Baxter's Headwinds Mostly Temporary

A number of factors are depressing Baxter's near-term cash flows. Generic competition for branded oncology drug cyclophosphamide at the end of 2014, currency headwinds, dis-synergies from the Baxalta split, regulatory and manufacturing issues, and pension expense adjustments have cumulatively shaved about $1 off Baxter's earnings per share, by our estimate, and place 2015 operating margins in the high single digits, considerably lower than those of close peers like Fresenius FRE, Hospira (acquired by Pfizer PFE), or CareFusion (acquired by Becton Dickinson BDX). Meanwhile, capital expenditures have been running high as management addresses regulatory issues and expands manufacturing capacity for solution products. Beyond these mostly temporary issues, we think gaining synergies from the Gambro acquisition, optimizing manufacturing and distribution operations, exiting unprofitable business lines, and refocusing on new product launches and higher-margin segments (nutrition, anesthetics, and biosurgery) can lead to long-term margin expansion.

Emerging-market exposure and healthy demand for many of Baxter's critical consumables support reasonably healthy long-term growth for the firm. About 60% of the company's sales are in international markets, with emerging markets making up an impressive 25% of sales. At nearly one third of new Baxter revenue, the renal segment, which is particularly exposed to international markets, should boost the company's growth trajectory. Thanks to rising global rates of diabetes, obesity, and high blood pressure, increasing global demand for dialysis should sustain strong dialysis market growth. This is especially true for Baxter's peritoneal dialysis operations in global markets where clinic infrastructure typically does not match that of the United States or Europe.

Economies of Scale Support Narrow Moat We think economies of scale support a narrow economic moat rating for the new Baxter, and modest switching costs in some of Baxter's segments like infusion pumps, anesthetics, and dialysis equipment add moat support. Although Baxter loses considerable diversification following the Baxalta spin-off, we think it retains sufficient exposure to a variety of oligopolistic med tech markets with fairly high barriers to entry--due to large up-front capital costs to achieve necessary scale and regulatory requirement--that diminish operating risk and should sustain returns above the cost of capital. A substantial portion of the company's sales comes from commodified products, such as dialysis solutions, dialyzers, injectable drugs, and IV solutions, which offer little pricing power. This leaves us hesitant to award a wide economic moat rating at this time.

We think approximately 75% of Baxter's operations (as measured by revenue) in hemodialysis, peritoneal dialysis, parenteral nutrition, IV pumps and solutions, biosurgery, and anesthetics possess competitive advantages worthy of an economic moat. While we tend to view Baxter's other operating segments--compounding, contract manufacturing, and injectable generic drugs--as having fewer competitive advantages, they nonetheless share significant synergies with Baxter's manufacturing processes and leverage its hospital salesforce, which help contribute to the company's overall scale-related cost advantages.

Baxter is a major player in the global dialysis equipment market. We think Fresenius Medical Care's FMS unique vertically integrated business as both the largest dialysis service provider and equipment manufacturer gives it a competitive edge, but Baxter takes second place in the larger hemodialysis product market and absolutely dominates the smaller peritoneal market with approximately 19% and 72% share, respectively, by our estimates. Economies of scale are vital in this market, especially in the manufacturing of more commoditylike dialysis consumables like dialyzers and dialysis solutions. The 2013 acquisition of Gambro also made Baxter a more formidable competitor by adding extra scale and expanding the product catalog.

In the global IV pump market, Baxter participates in a concentrated oligopoly including CareFusion, Hospira, B. Braun, and Fresenius. Infusion pumps have a long life (with an approximate five-year replacement cycle) and hospitals often stick with familiar brands, which keeps switching costs high. High-end pumps offer information technology networking software, which helps these devices become embedded in customer operations as hospitals seek to lower medication administration costs and increase drug safety. Once a device and its corresponding software are integrated into a hospital's IT infrastructure, transferring to competitive products becomes less likely. These devices provide a recurring revenue stream from higher-margin dedicated consumables, and Hospira, Baxter, and Fresenius are also among the primary manufacturers of IV solutions used by infusion pumps. When including both pumps and solutions, we estimate Baxter's global IV market share is near 30%.

