I instantly liked the company’s fundamentals, and its foreign ‘hidden’ character. It seems to fly very much under the radar when international investors are concerned. I generally believe this to be a real advantage and can be a strong investor’s edge.
Looking at the company more closely, I liked the vertically integrated business model. But I had to be careful, since I bought into a competitor some years ago. And that investment turned out …
… well, the trade was not profitable so far. Thus, it is my utmost desire not to repeat this.
This is not investment advice. Please read the disclaimer.
I do currently own shares (economic interest) in mentioned companies.
Where is the Idea From ?
I got to know about the company during a very pleasant call with Stephan Howaldt (Howaldt & Co. Wertanlagen Fund based in Germany), in October. During our call, we shared some of our investment ideas. I shortly introduced some of my investments, including Check Point, SES and Oriental Watch, if I remember correctly. We both came to the conclusion that our value investing philosophies are quite similar. He also introduced some of his investment ideas to me. I just loved the below characteristics he mentioned about one of his investment opportunities …
(I started writing this analysis on Nov 10th.)
- the company has a small share of international shareholders
- it is very profitable
- it operates a vertically integrated business model
- though, state-related institutions are involved via a stake in the company
So I took a quick look at the company’s fundamentals and really liked them. This company is very profitable and highly cash generative while growing.
Some Quick Facts
Krka is one of the world’s leading generic pharmaceuticals. Its medicines are used to treat more than 45 million patients every day in over 70 markets. It has over 12,000 employees. Its history is going back as far as 1954 when Krka Pharmaceutical Laboratory was established. Krka d.d. is headquartered in Novo Mesto.
The shares traded at a low 10x P/E and offer a 5% dividend yield, based on 2019 numbers. Trading the shares is actually not that easy, which may well be a reason for the low valuation and may give me and you the desired investor’s edge.
Krka’s financial KPIs are very promising.
Insights
Because the below quote from Pat Dorsey contains much truth I will try to reduce this company analysis to the essentials. Thus I will not describe (copy and paste) all the company’s characterics in much detail, but focus a bit more on my conclusions instead.
»Insight makes money […]. Information costs money.« – Pat Dorsey
Par Dorsey, at Texas Lutheran
Generic pharmaceuticals is a tough business and can be compared to a commodity business where the lowest price producer takes market share and usually wins. Afterall, the main reason why generics exist is to lower prices of prescriptions (i.e. after patents expire) to the benefit of consumers (and public health insurers).
Generics isn’t easy. The industry has its issues.
I bought Teva a few years ago.
So where is the moat? That is the most critical question when considering investing in a generics producer. When I bought Teva shares — before starting my blog and performing more serious analysis before buying — my line of thinking was the worlds growing population is in need of cheap medicines and Teva is the biggest producer. Size by itself is clearly not a moat in this industry (or most others)!
Krka offers high-quality generics at accessible prices (nothing special so far, though quality is a necessity). But, Krka has a recognisable name in many parts of the world which can be an important advantage (consumer trust). Its strategy focus on research and development offers (competitive) advatages in the long-run. But the single most important differentiator is probably the following fact.
Krka produces its own ingredients. Many pharmaceutical companies source their ‘active ingredients’ from Asian countries, which can result in supply-chain or quality issues.
»Our generic pharmaceuticals are based on our own innovative procedures for synthesising or isolating active pharmaceutical ingredients and our own innovative pharmaceutical formulations. Today, we have over 350 patent protected innovations for which numerous patents have been issued in various European, American and Asian countries.« – generic-pharmaceuticals
Moats can be extremely valuable (read more about moats here), if companies are able to invest further capital at high incremental returns on investment. This seems to be possible for Krka, since they can invest in further production capacity and research facilities within its integrated business. Such investments not only enable the company to sell more products, resulting in higher revenues and profits in the long-run, but these invesmtents can further strengthen Krka’s moat producing in time what is needed.
Strategy
Its financial strategy includes to grow sales at 5% p.a. or more until 2024 while achieving Ebitda margins between 21% and 25% and investing 10% of sales in R&D. 50% of profits shall be distributed via dividends. These financial goals are embedded between various reasonable qualitative goals, like focussing on quality and increasing automation within all processes.
Revenues
Revenues are generated primarily by prescription pharmaceuticals (84%, thereof 56% cardiovascular) and non-prescriptions products (9%). Other activities (7.5%) are animal health products and health resorts and touristic services. Most important markets are within East Europe, but Western Europe and other international markets become more important.
