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A growth stock for value investors

CSL is often ridiculed for having one of the highest valuations in healthcare. Is it worth paying up?

I’ve found the perfect stock for you. It’s in healthcare and its market cap is a bit over $1.0bn. Revenue was up 9% this year, but profits rose 21% thanks to operating leverage. The company has some competitive advantages and a decent return on equity of 10%. The only catch is that this stock has a price-earnings ratio of 30. Does that seem steep to you? A deal breaker, even?

Let’s say you have perfect foresight and know that earnings will grow at 22% a year for the next 20 years. You also know that the price-earnings ratio will be 36 at the end of that period. The question is: assuming you want a ‘normal’ 10% return on your investment, what earnings multiple would be fair to pay at the outset? 

If you’re like most level-headed investors, you baulk at stocks with high price-earnings ratios. The average stock in the S&P/ASX All Ordinaries has a price-earnings ratio of 16, so anything above 20 starts to look pricey. Investors willing to pay 30 for something look cocksure; above 40 looks downright insane.

Yet for our mystery stock above, you could pay 280 times earnings and still get your desired return – yes, three digits. As you may have guessed, the company is plasma therapy maker CSL, only the statistics are from its 1998 annual report. Profits have grown 53-fold since then, a 22% annual return.

Source: InvestSMART

Most investors understand that growth is valuable, but they often underestimate just how valuable it is.

To illustrate, the Table 1 shows the return you will get at different starting price-earnings ratios if earnings grow at 20% a year over 10 years, and you believe the stock will be worth 20 times earnings at the end of that period. As you can see, even seemingly high price-earnings ratios can still produce a good return if earnings are growing strongly.

Reinvested capital

CSL currently has a forward price-earnings ratio of 36 based on management forecasts for 2018 earnings. On the face of it, that seems steep – it’s higher than almost any other healthcare stock – but let’s run a few more numbers. 

Though CSL’s intrinsic value can’t be precisely calculated, one factor carries most of the weight: how well management reinvests profits. 

Management expects around US$1.6bn in net profit for 2018, so, when you buy CSL, you get around $4.75 of earnings per share at today’s exchange rate. The company pays roughly $1.75 a share in dividends, leaving $3.00 a share to be reinvested.

Historically, management has favoured share buybacks. Over the last five years, CSL has earned US$6.4bn in cumulative profits. It paid dividends of US$2.7bn and used US$3.6bn to buy back stock, with the remainder reinvested in operations. In other words, 42% of CSL’s earnings went to dividends and 56% went to stock buy backs over the last five years.

The next five, however, are likely to be very different. CSL has several large clinical trials in the works and is investing heavily in infrastructure to boost capacity. CSL also recently entered the Chinese market, where there's a growing gap between supply and demand for antibody therapies (see CSL takes on China). The company is the first of the big three plasma therapy makers to have Chinese operations, giving CSL a huge advantage over its competitors in the second-largest and fastest-growing market in the world. Management has been tight-lipped about its plans, but we expect significant investment in the region over the next few years.  

Management expects capital expenditure over the next couple of years to be around US$1bn a year, before it starts to tail off again. As such, free cash flow will only amount to around $500m, nearly half what it was in 2013.  

More efficient

What this means for shareholders is that less money will wind up in their pockets and returns will mainly come from how much growth the reinvested profits deliver.

While that’s a more speculative equation, we don’t worry about CSL retaining more earnings than before. The executive team has a great track record at capital management.

Operating leverage and economies of scale have made CSL a far more efficient business than it was 20 years ago. Margins have improved dramatically, with CSL’s earnings before interest and tax (EBIT) margin rising from 15% in 1998 to 30% today.

What's more, net profit has grown nearly 60% over the past five years, while shareholder equity has only risen 10%. The company’s return on invested capital has risen from 12% in 1998 to 34% in 2017. And as far as icing goes, the company has repurchased nearly a quarter of its stock over the past eight years at an average share price of $49.

If a company switches from paying out most of its earnings to retaining them, you want to make sure it has a decent ‘moat’ – a sustainable competitive advantage to protect its profitability and invested capital. 

Here, you can rest easy – CSL is a fortress. The antibody industry is a tight oligopoly and CSL is the largest player, with around 34% of the global market. Many of the company's life-saving plasma therapies have few, if any, viable substitutes, so it has significant pricing power against private health insurers. The company has the largest research budget among its peers and CSL is also the lowest-cost producer, so has a profit margin of 22%, compared to Baxalta’s 16% and Grifols’ 13%. You can see why we regard CSL as one of Australia's 10 best businesses. 

Today’s outlook

We started this article with a table showing you how much you can pay for a stock if it is growing at 20% a year. But the table is misleading. You can never know with certainty how much a stock’s earnings will grow, and the number of companies that can grow at 20% over the next 10 years is very, very small. For rapidly growing companies, it’s next to impossible to value them by forecasting earnings. 

Source: InvestSMART

The better way to think about it is to use the current market’s valuation as a starting point, and then consider a range of assumptions, as in Table 2, and what returns those assumptions would deliver. It’s a subtle difference, but it’s a reminder that there’s a wide range of outcomes – your job as an investor is to see whether you like most of those outcomes and, more importantly, can handle the worst of them. 

In hindsight, it’s easy to see that CSL was worth a price-earnings ratio of 280 in 1998, but investors at the time were still right to be cautious. A lot of things had to go right to get CSL where it is today – a single management mishap, product recall, or regulatory change could have put the company on a wildly different trajectory. 

Nonetheless, CSL earned US$1.1bn in net profit for the six months to December – more than the company’s entire market cap in 1998. What’s more, profits are up 31% compared to last year so this 100-year-old stalwart is still growing at breakneck speed.  

We don’t know whether CSL will be able to grow at 20%-plus for another ten years. However, the market for CSL’s main products is growing in the high single digits. If the company continues to increase its operating efficiency and buys back stock with free cash flow, then earnings growth between 10% and 20% seems likely. 

This isn’t an article suggesting you run out and buy CSL; there are plenty of risks we haven’t touched on. Our point is that you shouldn’t be scared out of owning CSL or any other stock merely because it has a seemingly high price-earnings ratio – the best investments frequently do. HOLD

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