Bayer AG (BAYRY)

Headquartered in Leverkusen, Germany, Bayer AG (BAY) is ranked as one of the world's largest healthcare and chemical corporations. Europe is the company's primary market, accounting for 44.3% of total sales for the year of 2007. The remaining revenue comes from North America (25.2%), Asia/Pacific (16.1%), and Latin America/Africa/Middle East (14.4%). The company operates in three major segments: Healthcare, accounting for 45.7% of total revenues in the year of 2007 CropScience (18.0%), and Material Science (32.2%) with the remaining 4.0% coming from other items. With the acquisition of Schering AG (its business and financials were incorporated into Bay Healthcare in 3Q06), we believe revenue from the healthcare segment will account for more of the total revenue going forward.

INVESTMENT THESIS

Bayer was doing fine in the second quarter

Bayer reported second quarter financial results on July 30, 2008. In the first second of 2008, total revenue came in at 8511 million, up 3.6% compared to 8217 million in the second qaurter of 2007. 2Q08 revenue revenue was higher than our estimate of 8286 million and the concensus estimate of 8346 million. The increase in net revenue was mainly due to volume incresae.

Much of the sales growth in the second quarter was from CropScience segment. Sales in CropScience segment increased by 15.5% to 804 million in 2Q08 from 1562 million in 2Q07, beating our estimate of 1601 million. Sales in healthcare segment increased only by 0.5% to 3734 million, below our estimate of 3840 million. Sales in MaterialScience was flat in 2Q08 with sales of 2622 million, beating our estimate of 2515 million. The low growth in Healthcare segment is a matter of convern to us. Since healthcare business is Bayer's major focus and accounts for about 46% of total revenue, stalled growth in this segment will have material impact on its top line growth going forward.

Gross profit was 4255 million in 2Q08, vs 4145 million in 1Q07. Gross margin was 50% in 2Q08 vs 50.4% in 2Q07. EBIT in 2Q08 was 1105 million, vs 917 million in 2Q07, up 21%. EBITDA before special items was 1896 million in 2Q08 vs 1806 million in 2Q07, up 5%. EBITDA margin before special items was 22.3% in 2Q08, slightly higer than 22% in 2Q07. Adjusted core net income (excluding discontinued operations and one time charges) was 971 million in 2Q08 vs 847 million in 2Q07. Adjusted core EPS for the second quarter of 2008 was 1.18 compared to 1.03 in the second quarter of 2007, beating concensus estimate of 1.10.

Bayer had cash and cash equivalents of 2058 million at the end of 2Q08. Net cash provided by operating activities excluding discontinued operations was 889 million in 2Q08 vs 816 million in 2Q07. Net debt stood at 8925 million at the end of second quarter.

Slowdown in healthcare business a matter of concern

The Healthcare segment researches, develops, manufactures and markets products for the prevention, diagnosis and treatment of diseases. The segment's goals are to improve the health of people and animals. The company has steadily shifted the balance of its porfolio of products towards the HealthCare segment in the last five years. As a result of this strategy, Bayer acquired Schering AG in 2006, a pharmaceutical company based in Germany. Bayer remains focussed on re-balancing its portfolio as it aims to incorporate a certain degree of flexibility in the rapidly changing business environment.

Growth in the healhcare sector apparently slowed since in the third quarter of 2007 with a growth rate of 5.7% for 3Q07 and 0.5% for 4Q07 respectively. Apparently, this slowdown in growth was partly due to the icreased size of the business after the Schering AG acquisition completed in 3Q06. In 1Q08, sales from helthcare segment reached $3.7 billion, up 3.4% from $3.6 billion in 1Q07, but was still in the lower sigle digit growth. In 2Q08, sales from heathcare were 3734 million, only up 0.5% year over year compared to 3717 million in 2Q07. This creates great concern for us since healthcare business is currently Bayer's major focus and should be the key growth driver in the future. Revenue from Healthcare segment accounted for 45.7% of total revenue in 2007. Recent two pieces of news further cast negative impact on the growth of Bayer's healthcare business.

