Csl: the bear case and why we aren't worried

Blood products make up an incredible 1.6% of American exports - more than corn, crude oil, or even plastic products. CSL is at the heart of that industry, with a 34% share of the antibody market and the largest network of plasma collection centres. It's the undisputed darling of Australian healthcare. 

The case that CSL is worth more than the current share price is easy to make. Just as easy, in fact, as the case that it is worth much less. So far, the bull case has won hands down: after listing at 77 cents in 1994 (split adjusted), the stock is now a '230-bagger', having risen to more than $180 for a total return closing in on 30% a year. 

Key Points

·        New therapies put haemophilia and antibodies at risk

·        Downside minimal, moat remains

·        Research spending to offset some risks

Yet CSL's share price has fallen around 20% since September, weighed down by an overall market decline and rising US interest rates. Is this an opportunity or a time for caution? Let's examine both the bull and the bear case to find out.

Bear case

Perhaps the biggest risk that CSL faces is slowing growth in its antibody business. Also known as immunoglobulins, antibodies are molecules that recognise and bind to bacteria and viruses to 'tag' them for attack by other parts of the immune system. The company's main profit engine, CSL Behring, makes a range of antibody products to treat people with immune system disorders. Some 42% of CSL Behring's revenue is from two products: Privigen and Hizentra. 

Industry-wide, research is increasingly directed towards a new generation of antibody therapies based on a protein called FcRn. The trouble, from CSL's point of view, is that FcRn extends the half-life of immunoglobulin by diverting it away from a process which degrades it. If antibodies last longer in the blood, patients don't need as much. As FcRn products come to market, it could reduce demand for antibodies in general.  

A similar danger exists for CSL's haemophilia products, which account for around 16% of total revenue. Here, CSL extracts various clotting factor proteins from plasma, which can then be used by haemophilia patients to control bleeding. 

One of CSL's competitors, Alnylam Pharmaceuticals, has developed a gene therapy called Fitusiran, which increases production of the protein thrombin and aids clotting. Fitusiran helps to prevent bleeding episodes in patients with haemophilia A and B and is now in Phase 3 clinical trials. If successfully commercialised, it would reduce the need for CSL's clotting factor proteins.

Anti-operating leverage

Combined, a reduction in sales of antibodies and haemophilia products would have a significant effect on CSL's profitability due to the unusual economics of blood products. 

CSL extracts dozens of therapeutic proteins from plasma, but immunoglobulins are the most valuable. The company determines how much plasma to collect based entirely on demand forecasts for immunoglobulin - everything else it extracts is essentially a by-product that CSL happens to be able to sell.

Collecting and fractionating plasma is an expensive fixed cost, which acts as a barrier to new players entering the market. In fact, just three companies make up 90% of the industry (see Chart 1). However, these substantial fixed costs mean that profitability is driven by the number of products CSL can extract and sell. Although haemophilia products, for example, only account for 16% of sales, many of the costs to extract them would remain even if those sales disappeared, because CSL would still need to fractionate the plasma to get the immunoglobulins. Profits would fall by much more than 16%. 

One final leg of the bear case is a matter of valuation. CSL trades on a forward price-earnings ratio of 30 based on management estimates for 2019 earnings. Investors are used to positive surprises and double-digit profit growth. If earnings start to grow more slowly - or even fall - then shareholders are likely to cop a double whammy: lower earnings, and a reduction in the multiple investors are willing to pay for those earnings. To put it in context, if earnings growth slows from 10% to 5%, and CSL trades at a more normal 20 times earnings 10 years from now, today's investors will barely earn a 1% return. Substantial earnings growth isn't just desirable, it's necessary. 
 

The case for optimism

Despite the risks mentioned above, we aren't losing any sleep. For starters, haemophilia gene therapies are not yet on the market and, until Phase 3 trials are completed, the odds are against success. Last September, Phase 2 Fitusiran trials were suspended after a patient with haemophilia A died of swelling in the brain. Though trials have resumed, it's a reminder that promising drugs can often throw up surprises. The ongoing Phase 3 trial may still show Fitusiran to be unsafe or ineffective. 

As for FcRn, we do consider this the biggest risk to sales growth and a few products are already on the market. However, CSL is developing its own FcRn products, so is unlikely to be sidelined with complete obsolescence and the company recently entered a licence agreement with biotech firm Momenta to develop FcRn immunoglobulins. 

CSL is currently serving just a fraction of its potential customers. Antibodies are widely used in Australia and the US due to Government reimbursement, but many parts of the world lack access due to affordability - a once-a-month infusion of Hizentra can run at around US$9,000. Most of Europe has a utilisation rate half that of Australia, let alone developing markets such as China, where only one person is treated with antibodies for every 10 in Australia (see Chart 2). 

As economies develop and spending on healthcare increases, we expect utilisation rates to increase. The number of immunoglobulin doses per capita doubled in China and Turkey over the past five years, for example, and the worldwide market has grown at around 8% a year since 2013. We expect the effect of rising incomes and accessibility to dwarf any downward push on utilisation rates due to lengthening half-lives. 

Let's assume CSL successfully commercialises a few FcRn products. Should they prove to be the half-life extending miracle that many expect, the cost of treatment will fall. CSL might be selling fewer doses to each individual, but with more people able to afford treatment, total sales could still rise. 

Alternatively, let's say the development of FcRn antibodies or gene therapies make CSL's products obsolete. What's often forgotten is that they would only be obsolete at their current price point. Many of CSL's products are already functionally obsolete, yet still sell millions of doses each year as lower-cost alternatives sold to uninsured patients or people in developing countries. This is the typical cycle of pharmaceuticals and the development of FcRn and gene therapies is just the next iteration of that. 

Finally, the risks to CSL's immunoglobulin and haemophilia products are widely known. All the big brokers are talking about the potential impact of gene therapy and FcRn, so these risks are probably already 'priced in'. 
 

Wide moat

Twenty years from now, it's likely that CSL's entire product line-up will be completely different. CSL's long-term advantage, however, is not based on its current line-up - the company's 'moat', as Warren Buffett would say, is grounded in its economies of scale, low-cost plasma collection network, and industry-leading research capability. 

CSL's share of the immunoglobulin market has grown from 1% in 1994 to 34% today, and it continues to take market share: antibody sales grew 11% in 2018, compared to around 9% for Grifols and Shire, its main competitors. The company spent US$700m on research and development in 2018. Some of that research spending will go to waste, but it's also reasonable to expect a few decent discoveries that will drive sales a decade from now, such as the company's promising new 'cholesterol killer'. 

Undoubtedly, CSL is not a risk-free investment, but making the case that it's overvalued is more difficult. Management expects net profit of US$1,880m-1,950m in 2018, up 10-14%, for a forward price-earnings ratio of around 31 at current exchange rates. With formidable competitive advantages, a dominant market position, economies of scale, and an army of 1,500 researchers working to develop its next generation of products, we're sticking with HOLD.

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