Makings of a Wide Moat in Diabetes Care

• If we were to assign the diabetes therapeutic area a moat, it would be wide, as we think barriers to biosimilar competition are high, pipeline productivity is strong, and unmet patient need remains high.
• Next-generation insulins and novel oral therapies continue to offer safer and more effective ways of both controlling blood sugar and also lowering the risk of hypoglycemia and cardiovascular complications.
• We expect sales of branded diabetes products to increase to $58 billion in 2018 from $33 billion in 2013, a 12% compound annual growth rate, and we think undervalued Sanofi (SNY) is well-positioned to benefit from the demographic trends supporting the diabetes growth.

Strong Outlook for Diabetes Market Growth
Diabetes care creates a $45 billion global drug market, and demographics favor continued strong growth. The number of people affected by diabetes worldwide is expected to grow to 592 million by 2035 from 382 million today, as prevalence rises to 10.1% of the population from 8.3%. While Type 1 diabetes is also on the rise, the increase stems primarily from the growing prevalence of Type 2 diabetes because of an increasingly urbanized, sedentary, and obese global population.

In addition, we expect diagnosis and treatment rates to climb, particularly in emerging markets, where access to care is improving. We expect the branded portion of the market to grow to $58 billion in 2018 from $33 billion in 2013, a 12% average annual growth rate. This is slightly higher than the 10.5% 10-year historical market growth rate (which incorporates sales of generic products like metformin), but lower than growth in more recent years ( Novo Nordisk (NVO) cites a 14.1% five-year historical market growth rate).

Overall, while the tremendous U.S. pricing power of 2013 will probably abate, we continue to think that novel products will allow drug firms to achieve price premiums on diabetes drugs in the U.S. and at least retain level pricing internationally.

Traditional Therapies for Diabetes
After diagnosis, the first step of diabetes treatment involves lifestyle intervention and the initiation of metformin. Metformin is an oral drug, available as a generic, designed to slow the release of sugar by the liver and promote the uptake of glucose by body tissues. Metformin typically results in a 1.5% decrease in A1c, a measure of average blood glucose concentration. The American Diabetes Association recommends that A1c levels stay under 7% to avoid hyperglycemia, and A1c is used as a primary measure of efficacy for most experimental diabetes trials. Metformin used alone typically does not cause hypoglycemia (dangerously low levels of blood sugar that can cause seizures and coma) and has been associated with a favorable effect on body weight (probably because it causes a metallic taste and adverse gastrointestinal events). If the A1c goal is not met after a few months of therapy, another medication must be added.

The second step of diabetes treatment traditionally involves the addition of a sulfonylurea (SU), thiazolidinedione (TZD), GLP-1 analog, DPP-IV inhibitor, SGLT-2 inhibitor, or insulin to metformin. There is no general agreement on which drug should be added after metformin fails to provide an adequate response. Historically, SUs and TZDs have generally followed metformin. SUs increase insulin secretion by the pancreas and can decrease A1c levels by about 1.5%. Because they are available as generics, sulfonylureas are a relatively inexpensive treatment option. However, they become less effective as diabetes progresses and beta-cell function declines, requiring the addition of a new drug with a different mechanism of action to treatment. Sulfonylurea use is also associated with increased risk of hypoglycemia and weight gain. As a result, TZDs have historically been prescribed as a second-line therapy when hypoglycemia is a major concern. There are only two primary TZDs on the market: Takeda's Actos (pioglitazone) and GlaxoSmithKline's Avandia (rosiglitazone). However, both drugs are now generic in most markets. Despite their hypoglycemia benefit, TZDs are also associated with increased incidence of bone fractures, greater weight gain, and a number of cardiovascular risks (especially in the case of Avandia). We believe the heightened concern of cardiovascular risks along with the lack of marketing support for generic drugs has led to the sharp drop-off in prescribing of TZDs.

