Novo Nordisk – Great company but also a great investment ?

The company

novo-nordisk

Novo Nordisk is a company which has been on my radar screen for a long time. The company is well-known and clearly a “high quality” company. A quick list of why the company is a favorite of many investors and has delivered 22% p.a. over the last 20 years:

+ market leader in insulin /diabetes care
+ significant growth opportunity despite significant global market share
+ customers/ patients are “locked-in”
+ market grows automatically (Emerging markets obesity etc.)
+ well-managed, manager salary relatively modest, good incentives
+ organic growth, no goodwill, no debt
+ ~100% earnings to cash conversion

This clearly has been not gone unnoticed by the market, the valuation is clearly not cheap despite an almost -20% drop since the beginning of the year:

Market Cap: ~110 bn EUR
P/E 2015: 22,2P/E 2016: 20,6
P/B 18,8
EV/EBIT ~16,6

Interestingly, based on trailing P/Es etc. Novo is slightly cheaper than most large Pharma companies like Novartis, despite earning significantly better margins and “Returns on everything”, however it looks like that for the other players the market expects better growth.

Novo has also some issues which, according to my understanding are the following:

  • growth targets reduced, especially no further margin improvement expected
  • Margins well above historic average – mean reversion ?
  • Analyst consensus is still high
  • potential technological changes in the diabetes care market
  • market share already very high
  • cost pressure from insurers (some new products for instance were rejected in Germany as too expensive)

Despite the negative points I have mentioned (and which they share with almost any pharmaceutical company), Novo is clearly a very very good company with a “real moat”.

The big question: Is it a good investment then ?

Personally, I find Novo is a difficult case. First, I have little experience with pharmaceutical companies. It is not an easy industry and there is high regulatory risk.

Secondly, Novo is a well researched company. As a large cap market leader, it is well covered (37 analysts at Bloomberg), analyst consensus is still positive with an average target price of ~380 DKK per share.

The only reason why I actually look at it is that Rob Vinall, a great value investor had laid out the case very well almost 2,5 years ago. This is how Rob summarized his thoughts on valuation:

At the time I bought our stake, Novo Nordisk was trading at around 18x my estimate of
2014 net income. Though cheap compared to where the Company has traded historically,this is not generally considered to be a level that gets the average value investor’s pulse racing.
From the perspective of the long-term business owner, I believe it should. Novo Nordisk belongs to that rare class of business which does not require capital to
grow. Thus a not particular sexy sounding 18x earnings translates into an altogether
punchier yield of just over 5%, made up approximately half in dividend and half in share buy backs. There are very few non-cyclical companies in Europe with a 5% yield at the moment and none with Novo Nordisk’s business quality.
Furthermore, the Company is growing rapidly. Historically, it has grown its revenues at alow double digit rate and its earnings at a high double digit rate in Danish Krone.
Fundamentally, the market structure and drivers are unchanged even if the stock market has temporarily taken a more pessimistic view of the future. There is no reason to believe that the future will not look a lot like the past. The company itself has a long-term guidance of 15% operating profit growth.
Taking the cash return and growth in business value together, it does not seem
unrealistic that the long-term owner can expect an annual return of close to 20%. Even at a fraction of this amount, the ownership experience should prove highly satisfactory a ta time when decent opportunities are otherwise scarce.

But 2 important assumptions have changed:

  1. The price is higher than back then. I guess Rob had bought the stock around 180 DKK (18 times 2014 profit of 10 DKK), Now, despite the drop in the stock price and a 50% increase in profits, the stock trades at ~21 times 2016 earnings, a lower “yield” than back then (~4.5%)
  2. Novo Nordisk itself has lowered it’s growth targets to ~5-8% at least for 2016. So the times of double-digit profit growth seem to be over for the time being.

So when Rob was investing back then at 20% p.a. expected yield (5% “current” + 15% growth), the same calculation right now would rather look like the following:

4,5% “Current” yield + 6,5% (mid-point) growth = 11% “expected yield”.

Not bad for a high quality company like Novo but not that great either. This has to include currency risk as well as any regulatory risks or technological disruptions.

