Novartis Stock: Exceedingly Stable Swiss Pharma (NYSE:NVS)

Author’s note: This is the heavily cut version of an article posted on iREIT on Alpha in early March of 2022.

Novartis (NVS) is one of the biggest pharma businesses on earth. I’ve written some about it on the free side, but I haven’t yet done a premium deep review. This is the article for that.

In this article, we’ll deconstruct Novartis to a detailed level and look both at the upside and downsides to the company. I successfully rotated some of my good returns in pharma, including AbbVie (ABBV) into Novartis, and I’ve not regretted the partial reallocation one bit.

Let me show you why.

Novartis – A review

Novartis is a Swiss multinational pharma business, and with its revenues of $50B, a market cap of 180 billion Swiss francs, and 110,000 employees, it’s one of the largest in the entire world.

The company is a merger of the two companies Ciba-Geigy and Sandoz, both of which have their own long histories. During the merger, several sub-segments of the two operations were sold or spun off, like Ciba Specialty Chemicals. Sandoz didn’t exist after the merger until 2003 when it was revived as the generics brand for Novartis. The company has also since then divested its Agrochem business, similar to AstraZeneca (AZN), and therefore today only works with pharmaceuticals.

In terms of sales, Novartis is the third-largest pharma business on earth. This is behind Pfizer (PFE) and Roche (OTCQX:RHHBY). From a high level, we can say that Novartis is involved in the R&D and effective commercialization of drugs for various therapeutic areas.

The company divides its operations into two areas:

• Innovative Medicines – specialized, patent-protected drugs
• Sandoz – Generics/Biosimilars

They are then further split into a variety of sub-segments, usually related to specific treatment areas.

Novartis is the second-largest company in Oncology on earth, behind Roche, and is also the second-largest generic company, behind Teva (TEVA). The company has a concentrated focus on all things pharma and does not have any other relevant operations.

The company’s asset base, both in terms of production and research, is concentrated in legacy areas. By that, I mean that 97% of all of the company’s non-current assets are either in Europe or the USA, with 43% of assets in Switzerland alone. Novartis is not a company to outsource either production or research to cheaper areas, such as Asia or Africa – at least not yet. That isn’t the same as the company not having China sales – which it does through Sandoz, where it’s the largest supplier to the entire Chinese state. However, I view it as likely that Novartis will revisit its Chinese dependence given the current trade trends between west and Asia.

Novartis doesn’t have as concentrated a manufacturing base as any of its peers. Compared to Roche, Novartis has 5X as many manufacturing sites, due to a well-spread generics business. While there is a planned reduction here, the company will likely retain a somewhat more spread-out asset base.

While I also focused on Sandoz, it’s important to point out that the company’s revenues are barely 20% Sandoz, and 80% Pharma/Innovative medicines. So Sandoz isn’t as important as some might think. Novartis has denied that they’re looking to spin off all of Sandoz, but recently failed to sell part of Sandoz assets to an Indian peer. Only 8% of the company’s divisional EBIT is from Sandoz, due to increased pricing pressure in the generics segment. This is also part of the reason Novartis may be looking to do something else with Sandoz.

Novartis has extremely strong trends.

The company targets, and expects to be able to grow sales at a 4% CAGR until 2026, in addition to small bumps to the dividend. In 2021, the company saw excellent sales overall, and good sales growth despite the COVID-19 pandemic.

What sets Novartis apart from other pharma companies, as I see it, is its lack of reliance on single blockbuster drugs. While its main drugs do see blockbuster sales, the company has the world’s second-largest portfolio pipeline after AstraZeneca. Its portfolio lacks the exposure we see in some, and certainly the risk concentration of some peers like AbbVie and Humira.

Next to Roche, I would consider Novartis one of the best-diversified pharmas out there – with both plenty of legacy brand appeal, and also good pipeline appeal across a variety of sectors.

Also, as you can see, the LoE is 2029+ for all of these brands – over 7 years. There’s plenty of time for the company to plan. Its pipeline continues to pan out, with plenty of new approvals, submissions, designations, and study starting in 4Q21 alone.

Recent years have also finally seen a stabilization in the Sandoz segment, with YoY sales growth in generics. The outlook for 2022 here is positive, and Novartis expects things to continue to improve for the biosimilar segment, with material growth in 2024 due to scale, expertise, global footprint, and targeting $80B in originator sales by 2030.

