After A Good Run, Novartis Looks Fairly Valued

By Stephen D. Simpson, CFA | June 12, 2013 AAA

Like so many other pharmaceutical stocks, Novartis (NYSE:NVS) has done pretty well for its shareholders over the past year and solidly beat the S&P 500. With that move, the multi-year discount in most Big Pharma shares has evaporated and Novartis is no exception. Novartis has a deep and high-potential pipeline, but threats from generic competition, competition to its branded drugs, margin pressure, and strategic uncertainties do mitigate some of that pipeline value.

SEE: Evaluating Pharmaceutical Companies

Decent Growth, Relatively Speaking
While Novartis's first quarter earnings report is pretty stale at this point, I think it's worth noting that the company is logging decent growth at a time when many of its peers are struggling to show much of any momentum.

Revenue was up 2% in the last quarter (or 4% in constant currency), with the core pharmaceutical business the weakest at 0% and 3% growth. Generics and consumer health are both growing at mid-single digit rates, while the small vaccine and diagnostics business logged a double-digit constant currency improvement. Alcon results are still a little sluggish, with growth on par with the pharmaceutical business.

Due in part to the revenue mix, Novartis's margins are not quite as impressive as some peers. Operating income rose 1% (or 6% in constant currency), but the 26% operating margin isn't so impressive relative to Pfizer (NYSE:PFE) at 42% or Roche (OTC:RHHBY) at 31%. This less impressive margin is due at least in part to the company's very large generics business, as well as the very low margins of the vaccines/diagnostics business.

SEE: Analyze Investments Quickly With Ratios

A Strong Pipeline, But Near-Term Competition
Novartis has a broad and deep pipeline, and this pipeline could deliver billions of dollars in new revenue over the next five years. Importantly, Novartis is diversified across many disease categories – the company is quite strong in ophthalmology and oncology, but has meaningful presences in other areas like metabolic/endocrine and auto-immune.

Affinitor is not exactly a pipeline drug, as it is on the market, but label and market extension opportunities should lead to multiple billions of sales in a few years. The company's COPD drug is going to be trailing Glaxo (NYSE:GSK) in terms of reaching the market, but still has multi-billion dollar potential. Investors will soon have Phase III clinical data on AIN457 in psoriasis and rheumatoid arthritis, and the much-delayed Bexsero meningitis vaccine could still be a multi-billion dollar product when it reaches the market.

Last and not least is the company's efforts in immunotherapy, specifically its CART-19 product. CARs (Chimeric antigen receptors) are starting to get more attention as high-potential options in multiple cancers, and this could be a major oncology platform for Novartis. While Bristol-Myers (NYSE:BMY) and Merck (NYSE:MRK) are getting well-deserved attention for their immunotherapy pipelines, I wouldn't sleep on Novartis.

The flip side to this pipeline potential is the risk of real competition to the existing business. Biogen Idec's (Nasdaq:BIIB) Tecfidera is the real deal and likely to seriously challenge Novartis's position in multiple sclerosis. Likewise, newer drugs in diabetes (particularly SGLT2 inhibitors) will likely pressure the company's diabetes business. Last and not least, there is no shortage of competition in oncology, with established players like Roche looking to increase their share and other rivals bringing new drugs to market.

It also doesn't help matters that Novartis is still facing one of the larger patent cliffs in the space. Competition to Diovan (over $4 billion in 2012 sales) has been slow to arrive, but Diovan, Zometa, and Femara are all vulnerable in the near term.

SEE: Pharmaceutical Phenoms: America’s Best-Selling Medicines

A Change In Capital?
There has been ample speculation about what Novartis will do with its stake in Roche. It is pretty clear that Roche has no interest in merging with Novartis and the ownership structure of Roche pretty much prevents Novartis from doing anything about it. With the market finally valuing Roche at a more appropriate level, now could be an opportunity to sell.

It's not quite that simple, though. Novartis has 33% voting control of Roche, but a share capital stake of 6%. The best situation (for Novartis, at least) would likely be Roche borrowing the funds and buying back that stake. It would be at least a partial “win” for Roche as well given the low cost of debt today and the boost to reported earnings, but Roche may be more interested in deploying capital towards growth projects. Should Novartis manage to monetize this stake, look for a dividend or share buyback.

The Bottom Line
As I said in the intro, the Street has basically caught up with most of the companies in this sector and Novartis is no exception. I actually expect Novartis to be one of the better growth stories in the space over the long term (3% revenue growth, nearly 5% free cash flow (FCF) growth), but that works out to about $72 per share today, or “fairly valued”. The ability to sell the Roche stake at a premium would add a bit to that sum, but not enough to really make Novartis a must-own stock today.

At the time of writing, Stephen D. Simpson owned shares of Roche.

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