Australian share markets have had a roaring start to 2020, with sizeable gains driven by momentum stocks, especially in IT and healthcare. Yet while companies like CSL are undoubtedly impressive, a closer inspection reveals some troubling nuances to the growth story, calling into question the high expectations imposed by a growth-starved market.
It wasn’t just temperatures that sizzled in Australia through January. The ASX200 was also on fire, starting the year with a 4.98% gain for the month. In fact, temperatures across all of the physical, political, economic and listed company divides in Australia have been rising: CSL keeps hitting record highs in rising markets and outperforming on down days; the direct and indirect impacts of the coronavirus have occupied much attention; and horrific fires lit the eastern seaboard throughout the Australian summer, reinforcing the pace and quantum of changes in the energy mix required because of global warming and its consequences.
The wrinkles in CSL’s billion dollar growth story
CSL has been a stunning performer, and not just through the past year when it has put on 70% – adding $60bn in market capitalisation. It’s been a good company we have been happy to invest in for many years. Our inimitable colleague Mr Conlon heavily invested in CSL when it acquired Aventis Behring in 2003, to the extent that the Schroders Australian equity funds were collectively the second biggest holders of equity in the company. While Aventis Behring was purchased at less than inventory value, the group today trades at almost 50 times inventory value. By vertically and horizontally integrating through that time, the quality of the business has improved materially; but the question remains for investors as to what extent that has increased the value of the group.
CSL is a relatively mature competitor in a mature industry. For example, flu vaccines have been a large part of CSL’s EBIT growth in the past few years. Today they comprise 15% of revenues, in an industry growing at 2.5% in 2019. Although CSL has been winning share, we doubt competitors like GSK and Sanofi will allow this to keep occurring. This, however, is critically important for CSL; its EBIT has grown by US$1bn in the past four years to $2.5bn, which in itself makes the forecasts for a further US$1bn of growth in the next several years appear plausible.
There are a few nuances to the CSL story, however, interrupting its apparently smooth growth trajectory. Firstly, in 2016, CSL’s flu vaccine Seqirus lost US$250m; in 2019 this turned into a US$150m gain – a US$400m turnaround which accounts for almost half of the group EBIT growth in that time. Given we assume a sustainable EBIT from Sequris of US$350m, this source of EBIT growth has largely played out, unless GSK and Sanofi continue to cede share without a competitive reaction – unlikely, as we noted above.
The second large source of EBIT growth in recent years has been CSL Behring, which has driven growth in both volume and price in the US market. Market growth for immunoglobulin (IG) products in the US had long been mid-single digits – until the past two years, when it doubled. Given IG products are sold in the US at the highest price per gram in the world (a price premium of between 50% and 200%), the tailwind from this market growth in the past two years has been acute, driving CSL’s profitability.
Can CSL maintain the momentum for another 20 years?
A critical issue here is that the profit growth for CSL in the recent past is largely a consequence of a business acquired almost 20 years ago. While it has been adroitly developed since, it is not a consequence of the commercialisation of new drugs discovered by CSL in the interim. Indeed, our analyst Dr Sally Warneford notes that CSL has tended to lag rivals in new product development during this period. For example, haemophilia drug Afstyla was fifth to market, and even Idelvion, a successful launch, was second or third to market. Another product which had seen significant investment was dropped as its commercial prospects were competed away.
None of this is to say that CSL is not an excellent company – of course it is. Yet it would be folly to believe that its current, record research and development pipeline will automatically translate to success along the lines of what has been experienced with its flu and IG products in recent years. CSL’s R&D success has tended to come through ‘life-cycle management’ and ‘market developments’ such as improved drug delivery, dose forms and new indications with existing plasma proteins rather than risky new molecules. As we detailed, CSL’s EBIT has been driven by growth in flu and IG products, and we forecast continued growth by capitalising US$4.1bn of EBIT in mid cycle (including a US$400m contribution from the R&D portfolio). Those forecasts give us a valuation of $150 per share. To justify a price more than double this clearly requires earnings growth expectations that are very long-dated, which is why we continue to be very underweight CSL, painful as it has been.
Other IT and healthcare stocks have benefited from earnings momentum in the ASX200 index in recent years, and especially through the past year. CSL just happens to be the largest beneficiary, which is why we have explained our position in detail here. However, the thematic is broad, and applies to many more companies than just CSL. And, of course, it also works both ways.
Coronavirus and climate change casting shade
With the oil price suffering through the past year, energy stocks have been a material laggard as their earnings have been revised downwards. Most recently, the market’s gaze has shifted towards those presumed to be affected by the emergence of the coronavirus. The initial reaction has been the obvious one: to sell material stocks, along with education and consumer goods companies that have a business case reliant upon Chinese demand, and buy the perceived “defensive” stocks.
Some situations fall in the middle, however, such as Chinese passenger traffic through Sydney Airport (SYD), which accounts for approximately 20% of the international passenger mix. Our analyst Daniel Peters notes that Sydney Airport makes double the EBITDA per passenger of many other international airports (including Singapore), because spend per international visitor in Australia by Chinese tourists is $A8,000 per capita – significantly higher than visitors from any other country and double, for example, that of Japanese tourists. In the context of the coronavirus, SYD is not a defensive equity; it may well be the most directly exposed stock listed on the ASX, and given this, it is a little surprising that the stock remains within 10% of its all-time high.
Yet perhaps the hottest social thematic throughout summer has been the bushfires, along with the impact of climate change and the consequent need for a rapid change in our – and the world’s – energy mix. In that light, two recent reports from the Australian Energy Market Operator (AEMO) are instructive for investors.
Firstly, GenCost 2019-20, a study jointly conducted with the CSIRO, compared capital costs across different power generation technologies, concluding that solar and wind are now the cheapest forms of new energy in the Australian market, and nuclear is the most expensive. It didn’t assess the net impact on global CO2 emissions from the transition to each form of energy. Our Data Scientist, James Bandara, has concluded the energy required to produce a solar panel (through its value chain, especially polysilicon) may be greater than the energy produced by the panel.
Secondly, AEMO’s quarterly Energy Dynamics report highlighted that solar and wind energy generators were curtailed to a record extent in the December quarter – 6% of their output across the national energy market was curtailed. AEMO cut in half the output of five large and relatively new solar farms, reflecting concerns about system strength.
AEMO’s view is that the emerging issues are “unique in the world” given the “skinny” nature of the Australian network, and has warned that the stability of the Australian electricity grid is currently “balanced on a knife edge”. Hence, fires or no fires, the capacity for the Australian energy network to quickly absorb large volumes of new renewable energy is limited; it may be that AGL and Origin continue to make excess profits from baseload power generation for a longer period than currently envisaged – subject to policy changes and notwithstanding the strong environmental arguments to the contrary.
The bifurcation of stocks by multiple within the ASX continues to be extreme. Most IT stocks trade at more than 40 times earnings, as do most healthcare companies. Globally, IT has been such a strong performer that its share of global market indices is now almost 25% – the same level as in the telecommunications, media, and technology (TMT) bubble days of 1999 and early 2000. Of course, global profits are much higher for IT stocks than they were then, which is not the case with almost all of the big names in Australian IT. It may be that they ultimately grow into it – but, as we detailed in our June 2019 commentary, an investor in Computershare in 1999 took 17 years to get back to the share price they invested at, and in the meantime the company’s profits grew tenfold.
Unashamedly, we currently continue to skew our portfolios towards lower-multiple sectors of the market, where we accept lower earnings growth. This is simply because the risks attached to such investments are usually copious but visible, and not related to valuation, which remains the biggest risk of all.
Originally published by Schroders