What Makes a Winner-Take-All Game

What are the industry contexts that leads to a winner-take-all game? Are there industry properties that naturally encourages consolidation and oligopolies? Network effect is the first that comes to mind. But surely that can’t be the only one? I have been struggling with this question.

Then I realized - invert. The question is really “what makes an industry fragmented?” There’s literally a whole chapter in Michael Porter’s “competitive strategy” that answers this question.

Porter’s Causes of Fragmentation

Here’s Porter’s list of causes for fragmentation:

• Low entry barrier
• Absence of economies of scale or experience curve
• High transportation cost
• High inventory cost or erratic sales fluctuations
• So scale is less of an advantage because your plants can’t operate production continuously. Scale may and down
• No advantages of size in dealing with buyers or suppliers
• Perhaps because buyers or suppliers are even bigger
• Dis-economies of scale in some important aspects
• Rapid product/style changes
• Low overhead important
• Diverse product line that requires customization
• Heavy creative content
• Close local control
• Personal services important
• Local image and local contacts are important
• Diverse market needs
• High product differentiation, particularly if based on image
• Exit barriers. This reinforces low entry barrier, as too many competitors can come into the industry and not exit.
• Local regulation
• Government prohibition or concentration
• Newness. This bears a lengthier discussion. If fragmentation is caused by newness, then it may be a temporary condition. The industry may actually be ripe for consolidation.

Simplified List

We can consolidate this list into a few big buckets: 1) low entry barrier (a pre-requisite to be combined with other attributes according Porter), 2) no advantage to size, 3) diverse buyer segments/needs, and 4) distribution friction (high transport cost, local regulation). Of course, regulation is an ever present force.

Invert back. The reverse of the above properties enables winner-take-all dynamics: 1) high entry barrier/low exit barriers, 2) big advantages to size, 3) homogeneous buyer segments, and 4) low distribution friction.

It’s the “advantage to size” that made me say “duh ! Why didn’t I think of that?” Of course there has to be advantages to size! Otherwise what’s the point of getting bigger? The two most prominent types are:

• Network effect: Better value proposition for the customer as you add nodes to the network
• Economy of scale: Unit cost declines as volume increases.

As a firm gets bigger, the former increases customer benefits (“B”) while the latter decrease cost of production (“C”). Both creates a widening gap between B minus C that leads to increasing returns on capital. 

Ideally there’s a positive feedback loop of increasing return to scale: a company grows in size, which gives it some competitive advantages over rivals, this allows the company to gain more market share, and the increased size yields even more competitive advantages. This feedback loop continues as long as the advantage to size overwhelms any advantages to smallness. This is as opposed to the reverse dynamic where a firm’s growth gets constrained by dis-economy of scale (negative feedback loop).

Porter also talked about how to overcome fragmentation and achieve consolidation. His approaches mirror the 4 buckets I gave, with emphasis on increasing scale and using standardization to overcome diverse market needs.

Growth Industries

The last point in Porter's list is "newness". Where the industry is in its life cycle also matters. Winner-take-all games are more likely to happen in fast growing industries facing disruptive innovation. This is because the industry has to create a whole new value chain, and that value chain needs a leader. Ideally the leader pushes forward with standardization schemes, which helps 1) various parts of the chain to interface with each other, 2) customer adoption.


How About Switching Cost and Differentiation?

That’s all great, but how about switching cost and differentiation?

Remember, the above are industry properties that encourage winner-take-all games. They apply to all companies in the industry. But I think switching cost and differentiation are best discussed in terms of how a specific firm can become that “winner”.

Differentiation is obviously a firm specific factor, while switching cost can be both industry-wide and firm specific.

In the industry context, switching cost appears under multiple categories. It is cited as a barrier to entry by Porter and is related to network effect (which I categorize as a form of “advantage to scale”).

