We See Steady Growth for Bayer

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 BAYRY has created a wide economic moat. Also, the recent divestiture of no-moat material science group Covestro leaves the company in a stronger competitive position.

In the healthcare division, Bayer’s strong lineup of recently launched drugs and solid exposure to biologics should support steady long-term growth. Two of Bayer’s key 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 consumer group.

Bayer also sells products for animal health where intangible assets and scale help the company’s competitive positioning. Bayer’s leading lines include Advantage and Baytril. While we don’t expect robust growth for this mature segment, the cash flows should be steady. However, in late 2018, Bayer decided to divest the unit, which should gain a solid sales price given the high market interest in the industry.

Bayer runs a leading 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. The acquisition of Monsanto has significantly expanded Bayer’s competitive position in this industry.

Several Factors Widen Bayer's Moat The divestment of no-moat Covestro, the minor synergistic impact of adding the wide-moat Monsanto business to Bayer's crop science business, and the wide-moat drug unit at Bayer lead to our overall wide moat rating for company. The $62 billion purchase of Monsanto didn't increase the company's moat to wide directly, but rather indirectly through the sale of the Covestro unit, whose proceeds were used to partly fund the Monsanto acquisition. Since the acquisition of Monsanto was completed at close to fair value, we don't see the new portfolio assets from Monsanto driving the moat upgrade to wide. Nevertheless, the Monsanto assets should drive some top- and bottom-line synergies (likely close to management's $1.2 billion estimate) with Bayer's crop science group. The full divestment of Covestro for over EUR 10 billion eliminated over EUR 5 billion of invested capital (just under 10% of Bayer's total) that was not likely to earn excess returns.

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. It also has a strong global salesforce that can attract smaller drug companies 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 power. Consumers continue to pay a premium for Aspirin and Aleve even though significant generic competition has existed for many years.

Bayer also has a wide 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 strong pricing power.

Glyphosate Concern Keeps Risk High Bayer faces the standard pharmaceutical risks of regulatory delays or nonapprovals for pipeline drugs. With consolidation in the managed-care and pharmacy benefit manager industry and budget deficits facing many governments, payers are increasingly pushing for lower drug prices and higher rebates. 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. Additionally, on both the healthcare and crop science segments, litigation risks are elevated, especially with ongoing litigation around Xarelto and glyphosate weedkillers. Overall, we view the uncertainty level as high largely due to the heightened glyphosate litigation.

Based on the support by key regulatory agencies and the large amount of scientific studies showing no causal relationship between glyphosate and cancer, we expect Bayer will prevail in most legal cases facing it. With over 11,000 cases in front of Bayer and the initial jury verdicts going against Bayer, the legal challenges are concerning. However, scientific data from the Environmental Protection Agency, National Institutes of Health, European Chemicals Agency, and European Food Safety Authority all suggest there is no link from glyphosate to cancer, and we believe most plaintiffs will not be successful. We still model EUR 2 billion in legal costs for Bayer and expect this legal process to continue for several years. While the number of remaining cases is high, we believe most of them have low validity and are probably looking for any minor payment that might come with a potential class-action settlement. Six more trials are expected to start later in the year.

The merger with Monsanto has significantly increased debt, but we believe the cash flows from the business would easily meet the increase in related interest payments. We project a 2019 net debt position for the company of close to EUR 37 billion, falling to close to EUR 29 billion by 2022. However, Bayer’s steady cash flows from healthcare and crop science products should enable the company to both reduce debt and service current debt levels.