Strong Pipeline Helps Protect Baxter's Wide Moat From Competition

While competition is around the corner for Advate,  Baxter's (BAX) highly profitable hemophilia A product, we think this diversified health-care firm's competitive advantages remain strong.

Baxter's BioScience division represents slightly less than half of the firm's sales, but a higher proportion of profits. Recombinant factor VIII therapy Advate dominates the U.S. market (Bayer's (BAYRY) Kogenate leads in Europe), and the drug's prophylaxis label and conversion of patients previously on plasma-derived products is allowing it to achieve strong growth, particularly among the underpenetrated adult segment. Competition is growing in this market, as Biogen Idec (BIIB) plans to launch a long-acting product in 2014 that could support once-weekly dosing schedule (Advate can be given every three days), and Novo Nordisk (NVO) has filed for approval of a recombinant Factor VIII and has a long-acting version in late-stage development. However, Baxter's pipeline investments will help shield it from these challenges. Baxter has accelerated development of long-acting factor VIII protein BAX855, aiming for a 2015 launch. In addition, HyQvia, a long-acting version of Baxter's immunoglobulin product Gammagard, recently received regulatory approval in Europe and should launch in the United States in 2014. HyQvia's improved convenience should translate into market share gains and better pricing power.

The medical product segment should also be a steady performer for Baxter. In addition to supplying items such as IV solutions, infusion pumps, injectables, and anesthesia gases to hospitals and their pharmacies, Baxter offers contract manufacturing services to drug firms and is a leading provider of at-home dialysis solutions outside the U.S. With the acquisition of Swedish dialysis player Gambro, medical products is likely to remain Baxter's largest overall business for the foreseeable future. We think Baxter will now achieve critical mass in its renal disease offerings, and recent reimbursement changes in the U.S. and new product offerings on tap between 2013 and 2015 will accelerate growth. Synergies with Gambro will also prevent low gross margins in the renal market from weighing on the bottom line.

Efficient Scale, Economies of Scale Result in Wide Moat
We think Baxter has earned a wide economic moat, stemming from efficient scale in its hemophilia franchise and economies of scale in plasma processing, injectable therapies, and dialysis products. Intangible assets--like strong brands, patent protection, and pipeline productivity--also allow the firm to remain remarkably profitable in tough industries. More than 70% of Baxter's sales come from products with market-leading positions, and the safety and quality of its biologic therapies allow it to charge a price premium to competitors.

Baxter's BioScience business has its roots in Advate, its blockbuster recombinant Factor VIII protein therapy for hemophilia A, and plasma-derived immunoglobulin therapy Gammagard for immune disorders. Advate is the leading product in the U.S. and the only one indicated for prophylaxis of bleeding episodes in both children and adults. We think the small but significant improvements Baxter has made to its product offerings--like higher-dose vials of Advate that allow for every-three-day dosing--confer significant convenience and safety advantages and reflect the firm's ability to innovate. Baxter also benefits from efficient scale in the hemophilia market, as market needs only allow for a low number of successful competitors.

Cost advantages and intangible assets like pricing power and a strong research and development strategy are apparent in the immunoglobulin market. Global plasma supply and fractionation capacity are limited, and a stable oligopoly exists among Baxter, Spain-based Grifols (GRFS), and Australia-based CSL (CSL). Baxter has locked in contracts with plasma collection centers and continues to invest in its sizable manufacturing capabilities, making it a low-cost provider of plasma-derived therapies. We see large barriers to entry in the plasma protein business, given the capital-intensive nature of plasma fractionation, long lead time (five to seven years) until any new capacity could be approved, and the sizable experience of current players, which contributes to strong plasma yields and solid reputations. In addition, Baxter's plasma-derived Gammagard sells at a price premium to products from CSL and Grifols, a tribute to the strength of the brand. Baxter's R&D productivity has also been strong with Gammagard. A subcutaneous version of the product substantially improves convenience to patients, commands a higher price than the intravenous version, and sees fewer competitors. Baxter's HyQvia recently received approval and Europe and is poised to launch in the U.S. in 2014, offering additional convenience benefits to patients.

Baxter's medical product division benefits from economies of scale, particularly in dialysis and injectable therapies. While this division is less profitable than BioScience, hospital-focused IV and injectable therapies diversify the firm and lower its risk, and the acquisition of Swedish dialysis firm Gambro improves Baxter's economies of scale and product breadth. Gambro strengthens Baxter's competitive advantages in renal disease beyond its current in-home peritoneal dialysis offerings, bringing Baxter's $2.5 billion renal business (roughly 20% of the firm's total sales) to $4.2 billion (27% of sales) and putting it at least on par with dialysis leader Fresenius (FMS). Although the renal business is slightly less profitable than its overall business, Baxter now expects overall operating margin improvements to be slightly better than previously anticipated over the next five years. We see this as a tribute to increased economies of scale and cross-selling opportunities in geographies like Europe (Gambro sees the majority of sales from Europe, the Middle East, and Africa) and emerging markets (Baxter has a strong footprint in Latin America and Asia).

New Competition, Lack of Capacity Are Risks
Baxter's business is well diversified, reducing the volatility of its share price and contributing to its low fair value 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 and make it difficult for Baxter to regain lost sales. Baxter recently completed a costly recall of its Colleague infusion pump in its medical product segment, and any future recalls--or contamination of IV solutions or injectables--would weigh on near-term profitability.