Due to a combination of company-specific and industry-related reasons, we believe that Swiss drug-maker Novartis (NYSE: NVS) currently presents an attractive investment idea which is neither unknown nor under followed, yet is underestimated and under priced by Mr. Market. NVS is an extremely well-managed business, with reliably high returns on invested capital and sustainable long term competitive advantages. Most importantly, we believe that this high quality business can be bought today with a 25% margin of safety to its intrinsic value.

 

Healthcare businesses present one of our favorite investment themes for today and for the first half of the 21st century. Nevertheless, we are not going to spend time here exposing the impressive figures behind the aging of the world’s population, or the health care spending that comes with it. These ideas are well known to most readers of this piece, and widely available in various media. Rather, we will restrict ourselves to showing why we believe Novartis is an excellent risk / reward proposition at today’s prices.

 

 

 

In its current form (we’ll talk about the company’s century-long tradition, and its recent transformation later), Novartis operates under four different strategically established segments and is one of the top market players in each of them. As we progress through each of the company’s divisions, it is possible to notice how NVS, through the vision and leadership of CEO Daniel Vasella, has built its business around key strategic initiatives which address the challenging environment in which pharmaceutical companies must operate. The table below illustrates the relationship between these industry challenges and the consequent guidelines adopted by the company:

 

 

The Pharmaceuticals division is the company’s most important segment and represented approximately 63% of group net sales and 84% of group operating income in 2006. Different from several industry peers, NVS has been able to diversify pharma revenues among a reasonable number of different drugs. The company’s largest selling drug last year was blood pressure medicine Diovan, which sold $4.2 billion* (11.7% of total net sales), followed by oncology therapy Gleevec ($2.6 billion, or 7.2% of total net sales), and antihypertensive drug Lotrel ($1.4 billion, or 3.9% of net sales). In fact, each of the company’s top ten selling products contributed with at least $700 million to total sales, and, as a whole made up just 39% of total net sales in 2006. Last year marked the sixth consecutive year of double-digit sales growth and the fifth straight year of double-digit operating income growth for NVS’s pharmaceuticals. Due to its great depth and importance to the company’s long term prospects, NVS’s industry-leading pipeline will be examined in a separate section of this thesis.

*All financial figures in USD.

 

Sandoz is the company’s generics division and an extremely important strategic asset in the currently challenging environment for pharmaceutical companies. This division of Novartis is the second largest player in the worldwide generics market and generated 16% of group net sales and 8% of group operating income in 2006, with 27% sales growth fueled by successful new product launches as well as by the Hexal and Eon Labs acquisitions. Sandoz is at the forefront of such key fields as the development of biological generic drugs (its has the only approved biosimilar to date -- growth hormone Omnitrope -- and is close to getting its second approval), and has top expertise in difficult-to-make drugs, an important differentiation factor among generic companies. Novartis has been the leader among large drug companies in truly embracing the co-existence of branded and generics drugs businesses under the same umbrella. In our view, this business structure brings significant competitive advantages to NVS, such as the ability to offer pharmacy benefits managers lower prices across the board for its branded and generic medicines in exchange for preferential status in PBMs formularies.

The new Vaccines & Diagnostics (V&D) division was recently created with the completion of the acquisition of Chiron Corporation on April 2006 and is an important potential driver of future growth for the company. It generated just over 2% of total net sales in 2006 and generated operating margins of 32%, excluding acquisition costs. In its first eight months of operation as a fully consolidated division of NVS, V&D already achieved important milestones, including the turnaround of its influenza vaccine business led by stockpiling contracts with the U.S. (it is already the second largest supplier of influenza vaccines in the U.S.), U.K., and France in pandemic preparations, good progress in the integration and stabilization of the business (management team established, key regulatory inspections passed, ongoing quality remediation projects on track), and a grant from the U.S. government to support the building of a cell culture facility in North Carolina. This year, V&D has continued to make progress and has gained European approval of two innovative influenza vaccines, Focetria and Optaflu, and US approval of West Nile Virus tests used in blood banks.

