CSL Limited (OTCPK:CSLLY) has become the second-largest company in the Australian Stock Exchange after an excellent run in the past twelve months, where its share price shot up ~54% compared to the ~18% gain in the S&P/ASX 200 index. A global leader in plasma fractionation, and touted as an Australian success story, CSL is now facing intense competition in the U.S., its largest market. Forced to diversify its revenue stream, the recent acquisitions in China have burdened its balance sheet with debt, as the ventures outside its expertise bring in additional risks.
Meanwhile, its competitors are making an entry into the promising Chinese market through less-risky partnerships. Despite the sales potential, the CSL’s nascent plasma collection network in China could, however, overstretch the supply chain necessitating more acquisitions, though unlikely given the debt-heavy balance sheet and declining cash flows. However, in terms of its TTM (trailing-twelve-month) earnings, the company currently trades at a significant premium to its last five-year average. A premium in line with its peers and the company’s FY20 earnings guidance implies a sizable overvaluation of the stock. With notable benefits to the bottom line from the newfound strategic focus unlikely in the near term, CSL is currently a ‘Sell’ in my view.
Plasma, which makes up nearly 55% of the human blood by volume, is rich in proteins and other biochemicals such as IG (immunoglobulins) and albumin. The plasma fractionation involves the segregation of blood and subsequent purification of its components for therapeutic use. According to Market Data Forecast, the global plasma fractionation market is estimated at ~$22.3B in 2019 and expected to reach ~$31.6B by 2026 at ~7.2% of CAGR (compound annual growth rate). Zion Market Research forecasts the global market for IVIG (intravenous immunoglobulin), a major component of plasma, could reach ~$16.4B in 2025 from ~$9.9B in 2018, growing at ~7.6% of CAGR during the period. The U.S. is the largest IG market in the world, accounting for 44% of global industry sales in 2018.
In response to intense competition in the U.S. from where CSL sources ~47% of revenue, the company is diversifying geographically. Narrowing its focus in the fast-growing Chinese market, CSL acquired two Chinese companies in 2018. In the three years up to FY19 (2019 fiscal year), CSL’s segment for plasma-derived products, CSL Behring, has dominated the revenue-generation, bringing ~86% of total sales. Sequirus, the fast-growing, and low-margin segment, for non-plasma products, contributed the rest led by the sales of CSL’s influenza vaccines.
Sources: The Author; Data from Company Financials
On a reported basis, both CSL Behring and Sequirus have witnessed their revenue growth decelerating in FY19, resulting in a slowdown of the overall revenue growth to ~8% YoY (year-over-year) from ~14% YoY in FY18. The FDA (the U.S. Food and Drug Administration) granting approval for Privigen® and Hizentra® for the treatment of CIPD (Chronic Inﬂammatory Demyelinating Polyneuropathy) was a major milestone for CSL in 2018 as IG sales made up ~40% of the top line in the past three years. CIPD, along with PIDD (Primary Immunodeficiency Diseases), are the two largest clinical indications for IG.
However, the company’s U.S. revenue growth slowed to ~13% YoY in FY19 from ~22% YoY in the prior year as Gamunex®-C, from its closest competitor, Grifols, S.A. (GRFS) continued to dominate the U.S. CIDP market. Even the key markets have under-performed with revenue from Germany shrinking ~7% YoY compared to ~17% YoY growth in FY18 and China slowing to ~6% YoY growth from ~16% YoY growth in the prior year.
Sources: The Author; Data from Company Financials
Further pressure on IG sales is likely in FY20 as CSL’s Hizentra® battles Grifol’s subcutaneous IG option, Xembify™, a newly-approved therapy for PIDD. CSL’s drug portfolio for hemophilia contributing ~14% of total sales, went through ~6% of the decline in FY19 and could expect further sales pressure as Hemlibra® from Roche Holding AG (OTCQX:RHHBY) consolidates its position. Hemlibra®, the only subcutaneous and non-factor replacement treatment for hemophilia A obtained FDA approval in October 2018 and competes against CSL’s intravenous therapy AFSTYLA®.
As the market rivalry heats up in the U.S., CSL has resorted to geographic expansion, acquiring two Chinese companies in FY18, Wuhan Zhong Yuan Rui De Biological Products Co. Ltd. and Guangzhou Junxin Pharmaceutical Limited. However, the competitors are following suit. Overly reliant on the U.S. for plasma collection and revenue generation, Grifols has embarked on an expansion drive in China. Its deal with Jiangxi Boya last year to build and manage plasma collection centers and the acquisition of ~26% of stake in Shanghai RAAS Blood Products Co. in March 2019 will bolster the distribution network, as well as the plasma supply.
