So this company, which has virtually no competition, has barriers to entry impossible for a new entrant to overcome, and a cash printing machine will be sold for about 12 times free cash flows. Over the past year we’ve seen much lower quality companies being sold for much higher valuations than this.  Most recently, Burlington Northern Santa Fe, which has a significant competitive advantage but has far inferior return on capital and free cash flow generation than IMS, is to be purchased by Mr. Buffett for about 20 times earnings and 30 or more times free cash flows. IMS Health’s management and board have a history of making dumb capital allocation decisions, but this one may go down in history as their dumbest.

We own these shares and will probably hold on to them in the hope that shareholders will refuse this offer.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). For more information click here.

P.S. Here is a PDF of my recommended book list for 2009.

IMS Health (RX)

The company lowered earnings guidance for the year by 10 cents, though this is not uncommon in today’s environment, but the management was pounding the table only last month that $1.70 was a set-in-stone number. As of today the set-in-stone number is $1.60 (lower side of the guidance). Wall Street obviously did not like that and took down the stock.

But here is how I look at the quarter. First of all, the company did not change free cash flow guidance for the year – $380 million ($320 if you take out the one-time stuff). That is good news. Also, the company is going to cut costs by $80-85 million by 2011. In other words, they’ll be rightsizing the company for a new operating environment. Things are not improving in the pharmaceutical sector. We knew that, but the pharmaceutical sector worldwide is not falling off the cliff.

Another thing to consider, the most revenue decline at RX is taking part in the lower margin consulting business. Thus, as we saw this quarter, the impact on the bottom line is a lot lower than the top line would lead you to believe.

Finally, this quarter’s performance reminds me of eBay’s (EBAY) performance a couple of quarters back. It seemed then that there was no end of bad news in sight. Consumers were retrenching and sales declines were accelerating. eBay reported numbers yesterday and suddenly investors realized that its business has a fairly high competitive advantage and high recurrence of revenues and was not completely destroyed by Amazon (AMZN) and the economy. RX shares these qualities too, to an even greater degree.

I don’t know when (do you ever really know?) but in the not so distant future IMS Health will likely be turning around and its numbers will be less bad. Then they’ll become better and then good. At today’s valuation – IMS is trading at 7.8 times earnings. I am not particularly worried about when they’ll become less bad, as long as they don’t turn horrible – which my research leads me to believe is an unlikely scenario.

The word contrarian is often overused in investing, I have yet to meet an investor who bragged about being a crowd follower; therefore, everyone is a contrarian.  Contrarian investing is very difficult as it requires one to be on the lonely side of the ledger as truly great opportunities present themselves in stocks that everyone hates, and thus, no one wants to own.

IMS Health (RX) collects prescription data from transactions at pharmacies all over the world. It aggregates, analyzes, combines it with other databases, and sells it to pharmaceutical companies.

For instance, from a script filled at pharmacy in combination with other sources, RX would collect drug, dosage, doctor name, doctor’s specialty, zip code, illness, and so on. (Patients’ names are anonymized before RX receives them.) Pharmaceutical companies use this data to gain market intelligence on what’s taking place in the industry globally and to determine compensation for their sales force.

RX collects data from over 100,000 locations, globally (key word: globally), which — together with its tremendous intellectual property developed over the last 50 years — are sources of significant competitive advantage. RX drove most of its competitors out of business, and new ones are hesitant to enter as they’d likely suffer the fate of RX’s  former competitors. Investors don’t like RX stock — to put it mildly.

Here are some of the reasons why — and why they’re wrong:

1. Political uncertainty in the healthcare industry
Even if US healthcare turns into Obama social care, RX is well equipped to operate in this environment. Almost two-thirds of RX’s revenue comes from outside of the US, a lot of it in the countries where health care is run by government. As a side note, I do believe that, due to significant budget deficits, Obama will fail to achieve his ambitious health care plan in the US.

2.  Pharmaceutical company mergers
Mergers of pharmaceutical companies are negative for RX, but that’s not a new development — they’ve been merging throughout RX’s existence. RX has a very large customer base and no single customer, not even Pfizer (PFE), accounts for more than 5% of sales.

Also, RX’s product is very important to its customers, since marketing and sales is typically their second-largest expense after research and development. They desperately need RX’s data to stay efficient (and RX happens to be the only provider) . Finally, money spent on RX is insignificant to its customers in the grander scheme of things — RX’s revenue worldwide is only $2 billion, whereas a pharma companies spend hundreds of billions of dollars on their sales forces and marketing globally.

3. Regulatory risk
New Hampshire passed a law limiting RX’s ability to use doctor specific data. RX appealed, won, and then lost. The state’s impact on sales is insignificant, but there’s a risk that other states will pass similar laws. Thus far, 23 states have looked into it, and 20 have decided not to pursue it.

4.  Indebtedness
RX has $1.3 billion of debt and negative common equity. The debt-to-assets ratio is 57% — on the surface a very high ratio, and an indication of an over-levered company. However, this is very far from the truth. RX’s balance sheet and debt ratios are distorted by the restructuring and share buybacks it’s done over the years.

RX was spun off from Dun & Bradstreet (DNB) in late 1996 with a lot of other unrelated businesses. Over the years, RX sold off these businesses and bought back almost half of its outstanding shares. In addition, half of its debt is in Japan where the company pays interest rates of around 1%. It also has a very large and profitable business in Japan that can easily support that debt. Finally, RX could pay off all of its debt from free-cash flows, which are very stable, in about 4 years.

This stock is incredibly cheap as it’s trading at about 7 times its earnings estimates for 2009, and 8.5 times its lowest estimates.

Note: The weakest link is RX management’s thirst to run a larger empire (though this is not why the stock is down). Its management has done a decent job running the company (though one could argue that the business is so good a well-dressed monkey could run it) every so often it has an itch to do something less than smart on the acquisition-merger front.

In 2005 they almost merged with VNU. I was very critical of this merger and I’m glad it fell through. I keep my fingers crossed that RX management learned from that last sour experience and won’t attempt any more grandiose mergers-acquisitions for a while.

Here are some excerpts from the article:

1. Blockbuster success is a double-edged sword. In this litigious society a discovery of side-effects brings an army of tort lawyers to the doorsteps of pharmaceutical companies. 
2. The demographic trends of ageing baby boomers will push demand for the pharmaceuticals into the stratosphere for a long time. However, investors should add another dimension to their analysis – product diversification.  Companies that have a high concentration of sales in just a few blockbuster drugs should either be avoided or have a much smaller place in the portfolio. Also, investors should temper valuation premium expectations for the overall sector as it is unlikely to return to its old levels.
3. Medical device/instrument companies are likely to take over the leadership from pharmaceutical companies and inherit the premium valuation.  [Zimmer (ZMH), Biomet (BMET) come to mind here].  They will reap the rewards from the baby boomers’ desire for longer and healthier lives. With few exceptions, medical device/instruments companies have a much more diversified product line.
4. Companies that provide services to the pharmaceutical industry are a good sidedoor to participate in the industry’s future prosperity without subjecting investors to the all risks. IMS Health (RX), a provider of market intelligence to the pharmaceutical industry, comes to mind as a good side position. It has all the qualities of a pharmaceutical company: strong competitive advantage, terrific return on capital, monopoly-like profit margins, great cash flows, very reasonable valuation and good consistent growth prospects ahead, without all the aforementioned risks. [I no longer own RX, but it maybe a good time revisit the stock.]

Position in ZMH