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CSL: No time for holy grails

The 1918 influenza pandemic was one of the worst disasters of the 20th Century - perhaps of any century. The virus infected a quarter of the world's population, killing as many as 100 million people. 

We still face mini-epidemics of flu each winter. The virus's biology is a big reason - but the economics of it might be a bigger one, as we'll explain shortly. 

First, let's tackle the biology. The flu virus is crafty; a master of disguise. It looks a bit like a tennis racquet, with a head and a handle. The handle is stable, but the head is constantly evolving, so it's difficult for us to build immunity. Just as soon as our body recognises the virus and produces antibodies, the virus changes shape.

This makes vaccine development complicated because a vaccine's effectiveness falls to zero in a year or two. It also means manufacturers are stuck on an innovation treadmill, trying to stay one step ahead of the virus.

A six-month race begins in each hemisphere's spring to develop a fresh vaccine for the next flu season. The starting pistol goes off when researchers from the World Health Organisation (WHO) gather to decide which strains of virus should be included in the vaccine based on what was prevalent in the opposite hemisphere's prior flu season. 

From there, national health authorities distribute seed viruses to the three manufacturers that dominate the industry: Sanofi Pasteur with its 37% share of the US market, CSL with a 30% share, and GlaxoSmithKline with a 21% share. 

Each of them then buys a whole lot of chicken eggs. CSL, for example, buys about 50 million to inoculate with the virus and serve as mini-factories. After leaving the virus to replicate inside the eggs for a few days, it's then killed and isolated before being separated into individual doses (see CSL solves chicken and egg problem).

 

Market timing

So that's the biology lesson. Now for the economics. All manufacturers get the same seed viruses so the vaccines don't differ other than the number of strains per dose. Pricing tends to be similar. 

Table 1: Vaccine divisional results

Year to June

2018

2017

/(-)
(%)

Revenue (US$m)

1,088

924

18

EBITDA (US$m)

96.6

(124.4)

big

Capex (US$)

136.0

142.2

(4)

Assets employed (US$m)

1,568

1,417

11

That being the case, customers - mainly pharmacies, hospitals and GPs -  shop around for time instead. If your pharmacy can offer vaccines in April, instead of May, you have a sales advantage. It's very important to be the fastest manufacturer to market because customers like to commit to whoever can deliver the earliest.

CSL has an advantage - for now - on the timing front. While most of its flu vaccine production uses traditional egg-based processing, the company can also produce vaccines by propagating the virus in cell cultures using a state-of-the-art facility in Holly Springs, USA. CSL is the only manufacturer with an approved cell culture manufacturing process. 

Holly Springs has a shorter production time than egg manufacturing and can be expanded quickly on short notice, compared to the long lead-time necessary to get millions of eggs. This one plant could produce enough vaccine for half the US population within six months of the start of a pandemic. CSL also recently announced a US$140m expansion of the plant to beef up capacity for four-strain flu vaccines. 

The downside of cell culture production is that it's a more expensive process. A dose of CSL's quadrivalent vaccine produced at Holly Springs costs $24, compared to the $17 for a standard dose. So, while CSL has a timing advantage, it has a cost disadvantage, so its cell culture vaccines tend to be reserved for people with egg allergies or where a higher level of purity is needed. 

Egg-based production is still the main process and, here, CSL, Sanofi and Glaxo are evenly matched - it's a roll of the dice to see who gets to market first each year. If and as CSL improves the efficiency of the Holly Springs plant, the cost difference may decline and CSL's first-to-market advantage might become more important. But that's speculation.

 

Holy grail

As we mentioned earlier, the flu virus is constantly mutating. For this reason, flu vaccines aren't as effective as other vaccines and can vary significantly year to year. Over the past 15 years, vaccine effectiveness has ranged from 10% to 60%; in 2018, the figure was 40%. It's worth mentioning, though, that the number is always above zero, so there's always some advantage to getting vaccinated.

Given the potential for a global pandemic to kill hundreds of millions of people, developing a more effective and long-lasting flu shot is considered one of the holy grails of medicine. That being the case, you might think that CSL and the other vaccine oligarchs would be working feverishly to develop one. 

Not by a long shot.

If you had to pick one disease that most burdens humanity, it would be the flu - it has both the highest number of infections per year, and the highest number of deaths. But then there's the fact that the flu changes every year, so vaccines must be constantly renewed. From an economic standpoint, that's a dream situation for vaccine manufacturers. 

The industry collectively sells just under 500 million doses each year worldwide, generating around US$5bn in revenue (US$1.1bn for CSL). Sales have been growing at 8-10% a year as governments push for coverage rates to rise from 40% or so to 70% or more. 

If a universal vaccine was developed, the seasonal vaccine would be obsolete. Switching a yearly shot to a once or twice a lifetime vaccine would cause a huge decline in sales. 

In theory, one way to offset the losses would be to price the universal vaccine much higher than the seasonal vaccine. But let's do the maths: if we assume the seasonal vaccine averages US$10 a dose, and a child gets it for their first 15 years of life and their last 30, the universal vaccine would need to be US$160 or more after discounting back to today's dollars for it to be worthwhile for manufacturers to switch. That would raise affordability issues for many people, so sales would be modest without government support. 

Add to this the fact that a universal vaccine would cost a fortune to develop. Getting any drug or vaccine through the lengthy clinical trial process could clock up US$200m-800m. And you can add to that another US$500m to build a new manufacturing facility, which would be needed as the technology behind a universal vaccine is unlikely to overlap with the seasonal version.

Updating the seasonal vaccine each year only costs CSL around US$5m-20m. The economic incentive for CSL, Sanofi and Glaxo to develop a universal vaccine just isn't there. The only way one will be developed is by government funding and university-led research. 

There are actually a few candidate vaccines already floating about that target the stable handle of the flu 'tennis racquet', but none are past the early stages of the clinical trial process. Funding does seem to be rising, though - last year, the Bill & Melinda Gates Foundation earmarked US$12m for universal flu vaccine development, and the US Government increased funding to US$160m this year, up from US$60m two years ago. 

So the way we see this playing out is that a universal vaccine is one day developed - no sure thing, mind you - but the patents are likely to be owned by a university or government, which will then license the vaccine to CSL and its competitors, much as CSL licensed the Gardasil vaccine after it was developed at the University of Queensland. 

Being the second-largest vaccine manufacturer - and the one with the broadest technological know-how - CSL is well placed to bid for an exclusive licence, though governments may insist that such a critical vaccine be shared among manufacturers to reduce the risk of disruption and boost affordability.  

Nonetheless, the vaccine is likely to be priced significantly higher than the seasonal vaccine, so it could mean a short-term boost to earnings in the year around its release, potentially adding a couple of billion to revenue if we assume commercialisation is split between the three big manufacturers equally - though competition or government mandates are likely to ensure that it's low-margin work, so the impact on profits would be lower. Still, that one-time up-front boost to earnings would offset some of the damage caused to recurring sales.

Depending on where vaccine pricing falls, we do consider a universal vaccine to be a threat to CSL's vaccine business, which accounts for around 14% of total revenue. However, it could be a decade or more before one is developed and, if it is developed, CSL has some advantages when it comes to bidding for the rights to commercialise it. The stock trades on a forward price-earnings ratio of 33 based on consensus estimates for 2019 earnings. We're sticking with HOLD.

InvestSMART staff members may own securities mentioned in this article.

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Graham Witcomb is an analyst at InvestSMART (AFSL 282288). This article contains general investment advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. You should consider the product disclosure statement before making a decision about a product. This article does not reflect the views of WealthHub Securities Limited. The article was originally published on 10 May 2019.