Incretin-Based Therapies and SGLT-2s To Move Up the Treatment Curve
Following the cardiovascular concerns with the TZD class, GLP-1s and DPP-IVs took significant market share over the past five years. Similar to the TZD market share collapse, we expect sulfonylureas will lose market share to SGLT-2s and GLP-1s over the next five years. Both GLP-1s and SGLT-2s provide weight loss of 2%–3% relative to weight gain with SUs. In addition, the nausea associated with GLP-1s and genital/urinary tract infections associated with SGLT-2s appear much more manageable than SUs' side effects of hypoglycemia. Over the next five years, we project that more than $5 billion will be spent marketing GLP-1s and SGLT-2s versus virtually no marketing spending behind SUs. Major studies are also supporting other drugs over SUs when metformin is not adequate; in 2012, The Lancet published superior data for Byetta over glimepiride (SU) in patients with metformin failure. However, the low cost of SUs will encourage payers to use the drugs before moving on to other diabetes drugs, which will probably result in SUs still holding a significant share of the market. Over the next decade, we project the key GLP-1a will include AstraZeneca's (AZN) Byetta/Bydureon, Novo's Victoza, Sanofi's Lyxumia, GlaxoSmithKline's (GSK) albiglutide, and Eli Lilly's (LLY) dulaglutide. On the DPP-IV side, we project the key drugs will be Merck's (MRK) Januiva, AstraZeneca's Onglyza, Eli Lilly's Trajenta, Novartis' (NVS) Glavus, and Takeda's Nesina.

Insulin Replacement: The Final Destination for Diabetes Therapy
Oral therapies are unable to prevent the progressive loss of beta-cell function over time, and most patients will eventually require insulin replacement therapy to maintain glycemic control. Regular human insulin has been used for decades to control blood sugar levels, but this remains a less-than-ideal treatment option because of its slow absorption and delayed onset of action. These shortcomings have opened the door for modern insulin analogs, which offer improved durations of action, lower risk of hypoglycemia, and less weight gain. However, these products are still unable to mimic the body's natural insulin response and require patients to inject themselves at least once daily at specific times. Next-generation therapies—like Novo's Tresiba, Sanofi's U300, and MannKind's (MNKD) Afrezza—are all poised to offer further improvements in blood glucose control.

We believe the emergence of new drug therapies that further delay disease progression represents a competitive threat to insulin makers, as insulin is the diabetes treatment of last resort. While the aging of the population would naturally push a higher percentage of diabetes patients onto insulin as their disease becomes more severe, we think progress with oral options, such as new combinations of DPP-IV and SGLT-2 inhibitors, will prevent this percentage from rising. For example, in the U.S. market, we assume that the percentage of patients on insulin will stay relatively flat at 28% of diagnosed patients going forward. This assumes that the percentage of patients taking insulin alone will slowly decline, and that combination use of insulin with other therapies—including oral therapies but also increasingly GLP-1s—will slowly increase. We think that overall treatment rates among diagnosed patients should increase from 85% to more than 87%, particularly as more Americans are covered under the Affordable Care Act. This growth will largely be captured by oral treatments, in our opinion, as we expect the percentage of diagnosed patients on pills or GLP-1 analogs (and not taking insulin) to increase to more than 59% by 2022 from 57% in 2012.

Moats Among Global Insulin Players Remain Strong Because of Global Scale and Strong Pipelines
Economies of scale, innovation in manufacturing and R&D, and a strong sales presence support sustainable competitive advantages for global insulin players Sanofi, Lilly, and Novo Nordisk. As a result of their wide economic moats, branded insulin players retain more than 90% of the global insulin market despite biosimilar human insulin competitors. As in many other biologic therapy markets, we expect regulatory hurdles and complex manufacturing will prevent biosimilar insulin competition from reaching the intensity seen with small-molecule drugs. We expect the three large global players to enjoy continued insulin volume growth for the foreseeable future; our 5.5% global insulin volume growth rate extends through our 10-year explicit forecast period and will probably extend beyond this, as the increasingly overweight and aging global population initiates or requires more intensive treatment to control blood sugar and prevent diabetes-related complications or death.

Entering the most lucrative insulin markets in most developed countries requires significant upfront costs, including high costs for clinical trials as well as high-cost manufacturing relative to small-molecule therapies. Pen systems that allow for more convenient injections have also made drug delivery a barrier to entry, as a competitor would need to invest significantly—including upfront costs and ongoing production costs—to compete with the most convenient method of administering modern insulin products. Pen systems account for virtually all of Novo's sales in Europe, Japan, and China, as well as 35% of U.S. sales and 59% of sales in other international markets.