CSL expects a one-off revenue impact of ~$340M-$370M in FY20 as it transitions to a direct distribution model for albumin in China following the acquisition of Guangzhou Junxin. On a constant currency basis, the company is guiding a revenue growth of ~6% YoY in FY20, a further slowdown from the prior year. Assuming there is no revenue impact, the forecast implies a ~10% YoY growth, an overly aggressive estimate in my view, given the intense competitive pressures in CSL’s largest market. Therefore, my forecast for FY20 assumes unadjusted revenue growth of ~9% YoY, and ~5% YoY growth after the adjustment for the revenue impact.
Despite slowing revenue growth, CSL’s EBITDA and net margins for FY19 have held up from last year at ~34% and ~22%, respectively. At the midpoint of the guidance, the company expects net income to grow at ~8% YoY in FY20 to ~$2.05B-$2.11B, a slowdown from the ~11% YoY growth in the prior year. Despite the slight uptick in net margin to ~23% accordingly, margins are likely to squeeze as competitive pressure builds up in the established and emerging markets. R&D expenses could surge amid the ongoing late-stage clinical trials for CSL112 and CSL964. CSL112, a plasma-derived product targeting early recurrent cardiovascular events, is currently undergoing a Phase 3 clinical trial, the largest ever undertaken by the company. All in all, I conservatively forecast the net margin to remain steady at 22% in FY20.
Sources: The Author; Data from Company Financials
Amid ~17% CAGR in the capital expenditure from FY13 to FY19, a series of acquisitions have increased the leverage with net debt to EBITDA rising to ~1.4x in FY19 from ~0.6x in FY13. The company forecasts a further ~16% YoY growth in capex next year as it expects to open 40 new plasma collection centers, a further increase from 31 opened last year. The pressure on operating cash flow, which for the first time since FY16, dipped by as much as ~14% YoY in FY19, will challenge the expansion plans amid the higher leverage and heavy debt repayments scheduled beyond FY21.
As the table below illustrates, CSL, compared to RAAS and Grifols, currently trades with the highest premium to its last five-year average TTM PE. The ultra-low leverage of RAAS could support its expansion in the home market. The modest premium of Grifols accounts for the increased leverage subsequent to a series of acquisitions. The sizable premium of CSL is questionable as the two peers collaborate and leverage their competitive product portfolio to access the Chinese market.
In the valuation, I have revised down CSL’s premium to ~18% from ~27%, similar to those of RAAS and Grifols, respectively, and assumed the share count to remain unchanged from last year. The forecasts for revenue growth and net margin for FY20 as mentioned above suggest a discount in the range of ~38%-42% to the current share price, while the company’s own profit guidance points to a discount of ~36%-40%. The steep discount indicates a massive overvaluation of the stock as the company diversifies its revenue base with no immediate benefits to the bottom line.
CSL has rightly focused on China to power its next phase of expansion. As the Chinese economy grows and the per capita healthcare expenditure rises, the market for plasma-derived products will expand further. China already claims 55% of the global albumin sales, and even with a low per capita clinical usage, is the second biggest IG market. One of the largest hemophilia populations in the world, the diagnosis rate, however, remains very low in China.
Despite the sales potential, the margins will remain under pressure until CSL’s supply network in China widens. The top six players account for ~74% of plasma collection in the country, with Shanghai RAAS making up the second largest network. In contrast, CSL has only 5 collection centers there, with the majority of plasma supply originating from the U.S. A wider network will secure the supplies and improve the margins over time even though a debt-heavy balance sheet and slipping cash flows will discourage the acquisitions necessary for faster expansion.
Given the over-dependence on hemoderivatives for growth, CSL is diversifying the business segments. The company ventured into gene therapy in FY18 with the acquisition of Calimmune Inc., a U.S. biotech firm. Also, it is experimenting with data science and artificial intelligence to optimize treatment options. A shift to such non-core areas of expertise will, however, constrain margins in the near term and add more risks to an already-frothy valuation.
A slowdown in the biggest market has forced CSL to diversify its revenue stream despite declining operating cash flows. The acquisitions in China have increased the leverage while the moves into non-core areas have raised the overall company risk. With more focus and capital, the competitors are following suit. However, in contrast to peers, CSL trades at a significant premium to its last five-year average TTM PE. The company’s own FY20 earnings guidance and a premium in line with peers indicate a significant overvaluation of the stock. With the new strategic focus bringing in no significant near-term benefit to the bottom line, CSL is currently a ‘Sell’ in my view.
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