In Feb 2008, Bayer and its partner Onyx Phamraceutical company announced early termination of a phase III ESCAPE trial of Nexavar for non-small lung cancer following a planned interim analysis. The independent Data Monitoring Committee (DMC) concluded that the study would not meet its primary endpoint of improved overall survival. The phase III ESCAPE trial evaluated Nexavar when administered in combination with the chemotherapeutic agents carboplatin and paclitaxel in patients with non-small cell lung cancer (NSCLC). Safety events were generally consistent with those previously reported. However, higher mortality was observed in the subset of patients with squamous cell carcinoma of the lung treated with Nexavar and carboplatin and paclitaxel versus those treated with carboplatin and paclitaxel alone. The companies will further review the findings of this analysis and DMC recommendation to determine what, if any, impact they have on other ongoing Nexavar lung cancer trials. Bayer and Onyx have multiple clinical trials for NSCLC, but ESCAPE is the most advanced. The failure of ESCAPE cast great shadow on other lung cancer programs. Although the program is not totally dead, the success rate is very low in our view. Nexavar (already approved for kidney cancer and liver cancer) is a lead cancer drug for Bayer and is one of the key growth drivers for its cancer franchise. Without the lung cancer and melanoma (also failed) indications, Nexavar's potential is reduced greatly.

To make things worse, in March 2008, the US court ruled that the patent on Bayer's birth-control pill Yasmin was invalid because the product was obvious. The patent ruling could also affect Bayer's Yaz, which is a low-dose version of Yasmin, although Bayer claims to have the exclusive distribution to Yaz until March of next year. Yasmin is one of Bayer's best selling drugs with total sales of about $500 million in the US in 2007. Watson Pharmaceuticals Inc and Sandoz USA already submitted ANDA on Yasmin with the US FDA. If approved for marketing, these generic Yasmin products will greatly reduce Bayer's branded Yasmin sales.

We believe sales growth in the healthcare segment will slow down in 2008. We lowered our estimate to 15.2 billion in 2008 (previous 16.5 billion), vs 14.8 billion in 2007 with a 2.8% growth rate in 2008 and 6.5% in 2009 when new drug candidates enter into the market. This healthcare group includes the subgroups Pharmaceuticals (31.7% of total revenues, and 69.3% of Healthcare), and Consumer Health (14% of total revenue, and 31% of Healthcare).

The Pharmaceuticals subgroup got a major boost since its acquisition of Schering AG in 2006. As a reminder, Bayer outbid Merck KGaA for Schering AG in March 2006. The acquisition was completed in December 2006. The acquired business of Schering AG was included in the Pharmaceuticals segment on June 23, 2007. The combined business has a leading position in key therapeutics categories like gynecology, hematology, multiple sclerosis, and oncology. Its best-selling drugs are Betaferon /Betaseron (for treatment of Multiple Sclerosis from Schering), Yasmin (a female oral contraceptive from Schering), Kogenate (for the treatment of hemophilia), Adalat (for the treatment of hypertension), Ciprobay /Cipro (for urinary tract infections), Avelox /Avalox (a prescription oral antibiotic), Magnevisit (used for enhancing the contrast on MRI's from Schering), Levitra (for erectile dysfunction) and Nexavar for cancer. The company has the largest research spending relative to any pharma and chemical companies in Germany, and to boost profits in this segment, Bayer plans to broaden its R&D focus to cardiovascular risk management, diabetes, and oncology areas. As part of this refocusing, the company also plans consolidate some of its R&D plants, which will result in workforce reduction in Germany and the U.S., thereby helping Bayer cope with high costs and rigid labor laws. The acquisition of Schering AG will also enhance the sales and marketing operations of the company. Management expects this acquisition to be accretive to earnings by 2008 and is likely to generate positive cash flow by 2009. Moreover, the company divested the Diagonistics division to Siemens AG and is planning on phasing out its plasma business, which will enable Bayer to concentrate on pharmaceuticals for both humans and animals. We expect Bayer to ramp up its integration efforts with Schering, and to realize cost-savings from 2008 and beyond.

Sales from pharmaceuticals in 2Q08 reached 2584 million, matched those of 2Q07. The main growth dirvers were the Yasmin product family along with Nexavar, Mirena and Aspirin Cardio, offset by decline in Cipro, Magnevist, Diane and Kogenate. In 2Q08, Yasmin sales rose by 22% to 305 million Nexavar sales rose by 80% to 108 millon. Cipro sales declined by 17% to 77 million Magnevist slaes declined by 20% to 59 million. Underlying EBITDA (EBITDA before special items) reached 744 million, up 4.6%. This was mainly due to the gratifying business and synergies already realized.

