Description

Baxter “BAX” is a solid and well-run international company in the medical products space with one of the best balance sheets in the industry. We believe the stock is attractive right now given upcoming inflection points, particularly in Renal Care, that are not fully reflected in company or market expectations.

Overview and Background:

BAX prides itself on selling “medically necessary, life-saving and sustaining products”. In today’s world where everyone is worried about Covid-19 and its impact on the economy, this is a good place to be, especially with a strong balance sheet that is under1x levered.  

The company reports revenue in seven different revenue line-items but the more simple view is that BAX has two main businesses: (1) selling a large basket of essential products such as IV bags and infusion pumps to hospitals and (2) Renal Care, which is a leading provider of equipment and supplies for dialysis patients, both in clinics and in the home. The Renal Care business is 32% of revenues with the hospital-based business comprising the rest.

 The recent history of BAX includes a 2015 spin-off of its biopharmaceutical business (Baxalta), a retiring CEO, and Third Point building a large position and gaining a seat on the board.  The company’s new CEO, Joe Almeida is viewed as a strong leader. Almeida was the CEO of Covidean from July 2011, where he helped drive the stock from around $40 when he joined to around $105 as a result of the company being acquired by Medtronic for $43 billion in 2015.

After BAX spun off Baxalta, we believe Third Point saw a very large opportunity to drive cost savings and in fact, $1 billion of SG&A costs were taken out of the business by removing layers, rationalizing the portfolio, and focusing R&D. EBIT margins increased from 9% in 2015 to near 19% in 2019. While Third Point has realized substantial gains on its position, BAX is still its largest position representing 17% of its most recent 13F holdings. 

For the stock to work going forward, we believe the story needs to shift from one of cost-cutting to top-line growth. Back in 2018, Management talked about the company being able to grow slightly above-market growth of 3-4% leading to annual 4-5% growth, with the potential to grow 5-6% annually beginning 2020 as a result of pipeline investments starting to come to fruition. What is important to know is that those targets do not consider additional catalysts outlined below such as AAKHI that we think will catapult growth in 2021 and beyond.

Hospital Business:

A lot of the products that Baxter sells in the hospital aren’t sexy or highly engineered such as pacemakers. The competitive advantages of this business are not readily apparent but are quite strong. The first is that company is generally #1 or #2 in each product and for many of those, it is the sole supplier or second supplier to the hospital. BAX leverages this with a very broad portfolio such that the more hospitals spend with BAX the greater discounts they receive.

BAX also has scale in manufacturing these products with a very strong and international supply chain to bring dependability to these customers.  Security of supply is a big concern in this industry and CEO Almeida has done an excellent job of improving BAX’s supply chain and making it more flexible and reliable. After Hurricane Maria hit in 2017, there was a large shortage of IV solutions due to issues at two main competitors. BAX had the supply and was able to leverage this advantage by locking up 3-5-year contracts with key customers.

Another good example is in infusion pumps, which deliver fluids to patients. Pumps don’t appear very high tech, but they are increasingly relied upon to communicate wirelessly with hospital systems and to deliver medication exactly as programmed. If there is an error the patient can die so the tolerance from regulators is extremely low. Meanwhile, the product itself is not considered high margin so competitors generally don’t have the incentive to spend a lot on R&D which opens the product up for frequent issues, whereas BAX has taken an approach of investing to become the leader and stay ahead of regulators. There are also only a couple of primary competitors, so when one is down it can impact the supply of the entire market. In February 2020 pump market leader Becton Dickinson (“BD”) announced a “ship hold”/recall that prevents it from actively marketing its Aleris pumps and this will last until BD receives FDA 510(k) approval, which probably won’t happen until at least the first quarter of 2021.

This hurts the reputation of BD’s pumps and presents an opportunity for BAX to win share as new pump contracts come up for bid. BAX is also in the process of launching a more comprehensive product line pumps.  BAX has over 50% share in IV solutions but only low-to-mid 20% market share in pumps. With the new offerings, we have consistently heard from people in the field that it will make BAX much more competitive and help them gain share.

Overall, our impression is that BAX wants to own the fluid management system that is bedside at a hospital with a fully integrated ecosystem including sensing technology that can better understand and monitor the hydrodynamic status of the patient and lead to better clinical decisions. The company’s October 2019 tuck-in acquisition of Cheetah Medical for $230 million was a step in this direction. 

The other key area that drives growth is new products, often complementary to existing products that provide some combination of increased simplification, differentiated packaging, and/or better delivery mechanisms that reduce error and/or save time for the hospital. Recent and upcoming product launches in the company’s Pharmaceuticals business are great examples. Baxter has a proprietary packaging technology named GALAXY that allows for pre-mixed molecule solutions that eliminate the need for a hospital pharmacy to do compounding.  As BAX keeps introducing new products under this platform, it can add up to a lot of “singles” for BAX and help overall revenue growth. These products may not be revolutionary but when added to the mix of what BAX already has it makes a difference.

