3 companies with significant tailwinds

After nearly a year of volatile markets, we reached out to three of our portfolio managers to get their thoughts on the most exciting investments for the year ahead. From the latest innovations in cancer treatment, a company providing machines with the gift of sight, and a hotel operator targeting 250% growth, here are some of our best picks.

Using innovation to fight cancer

1 in 2 people will be diagnosed with cancer in their lifetime and nearly half of cancer patients have radiation therapy at some point during their cancer treatment. Varian is a global market leader in the field of radiation therapy, developing devices including linear accelerators and software for treating cancer. Its vision is a world without fear of cancer. Varian aims to increase the number of patients worldwide cared for with its technology from 3 million today to 6 million by 2022.

With the advance of medical technologies and improving diets, global average life expectancy has increased. Sadly, as we live longer, cancer risk also increases. This backdrop creates a growing demand for radiation therapy as it is an effective and relatively affordable treatment option for cancer patients. This market is estimated to grow at 4% annually to $6.3 billion in 2022. The market for radiation therapy equipment is consolidated, dominated by two major players Varian and Elekta. They compete on innovation and technology, which results in better clinical outcomes and lower side-effects for patients.

Varian’s strategy is to transform itself from a global leader in radiation therapy to be a front-runner in multi-disciplinary integrated cancer care solutions. 

This approach helps it strengthen its leadership in radiation therapy, expand its addressable market and extend its global footprint. One of its plans is to expand into the adjacent markets of Care Coordination and Interventional Oncology. Care Coordination is a fast growing market due to the increasing complexity of cancer care. The market is expected to grow 20% annually to $6 billion in 2022. Varian introduced its 360 Oncology care management platform in 2016, bringing together radiation, medical and surgical oncology, social services and primary care physicians to facilitate true coordinated care. This platform enables doctors to provide the highest quality, evidence-based care plan and best clinical outcome possible. Interventional Oncology is another fast growing adjacent market, estimated to grow at 8% annually to 2022. Varian launched Rapidsphere in 2018, a cancer imaging software for the interventional oncology market. The software can aggregate unstructured treatment and imaging data from diverse systems to show a comprehensive view of a patient’s diagnostic imaging and treatment history.

To maintain its competitiveness, Varian is committed to innovation and generally spends 8% of its sales on research and development. There are numerous examples which demonstrate its leadership in innovation. Varian introduced a new cancer treatment device Halycon in 2017 to target emerging markets. Halycon aims to reduce the total cost of ownership and provide faster treatment times to meet the high demand for high-throughput cancer centres in the emerging markets. It also launched a new proton therapy system ProBeam 360 in 2018 with 30% smaller footprint and faster treatment times.

Varian is a pioneer in radiation therapy and we believe it will play an even bigger role in cancer care solutions in the future.

We invest in this stock for the following reasons:

1. Secular market growth: Radiation therapy is a growing market driven by the growing prevalence of cancer and the increasing adoption of radiation therapy in emerging markets.
2. Dominant market leader: Varian has around 50% market share in radiation therapy and is increasing its share.
3. Innovative excellence: Varian is fully committed to innovation. Its technological leadership is evidenced by the successful launch of Halycon, which was selected as one of 2018’s most exceptional innovations in science and technology.
4. Expanding addressable market: Varian has successfully expanded into faster growing adjacent markets through internal development and acquisition.

Enabling machines to see

Lumentum is the world leading manufacturer of optical products for telecom networks. It specialises in lasers that send light long distances over optical fibres, optical switches, industrial lasers used in applications such as cutting and welding, and is the dominant producer of lasers for 3D sensing.

Its 3D laser design, developed over several years primarily for Apple, enables highly reliable lasers to be produced at high volume. 

Lumentum has 80% market share of 3D lasers used in smartphones, which is currently a $500mln market growing to an estimated $2bn market by 2021. 