     

Last but not least, the Consumer Health division has valuable brands in its portfolio of over-the-counter (OTC) drugs and Animal Health products, and offers an important source of growth and stable cash flows. Among the better-known OTC names are Maalox, Voltaren, Lamisil, Bufferin and Excedrin, the last two acquired from Bristol-Myers-Squibb in a 2005 transaction. In 2006, Consumer Health revenues grew 8% to $6.5 billion (21% of group net revenues), and operating income grew 12% to $1.1 billion (17% of group operating income). In 2007, the Consumer Health division has undergone further transformation with the divestiture of its Medical Nutrition and Gerber baby foods businesses, both to Nestlé, allowing the division to focus on its highest growing segments (OTC and Animal Health, with 14% and 18% sales growth in 2006 vs. global market growth of 4% and 3%, respectively) and providing an $8 billion cash boost to NVS’s balance sheet. 

 

Novartis’s Wide Moat

Due to its sheer scale, it is not surprising to note that Novartis sports significant defenses around its market position. However, we think that Novartis generates compelling value due to the existence of several other sustainable competitive advantages which allow the company to generate consistently superior returns on invested capital. Below, we summarize the key aspects that lead us to believe that Novartis indeed has built itself a wide business moat which is currently being undervalued by the market:

 

Novartis generated revenues of $38.3 billion in the twelve months ended March 31, 2007, a figure that ranks it as the third largest drug maker in the world, only behind Pfizer and GlaxoSmithKline. In addition, for each of the past five years, the company has been able to turn, on average, approximately 20% of its sales into free cash flow. This massive scale and the consequent financial heft gives NVS the ability to defend its market position through strategic acquisitions, substantial investment in R&D, and attraction/retention of the top brains in the industry.

2. Superior Research and Development Capabilities
In the past five years, Novartis has increased its R&D investment from $2.84 billion in 2002 to $5.36 billion in 2006 (17% CAGR). More importantly, NVS has been extremely successful at moving molecular agents through trial phases and bringing new medicines to the market, allowing pharmaceutical sales to grown from $12 billion in 2001 to $22.6 billion in 2006. Evidence of this superior capability is the fact that in the years 2000-2006 no other pharmaceutical company had more U.S. approvals for its medicines, including vaccines, than Novartis with 15 U.S. approvals (Pfizer was second with 12, and Sanofi-Aventis was third with 11). So far in 2007, NVS has already had two additional drugs approved in the U.S. (Tekturna and Exforge, both for hypertension). Further, Novartis currently has a pipeline with 138 projects, of which 94 are in late stage development (more on these soon). The amount of capital, time, and skill needed to replicate such a strong base of intellectual property creation represents a formidable barrier against the entrance of additional relevant/sizeable players, and assures us that the company’s competitive position is well-defended for the foreseeable future.      

 

3. Low Geographic and Product Concentration
In terms of broad geographic reach, Novartis is what we can unmistakably call a global business. It is politically and economically comforting to see that, in 2006, 41% of revenues were generated in the U.S., 37% in Europe, 15% in Asia / Australia / Africa, and 7% in the rest of the Americas. As presented in the previous section of this write-up, in terms of product concentration, Novartis’s revenues are diversified not only among its four different divisions, but also among the products within each of them. This type of broad revenue diversification helps mitigate the effect of product specific issues and regional (economic/political) difficulties, providing a stable base of revenue streams that further solidifies the company’s competitive position.

 

4. Superior Leadership and Corporate Culture
In March 2007, based on a survey of 1,500 pharmaceuticals industry executives and financial analysts worldwide conducted annually by Fortune magazine, NVS was ranked as the #1 company worldwide in the pharmaceutical industry. Companies were ranked on attributes such as innovation, management quality, people management, quality of products and services, commitment to corporate social responsibility and financial soundness. Despite the fact that we are not huge fans of corporate awards as measures of business success and are usually skeptical of such claims, we see this particular one as a good illustration of the company’s superior leadership and deeply ingrained corporate culture. CEO Daniel Vasella and his management team have been successful at creating a company that fosters strong values and translates them into performance and results. This is usually the type of element that escapes quantitative analysis and tends to be ignored when analyzing a business; yet we believe it adds value to the company and represents a truly sustainable competitive advantage.   

 

 

Novartis currently has a rich pipeline of 138 products, of which 94 are in late stages of development, divided into six major therapeutic areas. The pipeline includes 50 new molecular entities (NMEs), while 88 are life-cycle management drugs (LCM’s). There was an addition of more than 20 drugs during FY 2006. Novartis plans to launch several new drugs in the next two years. Filings are planned for four NME’s and four LCM’s in FY 2008. Priority late-stage compounds include FTY720 (multiple sclerosis), QAB149 (respiratory diseases), AGO178 (depression), RAD001 (cancer), ABF656 (hepatitis C) and SOM230 (Cushing’s disease).

