Saturday, June 9, 2012

An Emerging Market Healthcare Play

Healthcare is a sector that creates many contradictory investment ideas which sometimes make it difficult to see the big picture. For example, there are no shortages of healthcare enthusiasts that remind investors that populations are aging, so volume demand for healthcare will increase.  However, there are also plenty of commentators who point out that bloated Government debt plus the need to restructure health care will create a lot of political pressure on healthcare pricing.

Somehow with pressures on volumes and pricing moving in different directions, an investor is supposed to pick his way through! One solution to this sort of conundrum is to focus on a disease that is disproportionally going to affect emerging markets and is set for growth.

I’m confident that diabetes is such a disease. Emerging markets are attractive from a healthcare perspective, because in many of these countries, healthcare spending per capita is far lower than in developed economies. Moreover, as these countries grow, the need to generate domestic demand via spending on social infrastructure is going to increase. Finally, diabetes is a disease that is set to increase significantly in the emerging world. Here is a table from the International Diabetes Federation.
So why is diabetes set to increase?

Diabetes on the Rise in Emerging Markets

The most oft cited reasons are due to shifts in incomes, life style, and diets. Simply put, increasing urbanization is causing a shift from active lifestyles with low calorie vegetable diets, towards a sedentary lifestyle rich in meat, dairy, and processed (particularly sugar enriched) foods.
Of the two main types of diabetes, Type 1 (around 5-10% of total) is caused when the body starts destroying the pancreatic cells that creates insulin. This leads to high blood sugar levels which severely threaten health. Type 2 (90-95%) is when the body produces insulin, but its cells do not react to it. Clearly, the far more prevalent, Type 2, is accelerating in emerging markets due to the reasons outlined above.

So, how to play this theme? I think there are two main ways; The first is through kidney dialysis and, the second through insulin treatments.

Kidney Dialysis

Diabetes is a major cause of Kidney disease. High blood sugar levels will, in time, severely damage a kidney and cause the need for kidney dialysis, if not, replacement. The two major players in dialysis are DaVita $DVA and Fresenius $FMSBoth run dialysis centers and provide related services in hospitals. On a standalone basis, both companies are extremely attractively priced, and offer good recurring cash flows to investors from within growing end markets.

However, both are exposed to a significant amount of uncertainty.  The threat of reimbursement cuts hangs like the sword of Damocles over these two companies. Moreover, the economics of running these centers is not as simple as it may appear.

For example, with DaVita in the US, the majority of patients (85-90%) are funded by the Government, and private patient minority (10-15%) tends to produce 40% of the revenue with 110-115% of the profits!  In other words, DaVita loses money on 85-90% of its patients. Whether private reimbursement will continue to carry the costs in this way is another story.

Furthermore, whilst, it is fair to expect DaVita to be a profit maximizing organization, it should also be understood that this does not mean they are free from Government influence or pressure. In other words, DaVita can’t just cherry pick where to run centers.

In addition, another potential threat exists from home dialysis. The most common type of home dialysis is peritoneal. This contrasts with in-center hemodialysis, which is how DaVita and Fresenius tend to make revenue. Peritoneal has a far smaller market share but many people appreciate the opportunity to carry out dialysis at home, as opposed to at a treatment center. There are pros and cons to both treatments, and this is far from an exhaustive analysis. My point here is that Fresenius and DaVita are not immune from margin erosion due to a potential pick up in home dialysis.

Another company, with a large kidney disease segment, is Baxter $BAX which has a number of products and services targeted at treating kidney disease. In fact, Baxter offers solutions to both the in-center and home dialysis markets, although the stock is definitely not a pure diabetes (or even renal) play. Although, for investors holding Baxter, the strength of this division should be noted.

Insulin based treatments

For Type 1 diabetes sufferers, insulin is a way of life. They will be taking it for the rest of their lives. With Type 2 diabetes, around 40% of sufferers will end up requiring insulin as part of their diabetes management regimen. The two major players here are Sanofi  $SNY which has the market leading product Lantus and, Novo Nordisk $NVO which has the broadest portfolio of diabetes products within healthcare.

Sanofi is a very interesting company in its own right. It is a high dividend stock that offers growth from a number of sources. It is strong in emerging markets, has good growth prospects from rare inherited disorders (via the Genzyme acquisition) and relatively little reimbursement issues from its consumer and animal health divisions. However, it does have a number of major selling drugs going off-patent in the next two years, and the pipeline looks a little thin. Indeed, by 2015, Sanofi expects that Genzyme and growth products (which include diabetes, emerging markets, consumer health, vaccines, animal health and innovative products) will make up 80% of sales. Clearly, defending Lantus (insulin glargine) which goes off patent in 2014, is very important to Sanofi.

Novo Nordisk might just have a product ready and approved by then, in order to grab market share. Novo already has a fast growing injectable, Victoza (not an insulin) which can be used to help raise blood sugar levels in Type 2 patients. Novo is already the market leader in this segment of diabetes treatments.

However, with its long acting insulin Degludec, Novo is seriously threatening to compete with Sanofi’s Lantus. Indeed, Novo claim that in trials, Degludec is non-inferior to Lantus and has a lower risk of nocturnal hypoglycaemia. The latter is the experience of low blood sugar levels at night. In addition, Novo claim that it also has a statistically significantly lower risk of severe hypoglycaemia than Lantus.
Degludec may also have a longer action profile which will give Type 2 patients much more flexibility and comfort. Whether, this is enough to justify a higher price point to Lantus, is a moot point. However, I suspect that for Type 2 patients who are being introduced to the idea of taking insulin (remember only 40% of them will) having a better safety profile might be something they are willing to pay extra for.

According to Novo, Degludec is on track in the regulatory approval process in both the US and in Europe, where they are currently under ongoing review. This could be a very exciting year for Novo Nordisk and, longer term, the outlook looks very good.


Fresenius and DaVita both offer a value proposition but carry the risk of reimbursement pressures within their core Western markets.

Novo Nordisk is definitely priced at a premium to the sector, but it deserves it for its growth profile.  As a pure play on diabetes, I think it is the best option. It currently has a PE ratio of 27 and, despite forecasts for double digit EBITDA and free cash flow growth over the next few years, it is hardly cheap. However, it has upside potential from possible Degludec approval. Furthermore, Novo claims to have 62% market share within the key China market for diabetes care, and if investors believe there is upside potential from emerging markets then Novo could be a key beneficiary.

On the other hand, Sanofi is cheap on current metrics, and I think it offers good value for income seeking investors. However, it is not a pure diabetes play and Lantus may be under threat from Degludec in future. Both stocks have strong emerging market potential, but before buying Sanofi, I would suggest looking closer at the rest of their product portfolio.

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