Ultimately though, a customer switching from Firm A to Firm B is good for one and bad for another. In this sense the discussion of switching cost requires a company specific perspective. Switching costs can also vary according to company strategy. For example one can increase stickiness by having multiple touch points with its customers.

Naturally, the next question is “how does a company win in a winner-take-all-game”. I’m still thinking through that, so any inputs/comments would be appreciated. Thanks!

Facebook and Google: How Online Ads Will Do In the Next Recession

Investors of Facebook (FB) and Google (GOOGL) have been worried about privacy issues and now anti-trust issues for the past couple years. I think an even more important question though, is how cyclical are their ad revenues?

Theoretically, advertising should be highly cyclical. Advertising acts as weapons in business wars for market shares gains, which primarily happens during an expansion.

Think about all the subscale/unprofitable startups that spend over 100% of revenue on sales/marketing. They’re willing to spend lavishly on advertising under the logic that market share begets more market share (network effect); that they will be able to retain customers, and therefore the lifetime value of those customers should exceed sales and marketing expenses. These companies are generally cash flow negative and depend on external funding. In a liquidity risk-off situation that funding get cut off, and their advertising spends on FB and GOOGL could come to a sudden halt.

In short, companies (especially SaaS guys) are treating advertising expenses as capital expenditures, and thus advertising revenues should reflect more cyclical characteristics.

This points to a downside scenario for Facebook and Google (disclosure: I’m long both). We will at some point hit a recession. Google and Facebooks’ revenues may not just stop growing but actually decline (volume and price both drop). Then you have operating deleveraging, lower margins, and earnings and free cash flow gets destroyed.

What Happened During 2008-2009

The easiest way to see how something might fare in a recession is check how well it did during 2008-2009. There the data is surprisingly good – online ads actually did well during the great recession. Google’s revenue growth slowed but never turned negative. 

Here’s a Harvard Business Review article from 2009 that discusses the strength of online advertising:

“Despite a deepening recession, marketers spent 14% more on online ads over the first three quarters of 2008 than they did over the same time frame in the previous year.”

There are structural and cyclical components to this phenomenon. The structural part is easy - digital ads were in its early innings during that time as people were still moving online.

The cyclical component is also intuitive. Companies become more budget conscious in a recession. They want more measurable ROI and more precise targeting as opposed to a scattershot approach. Both factors favor digital ads over broad based TV ads.

People also lean on their social networks more in a downturn, for job networking as well as emotional support. This resilient usage of social networks makes it a good media for ads. 

Differences Then vs Now, Conclusion

Granted, the current situation has important difference compared to 2008. Online ads are no longer in the early innings – 2019 will mark the first year digital ads make up over 50% share of advertising market. Furthermore, Google’s revenue was growing 50-60% a year heading into the 2007 downturn compared to the mid to high teens growth rate it now shows.

Both Facebook and Google have made strong moves into video advertising, where they still have the advantage of more quantifiable ROI and precise targeting against traditional TV. However, the competitive edge is less overwhelming nowadays with smart TVs like Roku that can also do targeted advertising.

The two companies will also have to fend off new entrant Amazon.

Despite these differences, some of the behavioral patterns should still hold. In a recession I think people will still network more, lean on their social circles more, and probably spend more time online searching for jobs and information.

Weighing these factors, my recession scenario for Google and Facebook is as follows:

• Ad prices should take a hit to maintain ad buyer ROI – (as conversion rates go down in a recession).
• Volume down 5-10%.
• Overall mid teens decline in revenue.
• Margins and earnings will take a hit and stock prices will get punished as well. 

Looking beyond though, there’s no question FB/GOOGL have the balance sheet to survive a recession. Once recession recovers, ad volumes would spike back up.

So for the long term investor, the question goes back to structural growth opportunities. Here the prospects are bright. Both companies continue to develop new products, both for consumers and for advertisers. Both have established strong presences in digital video advertising and taking the lead in trialing new formats to optimize advertiser ROI. From that perspective, they’re still in the early innings.