 

Novartis received important approvals so far during 2007, including:

- U.S. approval for Tekturna/Rasilez, a treatment for hypertension, which was launched subsequently in March 2007. The drug is a potential blockbuster and estimated to generate sales of approximately US$1.1 bn by 2009.

 

- EU and U.S. approval for Exforge. Exforge and Tekturna approvals further fortify the leadership of Novartis’ hypertension segment, complementing the in-market brands Diovan and Lotrel (recently gone generic).    

- Reclast/Aclasta, a treatment for Paget's disease of the bone which was submitted for regulatory approvals in FY 2006, received US approval in April 2007. The drug is already approved in a number of countries, including key European markets. The drug is also under review for EU and US approval as a once-yearly treatment for women with postmenopausal osteoporosis.

 

- Chinese approval for Sebivo, a drug for the treatment of hepatitis B which consequently received an EU approval in May 2007.

- Lucentis, a treatment for the eye disease wet age-related macular degeneration (AMD), received an EU approval for launch in Europe in January 2007.

 

Novartis received an approvable letter from US regulators in February 2007 for diabetes drug and potential blockbuster Galvus (Vildagliptin). The FDA has asked for more trials to exhibit the efficacy and safety of Galvus and should come out with a new decision in 1H2008. A European approval decision is expected in 3Q2007.

 

Another important source of innovative drugs is licensing activities. Novartis is also an industry leader in this category, with 32 licensing deals in the past two years (tied with JNJ). Recent deals include the acquisition of the rights to NicQb, a therapeutic vaccine against nicotine addiction, from Cytos Biotechnology, and the acquisition of rights to AS1404, an oncology drug targeted at cell lung cancer, from Antisoma plc. Both drugs are expected to begin phase III trials in mid-to-late 2008.   

 

The table below provides an overview of the projects in NVS’s rich pipeline divided by business unit (disease category / therapeutic area) and development phase:

 

 

As previously mentioned, one of the central aspects of the investment thesis for Novartis is the way the company was able to structure the parts of its business around a strategic vision of a challenging and dynamic health care marketplace. The following table presents a good starting point for understanding this transformation:

 

Novartis was created in 1996 through the $30 billion merger between Sandoz and Ciba-Geigy, two of the most iconic Swiss companies at the time with more than a century of tradition each, and gave birth to a conglomerate of 134,000 employees that included operations in specialty chemicals, plant protection and seeds, medical and baby nutrition and pharmaceuticals. In April 2007, with the sale of its Gerber baby foods business to Nestle, Novartis completed its efforts to establish a 100% concentration in health care. Rather than go into much detail regarding each of the spin-offs, divestitures and acquisitions that led to the current picture, we deemed it more insightful to focus this section of the thesis on the main characters that were behind the process, and that have contributed to make NVS a top player in its market.

Often, one of the main traits of a truly great business is the presence of a great leader at the helm, with the ability to look at things from a larger perspective and inspire others to follow suit. The birth of Novartis provided the opportunity for the emergence of one of these leaders in Daniel Vasella, an M.D. from the University of Bern with management skills honed at Harvard Business School. Dr. Vasella took the helm at the newly created Novartis in 1996 when he was only 43 years old and was also appointed Chairman of the Board in 1999. He was responsible for directing the integration of Ciba-Geigy and Sandoz, and has led the company through its decade of strong growth and focus on healthcare with pharmaceuticals at the core.

Dr. Vasella realized that Novartis had to become a truly global company in order to thrive in a challenging healthcare market and has directed several strategic initiatives in this direction during his tenure: Moved the company’s research headquarters from Basel to Cambridge, Massachusetts; Created the Novartis Institute for Biomedical Research with research sites located in the U.K., Austria, Japan, the U.S.A., Switzerland and China. Founded the Novartis Institute for Tropical Diseases in Singapore; and created the Genomics Institute of the Novartis Research Foundation, in La Jolla, California.