Recent trail data on Rivaroxaban opens up revenue potential for the company in the coming years. The company has submitted a regulatory filing to the European Agency for the Evaluation of Medicinal Products (EMEA) at the end of October 2007 for approval to market Rivaroxaban in the EU for the prevention of venous thromboembolism (VTE) in patients undergoing major orthopaedic surgery of the lower limbs. Upon regulatory approval, Rivaroxaban will be commercialized in Europe by Bayer Schering Pharma. A filing for rivaroxaban for a similar indication in the United States is planned in 3Q08, where upon approval, it will be commercialized by Scios Inc. and Ortho-McNeil, Inc., both of which are wholly-owned subsidiaries of Johnson & Johnson.

The Consumer Health subgroup is comprised of Bayer's Over the Counter (OTC) drug business for humans and animals, and apart from its line of Bayer Aspirin, Bayer s best-known brands include Alka-Seltzer and One-A-Day vitamins. In addition, Bayer s competitive position is likely to improve further with the positive impact of the acquisition of Roche s consumer health business. Sales of products acquired through this transaction such as Bepanthen /Bepanthol , Rennie and Supradyn continues to show improving performance. This acquisition not only increases sales potential of the OTC business, but also positioned Bayer among the world's top three leading suppliers of consumer health medicines.

Revenue from the consumer health division was 1150 million in 2Q08, up 1.4% compared with 1134 million in 2Q07. The best selling comsumer health products are Contour ( 145 million, diabetes care), Aspirin ( 105 million, consumer care), Advantage product line ( 100 million, amimal care) and Aleve ( 57 million, consumer care). Underlying EBITDA was 250 million in 2Q08 compared to 258 million in 2Q07. Underlying EBIT dropped to 179 million in 2Q08 compared to 224 million in 2Q07.

On March 11, 2008, Bayer HealthCare announced that its Consumer Care Division signed an agreement with US-based Sagmel, Inc. to acquire their over-the-counter (OTC) brand portfolio and related assets. Sagmel, Inc. operates this business in the Commonwealth of Independent States (CIS), including Russia, Belarus, Ukraine and Kazakhstan and other countries in the region and has developed a strong market position. The companies have agreed not to disclose the financial terms of the transaction. The transaction was closed in early June 2008.

The Sagmel portfolio, which delivered net sales of approximately EUR 80 million in 2007, includes Theraflex, a Glucosamine/Chondroitin supplement for the treatment of osteoarthritis and other joint/bone conditions, Nazol, a decongestant, the hemorrhoid treatment Relief, and nutritional brands Calcemin, Theravit and Jungle. This acquisition will now allow Bayer to play an even more active role in the OTC arena in the CIS. Increased marketing and selling investments will not only strengthen the acquired brands, but will also have a positive impact on Bayer's existing OTC portfolio.

Beginning June 3rd, the Sagmel OTC business will become part of Bayer HealthCare in Russia, the Ukraine, Kazakhstan, the Baltic's and several Caucasian and central Asian countries. The transaction will place Bayer among the top 5 OTC companies in the Commonwealth of Independent States (CIS).

Bayer continues to strength its OTC business in emerging market. On July 2, 2008, Bayer completed the acquisition of the Western over-the-counter (OTC) cough and cold portfolio of Topsun Science and Technology. Bayer paid Topsun RMB 1,072 million (approximately EUR 100 million) plus contingent payments of RMB 192 million (approximately EUR 18 million) subject to fulfillment of certain performance criteria. This acquisition substantially increases Bayer Consumer Care's presence in China, one of the fastest growing OTC markets in the world.

The CropScience business will grow nicely in 2008 and beyond

The CropScience segment is one of the world's leading crop-science companies in the area of crop protection, non agricultural pest-control, seeds and plant biotechnology. It develops and markets chemical crop protection products (insecticides, herbicides, and fungicides), seeds, and integrated plant biotechnology solutions for agricultural and non-agricultural uses. CropScience operates through two divisions: crop protection and environmental science/BioScience. The company intends to launch ten new active ingredients between 2006 and 2011, and expects an improvement in underlying margins of the CropScience division, backed by cost reductions.

CropScience business was pretty stable in 2007 with net sales of 5826 million, up 2.2% year over year. Quarterly growth was 0.8%, -1%, 10.3%, and 1.5% respectively. In the third quarter of 2007 increased cultivation of plants for the production of biofuels and internationally high prices for crop commodities, particularly in the Seed Treatment, Herbicides and Fungicides business units, led to the growth in this business.