Clearly, the overall yield level has dropped as well since 2013~2% p.a. in EUR for long maturities. But in any case, at the current valuation, the stock is less of a bargain than back then. Is the stock still a bargain ?  At the moment, valuations for high quality stocks are in general very rich. One could argue that maybe 8-10% in the current environment would be Ok for Novo. But with an “implied yield” of 11% there is not a lot of “margin for error” if anything bad happens to Novo.

What could make the stock interesting again ?

Well, that’s simple: Either a lower stock price or higher growth. Maybe management has low-balled growth ? Who knows. Maybe the market over reacts if the next quarters don’t look that good ? According to Bloomberg, analysts officially still expect double-digit earnings per share growth well into 2019. Even adjusting for share buy backs, this will be difficult to achieve based on the growth rates communicated by managment.

For me, the stock would become more interesting at around 250 DKK under the current growth assumptions. I think I would also like to see more negative comments from analysts.

Clearly in the current market with Central banks piling into stocks, anything could happen, but speculating on a further multiple expansion in my opinion is not “value investing”.

Summary:

If I would be a large cap fund manager who needs to invest (and maybe work for a Central bank), Novo still looks attractive. For me personally however I think that the stock  currently is not attractive enough despite its quite obvious qualities.

 

 

 

42 comments

  • Now Novo would be below my initial target. However they have again reduced their growth assumptions. “Too hard” for me at the moment.

    • Pharma remains a blackbox to the layman in my view.

      Even this guy lost money on his only pharma holding (BIIB): http://www.crossingwallstreet.com/archives/2015/12/the-2016-buy-list.html

    • With today’s warning Novo should compound 11% p.a. (5% growth+PEx15)…with the golden bullet (oral insuline) intact…too tasty for me at this stage 🙂

      • hmm, I am not an expert but I saw this headline from Novo:

        “*NOVO WON’T PROGRESS CURRENT DEV PROJECTS WITH ORAL INSULIN”

        • Yes, I saw it too. It is a little bit confusing. They stated: “As a result of the updated R&D strategy and priorities, Novo Nordisk will not progress its current development projects within oral insulin and combinations involving oral insulin. In addition, a number of changes to the portfolio of early-stage projects will also be implemented. Novo Nordisk furthermore intends to strengthen its activities for in- licensing of early and mid-stage projects as well as external academic collaborations. Novo Nordisk’s current late-stage development portfolio will not be affected by the changes.”
          One of the late stage pipeline drug is -precisely- Oral semaglutide (NN9924).
          I’ll ask IR.

        • Already talked to IR guys. I think there is a potential misunderstanding concerning oral insulin. Novo has confirmed to me that NN9924 oral semaglutide for GLP-1 diabetes treatment, currently on phase 3 (approval filing pending) keeps on track. I think they have not made their best effort to communicate this.

          Obviously this doesn’t change the fact that what they announced today (the elephant in the room) is a complete switch in strategy (they will defend market share as 1st priority) while expanding the products portfolio, ergo lowering the success ratio i.e. achieving a lower ROIC while increasing capex (new treatments/diseases)…in other words becoming similar to the rest of the industry. The new CEO (to be in charge by Jan) was the head of business development.

          Having said this, and considering some other important factors (diabetes being the 2nd illness in terms of growth -worldwide-, with a double digit growth from China) in my opinion is not crazy to rerate this stock as a 10% p.a. for the long term.

        • It will be interesting to see if the new CEO will do any “kitchen sinking” or what they currently do is already part of such an effort.

  • Good article about Novo Nordisk. Been following the company from Sweden for many ears but the price hasn’t been attractive enough. Now it started to look interesting. If the FCF can grow at 6% a year and we have FCF 14,5 DDK for 2016 I think you can get 10% in owner earnings at the share price of 255 DDK. /Cheers

  • Hi MMI: Good analysis! Your point that the margins are historically high and thus there is a potential for mean reversion is a major road block for the stock in my view.

    The tail wind of further margin expansion which could trigger multiple expansion I see as unlikely. I would not buy into the stock just due to older, richer and more obese population worldwide; it is hard to predict how much such “macro”-factors will support a single company like Novo.

    (This said I do not know Novo Nordisk well enough to be able to judge them properly so my views are very superficial)

  • As someone working for a big pharma company, I see several factors at play here: Everybody wants to live longer with less illnesses on the way. So demand for the product sold is very high and will never be satisfied. Also, there is a strong taboo associated with putting a price on life which makes it hard for payers to deny coverage (especially if the patient populations are vocal, elicit empathy and can make their voice heard which leads to the outrageous price difference between cancer drugs and antibiotics!).