Russia, Poland and Germany responsible for prescription pharmaceuticals sales with Scandinavian countries delivering highest relative growth. Russia is a key market and introduces some foreign exchange risk, with some local production it should be managable.
Not being reliant on one blockbuster product’s revenue stream mitigates a key risk for pharmaceutical companies. The most revenue (170m) was generated from products with the active ingredient of VALSACOR in 2019 (AR 2019, p101), equal to 11% of total revenue. Though, most revenues are generated from cardiovascular meds.
New products account for a third of sales, defined as launched within last five years. Krka is successful in launching new products ahead of competition due to its integrated business model.
In the past 10 years, we placed more than 40 new products on the market as the first generic pharmaceutical company.
2019 annual report, p. 102
Key financials
Krka has a fortress balance sheet. As of Dec 2019: Total assets of € 2,184m consist mostly of PP&E (862m) and intangibles (109m) as well as current assets (1,142m), thereof cash and cash equivalents: € 218m. Total equity of € 1,667m makes for an equity ratio of 76%. Total liabilitites (517m) mostly consist of provisions (120m, mostly post-employment benefits), trade payables (138m), contract liabilities (123m) and some leasing liabilities (12m), but no financial debt.
The company calculates its own net-debt metric including trade payables, again a conservative approach as with handling R&D expanses (no capitalization).
Krka just brought home the best business performance in its 65 year history as we can read in its 2019 annual report. All key financial indicators show a nice development for the last fice years.
The last nine months continued the above financial trends. On Nov 19th, Krka released stellar 9m results for nine months ending Sept 2020. It was astounding to watch the non-existent news-flow.
- I quickly increased my limit buy price to PLN 380 (€ 85) and got my shares at WSE.
- This initial buy was based on a preliminary base case indicating a strong undervaluation.
- Krka had cash of € 265m on its balance sheet and is free of financial debt.
Revenue and growth
Revenue growth was very solid for recent years. Total revenue growth (reported) was 6.4% p.a. from 2015 to 2019 and comes in at 8.3% from 2016 to 2019. YTD sales grew 6.4% including Q2 with -11%, indicating that current underlying growth is much stronger. Sales grew with 22.3% and 8.2% in Q1 and Q3 respectively. The 5% target could turn out as too conservative.
To turn Krka into one of my high-conviction investments, I will need to do a lot more research on its products and markets. I will do this indsutry specific research in a follow-up post on Krka.
Profitability and margins
Krka’s profitablity is very strong. The company is highly profitable, earning an average Ebitda margin of 24.3% during the last five years. It even reached 25.8% in 2019 and ’18, and 33% for the last nine months ending Sept ’20. These are high margins, way above their long-term target of (strategy). If these elevated margins can be earned (defended) in the future needs to be verified (in my follow-up).
Margins are usually lower in Q3, underscoring the strength of Krka’s recent Q3 results (seasonality is another one for my follow-up).
The generics industry features strong similarities of a commodity business, meaning the supplier with the cheapest offer/product wins market share (increases volume). This setting poses the risk of eroding profit margins. Krka’s integrated business model and its strategy to sell branded generics might enable Krka to sustain its high margins. (a quote from Bruce Greenwald about the pet and capacity decision comes to mind)
Krka’s cost structure is rather efficient and supported by relatively low wages. I like that general and admin only accounts for ~10% of gross profit, indicating a business without a bloated HQ and overhead costs (realtively low wages locally).
Investments are an important factor for Krka’s growth strategy and its long-term competitiveness. CapEx is needed to upgrade equipment and expand production as well as research capacity. Crucial research and development or R&D expenses are not capitalised (2020 H1, p13) but drive future business. This is a conservative accounting approach that I like.
Income taxes are usually significantly below the theoretical 19% tax rate due to tax incentives for R&D expenses and investments. Krka payed an effective tax rate of 14.1% only in the last two years. For nine months ending September, Krka payed an effective 16% tax rate, due to lower investments (and tax incentives) during the pandemic. The Slovenian corporate tax rate of 19% is low when compared to other European or global countries.
Assumptions
For now, I assume Krka’s financials to play out roughly as communicated in its strategy in the mid-term. Recent financial KPIs look much better and provide confidence that, at least near-term financial results could come out way above communicated targets. This is the foundation for my preliminary base case.
However, longer-term assumptions have to be verified in my follow-up post. Below are my valuation assumptions, resulting in a fair value estimate indicating a strong undervaluation with a sufficient probability in this early research stage.
Valuation inputs
The terminal growth rate is assumed to be 3%, which should be achievable keeping a growing and older population in mind (and currently seems conservative).
