Recent Drug Launches Buoy Bayer's Growth

Bayer announced updates to several phase 3 programs, which should help improve a weak pipeline, but the strategic decisions reinforce our view of the firm's conservative stance on risk-taking in drug development. We are most interested in the phase 3 start of vilaprisan in uterine fibroids, where there is a high unmet medical need and limited competition. We believe vilaprisan and the phase 3 AbbVie drug elagolix hold the most promise in an indication with close to 20 million patients, where surgery is the primary option. Additionally, we believe the focused decision to move finerenone into phase 3 development only for diabetic kidney disease and not heart failure is a good strategic move to reduce development expenses; the recent approval of Novartis' heart failure drug Entresto creates a higher hurdle for efficacy in this indication. Also, Bayer is now looking for a partner to start its phase 3 program for anemia drug molidustat, reinforcing its conservative approach of sharing the risk of drug development.

Strong Lineup Supports Steady Long-Term Growth Largely on the basis of the strong competitive advantages of the healthcare group and to a lesser extent the crop science business, we believe Bayer has created a narrow economic moat despite the lack of competitive positioning from its materials business.

In the healthcare division (close to 50% of sales), Bayer's strong lineup of recently launched drugs and solid exposure to biologics should support steady long-term growth. Two of Bayer's top-selling drugs are biologics--Betaferon for multiple sclerosis and Kogenate for hemophilia. While competition is increasing in both areas, the manufacturing complexity of these drugs deters generics from entering the market. Further, strong demand for cardiovascular drug Xarelto and ophthalmology drug Eylea should continue to drive growth.

Bayer's healthcare segment also includes a consumer health business with leading brands Aspirin and Aleve. Brand recognition is key in this segment, as evidenced by the company's iconic Aspirin, which continues to produce strong sales even after decades of generic competition. The 2014 acquisition of Merck's consumer products increased the scale of Bayer's group.

Bayer's materials segment, which produces polyurethane, polycarbonate, coatings, and adhesives, lacks a significant competitive advantage despite large market shares in each of these businesses. We view these businesses as highly competitive with little pricing power, and Bayer should continue seeing low margins in this segment relative to the rest of the company. The divestment of this unit should improve the company's overall competitive profile.

We are more optimistic regarding the crop science segment, which includes crop protection products (pesticides, herbicides, fungicides) and the fast-growing plant and seed biotechnology business. Similar to the drug business, this segment is research and development intensive, and Bayer has developed a strong portfolio of products. The downside to this business is that demand is heavily dictated by weather and commodity prices, which will determine how much farmers can afford to spend on crop treatment.

Material Science Sale Will Widen Moat We believe Bayer has a narrow economic moat. The combination of the company's wide-moat pharmaceutical business, narrow-moat consumer health and crop science businesses, and no-moat material science business leads us to our narrow moat rating.

Similar to other large pharmaceutical companies, Bayer's drug unit supports a wide economic moat. The company has a diverse portfolio of patent-protected drugs and a growing number of biologic drugs. The company also has a strong global salesforce that can attract smaller drug firms to partner with Bayer for commercialization efforts, which augment Bayer's internal drug-development efforts. The company's consumer health business benefits from a narrow economic moat, largely because of its strong brand names. Consumers continue to pay a premium for Aspirin and Aleve even though significant generic competition has existed for many years.

The company also has a narrow economic moat in its crop science business. While some of the crop science business is a commodity business with few barriers to entry, other areas, including biosciences, maintain high barriers to entry--rigorous research and development efforts required to participate in this market combined with strong patent protection keep the majority of competitors at bay and support stronger pricing power.

We think Bayer's material science business has no economic moat. In this segment, Bayer faces strong competition and has very little pricing power. Although Bayer is first or second in market share for all of the material sciences businesses where it competes, it is still largely a price taker in the industry because of the high level of competition. After Bayer sells this unit, we believe the moat of the remaining company will improve.

Risks Include Regulatory Issues The company faces the standard pharmaceutical risks of regulatory delays or nonapprovals for pipeline drugs. With consolidation in the managed-care industry and budget deficits facing many governments, payers are increasingly pushing for lower drug prices. Bayer faces heightened market risks as it is launching several new drugs that hold strong potential if the market embraces the new treatments. In the crop science business, demand depends heavily on highly variable commodity prices and weather conditions. The material science group faces highly cyclical demand depending on the overall state of the worldwide economy.

Bayer holds a relatively strong balance sheet, with close to EUR 2 billion in cash and a manageable amount of debt at EUR 16 billion. The company's 2015 leverage ratios of 45% debt/capital and 2 times debt/EBITDA suggest secure financial footing. Despite the solid financial standing, the firm does carry more debt than its peers, partially because of the 2014 purchase of Merck's consumer product group. However, with strong cash flows from operations of close to EUR 7 billion, we are confident that the firm can meet its debt obligations.

The biggest move the company made over the past decade was the acquisition of Schering in 2006, which we view as neutral with the benefits largely equaling the price paid for the company. However, the decision to break off its no-moat material science business should improve the company's overall competitive profile as the remaining business lines of healthcare and crop science hold much stronger competitive advantages. Additionally, we believe the acquisition of Merck's consumer business for $14 billion makes strong strategic sense, although the price paid for the unit was above our estimate.