    These underlying factors together with the breakthroughs in bringing biological drugs to market and improved scientific understanding of disease created a lollapalooza effect. Everybody active in the area profited and huge margins exist(ed) for a lot of these products. The resulting flow of huge amounts of capital is visible everywhere, but especially in startups and increased competition for valid disease targets. Look at how many companies are working in immunotherapy and a lot of other oncology targets. Of course only a few will be successful but combined with the existing therapies there will be competition – also via prices, especially in an era of increased transparency wrt to payments to doctors and cost pressures in government health budgets. Thus I’d be cautious with predictions that envision a continuation of the status quo or even an improvement – at least in the short and mid term.

    • Thx for this EasyWISA.

      The way I see it, it is very dangerous, in my opinion, to model a company taking the upper best case as projectable (which is based on opinions). Here are the facts:
      – The second product in importance (Sovaldi) has suffered a –50% decline in sales in just one year. On the contrary leading Harvoni multiplied by 6 its sales during the same period…
      – The company used to pay 27% tax rate in 2012, now it pays 16.5%, in a moment when all fiscal authorities are focusing on the Irish tax system.
      – China is rarely the solution to a sales problem. It has not been the case for many industries (with potential intellectual property disputes), and one should be careful not to count on the Chinese market to project the positive delta growth at least in the short and medium term.
      – Politicians have made their case. It is not only Gilead, it is Valeant, it is Shkreli’s scandal, there are many more cases on current industry’s pricing policy:

      http://www.bloomberg.com/news/articles/2016-02-02/shkreli-not-alone-in-drug-price-spikes-as-skin-gel-soars-1-860

      I agree with George W. comment and caution should be considered when projecting margins forward.

      When you cite China, Hep B, etc as possible future growth drivers when the company has not been able to provide visibility beyond 12 months during the last Q&A conf call results, in my opinion, you are not managing a valid/wide value margin. To put it simple, that is not margin of safety.
      The way I see it, the market already reflects all these uncertainties. Should the stock price provide enough margin of safety for all those uncertainties (with a lower price), I would look at this stock with renewed interest.

      Could I miss the opportunity? For sure, but I need to minimize risk rather than maximize profits.

      Thank you for the seeking alpha reference (I wasn’t aware of this guy, very interesting). This brings additional knowledge to the company and sector but doesn’t change my investment framework/methodology (always, always cover the downside).

      Take care and good luck with the hunt!

      Dave.

      • Hi Dave,

        you’re absolutely right with your comments and it could be a value trap. Your strategy ‘minimize risk rather maximize profits’ is almost always a good one (see Howard Marks or Prem Watsa) which I usually try to follow, too.

        On Sovaldi: I think Harvoni is something like an improved version of Sovaldi which just got approved later. So over time Harvoni will replace Sovaldi in most of the markets and Sovaldi-revenue will go next to 0. And the same might happen to Harvoni once Epclusa comes out… Epclusa has a list price of around 75′ $ for 84 day treatement (12 weeks) which might result in 35′-40′ as a ‘real’ price in the US. Harvoni is listed at 84′ if I remember right. And a liver transplant costs half a million…

        On China: you’re right in many cases. For Apple the China Mobile deal was a good thing, though 🙂

        Regarding my current investment in Gilead: I have to admit that I was too optimistic when I bought them but don’t wanna sell now because things might get dirty (I think they are not really dirty yet). I initially just looked at the numbers (PE ~10, good growth at that time, ROE > 100 %, ROA > 40 %, CCE of 10b compared to LTD of 12b at the beginning of 2015) and thought that it’s an interesting company with great fundamentals. Unfortunatly my assumptions of zero growth on the bottom line (often my version of margin of safety) were just too optimistic. Afterwards you’re always wiser (I couldn’t resist this 1:1 translations of a German saying 🙂 ). I guess I just prefer owning something like that (market cap of around 110b, ttm-FCF 16b) in my basket right now compared to Tesla (urgh), Twitter (urgh) or Amazon (great company, but just too expensive). Time will tell…

  • By the way mmi, I wanted to thank you for the Robert Vinall link. I wasn’t aware of him.
    It’s really blown my mind (a real source of inspiration) 🙂
    Take care

  • Had Novo on my watch list for a long time. Bought first installment at 308. Not only Vindall is a believer in the company, also great money allocators like Walter Scott and others. Coming out of a -1% environment ( I am Swiss), 11% is fine for a first entry point. Next target around 260. Have as well BIIB and Gilead. Roche is a little pricey at the moment, as important news are pending in the next 6 mths. (Binary bet!)