Baxter's anesthetics franchise is one of its most profitable segments thanks to high barriers to entry and strong switching costs. Baxter is the only competitor to offer all three commonly inhaled anesthetics: isoflurane, sevoflurane, and Suprane. Isoflurane and sevoflurane both face generic competition, primarily from AbbVie ABBV and Piramal, while desflurane (branded as Suprane) is likely to soon face generic competition in the U.S. as patents expired in late 2014. However, the complexity of manufacturing an inhaled drug, along with proprietary vaporizer hardware installed by manufacturers, helps keep barriers to entry and switching costs higher than most conventional drugs. This translates into a low level of competition. We estimate Baxter's market share in this segment at over 50%.

We think necessary economies of scale and product complexity support strong competitive advantages in Baxter's parenteral nutrition and biosurgery operations, which are among the company's highest-margin segments along with anesthetics. Similar to Baxter's other solutions and injectable products, the higher complexity of manufacturing intravenous nutrition products keeps barriers to entry higher than more common tube-fed nutrition products. Two surgical sealants, Tisseel and Floseal, make Baxter a major player in the biosurgery market, along with primary competitor Johnson & Johnson JNJ. Baxter has added to this franchise over time with the Apatech and Synovis acquisitions in 2010 and 2012, respectively, which enhanced its bone fusion and soft tissue repair capabilities.

Spinning Off Baxalta Lessens Risk We think Baxter shed its potentially riskier assets through the Baxalta spin-off, leaving a well-diversified company that participates in markets with little risk of disruption or competitive threat. Generic competition on cyclophosphamide in late 2014 has had a major effect on profitability in 2015, but since Baxter doesn't have any other major patent protected drugs, this issue will not be a recurring theme for investors. Despite the modest likelihood of future generic competition on Baxter's inhaled anesthetics portfolio, we think manufacturing and marketing barriers to entry in this product category will preserve Baxter's market share. Regulatory issues remain a concern for the business, including currently outstanding warning letters from the Food and Drug Administration, but we don't view any current problems as major threats to the business at this time. Baxter has faced major setbacks in the past, however, including the 2010 Colleague infusion pump recall. We think poor management of assets and the company's inability to improve profitability over the long term may be one of the greater risks to healthy returns in the future.

Margins Have Potential to Expand Although our $42 fair value estimate implies a high price/earnings multiple, we think earnings and cash flow are currently depressed due to a number of factors, many of which are temporary. We believe the potential of healthy margin expansion over the coming years combined with Baxter's 20% remaining equity stake in Baxalta, which is likely to be used to boost the company's underfunded pension, justifies our fair value estimate.

We think Baxter's longer-term revenue growth potential is near 6%, led largely by higher growth opportunities in renal, nutrition, and biosurgery segments, which together constitute nearly 55% of consolidated revenue. We expect low- to mid-single-digit growth in most of Baxter's other segments. Generic competition on cyclophosphamide (which had sales of nearly $450 million in 2014) and currency headwinds will be the two largest constraints on growth in 2015. Beyond 2016, we think revenue growth can return to the mid-single-digit range. In addition to focusing on higher-growth segments and new product launches, Baxter's international and emerging-market exposure supports the company's long-term growth outlook.

As Baxter moves beyond its mostly temporary headwinds, we think management's focus on controlling costs while boosting more profitable aspects of the business can lead to nearly 500 basis points of margin expansion over the next five years. Our forecast for operating margins of nearly 14.5% is within management's recently announced outlook. We also think capital spending as a percentage of sales will fall over the coming few years as efforts to expand solution manufacturing capacity draw to a close. Improved profitability combined with lower capital spending should push free cash flow near $1.3 billion in 2019, by our estimate. Our assumptions result in returns on capital near 12%, and we estimate Baxter's cost of equity at 9%.