Biotech Values

[DewDiligence]

Novartis Shares Are Cheap, Says Barron’s

http://online.barrons.com/article/SB50001424052970204870904575602683197788138.html

›Novartis is due to lose key patents and is struggling to complete its purchase of Alcon, but its shares are still cheap

SATURDAY, NOVEMBER 13, 2010
By VITO J. RACANELLI

Over the past 12 months, shares of drug maker Novartis have bounced up, down and up again, yet have managed only half the market's 11% gain. Over the longer term, at 56, its American depositary receipts (ticker: NVS) sit roughly where they did at the end of 2005, although since then, the Swiss health-care giant has doubled its dividend and increased profits at an average double-digit rate.

Blame the stock's sluggish performance partly on sector problems, such as expirations of drug patents over the next few years, which could mean revenue gaps across Big Pharma, including Novartis. Some observers deem expensive the company's $38.7 billion purchase this year of a 77% stake in Alcon (ACL). They're worried by potential dilution as Novartis battles to buy the rest of the fast-growing eye-care company from minority holders.

And just last week, the drug maker said it will halt testing of a lung-cancer drug after study results indicated it didn't improve patient survival rates [ASA404, licensed from Antisoma (#msg-56555376)]. As a result, Novartis will take a charge of $120 million against fourth-quarter earnings.

But failures, like successes, are part of the drug business, and the main concerns appear overblown. Novartis is one of the few drug companies likely to post double-digit earnings growth into the teeth of the patent-expiry period, thanks to a diverse pipeline of cardiovascular, oncology, ophthalmic, respiratory and immunology compounds.

The diversity is also geographic, with 68% of sales outside the U.S. and 22% in emerging markets, as well as operational, with important vaccine and generic businesses, in addition to branded drugs. Novartis has a strong balance sheet, prodigious cash flow and a dividend yield of 3.5%, with prospects for higher payouts.

Patent worries currently obscure the improvements to come at Novartis, but as revenue from new drugs and from Alcon kick in, the shares are poised for significant outperformance, with potential total returns of 25% to 30% over the next two years.

Over the next five years, Novartis will lose patents on key drugs. Hypertension drug Diovan, its most important drug at $6 billion annually, or about 14% of total revenue, loses patent protection in stages during 2011-13, and will most likely be hurt by generic competition. [However, Diovan generates a lot of business in emerging markets where it has never been patent-protected; these sales should enable Diovan to be a big-selling drug after the patents expire in the US and EU.]

And after paying a hefty $168 a share for its Alcon stake, or 25 times Alcon's 2009 earnings per share, Novartis is offering 2.8 of its own shares, currently worth about 157 a share, for each of the remaining 23% of Alcon shares it doesn't own. But a slate of independent Alcon board members has rejected this. A raised stock bid could mean more dilution at Novartis than expected, but with $10 billion in pre-Alcon annual free cash flow, Novartis could pay in cash, making the deal more accretive. Alcon shares closed Friday around 163.

Novartis faces typical sector headwinds, too: tougher regulatory oversight around the world, health-care reform in the U.S., price cuts in European markets and longer and costlier drug lead times. But investors seem to be overlooking some important differences between Novartis and the rest of the drug pack. For one, the Basel-based company is relatively less pained by patent expiries, and the stock's valuation seems to already discount this concern. Besides Diovan, Novartis' other big patent expiry is further out, the $4 billion of annual sales of Gleevec, a drug to treat certain forms of leukemia, in 2014-2016. [Fortunately, NVS has Tasigna to retain a decent portion of this market.]

"Diovan is going to hurt, but it's priced into the stock already," maintains Channing Smith, a money manager at Capital Advisors, a growth institutional investor that owns about 93,000 shares. He expects low-double-digit earnings growth, "much higher than the industry average," supported by Alcon, improving margins, new drugs that will surprise on the upside, and expense controls.

Novartis also sports deep research and development capabilities—among its rivals it's had the most compounds approved by U.S. and European authorities in the past three years—and a pipeline of 143 drug projects in development, including 56 molecular compounds. [LOL re the phrase, “molecular compounds”—obviously, the author meant to say *new* molecular compounds.]