  • The roadshow presentation of Novo-Nordisk indicates that during 2011-2015 the 20,3% CAGR consisted of 4,8% “volume contribution” and 15,5% “mix/price contribution”, of which the latter (mostly) translates into margin expansion (and some of it into inflation effects)

    So if Novo-Nordisk’s margin (which has doubled over the last decade) wouldn’t expand any more then about 50-75% of the CAGR would be gone.
    And this would still exclude a possible “mean reversal” of this extraordinarily high margin (which currently is even higher than biotechs such as AbbVie or Amgen).

    And Eli Lilly already having launched a biosimilar to Sanofi’s Lantus, thus putting additional pressure on the margin of insulin products, is not particularly helpful either.
    I consider the current margin of Novo-Nordisk not sustainable.

  • Let us all know, Dave 🙂

  • If I was you, I would go for Roche, 3.3% Divi on a x11 P/E and a CHF 211b MktCap enough to swallow for growth anything they fancy
    I like GSK too, but diivi is in GBP and stock price looks toppy

  • Thanks for your thoughts of NVO!
    I personally took the current 2% dividend yield additionally into account when I started buying into NVO @ approx. 310 DKK. Currently, I have invested 50% of my funds reserved for NVO…waiting for a further drop, which might not come..
    Innovative company, conservative management forecast, nice free cash-flow, no debt, reasonable valuation rising obesity in China and India makes NVO a great investment for me.

    Regards
    Ralf

    • I think it is “double counting” if you add the dividend yield. This is already inlcuded in the earnings yield.

      • Do not get me wrong, I do not add the dividend yield to your 11%. A 2% dividend yield in a zero interest rate environment is big plus for me and my investment style (high-quality and low debt companies, reasonable valuation with regard to moat, earnings and free cash-flow growth).

        Regards
        Ralf

        Btw, I like Roche, AstraZeneca and Gilead too.

  • Thanks for the article. Recently even sanofi stock is down even though their managment is not as competant as novo’s. Do you have any opinion / view on sanofi.

    • As I have mentioned, I am not an expert for pharma. So no opinion on Sanofi.

      • I read in an article on pharma sector that value investors like Warren Buffett go for a basket approach on pharma. Just for info Berkshire is a shareholder of Sanofi.(although insignificant for them). Also what about generic competetion risk from developing countries like India where some generic company can just copy their method.
        As warren often says the most imp. factors in an investment analysis are the price paid and company’s pricing power.

        Any way I found this analysis on Novo

        http://analysisreport.morningstar.com/stock/research/c-report?t=XNYS:NVO&region=usa&culture=en-US&productcode=MLE&cur=

        • Insulin can not have a generic replacement because (I am not expert, maybe the term is different) it is of biological origin. The copy will be only biosimilar not generic. Therefor it will have to go through the approval process and testing. This will require significant resources from anyone who wants to copy.

  • This is almost identical to my thought process for Kone Oyj. Excellent company (earnings to cash conversion of 100%), innovative, but the share prices has grown way faster than the earnings and earnings growth has diminished in the past 2-3 years.

  • Excellent writing mmi, it comes at the precise timing I am analyzing Gilead, also a quality player with incredible multiples but with far more uncertainties when it comes to that 10 year view of the company (the opposite to Novo Nordisk I guess).

    • Let me know what your view is on Gilead.