Expect a 3-6% annual growth in the dividend, no more, and a share buyback in the billions over time. Novartis will continue to allocate capital between R&D, bolt-ons, and shareholder returns. Like most Swiss companies, they do this well.

Just don’t expect 500% returns. Novartis won’t give you this. Novartis gives you, to some degree, stability from a healthy and fundamentally sound portfolio.

The company is fundamentally rated at AA- from S&P, Fitch, and A1 from Moody’s. This makes it one of the best-rated pharma businesses on the planet.

Debt is really a non-issue here. The average interest rate for the company’s debt is less than 2%, and the overall adj. net debt/EBITDA is less than 1X. The company not only has excellent access to debt and cash, it has a war chest and access to capital for massive M&As if it saw the need for this. This also doesn’t yet include the company’s stake sale in Roche. Novartis has a gearing level of less than 39%, which is compared to peers averaging 50%+.

Novartis is, simply put, better here.

On a high level, it’s simple to say that actually Novartis is better at a lot of things.

First off, if we look through filings and comparisons, it’s clear that Novartis manages to squeeze far lower discounts than its peers when they sell to purchasing organizations and governments, such as Medicaid. Novartis has by far the second-best net-to-gross sales ratio. The discount implied here is 25% or less, which is massive (40% discount average). Only Roche is better at a 16% discount. Why is this?

Because Novartis owns some of the most appealing, life-saving drugs on the planet. This alone isn’t a good explanation, since AstraZeneca averages around 58% discount in 2019-2020. Overall, it seems that Swiss companies manage these discount environments far better than their peers.

Over 80% of 2019-2020 EBITDA translates into operating cash flow, 74% into FCF, and massive FCF yield. This is why the company has been able to grow its dividend at mid-range single-digit numbers on an annual basis.

So, high-level advantages like better discounts to peers, superb debt, credit rating, a class-A portfolio, and the potential of Sandoz with a current yield of 4% make this company into, in my view, one of the best pharma investments out there, with the possible exception of perhaps Bristol-Myers Squibb (BMY).

Let’s dig deeper.

Novartis – The challenges

Novartis is not without its challenges. While there absolutely are massive advantages to the company that isn’t in any way to be underestimated, there are some issues we can point to that actually pressure the company and could be a catalyst for better future returns – if they’re solved.

First of all, are its returns and margins. While these have improved since mid-2015, mostly as a product of gross margin improvements (4% in 5 years), they’re still somewhat below peers. The improvements have been driven by the divestment of lower-performing business units like vaccines and consumer health. These might be nice safeties and income-generating segments, but they are at a relatively low margin. Sandoz is also weighing things down – but not as much as it previously was.

What I’m saying is that there is room for improvements through further divestment of underperforming assets. Novartis has an operating margin of just around 25%. Roche is at 33%. That’s still a massive distance to cross. Part of this is Sandoz – generics are not margin-friendly, but Novartis also has workplace/workforce improvements it could make, by reducing the production sites, streamlining its workforce, and lowering the average cost per employee which is nearly $40k higher on a per-employee basis next to its peers. The company is already working towards this – I’m not saying anything Novartis isn’t already doing or planning.

Novartis also has a bit of a reverse relationship when it comes to marketing & R&D. While most companies have a higher R&D and lower marketing, Novartis has the opposite. It can be theorized that Novartis may be overspending on its SG&A, although this isn’t a very easy thing to theorize or forecast.

Also, the company’s limited exposure to COVID-19 treatments has impacted the uptake appeal of its legacy therapeutic/business areas, at least for some time. This is especially apparent across lower-acuity sectors and generics. COVID-19 has not been kind to generic businesses overall.

Generally, it can be said that Novartis’s risks or limiting factors are the margins in its portfolio, in part due to Sandoz still finding “its place”, as well as its legacy portfolio that needs refreshing – though doesn’t suffer from a concentration like some peers.

It’s my firm view that Novartis’ advantages vastly outweigh the risks, but these are the ones that I see.