In leading Novartis through its decade of transformation and growth, Daniel Vasella has worked alongside one of the top management teams in the pharmaceutical industry, with tenures that in most cases span all ten years of company history. Here is a brief look:

- Thomas Ebeling, CEO Pharmaceuticals since 2000, joined Novartis in 1997 as General Manager of Novartis Nutrition for German and Austria. Before joining Novartis, he served as General Manager of Pepsi-Cola Germany, where he began his career with the company in 1991 as a Marketing Manager.

 

- Andreas Rummelt, Ph.D., CEO of Sandoz since 2004, joined Sandoz in 1985 and served in various positions before becoming a top officer in 1994. Following the acquisition of Hexal in Germany and Eon Labs in the US in 2005, Andreas Rummelt succesfully led the integration of the combined companies.

 

- Joerg Reinhart, Ph.D., CEO of Novartis Vaccines and Diagnostics, joined Sandoz in 1982 and was Global Head of Development in the Novartis Pharmaceuticals Division until being named CEO of the recently created division. Under his leadership, Novartis achieved an outstanding record in development quality, speed and productivity, resulting in a full product pipeline recognized as one of the most successful in the industry.

- Joseph Jimenez, CEO Consumer Health, joined Novartis in April 2007. Jimenez served as president and Chief Executive of H.J. Heinz in Europe from 2002 to 2006, and was most recently an advisor for private equity organization Blackstone Group. Jimenez was also a non-executive director of AztraZeneca plc from 2002 to 2007.  

 

- Raymund Breu, Ph.D., has been CFO of Novartis since the creation of the company on 1996. He joined the group treasury of Sandoz in 1975, became CFO of Sandoz Corporation in New York in 1985, and was named Head of Group Finance in 1993.

 

 

Who wants to own Novartis (or any pharmaceutical company)?

A very interesting aspect of studying the investment opportunity in Novartis today, or in almost any of the large pharmaceutical companies for that matter, is to historically follow the path of an industry that has gone from the top of the list of Wall Street darlings to the top of the “worst places for new money now” list. As each new episode of patent expiration, product withdrawal, or class-action lawsuit unfolded, one could almost hear the sound of institutional money managers dumping pharma stocks and sell-side analysts downgrading en masse. The performance of most large pharmaceutical companies in the past five years reflects this reality, as evidenced by the 17.4% return of the AMEX Pharmaceutical Index vs. a 60% return for the S&P 500 during the same period. 

 

Interestingly, if one looks at the best performers of the S&P 500 for the past 50 years, as presented by Wharton professor Jeremy Siegel in his book The Future for Investors, one will notice that of the top five performers, three are large pharmaceutical companies: Abbott Laboratories, Bristol-Myers Squibb and Pfizer, with 16.51%, 16.36%, and 16.03% annual returns, respectively.

 

The contrast between the abovementioned data points raises two opposing perspectives regarding the current state of the pharmaceutical business that are of real importance to this investment thesis: the notion of a disrupted pharmaceutical business model vs. the notion of a challenged pharmaceutical business model. In our view, Mr. Market currently looks at pharmaceutical stocks in general as if the model that turned $1,000 invested in Pfizer in 1957 into $1 million in 2003 were permanently broken (during this 46-year period Pfizer’s average P/E was 26.19; today it sits at 13.) Although we recognize that there are real challenges being faced by pharma companies and that the model may eventually prove unsustainable, we believe that the market’s typical aversion to uncertainty has overshadowed the fundamental strengths that still exist in several drug companies.

 

Through the lenses of Novartis, we highlight what we deem to be the most widely perceived risks to the achievement of superior long term returns in the pharmaceutical industry, and present the potential answers that Novartis has been giving to each of these challenges:

 

- Patent Expiries / Impact of Generics: We estimate that Novartis will lose an average of 3.5% of branded pharmaceutical sales per annum until 2013 from patent expiries. Nevertheless, there are three factors that are likely to mitigate this impact. First, due to diversification among four segments, the overall group exposure to revenue loss from patent expiries is far lower than the number above. Second, Sandoz will partially offset this loss as Novartis has the ability to produce generics of its own drugs as well as to capitalize on other companies’ patent expiries. Finally, the launches of four potential blockbusters (Tekturna, Exforge, Aclasta, and Galvus), as well as other promising drugs among the 50 medicines in late-stage development, should also help offset the losses.

