TheChek News Flow

BHP calls for extension of Anglo American takeover talks

World’s biggest miner seeks further negotiations on proposed £39bn deal

BHP has urged Anglo American to extend takeover talks as the world’s largest miner presses ahead with a £39bn attempt to buy its smaller rival.

Under UK takeover rules, the Sydney-based company faces a deadline of 5pm UK time on Wednesday to make an offer for Anglo or walk away.

The companies have been in talks since May 22 in an effort to find an agreement on the structure of the deal. BHP’s three approaches had all required Anglo to spin off its two South African businesses — a demand that angered the government in Pretoria and was strongly opposed by Anglo.

In a statement on Wednesday morning, BHP said “a further extension of the deadline is required to allow for further engagement on its proposal”.

Why valuations changed, part 2

Monday’s newsletter, about the regime change in US stock valuations in the 1990s, drew more reader comments and emails than Unhedged has ever received before. People are really interested in this topic, for reasons that are unclear. Whatever the reason, a lot of ideas passed through my inbox.

A majority of respondents took the view that the big step-up in valuations in the past 30 years comes down to one or more of three causes.

Probably the largest group of readers responded that it’s as simple as interest rates. Whatever model for stock prices you use, the risk-free rate is an important part of it. When rates fall, future cash flows become more valuable today.

My colleague Robin Wigglesworth referred me to a paper by the Fed economist Michael Smolyansky (which Unhedged has talked about it a bit before). The paper argues, among other things, that the change in interest rates accounts for the entirety of the increase in price/earnings multiples between 1989 and 2019. The argument is simple and brief. The price/earnings ratio can be analysed, using the basic dividend discount model, as follows: 

price/earnings = (payout ratio) * (1+growth rate)/(risk free rate + risk premium - growth rate) 

Between 1989 and 2019, Smolyansky points out, the 10-year Treasury yield fell from 8 per cent to 2 per cent. Using that yield as the proxy for the risk-free rate, that change alone, keeping everything else in the above equation constant, is enough to explain all of the observed change in the S&P 500’s trailing PE ratio over the same period (it rose from 12 to 20). 

This is very tidy. But everything else is definitely not constant. Specifically (as this newsletter never tires of pointing out), risk-free rates, growth rates and risk premia are closely and causally, if not very reliably, related. Very low rates often result from very low growth, for example.

This does not make Smolyansky’s basic argument hopeless. In a paper from 2017, Rob Arnott of Research Affiliates and two co-authors note that cyclically adjusted P/E ratios seem to have a curved or “mountain-shaped” relationship with both real interest rates and inflation. P/Es are highest when both are around 2-3 per cent, tailing off when they are higher or lower. Arnott explained this “sweet spot” in an email: 

This is presumably the range where risk tolerance goes up because economic uncertainty is low. Deflation or rapid inflation are terrible for P/E ratios. And if real interest rates are negative or very high, bad things are happening in the economy. For most of the last 30 years, we have been in that sweet spot.

As I pointed out on Monday, rates and inflation did recently rise above 3 per cent, and valuations rose rather than fell. But that may be down to long-term inflation expectations remaining under control even in the worst of the inflation surge.

Another large group of readers argued that the change in valuation multiples reflects a change in the financial structure of US companies. Many companies now have capital-light business models: technology, globalisation and the shift from manufacturing to services all reduce capital needs. Capital-light businesses have higher returns on equity; higher returns on equity mean that reinvested profits compound faster, leading to higher growth; higher growth merits a higher valuation multiple. 

Nick Sheridan wrote to point out that share buybacks, which started to take off in the 1980s after the SEC gave boards the official all-clear, push equity out of businesses and increase returns on equity. This might have increased financial leverage and risk — but was, happily, accompanied by an offsetting fall in interest rates.

Another reader pointed me towards a recent paper by Michael Mauboussin (who Unhedged interviewed here), which explains why the ROE point is not just about growth. The move to more capital-light business models makes valuation multiples less representative because the accounting treatment of these businesses tends to be different: 

Companies create value when their investments earn a return in excess of the opportunity cost of capital . . . [valuation] multiples provide no direct insight into the magnitude of a firm’s investments or whether they will generate a sufficient return . . . Today, the majority of investments are in intangible assets, including customer acquisition costs and branding. But companies commonly expense these investments on the income statement as they incur them. Accountants record these investments as selling, general, and administrative and research and development expenses. This reduces current earnings . . . the rise of intangibles means that both earnings and invested capital are understated, weakening the signal that earnings and multiples formerly provided

Of course there is an empirical question here. How much has return on equity at large US companies risen since the 1990s, and is it enough to explain a big change in multiples? If you have that data, send it along.

A final group of readers wrote to argue that the shift in valuations is driven by demographics. As the population ages and more people enter their prime earning-saving-investing years, demand for financial assets increases and their valuations rise. The point is intuitive enough (although there is a debate about whether it is demographic shifts or higher inequality that drives the savings accumulation). Arnott has views on this, too. He argues that

Markets command higher multiples (and deliver lower yields) when more people want to save than to dissave. That’s the 40 to 65-year-old cohort. As life expectancy rises, the imperative to save for retirement becomes stronger. The result is that investors are more willing to accept lower real interest rates and higher valuation multiples. Children and seniors, because they don’t work, impose dissaving on the working age population, which is why the 20 to 40-year-old cohort (parents!) doesn’t help market valuations (and children and seniors depress valuations)

All three explanations — which work pretty well together — demand we ask the same question. How long will these effects last? The shift to less capital-intensive business models might be here to stay. But rates and demographics (which are of course related) may not remain as equity-market friendly as they have been in the past three decades.