Novartis – The valuation

When it comes to Pharma, valuation is less complex than for some, especially in such an established business. Based on historical and future forecasts, I’m estimating a 1.5-2% annual top-line growth and EBITDA – but no more than that. I view this to be conservative and bump all other variables by 1-2% as well. Novartis has a WACC of 7.18%, including a low cost of debt of around 3.5%, and with that 1-2% growth, we get an implied native value range of 100-115 CHF/share. Not all that complex, but given Sandoz’s risks and the company’s relative margin instability compared to Roche, we might not want to weigh DCF all that heavily overall. It’s a massive upside here given that the native share price is currently 77 CHF.

Peers are more interesting. I could compare to US ones as well, but I’m going for straight European peers. That gives us Merck (OTCPK:MKKGY) – that’s the German Merck, not the US one, GlaxoSmithKline (NYSE:GSK), Sanofi (NASDAQ:SNY), AstraZeneca and Roche. The positive about this peer group is that it gives us a pretty good average of around 16-17x P/E and an average yield of about 2.86%.

Novartis is far better than this.

At a current P/E of 17.5X, the company may not be all that undervalued on P/E, but in terms of yield and assets, it’s definitely undervalued and underperformed so far. My analyst peers discount Novartis by 20% to reflect near-time risks from the DOJ investigation into Entresto. I cut this to 10% – while it’s a large blockbuster, I don’t see it as long-term impactful as warranting a 20% long-term discount on the entire asset base/valuation.

From a peer-based perspective, Novartis certainly shows undervaluation as well – though not as much.

In NAV, I use a set of peer-average sales multiples for the various medicine sub-segments, with Oncology being the most profitable at 5X sales multiple, and Sandoz being the lowest at a 2X sales multiple. It brings me to a gross asset valuation of 230B USD, which when reducing debt and commitments comes down to just south of 200B USD. Given its shares net of treasury, that gives us a CHF NAV of around 90 and a USD NAV of $97/share.

This also shows undervaluation, given the current $84/share price.

S&P Global analysts average a valuation range of a low of $91 and a high of $105. This is a fairly tight range, and 90%+ of the analysts following the company have either a “BUY” or “Outperform” rating on the company. Given what my different approaches have shown, this is not hard to decipher – and a valuation range I agree with. I would put less weight on DCF, and come to an average valuation target of around $93/share, discounted somewhat. This still gives the company a decent upside and a current yield of almost 4% with the latest dividend.

Novartis is unfortunately somewhat more unstable historically than we might like – though looking at the way M&As have flowed, this is not a strange thing. Still, 10 years have brought a 56% RoR – not market-beating, but positive. And the future, I argue, looks bright.

Novartis has averaged a growth trajectory of 7.16% CAGR on a 20-year EPS basis. That means the valuation hasn’t exactly tracked earnings growth, and Novartis was massively undervalued, similar to BYM for years.

It’s getting undervalued again.

This is also the reason why I rotated large amounts of my AbbVie stake into undervalued Novartis, given that the company was yielding less than 3.8% on my invested capital, and the return was well over 100%.

I put this money to work in Novartis, where I expect that over the next 2-3 years, it will grow at least 50%.

With the backdrop of the facts I’ve been presenting here, my decision should be fairly clear. The NVS is a 1:1 ADR, meaning 1 share represents 1 share of the native. Novartis pays out dividends once per year – in March. Analysts are near-perfect (5-8% miss with 10% margin of error) at hitting targets for the company, so it’s not at all odd to expect NVS to perform as it has historically. There’s further upside to the company, given that it has traded as high as 17-18X P/E before, but I consider the 20-year average to be a better target.

The target is 15-16% annually for AA-rated Pharma with 4% yield.

What more, exactly, do you want? The company has also shown very little correlation with the goings-on in Ukraine and has proven its stability here.

Thesis

My position in Novartis at this time is over $30,000 at a cost basis of less than $84.4. I’m up around 5% including FX on this investment, and I expect it to potentially drop lower, where I might pick up a bit more.

I would say that BMY, in terms of total potential RoR, is a better investment and at a similar safety rating. The problem is that I have a 5% portfolio in BMY. The same story with Merck (MRK). I’m already at maximum exposure here as well.

This makes Novartis, to me, a better upside and safety than most other peers in the sector at this time, and that’s why I’m investing in the business.

You know me – I like keeping things as short and concise as I possibly can while delivering solid value and conveying my targets and underlying thoughts.

I hope I have done this in this article.

I believe that Novartis serves the purpose of safe 15%+ annual RoR with a 4% yield at an AA-rating.

I believe there are very few investments in the sector to be made at a better safety or upside.