor Van Eck Associates Corporation for their exclusive use, and Van Eck has filed a notice to launch an ETF tracking the index under the symbol GNRX. The expected launch date is January 13, 2016.


i http://www.pharmacytimes.com/publications/issue/2012/april2012/generic-drug-trends-whats-next-
ii http://www.cubex.co.in/PDF/Global_Pharmaceutical_Market.pdf
iii http://www.scientificamerican.com/article/cost-to-develop-new-pharmaceutical-drug-now-exceeds-2-5b/
iv Biobetters are new molecules that are related to already-approved biologics, but are deliberately altered to improve their disposition, safety, efficacy, or manufacturing attributes. They offer patent period protection and exclusivity period privileges similar to new biologics.
v SuperGenerics differ from the original drug in terms of formulation or method of delivery. They are generally better in their potency or effectiveness compared to original drug. SuperGenerics get 3 years of market exclusivity.
vi https://www.ftc.gov/system/files/documents/public_events/Follow-On%20Biologics%20Workshop%3A%20Impact%20of%20Recent%20Legislative%20and%20Regulatory%20Naming%20Proposals%20on%20Competition/ramachandra.pdf
vi http://www.biorasi.com/wp-content/uploads/2015/03/bioRASI-Biosimilars-Presentation-04-12vw.pdf
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