Lessons from CSL's R&D day

CSL’s outgoing chief executive Brian McNamee once remarked that the smartest decision he ever made was employing Andrew Cuthbertson as research director.

Since Cuthbertson joined CSL in 1997, the company has grown earnings per share from 9 cents to a forecast $2.50 for 2013. Over the last 15 years, the share price has risen by 23% a year. Cuthbertson must be doing something right with the money he’s investing in research and development (R&D).

Of course, that performance is down to more than just R&D. Favourable economics and near-prefect execution have been just as important. But without innovative products that harnessed these advantages, CSL would not be the world-leading company it is.

In 2013 CSL will spend over $400m on R&D, more than the company’s revenue in 1997 and ten times its then R&D budget. Whether this pays off depends to a large extent on management. With CEO Brian McNamee stepping down as chief executive in July next year, the main question on my mind as I headed out to the company’s annual R&D briefing was around this issue.

Managing departure

As Cutherbertson and fellow executives Russell Basser, global director of clinical research and development, and Lutz Bonacker, vice president of global commercial development, walked investors through CSL’s R&D program the answer became clear. This is a company with sound internal systems and processes. It should deal with McNamee’s departure with ease.

The structure of the research team, for example, is built around capabilities, not geographies or products. If a team in Germany needs an immunoglobulin expert, and the best person for the role is based in Melbourne, they will be seconded. It’s a more sensible use of brainpower. WorleyParsons and Procter & Gamble use the same approach to great effect.

Also of importance is R&D’s integration with the clinical trial and commercialisation teams. No department works in isolation. CSL also benefits from its R&D team’s size, equivalent to that of a small university. It has huge flexibility in the types of projects it can pursue and a real depth of talent.

Next year’s huge R&D spending will fall into three broad categories: maintenance (making existing products better), market development (gaining regulatory approval to sell existing products in new markets or to treat different problems) and new products.

New products

Maintenance spending and market development remain important but offer only incremental gains. For example, the recent US approval of blood clotting agent Beriplex, which can reverse the effects of blood thinning agent Warfarin prior to surgery, expands the market size for the product.

The really big wins occur in new product development, which is why CSL has progressively invested more money in this area (see Chart 1).

The cervical cancer vaccine Gardasil demonstrates what’s possible. It cost CSL around $10m to develop but has generated more than $650m in licensing fees, most of which is profit.

A number of interesting and exciting projects are underway that, if successful, could significantly boost earnings. For example, CSL is researching the possibility of using monoclonal antibodies to treat a number of health problems (see Table 1). CSL346, for example, could help suffers of Type 2 diabetes by preventing insulin resistance.

This is a new area for the company but offers vast potential; there are over 300m people with Type 2 diabetes. Whether this research will yield marketable products is hard to say. Even CSL admits it doesn’t have all the answers, expressing a willingness to partner with other companies to further develop its findings. But that’s the point of R&D; to develop an idea and find out whether it works. Thus far, CSL has a great track record of doing so.

Superb business

The R&D program is becoming far larger and more sophisticated, moving the company beyond the traditional immunoglobulin and haemophilia markets.

This brings both opportunity and risk. But with a disciplined approach (not betting the company on any single program) combined with the company’s fantastic economics and financial strength, it’s an expansion that makes a lot of sense. Indeed, the company’s long standing commitment to R&D is what made it a truly great business in the first place.

Since upgrading in Competition is in CSL’s blood from 20 Jan 10 (Long Term Buy – $31.30), CSL’s share price has increased 74% and paid $2.43 in dividends along the way. Even with the share price up a further 9% since 27 Nov 12 (Hold – $50.24), this remains a high calibre business we’re very happy to HOLD.

Note: The model Growth portfolio owns shares in CSL.