Putting all of this together we believe it is reasonable to expect that in a normalized market, (i.e., non-Covid-19) BAX should be able to grow its hospital business at least 5% annually. Also, we believe Covid-19 could lead to greater growth on a sustained basis as Baxter may be able to once again take advantage of supply disruptions. If Covid-19 leads hospitals to a significant increase in the number of ICU beds at hospitals, that would represent an additional upside.

Renal Care HD: THERANOVA:

 A key driver in Renal Care is THERANOVA. THERANOVA is a new dialyzer which is essentially a disposable blood filter that goes into hemodialysis (“HD”) machines in clinics run by companies such as DaVita. There has not been any meaningful innovation in the US dialysis industry for 20-30 years. Dialyzers were once high margin products but had become commoditized around the world. We have seen downward pricing pressure for the last 7 years but recently this has started to stabilize.

THERANOVA is a new dialyzer that improves patient outcomes. During hemodialysis, the goal is to take out as much toxins and waste from the blood as you can, but it also takes out a lot of nutritional proteins that are good for people. What THERANOVA can do, through unique properties of its membrane, is remove the bad stuff but also preserve much more of the good stuff.  It brings dialysis to function more like the natural kidney and leads to better patient outcomes, including lower hospitalizations, fewer medications, etc. The important kicker here is that THERANOVA can be used in any standard HD dialysis machine around the world. So a 10-year old machine with 30-year technology in a DaVita clinic can plug in THERANAVA, call the new treatment HDx, and get superior results. No competitor has anything like THERANOVA, so the potential for BAX is to be able to sell this product to 100% of the world market of standard dialysis machines.

The reality is that it won’t be used by 100% of the market because (1) BAX is pricing it at a premium and (2) Fresenius, which has about 1/3 global market share, is vertically integrated (ie. it uses its own products and sells to others) and therefore, isn’t inclined to use a competitor product. Outside of the US, Fresenius markets and uses very expensive HDF machines to accomplish what THERANOVA enables. Why spend thousands of dollars on a new machine when you can buy a THERANOVA filter for $20? THERANOVA is arguably as good or better than an HDF machine. THERANOVA is by definition a game-changer.

In the US there is currently no financial incentive for dialysis providers to pay incrementally more for a product like THERANOVA since Medicare pays the dialysis provider a fixed bundled payment of around $240 for each treatment. For decades, the incentive has been to cut costs as much as possible and not innovate.  BAX invested $25 million in clinical trials to prove the superior outcomes of THERANOVA and finally submitted its data to CMS at the end of January. The hope is that when CMS issues its preliminary ESRD (“End-Stage Renal Disease”) dialysis rule in the November timeframe, that CMS approves an additional add-on payment to the bundle to cover the additional price of THERANOVA beginning 2021. We think this will be a no-brainer add for dialysis clinics and we also see increased adoption across the world as support and evidence behind THERANOVA increases.  We think the biggest problem for BAX will be the ramp-up of capacity to meet demand rather than the demand itself, which is a good problem to have.

Renal Care PD: AAKHI:

As noted above there has been an alarming lack of innovation in the HD dialysis space for decades while at the same time ESRD expenses continue to balloon as a percentage of the Medicare budget. Also, almost 90% of dialysis in the US is HD that is performed in clinics (mainly owned by DaVita and Fresenius) where the patient has to travel to the center three times a week and sit there for 3-4 hours during treatment with not great results. Receiving dialysis in the home via Peritoneal Dialysis (“PD”)  has many advantages over the clinic, including the patient being able to receive treatment seven days of the week instead of three, and while they sleep rather than consuming a large portion of their days at the clinic (that makes it hard for the patient hold a full-time job). In addition to driving better results (including lower mortality rates) for patients and increased convenience, PD is also less expensive. Technology in PD has been improved so that it is very easy to perform, even for older patients, and there is monitoring technology available to help patients and quickly identify any issues or missed dialysis. The main reason that share in the clinics is so high is because of the way that the system has been incented, including through reimbursement rates.

Picking up on this, in July 2019, President Trump signed an Executive Order named AAKHI (“Advancing American Kidney Health Initiative”). The release quotes HHS Secretary Alex Azar saying “Decades of paying for sickness and procedures in kidney care, rather than paying for health and outcomes, has produced less-than-satisfactory outcomes at tremendous cost. Through new payment models and many other actions under this initiative, the Trump Administration will transform this situation and deliver Americans better kidney health, more kidney treatment options, and more transplants.”

