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Why Following Activist Investors Can Make Your Cash Work For You In 2019

Many investors will agree that 2018 was a wipe-out with algorithms causing chaos. As computers tried to find value, prompting never-before-seen swings, human investors were left counting the cost.

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But there’s good news on the horizon as 2019 has the potential of decent returns for investors’ hard-earned cash.

Spinoffs and special situations, a niche of The Edge Consulting Group, are ripe for the picking, offering little-known low hanging fruit that can boost your portfolio big time. 

Star activists like Bill Ackman, Dan Loeb, John Paulson, Nelson Peltz, Jeffrey Smith and Paul Singer know exactly the right time to pounce during event-driven situations.

What’s more, each of these guys are intent on securing capital preservation over the long-term.

Every activist looks for flies in the ointment as large companies struggle to cope with debt burdens, distressed credit, recapitalizations, restructurings, and other corporate events that put pressure on their boards.

Activists are evolving

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While activist investors are nothing new, they are evolving. These days, they approach their targets with serious focus offering a viable alternative to those who are prepared to see the forest from the trees. The emergence of a significant activist can underpin a stock. In fact, it’s an added margin of safety and one that books don’t teach you.

Indeed, companies activists have turned their focus to in recent years like Yahoo, Darden Restaurants, Ebay  and Kraft & Heinz are coming out of the other end stable and stronger.

Third Point LLC wants Campbell Soup Co. to split into two major units – Getty ImagesGetty

Spinoff and special situations are still very rarely reported on and sure, for the uninitiated, they are difficult to analyze. To that end, here are three large cap companies which are potentially eyeing up for change.

These are situations in which, unless the companies themselves do something beforehand, activist involvement will likely arise as a path to value creation.

It’s important to consider all your options and weigh up whether you should get into the exciting world of activist investments, but keeping an eye out for the right special situation can make all the difference.

 Change could be in the cards for Oracle

Larry Ellison, executive chairman and chief technology officer of Oracle,   2017 Getty ImagesGetty

It wasn’t a surprise that Larry Ellison recently took a billion dollar stake in Tesla, joining its board of directors.

The 74-year-old is a no doubt a genius, and his “close friend” Elon Musk will undoubtedly breathe new life into his ideas, but the move seems timely.

As founder and CTO of Oracle and as a 30% owner, he is undoubtedly scratching his head at what the future holds for his firm.

Oracle’s market cap is $178 billion but has cloud revenue of only $6 billion compared to other tech conglomerates like Microsoft, Amazon  and International Business Machines Corp with cloud revenues of $30 billion, $19 billion and $17 billion, respectively. And that level of underperformance could soon force him to adapt or risk shareholders’ calls for change. Oracle is far behind its peers in establishing a foothold in the cloud space, which we believe is a primary reason of concern for the market.

Oracle Chairman Larry Ellison delivers a keynote address –  Getty ImagesGetty

Oracle shares have underperformed most of its US counterparts across the 1-year, 2-year (annualized) and 3-year (also annualized) Total Shareholder Return (as shown below). This indicates that conglomerates like Amazon and Microsoft have clearly adapted to changing business dynamics and established a cloud base earlier than Oracle, which is far behind these peers in this space.

TSR for ORCL vs. Peers & IndexThe Edge Special Situations Research Team, Company filings

Examining the space, many IT conglomerates have successful track records for break-ups of divergent businesses, including: eBay (July 2015), Hewlett Packard (multiple Spinoffs – October 2015, April 2017, September 2017), Computer Sciences Corp. (November 2015), Citrix Systems (January 2017) and DXC Technology (May 2018).

Oracle has not been able to establish a strong cloud base organically and now the limited disclosure on key cloud metrics has added to investor concerns. We believe that it makes sense for Oracle to shed its non-core businesses (Hardware and Services) and focus on growing the core cloud business by undertaking acquisitions in this space supported by its strong balance sheet (net cash of ~$7bn). 

Pharma is one to watch as Merck CEO takes the Senate hot seat

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US drug manufacturer Merck & Co’s CEO Kenneth Frazierwill testify at a Senate about rising prescription drug prices later this month. The United States has higher prices than in other countries, making it the world’s most lucrative market for manufacturers. And with a market cap of $190bn, it is one of the largest pharmaceutical companies in the world and has been for over 100 years.