This growth is fuelled by applications such as facial recognition, enhanced photography and augmented reality, which is being increasingly adopted by individuals and companies alike.

iPhones currently have two front facing 3D sensors with a third rear facing sensor expected to be added in 2020 for augmented reality, and whilst Android smartphone makers such as Huawei and Samsung have lagged behind Apple technologically, they are also gradually adopting the technology. Although we predict Lumentum will lose some of its market share particularly in the Android smartphone market, the company has a substantial lead producing higher specification sensors which offer reduced size and power consumption. 3D lasers are also expected to be used in LIDAR (light detection and ranging) sensors which enable advanced driver assist and autonomous driving in automobiles.

Last year the company acquired competitor Oclaro, which will generate earnings synergies this year and further sector consolidation is likely.

We find the company attractively valued at 11x FY20 PE. The company will be debt free by the end of 2019.

We have chosen to invest in Lumentum for the following reasons:

1. Industry consolidation: Major consolidation in the sector has seen the top 4 players becoming 2 over the last six months.
2. Attractive valuation: 11x FY20 PE and low debt
3. Strong demand: As consumer adoption and industry use increases for new technologies in the way of augmented reality, facial recognition and autonomous automobiles, so too will demand.

Chinese middle-class demand driving significant growth

Huazhu Group is the second largest hotel operator in China, with more than 4,000 hotels and 400,000 hotel rooms in its hotel network. Huazhu owns over 10 hotel brands and its agreement with Accor provides it with the rights to the Mercure, Ibis, Ibis Styles, Grand Mercure and Novotel brands in China. Some of the hotels are owned or leased by Huazhu but the majority of the hotels are operated under a managed franchise model, whereby Huazhu provides the franchisee with a hotel manager and receives ongoing franchising fees while the franchisee is responsible for all the hotel operating costs (rent, employee expenses and capital expenditures).

Huazhu has increased its hotel network from five hotels at the end of 2005 to more than 4,000 hotels at the end of 2018, with about 500 hotels opened in each of the last three years and 600-700 hotels expected in 2019. There are insufficient branded hotels in China compared to the US, especially in the midscale segment and this will continue to drive new hotel openings in the foreseeable future. 

Huazhu has a strong and increasing hotel pipeline and this provides a long and visible runway for growth, with management targeting 10,000 hotels in the longer term.

With the rise of the middle class in China, there is increasing demand for midscale hotels, which have much higher prices and margins compared to economy hotels. Furthermore, the majority of new hotel openings are asset light for Huazhu as the franchisee is responsible for all the upfront costs and this is also margin accretive. The asset light model also protects Huazhu in a cyclical downturn as Huazhu receives a percentage of the franchisees’ revenue but none of the costs.

Huazhu’s competitive advantage stems from its loyalty program with 122 million members, which continues to grow every quarter. The loyalty program reduces reliance on referrals from online travel agencies while making the hotel network more attractive to potential franchisees as being part of Huazhu’s network would immediately provide the franchisee with a potential customer base of 122 million.

Huazhu’s founder was the ex-founder of Ctrip (the largest online travel agency in China) and Home Inns (the third largest hotel chain in China) and under his leadership, Huazhu was able to grow from five hotels to more than 4,000 hotels over 13 years as well as outperform peers in terms of both hotel occupancy and average daily prices.

We invested in Huazhu Group for these main reasons:

1. Growth: The Company has a long, sustainable and visible runway for growth.
2. Management team: Huazhu’s management team has a strong track record of execution, growth and outperformance.
3. Business model: Due to Huazhu’s franchise model it does not incur operating costs and is asset light.
4. Risk: There is a relatively low level of regulatory risk.

NOTE: Since we invested Huazhu’s share price has recovered more than 70% and we recently fully exited our position as the valuation had become stretched. Nonetheless, it remains firmly in our sights should the share price again inexplicably materially decline.

Varian is currently held by our WHEB Sustainable Impact Fund
Lumentum is currently held by our Pengana High Conviction Equities Fund 
Huazhu Group was held by our Pengana International Fund

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