In 2Q08, revenue from CropScience segment came in at 1,804 million, up 15.5% from 1,562 million in the same period of 2007. Revenue growth was driven by higher volume increases and selling price increase. High price were mainly due to lower inventories worldwide and strong demand for plants as an alternative energy source. EBITDA before special items came in at 501 million in 2Q08, up 26.5% from 396 million in 2Q07. EBIT before special items rose by 43.1% to 375 million in 2Q08, versus 262 million in 2Q07. The significant earning improvement was due particularly to the growth in business, selling price increases and cost savings, which more than offset the negative currency effects.

Revenue from crop protection division was 1526 million in 2Q08, up 20.9%. Sales of all business units rose significantly in a positive market environment. Growth was driven mainly by the company's young products based on active ingredients that have been introduced to core markets since 2000. Sales of these products advanced by 50% year on year to more than 500 million.

Revenue from environmental and bioscience division was 278 million in 2Q08, down 7.3% from 300 million in 2Q07.

Best selling products in the segment are Confidor/Gaucho/Admire/Merit (insecticides/seed treatment/environmental science), Poncho (seed treatment), Policur/Raxil (fungicides/seed treatment), Decis/K-Othrine (insecticides), Basta/Liberty (herbicides), and Atlantis (herbicides).

We believe Bayer will continue to benefit from current global agricultural market environment. We estimate revenue from the CropScience segment will grow by 10.8% to 6453 million in 2008 and growth will decline to 2.8% in 2009.

The Material Science business will suffer due to economic slowdown in the US

The Material Science segment is one of the world's largest polymer manufacturers. Its main fields of activity are the production of high-tech polymer materials and the development of solutions for products used in many areas of everyday life. The main consumer sectors are the automotive, electrical/electronics, construction, sports and leisure industries. This segment consists of two units: Materials and Systems. The materials unit includes polycarbonates, thermoplastic polyurethanes, Wollf Walsrode (a world leader in cellulose products), and H.C. Starck (a manufacturer of metallic and ceramic powders) whereas the systems unit contains polyurethanes, coatings, and inorganic basic chemicals. Although the H.C Stark and Wolff Walsrode businesses are profitable, management announced plans to divest these two businesses in March 2007 to help finance its acquisition of Schering AG and concentrate on its other business lines. As a result, Bayer completed the sale of HC Stark to Advent International and the Carlyle Group for 1.2 billion in Feb 2007 and sold Wolff Walsrode to Dow Chemical for 540 million in July 2007.

Net sales for Material Science segment in 2Q08 came in at 2,622 million, compared to 2,623 million in 2Q07. Sales in North American were down 10.6% due to the slowdown in the US economy especially in the house marke which was offset by strong growth in Asia-Pacific/Latin America/Middle East region. Sales in Europe stayed steady. EBITDA before speical items was 372 million, lower than the previous year's level of 409 million. EBIT before special items was 253 million, down 12.8% year over year.

Sales from System division were 1935 million, up 3.7%. Sales from Materials division were 687 million, down 9.2% year over year.

Gworth in this sector had been declining since 2005 with growth rate of 9.9% for 2005, 7.6% for 2006, and 2.7% in 2007. In 2007, quarterly growth was 4.9% for Q1, 3.0% for Q2, 1.1% for Q3, and 1.9% for Q4. We estimate growth will further decline by 2.7% in 2008 and will stablize thereafter.

Bayer's success is predomiantly dependent on its diverse product portfolio, global presence, and strong market position. Apart from this, Bayer has been also benefitting from strict cost-cutting measures and is being able to offset the cyclical downturn in the industry. We expect the company to continue its strength in Healthcare. We also believe the problems with the CropScience division should dissipate in 2008 as the cost-saving measures have started to take effect. The company plans to grow slightly faster than the market and improve its sales and underlying EBITDA along with a slight increase in the underlying EBITDA margin in excess of 22% in 2009. In HealthCare business, the company is targeting a growth at or above market rate on a currency adjusted basis. The underlying EBITDA margin is expected to improve to 27% in 2008. In CropScience, the company is expected to grow sales by 5% on a currency adjusted basis and improve underlying EBITDA margin to greater than 23%. In MaterialScience, we expect the solid revenue growth to help alleviate the raw material costs and we believe that the division can generate value by earning a premium over capital and asset replacement costs. In all, we believe the company will continue to improve its revenues and earnings but at a declining rate. The growth at a declining rate in healthcare business has a great impact on the company's top line and bottom line since healthcare business has played and will continue to play more important role for Bayer's development.

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