The U.S. Food and Drug Administration has yet to finalize a pathway for such products, and this has historically protected insulin franchises against biosimilar competition in the U.S. There are no biosimilar insulin products on the market in the European Union, either, and one applicant (Marvel) withdrew its application in 2007 because of lack of sufficient data to satisfy regulators. Biosimilar insulin is available on a limited basis in some emerging markets, including China and India, where regulatory guidelines are largely absent. While biosimilar insulin represents 20% of nontender insulin volume in China—with 15% of nontender volume split between two leading human insulin players, Shanghai Fosun and Tonghua Dongbao—the appeal of modern insulins is steadily eroding biosimilar human insulin market share. In the nontender market (the most valuable market for insulin players), modern insulin penetration by volume in China has increased by roughly 5 percentage points annually over the past five years, and stands at 40% today. And while biosimilar modern insulins have been on the market in China and India for several years, we believe their inability to realize significant market reflects the importance of the brand names and strong safety records of global insulin players.

The price of human insulin is also quite low in virtually all markets, selling for as little as $0.20 per day through some tender markets. In the U.S. market, human insulin can sell at a more than 70% rebate to list prices. Even branded modern insulin analogs—which have a net price below $2,000 after rebates—are at least 90% cheaper than most biologics on an annual basis. As a result, it can be quite difficult for smaller, biosimilar insulin players to win important contracts while remaining profitable. For example, Novo typically wins a large Brazil tender, while other bidders like Biocon don't have the scale to win such bids. In addition, while insulin players are able to push through healthy price increases in the U.S., rebates to payers are increasing every year; Novo Nordisk net sales in North America represent a 37% discount to gross sales, and this discount has increased by roughly 200 basis points annually over the past five years. With 2%–4% annual price cuts in Europe, profitability is a steep hurdle for new players without sufficient scale.

Increasingly efficient manufacturing techniques and global salesforces also make it more difficult for biosimilar firms to compete. For example, Novo recently updated its manufacturing process and now uses a continuous perfusion process, allowing it to achieve four times the yields of the previous fed batch method. Novo is also continuing to roll out a salesforce expansion in key markets like China, the Middle East, and the U.S., and thousands of employees are needed to penetrate rural areas or smaller cities in China. Replicating this strategy would be cost prohibitive for most would-be competitors; one local insulin player in China, Gan & Lee, was recently accused of resorting to bribing doctors to boost prescriptions of its insulin therapies.

At a global level, pipeline productivity has made older, human insulin therapies less desirable for patients; for example, 75% of Novo's insulin sales today derive from modern insulin analogs. These products provide better control of blood sugar—with less hypoglycemia and weight gain—than their human counterparts. Patents on the biggest modern insulin therapies generally expire within the next few years, which could bring a wider threat of biosimilar modern insulin products. However, we expect the same dynamics to be at play in this market, as manufacturing hurdles will be even higher for biosimilar makers to re-create these modified insulin therapies, and recent innovation in manufacturing adds another layer of defense. Most importantly, all three global players are rolling out a new generation of premium-priced therapies that are innovative enough to reset the patent protection clock.

Most major generic players have no interest in the insulin market today, which we think reflects the challenging market dynamics for biosimilar insulin players. Actavis (ACT) exited its biosimilar insulin effort following the acquisition of Watson, and Teva (TEVA) management has also said that the profit potential for this market is not appealing enough to make it a strategic interest. Generic manufacturer Bioton has carved out a small portion of the insulin market in Poland, and generic firm Biocon, which sells biosimilar insulin in India, is now partnered with Mylan, the only major generic firm that still has strategic interests in developing biosimilar insulins. The team has disclosed that it is developing interchangeable versions of Sanofi's Lantus, Lilly's Humalog, and Novo's NovoLog in developed markets. Their Lantus program could enter Phase III development soon, while manufacturing techniques for Novolog and Humalog biosimilars are still being finalized. Given Mylan's poor track record of meeting its ambitious goals, we do not currently include sales from these programs in our Mylan valuation or our overall insulin market projections.