A discount rate of 10% seems conservative enough for me, despite taking into account the domicile in Slovenia. Within my general risk framework, the company has a rather low overall risk. It is non-cyclical and margins should be rahter stable, even facing a cyclical downturn or specific problems in single key-markets. Financial leverage is non-existent. In an an extreme case, obsolescence could be the sad fate for individual products. But, since there are no blockbuster products, obsolescence risk for the whole business is rather non-existent, though it might exist for its cardiovascular products (56% of prescription pharmaceuticals). The single most important risk might be the (perceived) political risk and general generics industry factors as commoditization, regulation and politics.
I demand a margin of safety of 30% based on a preliminary score of 82% for overall quality.
Key drivers and inputs
Growth is assumed to align with an annual rate of 5% in 2023 and 2024 as stated in their development strategy. My modeled revenue for FY 2020 of € 1,583m implies yoy growth of 5% in Q4. For the next two years I currently assume slightly higher growth rates of 7% and 6% in ’21 and ’22. Long-term FCFF growth of 3% is assumed in 2025 and afterwards and may well turn out to be too conservative.
Ebitda margins were above 30% in each of the last three quarters and above 25% in the last reported financial year 2019 (including Q3 with 19.6%). YTD, Krka earned total Ebitda of FY 2019. Krka expects an average Ebitda margin of between 21% and 25%. I am rahter confident, at least in the near term, that Krka will earn margins above their average targets.
For now, I will model an Ebitda margin of 31% for FY 2020, implying Ebitda of € 106m in Q4 (after 111 in Q2 and Q3). Further, I assume 28% in ’21, 25% (’22), 24% (’23) and stabilizing at the target range (21%-25%, strategy) midpoint of 23% in 2024.
CapEx should not be considerably higher than depreciation, since Krka has invested significantly in its production and research facilities in recent years. Longer-term, increasing sales volumes and productions capacity could require slightly positve net investments (depreciation & amortization minus net capex). For this preliminary base case, I will assume zero net investments, or D&A equals net capex. In FY 2020, capex for PPE is depressed due to the pandemic. (Leases are not a big issue here)
Working capital could have a slightly negative effect within the growth trajectory. I assume a € 10m charge in 2020 and 2021.
Income tax rate is assumed to be 16% until 2022 due to tax incentives for R&D activities and investments. Thereafter, the current official tax rate of 19% is assumed.
Valuation results
My fair value estimate per share comes in at € 123. Again, this represents my current preliminary base case. Preliminary, since I identified several topics I need to analyse in more detail. Despite this, I initiated a starter position as written above (9m release).
Sensitivities with regard to my valuation inputs are moderate due to a high spread of 7%-points between long-term growth (3%) and my used discount rate (10%).
Wrap-up
I like Krka for its defensive business model and its strong results. Further, its strategy seems to be set for long-term value creation. My current base case indicates an undervaluation, though at todays prices (€ 89) the discount (27%) to my fair value estimate is not high enough with my buy price calculated as € 86. Yet, I believe my valuation to be rather conservative and chances are skewed to the upside (follow-up).
Specific catalysts are just not on the horizon, I believe. In the long-term, international investors might ‘discover’ the stock and being enabled to trade the stock at Ljubljana exchange more easily. In the meantime shareholders receive nice dividends and own a company that grows its production and distribution capacity as well as its profits. With a discount rate of 10% time is on our side while we wait for higher prices (a catalyst).
Decision
I bought Krka shares at the Warsaw Stock Exchange (KRK PW) for PLN 380 (€ 85) in the morning of Nov 19th. After having a quick look at their 9m results, I raised my limit buy order, which got filled, despite the thin trading volume and high spreads at WSE. My analysis was not yet final on Nov 19th (and included an error), but a significant under valuation was foreseeable, based on my dcf valuation using rather conservative assumptions.
I am going to do a follow-up looking deeper into Krka’s products and markets to get a better understanding is specific risks, its growth runway and potential drivers for its margins.
I hope you enjoyed this blog post. Do you agree with my assumptions and used methods? If you liked my article … just like it and follow my blog 😉
Best, s4v
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— Appendix —
Shareholde structure
Major shareholders are primarily Slovenias and state-related entitities. Kapitalska družba (KAD), a public pension fund holds 11% and Slovenski državni holding (SDH) the Slovenian sovereign wealth fund holds 16.2%. The involvement of the state and related entities/institutions (27%) could be a negative, but so far it seems to work for Krka (and its shareholders). It could result in a tendency for beneficial politics (i.e. lower income taxes and incentives).