For example, Gilenya, the first oral medication for relapsing multiple sclerosis, which affects over two million people worldwide, is likely to be a blockbuster, notes Matthew Burdett of Thornburg Investment Management. Analysts expect the medication to pull in $1 billion to $3 billion at its peak.

Then there's Tasigna, a second- line therapy for leukemia, and Afinitor, an existing kidney-cancer drug that has been approved for new indications in Europe; Novartis expects Afinitor sales to top $1 billion. MenB, a meningitis vaccine for which Phase 3 trials were just completed, is expected to garner $500 million in annual sales [#msg-55887085]. With new drugs, "they have built a bridge over the patent cliff," says Burdett. Thornburg owns about 10 million shares.

Such compounds plus Alcon—which has higher operating margins, 34% versus Novartis' nearly 20%, and produced $2 billion in net income on $6.5 billion in sales—should handily offset the lost revenue and profits from patent expiries. Better still, Alcon "is a lot more steady than a drug," opines Sanford C. Bernstein analyst Timothy Anderson, who has an Overweight rating on Novartis.

Notes Joseph Jimenez, Novartis CEO, in an interview: To move Novartis through the patent cliff, "we've built a plan that doesn't rely on any one compound, like Gilenya, for example…and should result in significant growth for the company."

Drugs were about two-thirds of sales and 77% of operating profits in 2009, but the company has a small but growing vaccine business, 5% of sales, and its Sandoz subsidiary, 17% of sales and the world's No. 2 producer of generic drugs. Novartis' over-the-counter brands include Excedrin and Maalox.

With full ownership of Alcon, pharma will likely make up roughly 55% of total sales, adds Jimenez. Emerging-markets revenue is growing at double-digit rates versus single digits in developed nations, and 22% of Novartis' sales derives from emerging markets, where sales will grow significantly as a percentage of the total sales, he predicts.

Henry Smith, chief investment officer at institutional investor Haverford, adds that "through Novartis you can play several important health-care trends," like generics. "Sandoz doesn't get enough attention, and the drug maker also has a good presence in emerging markets, where the creation of a middle class will help purchasing power." [I.e. NVS is a clear beneficiary of The Global Demographic Tailwind.] Haverford owns about 760,000 Novartis shares.

With its better growth prospects, Novartis' shares are a relative value in its group. The stock changes hands at a sector multiple of about 10 times 2011 consensus estimates of $5.40. In 2009, Novartis posted revenue of $44.3 billion and earnings of $8 billion, or $3.71 a share. In the first nine months of 2010, which includes Alcon only partially in the third quarter, sales rose 16% to $36.4 billion and net income 26% to $7.7 billion, or $3.34 a share.

Patent-expiration dates for some key Novartis products, along with some big drugs in the pipeline.

 
 Product  Ailment      Patent ends  Sales $bln 
 Diovan   Hypertnsion  2011-2013    6.0 
 Gleevec  Leukemia     2014-2016    4.0 
 Gilenya  MS           NA           1-3E 
 Tasigna  Leukemia     2023         1.0E 
 MenB     Meningitis   NA           0.5E

Novartis' historically steady 10% growth in earnings per share suggests $6.50 in 2013. A price/earnings ratio of 10 brings the stock to 65. Add three years of dividends, currently about $2 a share, and at 71 the return is 25%—potentially higher if some of the new drugs prove better than expected.

Channing Smith, who believes Gilenya is a $3 billion drug and that Alcon's results aren't fully expressed in the estimates, argues the P/E should be higher, perhaps 12 to 13 times. An expanded multiple could provide a return [i.e. a share price] of around 80.

John DeGulis, a portfolio manager at Sound Shore Management, says Novartis has yet to make a disciplined attempt at expense reduction, which could add five percentage points of operating margin. DeGulis' firm owns about 2.6 million Novartis shares.

The shares have been afflicted with lethargy, but once the Alcon battle is over and as new drug successes emerge, the market will begin to recognize Novartis as one of the most attractive and diversified global health-care companies around.‹