To drive this, a listed goal of HHS is to have 80% of new ESRD patients in 2025 either receiving dialysis at home or receiving a transplant. In 2017, in the United States, there were about 125,000 new cases of ESRD and about 750,000 ESRD patients and growing about 20,000 per year. However, there were just 21,000 transplant procedures. Transplants are preferred but even if the number of transplants double (which is the goal of HHS by 2030) to meet the 80% criteria, the only way to get there is a massive increase in home dialysis. This is a very ambitious goal in line with Hong Kong, which has a “PD First” program in place and PD penetration of about 80%.

 Even if overall US PD penetration doubles from about 12-13% today to 25%, it makes a big difference as BAX essentially has a monopoly as the manufacturer of equipment and products for PD, which is the predominant form of home dialysis. Fresenius is the main competitor from a manufacturing point of view but does not prioritize PD. In February 2019, Fresenius closed on a $2 billion acquisition of NxStage Medical. NxStage is a leader in another form of home dialysis named home hemodialysis (“HDD”). HDD has a very low penetration of less than 1% worldwide. This is because there are still several feasibility challenges relating to HDD and we believe this is why BAX largely exited this business years ago. We think Fresenius acquiring NxStage Medical shows Fresenius realizes that home dialysis is the future and it was a defensive acquisition to do something, even if the technology wasn’t near being ready for prime time.

PD has been growing in the US at low double-digits.  AAKHI is a potential game-changer for BAX that could further accelerate that growth and wasn’t even considered when BAX Management came up with long-term revenue growth goals. While the Executive Order is already influencing the market, the big question right now is about when the new higher reimbursement rates for PD and enforcement provisions of the Executive Order are finalized by the government. The hope was to see this portion of AAKHI passed this summer, though it may be delayed due to Covid-19.

One thing everyone can agree on regarding President Trump is he wants more manufacturing to be done in the US. BAX, which again has an essential monopoly in PD, has kept a close dialogue with the President regarding AAKHI and has said once it finalizes, it is committed to spending $500 million on additional capex, including 1-2 new facilities in the US to meet increased demand.  Knowing that BAX is extremely disciplined with capital allocation, if it going to spend $500 million one has to believe it will be a meaningful revenue driver.

Also, Covid-19 is likely another factor to drive more treatment for home dialysis in the future. Elderly people with ESRD are by definition higher-risk individuals who are more likely to want to be treated at home and are also likely being forced to become more independent at home during the crisis.

BAX General Counsel:

One person who would have great insight into the likelihood of the CMS passing a special add-on rate for THERANOVA as well as on the final rule on AAKHI would be the General Counsel of Baxter, Sean Martin. On March 20th, with BAX stock at $82, he made an $804k purchase of stock, his first since joining the company in 2017. He was previously the general counsel of Apollo Education and had only sold stock there, from 2011 through 2016. Therefore, him buying BAX stock on the public market looks very unusual for him and gives us increased confidence in these catalysts.

M&A:

The other big driver for BAX stock could come from M&A. When Joe Almeida ran Covidean, the company was extremely acquisitive. M&A is clearly in his DNA but since he has taken over BAX there have not been any large deals announced. Through discussions with field contacts, we don’t think it’s for a lack of trying but more so because of extreme discipline to not overpay.

Given that BAX has a pristine balance sheet and the recent market disruption, we think it is very likely that we could see a near or medium-term M&A deal. Given how careful BAX has been with acquisitions, we think it is extremely likely that any large deal announced will be a strong and accretive deal.

Valuation and Price Target:

BAX’s stock today is around the same level where it was at the time of Trump’s AAKHI Executive Order. Many of BAX’s products are used on the front-lines to fight Covid-19 and compared to its peers, BAX will be hurt less from Covid-19 due to lower reliance on elective procedures (though it does impact some smaller areas of BAX such as advanced surgery and inhaled anesthesia), as well as stands to benefit from Covid-19. BAX also has one of the best balance sheets in the industry with leverage under 1x EBITDA.

Post-2020 consensus generally views BAX as a 5.5% annual revenue grower.  Beginning in 2021, we see double-digit growth in the Kidney business driving 7% consolidated growth in 2021 that accelerates to above 8% in 2022 and 8.5% in 2023.

We expect 2022 EBITDA of $3.45 billion, which is about 10% above consensus. Combine this with a couple of turns of EBITDA multiple expansion due to accelerated growth, and a modest amount of accretive M&A, we have a price target of $115 per share.

Catalyst

- Finalization of AAKHI and/or continued strong shifts towards PD

- Approval of an add-on payment for THERAVNOA

- Accretive M&A

- Continued supply disruptions at competitors