Biotech Values

[DewDiligence]

Some Healthy Respect for Novartis, Please

[This bullish piece in Barron’s contains some minor misunderstandings about NVS, but it’s a serviceable overview for investors who want to kick the tires.]

http://online.barrons.com/article/SB50001424053111904797004577277410025202908.html

›MARCH 17, 2012
By ANDREW BARY

Novartis has one of the healthier business mixes among major drug companies, and one of the stronger profit outlooks. But it has one of the weakest stocks.

This suggests that shares of the Swiss pharmaceutical giant could best their peers in the next 12 months. At $54.79, Novartis' U.S.- listed shares (ticker: NVS) were up just 1% in the past year. They trade for 10 times projected 2012 earnings, and yield 3.8%. The effective yield is above 4%, however, because American investors usually can get a credit for the 15% Swiss withholding tax levied on the annual dividend [provided that the shares are held in a taxable account]. Novartis has boosted its dividend for 15 straight years.

A recent report by JPMorgan European drug analyst Alexandra Hauber puts the company's asset value at about $80 a share. [This seems like a stretch, but not a huge one.] Tim Anderson, an analyst at Bernstein, says Novartis is valued like slower-growing companies such as Sanofi (SNY) and Pfizer (PFE), although its outlook resembles that of more highly valued Roche (RHHBY). He rates the stock Outperform.

Novartis has been hurt by ills besetting much of the industry. It is losing U.S. patent protection this year on Diovan, a treatment for high blood pressure with $5.6 billion in annual sales. [The US patent expires 9/21/12; patents in some major EU countries have expired already.] There have been safety concerns about another drug, Gilenya, for multiple sclerosis, plus a setback for a new hypertension product. And a Novartis over-the-counter drug plant in the Midwest was temporarily shut after the Food and Drug Administration found safety issues there.

This year's profits are likely to be $5.55 a share, little changed from 2011, due to generic competition for Diovan. Next year earnings could start climbing again, possibly hitting $6.50 by 2015.

Novartis, which has a $132 billion stock-market value, has become one of the world's top pharmaceutical makers, thanks to a strong record of developing drugs, including Lucentis for macular degeneration and Gleevec, for a form of leukemia. [This is somewhat misleading insofar as NVS merely licensed the ex-US rights to Lucentis from Genentech after Roche passed on it; still, it was one of NVS’ most astute business moves.] It spends heavily on research and development at a time when some rivals are cutting back. Novartis, with $59 billion in annual revenue, is likely to spend $10 billion on R&D in 2012, against $7 billion for Pfizer, which had $67 billion in sales last year. Bigger outlays might give Novartis an edge; it historically has bested rivals in turning pipeline drugs into commercial successes.

Novartis seems to suffer from a classic conglomerate discount. [I agree; compare NVS’ P/E ratio to that of the pharma “pure play” BMY or to BMY’s non-pharma pure-play spinoff, MJN.] In addition to its core pharmaceutical business, it has other valuable units that generate nearly half of sales, and likely would command higher price/earnings multiples than Novartis if they were independent.

The most valuable non-pharma business is Alcon [this, too, is somewhat misleading insofar as ophthalmic drugs comprise a material portion of Alcon’s sales], the big eye-care outfit whose products include artificial lenses, cataract and glaucoma treatments, and contact lenses and solutions. Novartis completed its purchase of Alcon last year, paying a total of $52 billion, or about 20 times after-tax earnings.

Novartis has a consumer division that produces Excedrin, Gas-X tablets and other over-the-counter remedies. It also owns 6% of Roche [including 33% of Roche’s voting shares], the other leading Swiss drug maker. And it owns Sandoz, the No. 2 player in generic drugs behind Teva Pharmaceuticals (TEVA). Sandoz's future looks bright because many leading drugs are losing patent protection in coming years. Sandoz also has an edge in developing biosimilars—generic versions of bio-engineered drugs.

In her report, JPMorgan's Hauber argues that, to surface the hidden value in Novartis, the branded and generic-drug businesses ought to remain together, but Alcon could be spun out as the separate company it once was. She doesn't expect this to happen, however. Hauber recently cut her rating on Novartis to Neutral from Overweight, with a price target of $60.

Novartis' approach runs counter to the rest of the industry. Abbott Laboratories (ABT) and Pfizer are breaking up or selling divisions to create smaller, more focused businesses, which are favored by many institutional investors. Eli Lilly (LLY), Bristol-Myers Squibb (BMY) and AstraZeneca (AZN) essentially are pure drug plays.

Novartis seems intent on sticking with its strategy, which management calls "focused diversification." CEO Joe Jimenez said in a statement: "We feel that our focus on our five growth platforms—pharmaceuticals, generics, eye care, vaccines and diagnostics, and consumer health—is the right strategy…and will continue to deliver strong performance in the years ahead."

Jimenez, an American, became chief executive in 2010, replacing longtime Novartis boss Daniel Vasella.

Breakup or not, Novartis is likely to command a higher stock price in coming years. An $80 asset-value calculation might be aggressive, but with strong assets, ample opportunities for growth, a modest valuation and a secure dividend, the company could produce healthy returns for investors.‹