Some Croatian banks toghether hold about 10% of shares.
For historical reasons, domestic individual investors hold 38% (the ownership transformation process allowed individuals to buy stocks at a discount). International investors (only) hold 23%. Insiders (members of the management and supervisory boards) only held a total of 39,787 Krka shares or 0.12% of total shares issued as of June. No employee share plan or share options exist at Krka. The company holds treasury shares
The high share of domestic retail investors, should als result in a favorable political treatment of hte company, since politicians do not want to scare voters away. Additionally, they could potentially act as a group of net-sellers of hte company’s shares, resulting in temporarily technically depressed (buying) prices.
As of Sept 30th, 2020, international or international shareholders are still underrepresented. Within the ten largest shareholders, Clearstream Banking S.A. (Luxembourg) holds 2.65% of issued shares, but these 870,134 shares are most likely held for various custody accounts. Smallcap World Fund Inc. (US) is the tenths largest shareholder (1%).
Capital allocation
Krka has a policy of stable dividends and wants to attribute at least 50% of net profit to equity holders (after taking into consideration investment and acquisition requirements), according to its 2019 annual report, p51.
- Krka’s Dividend History shows a nice upward trend and indicates a sound capital allocation (it has enough cash on hand, investments are high).
A program for share buy backs or SBBs was approved. Small amounts of capital were allocated to share buy backs in the past. The program allows Krka to repurchase shares up to a threshold. Total treasury shares must not exceed 10% or 3,279,344 shares. As at 30 September 2020, Krka held 1,480,782 treasury shares (4.515%).
- Some years ago, 2.6m treasury shares or 7.4% were cancelled (share information).
Besides dividends and SBBs, capital expenditures or capex for existing operations increasing research and production facilities may not be sufficient to put all free cashflow to use. Longer-term, excess cash could be used opportunistically to acquire other companies.
Trading Krka shares
Buying Krka shares is not easy (and might well be the reason for the low valuation). For international private investors, it is nearly impossible to trade at Ljubljana Stock Exchange (Slovenia; KRKG SV) and if at all, only with very high costs involved.
Another possibility is to buy the stocks at Warsaw Stock Exchange (WSE: KRK PW) in Poland, where the stock is listed since April 2012 under the trading code KRK. The stock is qouted in PLN, and accordingly you receive dividends in PLN as well. Spreads at the WSE are pretty wide. Krka’s trading volume is quite thin at WSE
You may find a London (OHLK) quote, but that seems to be for European trade reporting only. (back to quick facts)
searching 4 value 
Interesting blog! Krka looks like a quality stock at an attractive valuation. The main question I have is how sustainable is their profit i.e. potential competition from Asian competitors (and, less important, what can we learn from the fact that the stock used to trade higher years ago).
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Asian competition is not my primary worry (currently). The just started in China.
But I still want to get a better understanding of products/markets. They recently released a presentation (not yet viewed). I was not able to participate in their recent conference…
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The way I look at it, their moat is their R&D/patents. The question I ask myself is if that’s a sustainable advantage against an Asian competitor with more resources and perhaps a willingness to play it dirty…
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…I mean, even in their home markets (Europe).
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I had another look at Krka’s, and thought I’d share:
* 2020 was an unusual year for the world as well as for Krka’s results. I wonder if 2019 is perhaps more representative of what to expect in the future (that’s what I assumed, to be safe, but your 30% margin of safety achieves the same thing). EBITDA margins are well above what the company targets and what they were in 2019 (32 vs 25%). This is is also relevant for deciding at what price to sell.
* I calculated my expected multiyear returns at the current share price, and at the share price you bought: 9.5-10.4% per year, based on dividends and growth, and not including a possible P/E rerating. (This assumes 15% slovenia and 30% belgian dividend tax).
* Half of this is return is earnings growth, at least in theory (retained earnings x ROIC). But this seems quite uncertain since historical earnings (not sales but operating margins) have been EXTREMELY variable (see 2011-2016) and I don’t know the reasons (probably worth finding out why).
* In summary, my expectation is a ~10% yearly return, long-term — with some downside risk in case operating margins disappoint again, and with upside in case P/E goes higher. If the latter happens fast (a few years) then the upside seems higher than the downside to me. That’s also what’s happened so far this year 🙂
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… and like I said, that’s using 2019 EBITDA margins, so it’s conservative.
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Hi. Thx for the nice comment.
I did not gain enough knowledge about products and markets.
But, partially high(er) margins are driven from being faster into more profitable niches, if supply is short, they gain from their integrated business model (if my understanding is correct)
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