CSL Limited (ASX: CSL) has outperformed the ASX by 253% in the last five years. Its shares have gained 279% during that time and CSL now has a P/E ratio of 32.6. This may cause some investors to avoid buying CSL when the ASX has a P/E ratio of 17.9. However, in my view the company's valuation is appealing due to its growth potential.
Product development
CSL spent US$614 million on R&D in financial year 2016. This enabled it to deliver innovative biotechnology advancements which included a number of key treatments. In my view, CSL's newly launched novel recombinant therapies Idelvion and Afstyla will make a significant contribution to its bottom line. Their recent approval by the US FDA means that CSL will benefit from a full year's contribution in financial year 2017. CSL's earnings will also be positively catalysed by the performance of differentiated products such as Hizentra in my view.
The development of further treatments to build on existing product sales will benefit from CSL's cash flow and balance sheet strength. For example, CSL's free cash flow was US$683 million in financial year 2016 even after capital expenditure of US$495 million. I believe this shows that increased R&D spending is ahead.
Similarly, CSL's balance sheet could accommodate greater debt levels in order to fund acquisitions. It has a net debt to equity ratio of 100% and an interest coverage ratio of 20.3. This shows that CSL's current level of leverage is very manageable.
New growth
A key driver of CSL's future growth will be its influenza vaccine business, Seqirus. I think this is a major growth area because CSL has a dominant position, being the second largest influenza vaccine operator in the world. This provides it with a size, scale and cost advantage over most of its rivals.
Further, the influenza vaccine market is likely to grow over the long term. Currently, it affects up to 10% of adults across the globe each year. World population is forecast to increase from 7.2 billion to 9.7 billion by 2050 which provides a growth backdrop for Seqirus. Nearer term, Seqirus is forecast to breakeven in financial year 2018 and could act as a catalyst on CSL's earnings beyond then.
Income appeal
CSL's cash flow will also allow increasing dividends to be paid in the coming years. In the next two financial years it is forecast to raise dividends per share by 18% per annum. In the 2016 financial year CSL's earnings covered dividends 1.8 times. This means that dividends could rise at a faster pace than earnings. Further, CSL will consider a share buyback of $500 million following its $1 billion share buyback. This will provide support to its share price over the near term.
Outlook
Although CSL has a higher rating than the ASX, its P/E is lower than healthcare peers Cochlear Limited (ASX: COH) and Ramsay Health Care Limited (ASX: RHC). They have ratings of 40.6 and 35.5 respectively. I feel that CSL's Seqirus segment, new product development and income appeal will positively catalyse its share price in the long run.