US group hopes EyeBio will refill its pipeline with treatments targeting causes of blindness

US pharmaceutical group Merck has agreed to buy EyeBio, a start-up backed by UK venture capitalist Kate Bingham, for up to $3bn, as the maker of the world’s best-selling drug seeks to replenish its pipeline of treatments.

The deal for EyeBio, whose drugs under development treat common eye diseases, will come in the form of a $1.3bn upfront payment with a further $1.7bn dependent on certain milestones being achieved, Bingham and EyeBio chief executive David Guyer told the Financial Times.

Bingham, who led the UK government’s vaccine task force during the coronavirus pandemic, said EyeBio’s lead drug “could revolutionise the treatment of patients with diabetic macular oedema and age-related macular disease, which are the major forms of blindness in the western world”. The drug, restoret, is in early-stage trials.

For Merck, restoret would help boost its pipeline as it prepares for a projected fall in sales by 2029 as its blockbuster cancer drug Keytruda comes off patent. Bingham said the drug had the potential to generate several billion dollars in peak sales.

The US pharmaceutical group had already spent more than $20bn on business development since the start of last year, including $10.8bn on immunology biotech Prometheus Biosciences, as it prepares for Keytruda sales to peak at a projected $33bn in 2028.

“We believe that to accelerate development and to get this important, potential drug to patients with these diseases as soon as possible, partnering with . . . Merck made a lot of sense,” said Guyer.

Merck, which is known as MSD in Europe, declined to comment.

Age-related macular degeneration (AMD) is the main cause of irreversible blindness in the western world, while diabetic macular oedema (DME) is vision loss suffered by people with diabetes. Both occur when blood vessels leak into the back of the eye, leading to a build-up of fluid that causes blurred vision and blindness.

EyeBio’s drug is a once-monthly injection that restores the strength of the blood-retinal barrier and stops leakage. Early data from restoret released in February showed that the treatment could both improve AMD and DME patients’ eyesight in an eye test and reduce the thickness of the oedema, sparking a surge in interest for the company from prospective buyers, Bingham said.

“Virtually every patient showed extensive improvement. A lot of these eyes had oedema that went away and in many cases led to a normalised retina,” said Guyer. “That’s something that never happens . . . this is a form of regenerative, restorative medicine.”

Guyer said more data was required to determine if the drug could challenge or be used in combination with AMD drugs developed by Bayer and Genentech, which work in different ways. Merck will advance the treatment through late-stage trials in both disease areas.

Set up in 2021 by Guyer and Anthony Adamis, EyeBio received seed funding from SV Health Investors, the life sciences VC fund Bingham runs. She serves as EyeBio’s chair, while Merck was an early investor in 2022 through its venture fund.

EyeBio has raised just $130mn since being founded in 2021. “To end up with $1.3bn up front in less than two years is astonishing,” Bingham said.

Guyer, who also founded Iveric Bio, which Japan’s Astellas bought for $5.9bn last August, said EyeBio had another treatment in an earlier stage of development that could be complementary to restoret. He and Adamis plan to remain with EyeBio to develop the treatment further.

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Deal would value Houston-headquartered company at just over $15bn

ConocoPhillips is in advanced talks to buy Marathon Oil in a potential all-stock deal that would value the Houston-headquartered target company at a little over its current $15bn market value, people briefed on the matter said.

Although a deal appeared to be imminent late on Tuesday night there was still a risk the negotiations would fall apart or that a rival bidder would gatecrash Conoco’s takeover plan.

The transaction would be the latest in a series of mega deals that have reshaped the US energy sector over the past eight months, as large oil companies seek to snap up the country’s best remaining shale resources and consolidate a once-fragmented sector.

ExxonMobil and Chevron last October both agreed massive acquisitions, with price tags of $60bn and $53bn respectively, sparking a wave of transactions across the sector, with companies including Occidental Petroleum and Diamondback Energy following suit.

Conoco — the biggest independent producer globally with a market capitalisation of about $139bn — has been vying with its smaller rival Devon Energy to acquire Marathon for several weeks, three people briefed on the matter said.

Bloomberg reported in October that Devon had held preliminary talks about a combination with Marathon.

Conoco and Marathon did not respond to requests for comment about the prospective tie-up.

Earlier this year, Conoco lost out to Diamondback in a race to snap up Endeavor Energy Resources, one of the most sought-after private producers in the prolific Permian Basin of Texas and New Mexico.

Diamondback agreed a $26bn deal to buy Endeavor in February after a last-ditch bid that left Conoco smarting, according to people close to that deal.

An acquisition of Marathon would be Conoco’s biggest since it acquired Concho Resources for $10bn in 2020, taking advantage of the Covid-induced downturn.

Conoco’s chief Ryan Lance said in March that consolidation was “the right thing to be doing for our industry”.

“Our industry needs to consolidate. There’s too many players. Scale matters, diversity matters in the business,” he said in an interview on CNBC.

Marathon owns assets ranging from North Dakota’s Bakken oilfield to Oklahoma, Texas and the New Mexico side of the Permian. It also holds an integrated gas business in Equatorial Guinea.

The company dates back to 1887, starting out as the Ohio Oil Company before being subsumed by JD Rockefeller’s Standard Oil. After almost a century as an integrated oil company it spun off its refining arm, Marathon Petroleum, in 2011.