Well-Positioned in the Diabetes Market and Undervalued, Sanofi's Entrenchment With Lantus Bodes Well for Growth
Anchoring on Lantus, we expect Sanofi to remain the market leader in the basal insulin market through 2017. Additionally, the company's follow-on insulin U300 is well positioned to compete against new entrants to the basal insulin market. U300 is close to three times more concentrated than Lantus, and clinical studies to date show that the drug is able to product similar A1c reductions with improved hypoglycemia rates in certain patient populations. In EDITION I (basal insulin plus mealtime insulin) and EDITION II (basal insulin plus oral diabetes drug), nocturnal or severe hypoglycemia rates among U300 patients were 21%-22% lower than for patients taking Lantus, a statistically significant result. While the 11% risk reduction in the EDITION III (insulin naïve) study did not achieve statistical significance, we still expect that the product's improved safety profile will draw patients with more advanced disease. Similar to Novo's Tresiba, we believe the drug will be priced at a more than 20% premium to Lantus. Additionally, while we don't believe Sanofi's GLP-1 Lyxumia holds best-in-class potential, a combination injection with industry-leading basal insulin Lantus should turn Lyxumia into a blockbuster, as close to 50% of Lantus users have not reached their A1c goals. We expect Sanofi's diabetes contribution to grow from close to 20% of 2013 sales to 25% of 2018 sales as U300 and Lyxumia launch.

Valuations in the Health-Care Sector Overall Are Now Less Appealing
Turning to health care overall, with the impressive gains experienced in the U.S. stock market over the last two years, we peg the average price/fair value ratio for our health-care coverage at 1.09, which leaves few bargains. However, we do still see a few relatively undervalued firms, including Sanofi.

Top Health-Care Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Express Scripts		$89.00	Wide	Medium	$62.30
Sanofi		$64.00	Wide	Medium	$44.80
WellPoint		$100.00	Narrow	Medium	$70.00
Data as of 3-10-14.

Express Scripts (ESRX)
The delivery of pharmaceuticals to consumers encompasses many firms along the supply chain, and among the numerous players Express Scripts stands out as an elite participant. The firm's strong competitive advantages have churned out excellent returns on invested capital and have given it a wide economic moat. We anticipate robust growth for the pharmaceutical industry over the long term, which should provide Express Scripts with a solid platform for continued success. With more than 1.3 billion adjusted claims processed in 2012, Express Scripts is the largest PBM. This dynamic positions the firm positively as it is able to negotiate favorable supplier pricing and solid spread retention. The power of the firm's negotiating position was demonstrated recently with its Walgreen (WAG) contract negotiations. Even though Walgreen is the largest retail pharmacy chain, it had to relent to Express Scripts' pricing demands. More critically, however, the colossal claim volume processed by Express Scripts allows it to scale its centralized costs and leverage its asset-light capital structure into solid economic profits. The firm has some of the lowest selling, general, and administrative costs and highest operating profit per claim. These metrics have translated into ROICs well above its weighted average cost of capital.

Sanofi (SNY)
On the pipeline, Sanofi is making strides, which increases our confidence in the company's wide moat. We remain most bullish on next-generation insulin U300 and cholesterol-lowering drug alirocumab as both drugs will likely enter very large markets with leading efficacy and clean side effect profiles, which should set up strong pricing power. Additionally, the company's emerging multiple sclerosis franchise should further propel long-term growth as a large portion of these patients fail on current treatments and are seeking new drugs. The company also harnesses its research and development group to bring new drugs to emerging markets. While pricing in emerging markets is not usually as strong as in developed markets, the company can still leverage its investment in developing new drugs for developed markets by bringing the drugs to emerging markets. The rapid economic growth in emerging markets has created new geographic markets for Sanofi's drugs.

WellPoint (WLP)
Although WellPoint has faced a tough time over the past few years, we believe this managed-care organization has a solid membership and network base that it can take advantage of to produce long-term outsized returns. The firm participates in 14 states under the Blue Cross Blue Shield brand, which gives it unparalleled recognition among consumers of health-care services. We believe this will serve the firm well once the individual exchange markets go live in 2014 and beyond. WellPoint also has the ability to negotiate advantageous pricing with its provider network given its sizable and geographically dense membership base. Scale will also be a positive for the MCO as it can utilize its robust membership base to spread costs. In our opinion, the firm has failed recently to take advantage of its inherent advantages and investor pressure has led to a CEO switch.

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Endnotes: International Diabetes Foundation, Diabetes Atlas, 2013 http://www.idf.org/diabetesatlas, http://www.diabetes.org/, The Medical Letter July 2012, B Gallwitz Lancet 2012, Prevalence and Control of Diabetes in Chinese Adults, Yu Xu et al, JAMA. 2013;310(9):948-959.