Morningstar Magazine - February/March 2014 - (Page 76)

Best Ideas Heavy R&D investment over the past several years has created a strong pipeline of recombinant proteins that should allow the firm to maintain market share despite new competition. We think Advate's position in hemophilia A is strong; while competition from Novo Nordisk and Biogen Idec could enter the market in 2014, Advate's roughly twiceweekly administration and long record of safety and efficacy are likely to make current patients hesitant to switch, and low penetration of the global hemophilia market (and particularly prophylaxis in adults) leaves plenty of room for growth. Baxter's recombinant protein pipeline beyond Advate is strong; Factor IX protein Rixubis was recently approved in the U.S., and new products such as von Willebrand factor, Factor VIIa, and a long-acting Factor VIII are poised to enter the market between 2014 and 2016. A novel gene therapy treatment for hemophilia B is also entering development. Baxter's $1.6 billion immunoglobulin business is also well positioned for growth. The firm commands a price premium with Gammagard in the supply-constrained immunoglobulin market. Baxter's biosurgery business is growing strongly, and we expect high-single-digit growth from this unit to make it a growing portion of the firm's top line. Finally, Baxter has a leading position in the international dialysis market, and the acquisition of hemodialysis player Gambro as well as the introduction of a home hemodialysis product in 2014 will enable Baxter to offer a more comprehensive renal product portfolio and achieve critical mass as a top dialysis product provider. Baxter's pipeline also includes products that would move substantially away from its core focus on recombinant and plasma-derived protein therapies. The firm has a collaboration with Momenta to develop biosimilars, and another with Onconova that will focus on novel cancer therapeutics, such as rigosertib in Phase III trials for MDS. Baxter is also developing a stem cell treatment for angina that could become the first cardiac stem cell treatment. If Baxter's pipeline in these new areas 76 Morningstar February/March 2014 continues to move forward, we could assign a positive moat trend to the firm. Financial Health & Capital Structure Baxter's manageable debt position and strong cash flows from its injectable therapies give the firm a low risk of default, despite its recent leverage-increasing acquisition of Gambro and continued sizable returns of capital to shareholders. At the end of September, the firm's debt stood at $9.1 billion, and major maturities during the next five years include senior notes of $850 million due in 2014, $900 million due in 2015, $1.1 billion due in 2016, $670 million due in 2017, and $1.25 billion due in 2018. Free cash flow during the past 12 months totaled $1.6 billion and is projected to grow to about $3 billion within the next five years. Baxter just needs to repay debt as it comes due to reach its debt/EBITDA goal of 1.5 times by the end of 2016, down from 2.3 times at the end of September. Beyond debt repayment, Baxter focuses on allocating capital across three key areas: 35%-40% returned to operations via capital expenditures and working capital investments, 35%-40% returned to shareholders, and the remaining 20%-30% free for business development and acquisitions. Baxter's $4 billion acquisition of Gambro was larger than its typical tuck-in-size acquisition. As it integrates this deal, the firm may return its focus to manufacturing capacity expansion, share repurchases, and dividends. For example, Baxter plans to spend more than $1 billion on a plasma manufacturing plant over the next five years, and the firm paid out $1.0 billion in dividends in the past year. In addition, although management has cut repurchases substantially while integrating the Gambro acquisition, Baxter was authorized to repurchase $1.1 billion in shares at the end of September. Risks Baxter's business is well diversified, reducing volatility of share prices and contributing to its low uncertainty rating. However, new competition for Advate from the likes of Biogen Idec and Novo Nordisk over the next few years could begin to erode the firm's dominant position in the U.S. market for hemophilia A products if Baxter's pipeline fails. In addition, Baxter's plasma fractionation capacity is currently constrained, keeping its antibody therapy (Gammagard) growth rates well below market rates. Competitors like CSL and Grifols could steal share during the next couple of years. Baxter recently completed a costly recall of its Colleague infusion pump in its medical products segment, and any future recalls-or contamination of IV solutions or injectables- would weigh on near-term profitability. Management We assign Baxter a Standard Stewardship Rating. Robert Parkinson Jr. has been chairman and CEO since 2004. Before arriving at Baxter, he spent 25 years at Abbott Labs, serving for a time as president and COO. Parkinson has focused on investing in Baxter's pipeline, boosting R&D expense as a percentage of sales in the process. While it is still unclear how the investment will affect Baxter's long-term growth potential, we think the firm's broad late-stage pipeline-ranging from safer bets like home hemodialysis and new recombinant protein therapies to wild cards like cardiac stem cell treatments-is a positive sign. Leadership of Baxter's two divisions also hail from industry giants; Robert Davis, head of medical products, spent 14 years at Lilly, and Ludwig Hantson, head of BioScience, spent more than 20 years at Novartis and Johnson & Johnson. Overall, we think Baxter's capitalallocation strategy (split relatively evenly between capital expenditures and dividends/ share repurchases, with a slightly smaller focus on business development) makes sense for the firm, as it directly rewards shareholders in the near term and allows for prudent investment for future capacity, early-stage pipeline initiatives, and new segments such as specialty therapies (which includes novel oncology drug candidate rigosertib) and biosimilars. K Karen Andersen is a senior biotechnology analyst with Morningstar.

Table of Contents for the Digital Edition of Morningstar Magazine - February/March 2014

Morningstar Magazine - February/March 2014
Contents
Contributors
Letter From the Editor
Preparing for the Next 50 Years
Morningstar Managers of the Year
Fixing the Trust Deficit
Rethinking the Path to Retirement
Trends
Same Old, Same Old
Global Briefs
The Economic Implications of an Older World
Banking on Performance
Is the Affordable Care Act Healing Health Care’s Woes?70
Baxter Has a Positive Prognosis
Leading Fidelity’s Charge for RIAs
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Moving the Goal Post

Morningstar Magazine - February/March 2014