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Moats and Growth Drivers Look Solid for Post-Split Baxter

Focus remains on hemophilia competition, but Baxter's comprehensive product portfolios are unmatched.

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When  Baxter (BAX) spins off its biopharmaceutical business in mid-2015, the latter firm's flagship hemophilia product Advate will be battling  Biogen's (BIIB) Eloctate for market share, and two generic launches will be putting pressure on the new Baxter to make the most of the integration of dialysis firm Gambro. However, we think the new biopharmaceutical firm's hemophilia pipeline and differentiated immunoglobulin therapy HyQvia will serve as strong growth drivers, just as the new Baxter sees significant top-line synergies from Gambro and stronger hospital contracting power with the inclusion of biosurgery.

Baxter's strongest competitive advantages have traditionally been on the biopharmaceutical side of its business, thanks to intangible assets including pipeline productivity and a strong global salesforce in hemophilia as well as cost advantages in plasma fractionation. Our preliminary analysis points to a strong, stable moat for this side of the business, based on the global plasma market oligopoly and Baxter's ability to counter hemophilia competition with several (albeit smaller) new product launches.

We raised our Morningstar Economic Moat Rating for Baxter to wide following the announcement of the acquisition of Swedish dialysis player Gambro, as we saw this as an opportunity to build significant scale and contracting leverage to complement Baxter's global reach in the peritoneal dialysis niche. We think this supports the competitive advantages of the new Baxter, as does the addition of the firm's biosurgery business (which will be retained while other bioscience businesses will be spun off). Cost advantages from economies of scale in fluid systems, specialty pharma, renal, and biosurgery units might separately warrant narrow moat ratings. However, we think the new Baxter's global scale, strong focus on hospital contracting, critical mass in renal products for international tenders, and leading market share in most businesses could all support a stable, wide moat.

Baxter's Hemophilia Pipeline Will Counter Pressure on Advate and Recombinate
Several competitors are launching in the hemophilia A market over the next three years. However, we think Baxter's hemophilia pipeline and expanded labels for Feiba and Advate, as well as strong Advate prospects in Brazil, China, and Russia, will drive 4.8% hemophilia division sales during this period, above management's 3%-4% forecast.

We estimate that Baxter has a 45% share of the global $6 billion hemophilia A market, with 90% of its sales from recombinant products Recombinate (approximately $500 million) and Advate ($1.8 billion). The market is growing at a 5% average annual rate, driven by a combination of increased prophylaxis use (which requires 2-3 times the volume of Factor VIII compared with on-demand use), increased use of recombinant products (higher cost per unit), and higher diagnosis and treatment rates in emerging markets (only 30% of the 400,000 people with hemophilia A are diagnosed).

We expect Biogen's recent U.S. Eloctate launch will have a slow trajectory for several reasons. Less than half of Advate/Recombinate sales are in the U.S., and Biogen will initially serve only the U.S. adult market (international approval requires pediatric trial data). Baxter has estimated that the U.S. adult prophylaxis market represents about 20% of global Factor VIII sales for the firm, but that half of these patients have already converted to Advate's three-day dosing schedule (from the standard prophylaxis dosing, which is every other day). We think this makes the firm less vulnerable to switches, as the convenience benefit of long-acting products over Advate is minimal; half-lives of long-acting products tend to be roughly 1.5 times that of Advate, allowing only a minority of patients to achieve every-five-days dosing, with a median dosing of every 3.5 days for Eloctate in the A-LONG study. One third of patients have had inhibitors in the past, and if they are well served on Advate today (almost half of patients on three-day dosing for prophylaxis have a zero bleed rate), we don't see a strong rationale for switching to a new therapy. If patients develop inhibitors, they undergo immune tolerance induction, which can last for one year, costs as much as $1 million, and works only 70% of the time; if ITI fails, patients must move to a bypass therapy, like  Novo Nordisk's (NVO) NovoSeven or Baxter's Feiba, for life. We think Biogen lacks the long-term data in previously untreated patients to reassure physicians and patients on safety, and it also lacks marketing experience in hemophilia. These combine to make traction with physicians less certain, particularly given the product's lack of an efficacy advantage.

While we estimate that sales of non-Factor VIII products (primarily Feiba and Factor IX products) account for only 23% of Baxter's hemophilia division sales in 2013, we think this could rise to 44% by 2018, as several launches are either in progress or upcoming over the next three years.

Biotherapeutics: Near-Term Growth Ceiling, but Long-Term Differentiation
With plasma fractionation capacity serving as a ceiling to growth in the near term, we think Baxter can support 6% growth in 2014-15 in biotherapeutics, with 7%-8% growth in the U.S. Beyond 2015, we expect that HyQvia differentiation and premium pricing, as well as sales of albumin in China, could drive close to 10% annual growth for this segment. Therefore, with gross margins around the firm's average, biotherapeutics is one of Baxter's best growth drivers. Given the strong cost advantages of Baxter,  CSL (CSL), and  Grifols (GRFS) in the stable plasma market oligopoly, biotherapeutics also supports Baxter's wide moat.

