Drug Launches, Diversity Support Bayer's Steady Gains

Largely on the basis of the strong competitive advantages of its healthcare group and to a lesser extent its crop science business, we believe

In the healthcare division, which provides 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 material science 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. Bayer’s eventual 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.

Pharma Business Bolsters 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. It also has a strong global salesforce that can attract smaller drug firms to partner with Bayer for commercialization efforts, which augment its internal drug-development efforts. The company’s consumer health business benefits from a narrow economic moat, largely because of its strong brand name. 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 science businesses where it competes, it is still largely a price taker in the industry because of the high level of competition. As Bayer looks to sell this unit, we believe the overall moat of the remaining company would improve.

We believe Bayer’s economic moat trend is stable. While some pharmaceutical products are facing competition from generic drugs, the company’s pipeline should be able to mitigate this problem and replace lost revenue. Bayer is likely to see continued sales declines from multiple sclerosis drug Betaseron as competition increases, but those sales should be replaced by the next generation of drugs such as cardiovascular Xarelto. Further, the company’s focus on oncology and biologics should help offset some of the pricing pressure facing the entire drug industry. In the consumer health business, the company has a strong portfolio of well-established drugs, such as Aspirin and Aleve. These drugs have been generating growth for decades, and we project continued gains for several years. Lastly, the competitive dynamics in the crop and material science businesses appear largely stable in these relatively mature segments.

Regulatory Risk Exists 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 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. The material science group faces highly cyclical demand depending on the overall state of the worldwide economy.

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 Bayer’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 was above our estimate. Lastly, the decision to bid for Monsanto MON at a fair value looks to support the Bayer’s overall strategic positioning. We don’t expect this acquisition to cause a major change in our fair value estimate.