Coherus (CHRS) Part 3: What Happens After Udenyca Peaks

8/4/2019 Notes

I had a mistake here. Udenyca value should be more than I figured below because its pass-through status does not expire in 2 years as I assumed, but in 3 years.

Original Post:
I want to follow up on my last post about Coherus ("CHRS"). In the end I wrote:

"I do have some reservations about Coherus beyond Monday’s event. They are 1) Sandoz’s version of bNeulasta likely coming later this year. 2) what happens to Udenyca’s revenue after it peaks."

After thinking about it more, I’m not too concerned about Sandoz’s upcoming biosimilar. Sandoz will get its share and I already built that into my Udenyca peak sales estimate - by dividing the bNeulasta TAM between 7-8 players. Also, Udenyca’s superb launch performance should give Coherus some advantage, as the biosimilar market for hospitals has some stickiness.

The bigger uncertainty is how Udenyca will perform after it reaches peak revenue. Starting April 2019, Udenyca benefits from its “pass-through status”, a designation that allows 340b hospitals that use Udenyca to get reimbursed at ASP+6%, compared to the ASP-22.5% if they use original Neulasta. This obviously favors Udenyca and likely contributed to its sales spike starting April.

The problem is this pass-through status expires after 2 years, and then Udenyca would get reimbursed at ASP-22.5% as well.

This would make Udenyca less profitable for 340b hospitals. So Coherus will likely have to cut prices to let hospitals maintain their unit economics. Going from ASP + 6% to ASP-22.5% is almost a 30% cut to hospitals, and Coherus may have to eat that difference to maintain its market share. (Note this is 30% of Neulasta’s ASP, which by then should be fairly close to Udenyca’s ASP).

This is just for 340b hospitals, not non-340b hospital or clinics. But it’s probably safe to say a price cut in one customer segment will spill over to others. For modeling, I would 1) assume some peak revenue by 2020-2021, then 2) step that down by the almost 30% cut in reimbursement, keep revenue at the reduced level for a few years, and 3) use some decline rate afterwards in perpetuity.

So revenue cadence might look something like this (erring toward conservatism) 

• 2019. Already at $320mm runrate by 2Q19! But if Sandoz enters later this year growth will decelerate (but should still grow)
• 2020. Revenue of $350mm. This is too conservative given annualized revenue of $320mm in the second quarter of launch. But we’ll just use this for illustration purpose.
• 2021. Start out at $350mm run rate. But pass through status expires in April 2021 and Coherus could a 30% price cut, thus revenue goes down to $245mm run rate. Blended revenue for the year is about $300mm.
• 2022 – 2026. Revenue of $245mm
• 2027 and onward. Revenue declines 5% a year.

Using a 10% discount rate and 85% gross margin, the present value of Udenyca gross profit is well over $2bn. But to put a value on Udenyca, we have to consider the expenses as well.

So what is it worth, and to whom?

From Coherus’ perspective as a standalone company, most of the expenses for Udenyca will be SG&A, as there are little R&D expenses left. Using $140mm SG&A expense and 10% discount rate, I get to about $530mm of present value for Udenyca. Once they have other drugs in the market (bHumira for example), we can attribute less SG&A to Udenyca due to cost synergy, so the value for Udenyca would be much higher.

What is Udenyca worth in the marketplace though? Potential acquirers who already have the sales and marketing infrastructure can buy Udenyca and capture the bulk of gross profit. As we stated earlier, the present value of that cash flow stream would be over $2bn. This means Udenyca could be worth well over 5x peak revenue, even taking into account the expiration of pass through status and the price drop that will likely come with it.

CHRS’ market cap of $1.4bn compares favorably to this potential. That's not even considering pipeline value and platform value. So I will hold my core position, and trade around the incremental shares I added last week.