About three fourths of Baxter's biotherapeutics sales are tied to the immunoglobulin business. The $9 billion global immunoglobulin market focuses on a variety of immune system and neurological disorders, and demand growth remains the biggest driver, owing to improved diagnosis rates and additional indications. We think this market is insulated from pricing pressure despite growing manufacturing capacity among all three key players. Ten years ago, overproduction led to oversupply issues and a dramatic drop in immunoglobulin pricing, destroying profitability in an industry with more than a dozen players. However, today there are only three key U.S. players, with a fourth player (Octapharma) playing a significant role only in international markets. Not only are there fewer players, but Baxter and its competitors are now also vertically integrated, giving them more control over plasma collection and supply. We view the market as a stable oligopoly, with the top three players controlling about two thirds of the global market.

Baxter, CSL, and Grifols are the only key competitors in the $4 billion U.S. market, where margins are highest and annual market growth stands at about 10%. While direct price increases (price per gram) are minimal, pricing has been indirectly driving growth in recent years. For example, neurological indications are a growing portion of sales, and these require twice as much product as immune deficiencies. In addition, once-weekly subcutaneous administration is rapidly gaining favor in the U.S., as this allows patients to care for themselves at home. Patients require more volume of product when it is administered via this route, which also supports sales growth. CSL has dominated the $500 million subcutaneous market, as one of the first firms to receive approval for this type of administration, and Baxter has also enjoyed double-digit sales growth of its subcutaneous version of Gammagard.

Approved in Europe in 2013 and on track for Food and Drug Administration approval in mid-2014, HyQvia allows patients to administer immunoglobulin at home, but at the frequency of intravenous immunoglobulin (once every three to four weeks). We think this improved convenience over standard subcutaneous dosing (once per week) is particularly relevant for the chronic-use market, which accounts for about half of treated patients. We also think Baxter has a cost-effectiveness argument to make despite the expectation for a higher price tag, since it reduces the need for physician office visits and lowers the rate of infusion site reactions. Though the technology used in HyQvia (from Halozyme) is relatively new, we think Baxter has a very strong shot at approval. The key risk, in our eyes, remains capacity. Baxter's plasma fractionation partner Sanquin is likely to be delayed by manufacturing issues with a  Shire (SHPG) product, and despite the reintroduction of supply from Baxter's old Los Angeles facility, we expect that Baxter will not have the ability to grow faster than the market through the end of 2015.

Albumin use tends to track with surgical volume in most countries, except in China, where demand growth remains much higher: Per capita consumption of albumin in China today is much lower than in developed nations, and also the country has shut down domestic plasma collection. Margins in China are higher than in other regions, and the market is growing at a double-digit rate versus low- to mid-single-digit growth in the rest of the world.

Baxter's license renewal in China has been delayed, and the firm isn't likely to have product to re-enter the market until near the end of the year. However, we continue to think of the albumin business as one with relatively few competitors (the product is derived from plasma, like immunoglobulins) and a strong growth opportunity. The bottom line would also benefit from continued albumin growth; while immunoglobulins and Feiba are the biggest revenue contributors, incremental cost of goods sold is quite low when Baxter sells more products from its plasma fractions.

Renal Business Low-Margin but Powerful Growth Contributor for New Baxter
Baxter's $4 billion acquisition of Gambro in 2013 gives it a broader portfolio of products and a more balanced geographic exposure. Overall, Baxter now holds about one third of the $13 billion global dialysis product market, on par with only one other market player ( Fresenius (FMS)) and supporting its moat through cost advantages. On the top line, Baxter benefits from growth in global dialysis treatment rates (5%-6% annually), and Gambro gives it the product portfolio necessary to win international tenders, supporting commercial synergies on the top line. While Baxter's renal gross margins are the lowest of its divisions--and Gambro's margins were even lower--we expect cost synergies to drive significant margin improvements through 2017 and beyond.

Baxter has long been a leader in at-home peritoneal dialysis, where it holds about 75% of the global market. Recent changes to reimbursement have made PD more affordable than hemodialysis in the U.S., and the number of patients on PD has risen. However, PD represents only about 12% of dialysis patients, making it a relatively small niche of the broader dialysis market. Baxter received approval of its Vivia home hemodialysis system (which allows for high-dose hemodialysis) in Europe in 2013, and while the U.S. route to approval is less clear, we expect that the firm could receive U.S. approval in 2015. However, meaningful revenue from this business is beyond the firm's five-year long-range plan, as home hemodialysis remains a relatively undeveloped market.

With Gambro, Baxter was looking to diversify its business and gain critical mass as a renal disease player. Gambro primarily sells hemodialysis products to clinics and acute-care products to hospitals, making it quite complementary to Baxter. Given that the vast majority of the world's dialysis patients use hemodialysis, we think Baxter will now see several forms of top-line synergies. We expect Baxter to ramp up Gambro's geographic expansion outside Europe, but also boost its own organic growth through a stronger overall dialysis market presence and increased odds of winning international tenders. With almost half of dialysis patient growth expected to come from emerging markets like the BRIC nations by 2020, we think the expansion of Gambro's products in geographies where Baxter's renal business is strong, like Asia and Latin America, could be a key contributor to Baxter's top line in the long run. From a margin perspective, Baxter anticipates that 80% of the $300 million in cost synergies (split between manufacturing and marketing synergies) will be captured by the end of 2015, and all will be captured by the end of 2017.

Karen Andersen does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.