U.S. President Donald Trump and Kenneth Frazier – Getty ImagesGetty

But it’s not human health that is piquing interest. Within Merck, there is a very similar sub-business that deals with a different class of patient: animals. This is an interesting segment, given the animal health market is expected to grow significantly as technology helps to identify causes of animal diseases and aid in faster prevention. The global animal health market is expected to reach sales of $65 billion in 2025. It’s now around $40 billion.

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Combating diseases such as swine influenza and Ebola are major issues and as we move towards relying on our natural resources, animal health and the safety of humans becomes more and more important. 

How many times have you gone to the vet and just swallowed the bill? Western countries love their animals.

Although the Animal Health business provides stability to Merck’s cash flow, we believe that a Spinoff is the next logical step for the company considering the past success of the Pfizer, Inc. / Zoetis, Inc. separations. 

This would unleash the true valuation of its animal health business.

From its separation from Pfizer in 2013, Zoetis has produced nearly a +200% return company compared to a +90% return on the S&P.

Animal health has a much less risky and less expensive R&D cycle and does not face the post-patent expiration cliff compared to traditional pharma. 

Moreover, it faces significantly less third-party payer risk due to direct selling relationships, as well as limited government exposure. 

Due to these factors, the animal health industry has more sustainable growth prospects than the traditional pharma space.

Merck has outperformed the index over the last six months and could be mainly due to the vast potential of the its main drug Keytruda. 

We continue to see further upside to the stock in the case of a potential Spinoff of its Animal Health segment, which we see is highly probable considering the current industry trend of separating animal health business that is creating significant value for the shareholders. Henry Schein (HSIC) and Eli Lilly & Co. (LLY) are also scheduled for Spinoffs in 2019.

TSR for MRK vs. Peers & IndexThe Edge Special Situations Research Team, Company filings

Roper Technologies is looking to the future

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When he founded the company almost a century ago, George D. Roper had no idea how far his eponymous firm would go.

With a market cap of $29bn, Roper Technologies Inc. has just had another excellent set of figures.

In fact, CEO and President Neil Hunn couldn’t be happier, calling his firm’s success “a tremendous operational year, with strong organic growth, margin expansion, and excellent cash performance across our diversified set of technology businesses.”

The American diversified industrial company operates in four segments: RF Technology; Medical & Scientific Imaging; Industrial Technology; and Energy Systems & Controls.

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The major chunk of revenue (71.4%) and adjusted EBIT (72.5%) comes from the RF Technology and Medical & Scientific Imaging segments.

With ROP’s ongoing strategy of shifting its portfolio toward scale-able and asset-light solutions that are highly recurring in nature (~50% of revenues from aftermarket and subscription fees), it makes logical sense for the company to focus on these divisions and separate the other legacy/higher asset-intensity industrial businesses.

The RF segment has gained a lot of traction and Roper has undertaken multiple acquisitions in this business over the last 2-3 years, including Aderant (2015), ConstructConnect (2016), Deltek (2016) and PowerPlan (announced May 2018). 

This indicates an intentional shift in business mix towards highly scale-able, asset-light Software-as-a-Service (SaaS) businesses, a trajectory which will continue as Roper prioritizes M&A in the SaaS-heavy Medical & Scientific and RF Technology segments.

Roper’s exposure in both the Industrial Technology and Energy Systems & Controls segments have reduced in revenue contribution, with the Industrial Technology segment having gone down from 20.7% in FY15 to 18.6% in FY16 and 16.8% in FY17, and a decline in the contribution from the Energy Systems & Controls segment from 16.4% in FY15 to 13.4% in FY16 and 11.8% for FY17.

During the Q1FY18 earnings call, ROP’s CEO stated that the company will look forward to divesting its non-core assets via a sale/Spinoff considering the new US tax regime.

TSR for ROP vs. Peers & IndexThe Edge Special Situations Research Team, Company filings

Following this, the company announced in May 2018 the sale of its legacy cyclical electron microscopy imaging/camera business (Gatan) to Thermo Fisher for $925m. We believe this is in-line with our separation thesis as the divested business was highly cyclical, lacked significant recurring revenue streams, and required relatively more R&D investments and working capital.

Roper has potential for the Spinoff of certain businesses based on the above. There is an opportunity for activism like other industrial companies Honeywell (HON) and DowDuPont (DWDP), which may create pressure on the management to pursue such strategic alternatives.

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