Novo Nordisk Getting Its Trial By Fire

By Stephen D. Simpson, CFA | August 08, 2013 AAA

The past year or so has shown that Novo Nordisk (NYSE:NVO) isn't immune from seeing some serious challenges to its business. Between a serious setback in its insulin development program and nagging worries about incretins, 2013 isn't going to go down as a great year in the history of Novo Noridsk. All of that said, I have little doubt that the company will continue to be an uncommonly strong pharma company, with huge leverage to one of the fastest-growing diseases in the world. Although I think broadening both the diabetes business and the overall business would be beneficial, Novo Nordisk really doesn't have to do much to continue performing at a high level. Q2 Earnings – Not All They're Cracked Up To BeAlthough it seems like a fair number of sell-side analysts have gotten themselves excited about Novo Nordisk's second quarter results, I don't think they're all that strong on balance. Revenue did grow 10% from last year, and that was good for a 2% beat relative to expectations. The problem, though, is that growth would have been more on the order of 8% were it not for some rebate reversals and the timing of tenders. That would have still made for a good quarter, but I think investors should note that pretty much all of the upside this quarter was driven by those factors and the underlying business was more or less in line. SEE: Earnings: Quality Means Everything Gross margin improved about 70bp as reported, and operating income rose 12%, or almost 7% more than expected. Again, though, those rebate reversals went straight through to profits, so this isn't evidence of strong underlying profit improvements. The Diabetes Franchise Continue To Grow Like A ChampDiabetes revenue rose 11% this quarter, and the growth would have still been impressive after netting out the aforementioned benefits. The company's analog insulin business continues to grow at a double-digit clip (up 12%), while Victoza grew 26% and seems to be losing no momentum to Bristol-Myers (NYSE:BMY)/AstraZeneca's (NYSE:AZN) Bydureon. Better still, the threats to this business seem to be slowly fading away. Biosimilar analog insulin has proven a great deal more challenging than previously thought, with Teva (Nasdaq:TEVA) and Lonza recently dissolving their four-year partnership to develop such a product. Add that to similar past decisions from Actavis (NYSE:ACT) and Pfizer (NYSE:PFE), and biosimilar insulin is looking less and les of a clear and present danger to Novo Nordisk (as well as its rivals Sanofi (NYSE:SNY) and Lilly (NYSE:LLY). That should give the company more breathing room as well. Management has announced that it intends to begin a 7,500-patient CV outcomes study on Tresiba later this year, which would conceivably have the company re-filing for FDA approval before the end of 2016. That is not great news, particularly with the data on Sanofi's new U300 insulin at the recent ADA meeting, but it would look a lot worse if biosimilar Levemir and NovoRapid were close at hand. I still do wonder, though, if Novo Nordisk shouldn't broaden its horizons a bit. The insulin business is a cash-generating fortress and Victoza is still growing well, but there are persistent safety concerns about incretins like Victoza and perhaps the company would do well to add an SGLT-1/2 compound to its portfolio and/or expand its earlier-stage research on non-insulin diabetes treatments.SEE: Evaluating Pharmaceutical Companies Will Victoza Gain Any Traction In Obesity?Although Novo Nordisk did announce that an oral GLP-1 drug is moving into Phase II testing, there aren't likely to be a lot of near-term positive news events other than a launch of Victoza as an obesity treatment. Some will scoff at the idea that a drug that has to be injected daily could get any traction in the market, but I think the needle isn't the problem. Given the efficacy that Victoza has shown, I believe people would use it. The problem is the price – at $20 a day, I'm not sure the benefits are compelling enough for the drug to get wide acceptance, though some analysts are still projecting $1 billion or more in sales from this indication. The Bottom LineComplaining about Novo Nordisk's valuation is like complaining about the heat in summertime – it may be true, but it's not going to change anything. Low teens free cash flow growth is good for a fair value around $160, but Wall Street has long showed that it is willing to assign a lower discount rate to Novo Nordisk's cash flow than I deem attractive. Given the underlying growth, Novo Nordisk isn't a bad pick in an expensive sector, but investors should understand that Wall Street's positive bias toward the company will mean that any disappointments or bad news will be punished harshly. Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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