 

- Increasingly stringent regulatory controls / Product Liability Risks / Escalating R&D Costs: Since the widespread attention that Merck’s Vioxx case received a few years ago, the FDA has been under increasingly stronger pressure to tighten its regulatory standards and investors have been wary of potential product liabilities. So far in 2007, Novartis has already been hit with two negative decisions in these fronts: the delay in the approval for diabetes drug Galvus and the withdrawal of irritable bowel syndrome drug Zelnorm. These setbacks have been somewhat offset by the approvals of Tekturna, Reclast, and Exforge. As previously mentioned, we believe that NVS has diversified its revenues among several different products and developed a pipeline of innovative medicines in a way that mitigates the impact of these negative product-specific developments. Further, we believe that a stricter regulatory environment may even be a potential long term positive for large pharmaceuticals such as Novartis, because the escalating costs of Research and Development involved in bringing a drug to the market may heighten even more the barriers to entry in NVS’s market.

 

- Growing Role of Government in Healthcare as Purchasers and Price-Setters: The growing participation of government in healthcare spending and drug pricing, as illustrated by the enactment of Medicare Part D benefits in the U.S., is generally perceived as having more potential drawbacks than benefits for pharmaceutical companies. By acknowledging the central role that governments will play in the dynamics of the healthcare market, Novartis has positioned its business to benefit from this trend. By establishing market-leading businesses in both the generics and vaccines segments, NVS has the capability to answer to the demands brought about by this trend and to further translate this strategic edge into privileged market positions for its branded medicines, enhancing the protection of its intellectual property.    

 

Novartis’s traditionally European model of conservative financial management, along with its strong cash generating business model, has the company on very solid financial footing. The company has been successful in achieving the financial targets established for its strategic concentration on healthcare and, in 2006, achieved revenues of $36.0 billion, operating income of $7.9 billion, and net income of $7.0 billion, representing industry-leading annual compound average growth of 15%, 14%, and 11%, respectively, since 2002. Last year, the company generated $8.7 billion in cash from operations and had $1.8 billion in capital expenditures. Novartis is one of the few non-financial companies worldwide to have attained the highest credit rating (AAA) from all three rating agencies.

 

On April 12, 2007, Novartis made an announcement which had already been indicated by management in previous conference calls: the sale of the Gerber baby food business to Nestle for $5.5 billion and the completion of the company’s divestiture program in accordance with its strategy to focus on healthcare with pharmaceuticals at the core. In addition to the proceeds from this sale, another $2.5 billion have been added to the company’s coffers with the completion of the previously announced sale of NVS’s medical nutrition business also to Nestlé. This $8.0 billion cash inflow has further strengthened NVS’s capacity to maintain growth in R&D investment, pursue further strategic acquisitions, and increase dividends and buybacks. It is important to note that Novartis has a policy that, in the absence of acquisitions, calls for allocating up to half of free cash flow after the payment of dividends for the repurchase of shares, and in the 1Q2007 conference call management asserted that this year should see a pickup in buyback activity after a period of several acquisitions.         

 

In valuing Novartis through a DCF analysis, we have assumed annual revenue growth of 7% until 2011, and 5% annual growth until 2016. Free cash flow margins were normalized at 18% and we have attributed a sale multiple to projected FCF in 2017. Share count was held steady at today’s 2.36 billion. These assumptions are supported by NVS’s industry-leading pipeline, superior growth in generics and vaccines markets, and the company’s strong competitive advantages, which enables the company to generate consistent cash flows. Our sensitivity analysis indicates a fair value in the range of $71 - $77, representing a margin of safety of approximately 25% at the mid-point.

 

 

On a peer comparison basis, Novartis has historically traded at a premium to the industry average. This trend is not surprising, given the company’s portfolio diversification and superior earnings growth profile. Currently, the company sports and EV/EBITDA ratio of 13.5x compared with an industry average of 10.5x. At 128% of the industry average NVS is trading at the lowest relative valuation in the past four years. A more interesting way to value NVS in comparison to its peers might be the utilization of an estimate of the NPV of the company’s marketed drugs, pipeline drugs, and other earnings streams as a % of current EV. This analysis indicates that Novartis’s current NPV is approximately $70 per share, or approximately 125% of NVS’s current EV. NPV data is provided courtesy of Lehman Brothers equity research. It is important to note that Novartis is currently the only pharmaceutical stock in Lehman’s coverage universe that trades below NPV.