      • Well, this is clearly not my circle of competence (I am reading to learn about the pharma-bio sector and I still have a lot to read and much more to learn 🙂 but basically my view is what I already mentioned: quality with (too much) risk. Some points:

        – On the positive:
        o Moat: the company has a clear dominant position in a niche market (deadly illnesses)
        o Besides, the company is able to bring a complete healing on some life-threaten diseases (Hep C or HCV) and major advances on HIV, which is by far a superior solution when compared to other transitory treatments from competitors.
        o M&A activity is good so far: they nailed their last acquisition (Pharmaset) and they are not in a hurry to buy growth at exorbitant prices (they did not win the short list for yesterday’s Pfizer acquisition).
        o Pipeline for additional product lines seems to be advanced with a bunch of products in phase 3 testing.
        o Balance sheet is strong

        – On the negative:
        o Moral concern: as an investor I don’t like to see a company that earns money selling 1,000 USD pill to patients with deadly diseases
        o Regulatory risk: there’s a strong political debate about how to impose restrictions on this kind of pricing policy (they received a request from the US Senate about this)
        o Concentrated revenues (ca. 60%) on 2 products, which caused abnormal sales/returns during the last 2 years, could create a false sense of “cheapness” on the ratios (similar to other quality names such as Apple)
        o Those 2 products are subject to strong litigation with many other pharma co. (being Merck the most visible one)
        o Misalignment between business model (niche market-high end price) and the real potential long term growth (developing countries)
        o Though M&A activity seems reasonable, there is insufficient track record to properly value this skill (was Pharmaset purchase a bingo luck hit?)
        o Taxation: Gilead is established in Ireland for its European operations. As a result, corporate tax amounts to 16.5%. (FY’15) There is an ongoing examination by the IRS for the 2010, 2011 and 2012 tax years that might result in further litigation.
        o Management doesn’t seem to know what is doing regarding the buybacks: they either don’t do it at all or do it all the way down with the share but why did they stop it in the middle of the share decline? (Obviously they are preserving the cash for the potential growth opportunities but then they shouldn’t have initiated it at that impressive pace ($ 9bn so far)–in my opinion-)

        Don’t get me wrong, the company is doing great in the sense that they do procure healing to people with serious illnesses, but I would like to see how a promising business like this evolves towards a more sustainable framework (more affordable, more widespread distribution of its products, with long term demand growth prospects –i.e. fostering oncology- rather than Hep C and HIV, which –hopefully- should be niche markets with declining patients in the long run. In fact their HCV revenue is shrinking as of 1H’16).

        Note: although they claim to have a “Gilead Access Program”, with some products for HIV/AIDS and viral hepatitis available at –claimed-substantially reduced prices in the developing world; the reality is that only a very minor and insignificant part of revenues comes from 3rd developing countries.

        Valuation wise, if you take into consideration a normalized P&L (significant drop in the 2 star medicaments –Harvoni & Sovaldi- in line with the more stable Truvada and Atripla, I get current valuation levels (ca. 80 USD/share). So, in my opinion, the market is wisely discounting that current margin (FYe’16) and past growth (FY’14&’15) are not sustainable/projectable over time.
        I will follow the company but more from a qualitative point in order to see how the business evolves (niche/high-end price) but clearly is not for me on its current form.

        One could argue that the downside (from the expected negative growth) is pretty much limited at current prices but on the contrary I don’t see how these guys can grow thru M&A at current valuations without destroying value (maybe another Pharmaset deal?). On top one would ask some security margin on the valuation.

        I will keep on reading 🙂 but in the meantime I do apologize if I wrote something grossly stupid (I’m no expert on this field).

        Am I missing something? What are your views?

        Take care,

        • Hi Dave,

          very good comment. Just a few remarks:

          The 1000 $ per pill is no longer valid in my opinion. The prices alreay came down significantly because of the competition and will come down further in my opinion. Besides the critics have to compare the cost of the complete treatement to the life long treatement that was necessary before. I don’t have the illness but from what I read many of the patients were glad they are healed…

          Possible Catalysts:
          1. The end of the presidential election in the US: Pharma pricing is one of the areas where they try to get votes (both of the candidates).
          2. As far as I know they are not active in China yet, which is big market.
          3. HepB-Medicine?
          4. Their newest HepC-Medicine could also be a success because with it they can treat types (genotypes) of Hepatitis C that could only be treated in combination with other medicine before…

          I own Gilead right now but bought them too late (-10 % at the moment). Still own them because they are relativly cheap. They pay a nice dividend, produce huge amounts of cash right now and their margins are still exceptional in my opinion. Hint: User DoctoRx is always writing some good stuff about them on Seekingalpha.

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