Coherus (CHRS) Part 2: Thoughts on Monday’s Price Action

On Monday 7/8/2019, Coherus (“CHRS”) pre-announced revenues of $79-$84mm for 2Q19. This represents more than 100% increase over last quarter, and is well above consensus revenue estimate of around $50mm. It also blew away my own estimates. In my write up last week, I estimated Udenyca peak revenue of $300mm. Now, only in the second quarter of launch, Udenyca is already at annualized rate of $320mm! 

Yet the stock tanked, at one point down 20%. It bounced back slightly later in the day to sustain above its 50 day moving average. A couple days later it is back above $20 - still a material drop from peak of ~$23.

Thoughts on Monday’s Price Drop

So what might be the problem? No one knows for sure. But usually when something like this happens it’s due to 1) growth deceleration, 2) industry bad news, or 3) competitor did something.

Let’s review these possible causes one by one.

First is the question of growth deceleration. Udenyca’s volume spiked shortly after 1Q. Using Udenyca’s April pace of sales alone, I was able to project around $70mm in revenue for 2Q19. Some analysts had data that says May is even better. I can certainly see someone extrapolating the April and May growth into June, and came up with something like $90mm for 2Q19.

Viewed this way, 2Q19 revenue landing at $79-84mm does imply a slowdown in Udenyca sales for June. Take it a step further, does the slow down imply that previous revenues were boosted by some sort of inventory/channel pull forward? That’s certainly possible.

But I don’t invest base on monthly trends. If anything, given Udenyca’s way above expectation performance, we should be upgrading our estimate of peak sales. If some slowdown in June is the reason for the stock drop, then I’d say it’s a buying opportunity.

Second, industry news. I don’t think this is it. Trump made some noise about cutting drug prices, but it’s just that – noise. In fact, government effort to cut drug costs may actually be bullish for Coherus if it means pushing for more biosimilars.

Third is if there are any news from competitors. CHRS's next product in the pipeline is bHumira. On Monday, Samsung Bioepis's Imraldi (biosimilar Humira) received an updated EU label, allowing them to doubles the days of storage. So Samsung's bHumira could actually be better than the original Humira! This is not good for Coherus.

But does this matter that much? Coherus’ own bHumira doesn’t launch until 2023. It’s possible the company can still adjust the product to match whatever product advantage that Samsung Bioepis has. It’s also questionable if longer storage days really matter much to customers.


I concluded that none of the above factors have a material impact on Coherus’ big picture prospects. So I added a little bit to my position.

But I’m nervous. Stock dropping on good news is usually a bearish signal, and the vehemence of the sell-off tells me “someone knows something I don’t know”.

I do have some reservations about Coherus beyond Monday’s event. They are 1) Sandoz’s version of bNeulasta likely coming later this year. 2) what happens to Udenyca’s revenue after it peaks.

I will post some thoughts on these in the next few days.

Coherus (CHRS) Could Be Worth $30-$40 a Share

Coherus Biosciences ("Coherus", “CHRS”) is a pure play biosimilars company. With recent controversies regarding sky high biologic prices, biosimilars are looked upon to enhance market competition, contain prices, and broaden patient access.

Coherus currently has one product that just launched – Udenyca (biosimilar Neulasta). It also has a bunch of stuff in the pipelines, with the next product being CHS-1420 (biosimilar Humira) coming around 2023.

The stock trades at $22.5 at the time of this writing. Some quick estimates of revenues for bNeulasta and bHumira are enough to show that the CHRS can get to $30-$40 a share.

TAM and revenue estimate for Udenyca

A reasonable revenue estimate should factor in 1) lower revenue due to lower prices, 2) original brand's own retention, 3) market share, 4) OnPro (a separate discussion to follow). 

Here are some facts and baseline assumptions:

• Neulasta is a $4.5bn market.
• Mylan prices their biosimilar Neulasta ("Fulphila") @ 33% discount. So does CHRS’s Udentyca.
• Assume Amgen retains 20% of market post all the biosimilar launches.
• Assume about 7 players to evenly split the biosimilar Neulasta market.

So I estimate Udenyca peak revenue to be 4500 * 66% * (1-20%) / 7, or about $340mm. If we assume 8 players instead of 7, that’s still $300mm for Coherus.

This estimate is conservative for a couple reasons. First, I’m saying TAM for biosimilar Neulasta is 4500*.66 = $2970mm. Essentially I’m shrinking Neulasta market size by biosimilar pricing discount, while not taking into account that lower price should lead to greater patient access and greater volume.

Second, I assume market shares are split evenly. This will likely prove to be too conservative for CHRS. Now, maybe big guys like Sandoz would take disproportionate share, but CHRS is far from the weak hand here. Udenyca’s 1Q19 result was maybe the strongest biosimilar launch in history. The hospital market has some stickiness because biosimilars are not complete substitute for each other and the administrative cost of switching is high. I’m also counting competitors such as Cinfa and Accord Healthcare (raise your hand if you ever heard of these guys…) 

More On Udenyca – the Onpro discussion

Udenyca is a prefilled syringe. But some 60% of Neulasta revenue is from “Onpro”, the on-body injector version of Neulasta. That leaves only 40% for the pre-filled syringe market. So should I treat Onpro as a totally separate market, and therefor apply 60% haircut to my Udenyca revenue estimate?

I believe this was a big worry for the investment community, until 1Q19 results and commentaries changed that narrative. I also think that, along with higher than expected gross margins, explain the recent stock run up.

Udenyca brought in $37mm of revenues in its launch quarter (1Q19) – that’s a run rate of almost $150mm. This blew away estimates and would hint that Onpro is not a totally separate market immune to prefilled syringe competition.

The earning call gave more indications that OnPro will not be a barrier. Management said 40% of the biosimilar gains actually came from OnPro. They also confirmed that Coherus will go after the entire market and will have their own on-body device.

So I’m sticking with my $300-$340mm sales estimate for Udenyca because: 1) they are already taking share from Onpro. 2) CHRS plans to go after the entire Neulasta market including Onpro, and confirmed they will have their own on-body device, 3) Onpro itself packs a prefilled syringe and does not seem that hard to make, and 4) OnPro is a single use device, the main benefit being that patient do not have to return next day to get an injection. That seems to me a marginal benefit CHRS can overcome with the right pricing incentives.

Biosimilar Humira

So I think Udenyca gets to peak revenue of $300mm. I will use that exact same number for biosimilar Humira, the next in Coherus’ pipeline.

Humira market is a multiple of Neulasta’s ($20bn versus $4.5bn), so this should be conservative enough. Offsetting that is the possibility of more competitors for bHumira compared to for bNeulasta. Sandoz, Boehringer, Amgen are all FDA approved while a few others including CHRS are still in pipeline. Also, unlike in Udenyca’s case, CHRS will not be one of the earliest to market. 

I think these factors offset, and peg the combined peak revenues for Udenyca and bHumira at $600mm. This should happen around 2025-2027 timeframe.

Valuation

Coherus' market cap of ~$1.5bn look cheap compared to my estimated peak revenue of $600mm. Keep in mind this is a business with gross margins over 90%. Also, I have not assigned any value to other pipeline products such as biosimilars for Enbrel and Eylea.

As a sanity check, below is what I think normalized EBIT might look like once biosimilar Humira hits market. I assume gross profit of 85%, normalized R&D as trials tail off, and higher SG&A due to sales force expansion. Again, projected EBIT of $170mm would make current enterprise value of $1.6bn look cheap. 

As for the upside, I will simply take this $600mm revenue and apply a typical 4-5x revenue multiple for biopharma stocks. That gets us to $2.4bn-$3bn market cap, or around $30-$40 a share depending on your assumptions for cash burn and equity dilution.

Finally, CHRS will approach cash flow breakeven in an year or so. So there won’t be too much dilution that makes stock more expensive than it looks.