Novartis AG (NYSE: NVS)

Disston Moore and Scott Schimmel

November 15, 2009

Company Profile:

“Novartis AG, through its subsidiaries, engages in the research, development, manufacture, and marketing of healthcare products worldwide” (yahoofinance.com). Created from the merger of the two Swiss companies, Ciba-Geigy and Sandoz Laboratories, in 1996, today Novartis is the world’s third largest healthcare company with a market capitalization over $140B (Bloomberg LP). The company is broken down into four divisions: branded pharmaceuticals, generic pharmaceuticals, vaccines, and consumer health products. “Its Pharmaceuticals division engages in the research, development, manufacture, distribution, and sale of pharmaceuticals in various therapeutic areas, including cardiovascular and metabolism; oncology; neuroscience and ophthalmics; respiratory; and immunology and infectious diseases. The company’s generic (Sandoz) division offers drugs as well as pharmaceutical and biotechnological active substances. This division provides active ingredients and finished dosage forms of pharmaceuticals; anti-infectives; protein or biotechnology-based products; and biotech manufacturing to other companies on a contract basis” (yahoofinance.com). Starting in 2005, Novartis entered the vaccine industry by acquiring Chiron Corporation. This new “Vaccines and Diagnostics division offers preventive vaccine treatments and diagnostic tools. It provides influenza, meningococcal, pediatric, and traveler vaccines; and blood testing and molecular diagnostics to prevent the spread of infectious diseases. Its Consumer Health division consists of three business units: over-the-counter medicines (OTC), Animal Health, and CIBA Vision. OTC offers over-the-counter self medications. Animal Health provides veterinary products for farm and companion animals. CIBA Vision manufactures contact lenses and lens care products” (yahoofinance.com). The CIBA Vision department will be further enhanced in 2010 when Novartis finishes its purchase of Alcon, a global healthcare company that is the world leader eye care products. Founded in 1895, the company employs approximately 99,000 people worldwide and is headquartered in Basel, Switzerland.

Management & Business Model:

After completing the sale of its baby food division Gerber to Nestle for $5.5B in 2007, Novartis completed its 11 year transformation away from being a diversified healthcare company (where

Stock Data Current Price (11/13): $53.24 52 Week High: $53.81 52 Week Low: $33.34 Market Cap: $140B Avg. Volume: 1.3M EPS (ttm): 3.34 P/E (ttm): 15.94 Sector: Healthcare Industry: Pharmaceuticals

originally 50% of sales came from consumer health-care products) into a company that almost solely focuses on branded and generic drugs (Morningstar.com). This strategy has been led by the only CEO Novartis has ever had, 55 year-old Dr. Daniel Vasella. Being one of the few doctors running a drug company, Dr. Vasella has “turned Novartis’ R&D model upside down,” pushing branded drugs through their pipeline “only if they are backed by proven science” (Capell, 1). The traditional pharmaceutical company spends lots of money on diseases with huge potential markets such as cancer, heart disease, and depression despite having a strong, scientific understanding. Dr. Vasella’s company focuses on diseases where new drugs are needed, usually in more niche areas of medicine. By focusing on more narrow targets, treatments will be more effective leading to more approvals from regulators and more consistent reimbursements (Capell, 2). Dr. Vasella believes that many illnesses share “genetic underpinnings with more common ailments” because of the “24,000 genes in the genome…there are only a few dozen pathways” (Capell, 3). Once the science has been perfected, a treatment can be used on multiple diseases that share the same pathways.

In 2007, Novartis began a company-wide initiative called “Forward,” that would simplify the organization of the company while making it a leaner sales machine. The major focus of the initiative was a streamlining of the organizational structure in corporate management, pharmaceuticals, and consumer health divisions. The pharmaceutical sales force was revamped, focusing on each geographic region individually and eliminating global, regional, and local duplications in marketing (Novartis Media Release, 2007). Organizational layers were removed from the consumer health division to eliminate duplications while supply chains were restructured to maximize capacity utilization (NVR, 2007). Approximately 2,500 full-time employees were let go at this time, and the company cited a goal of achieving $1.6B in annual pre-tax savings for 2010 (NVR, 2007).

Geographic/Division Revenue 2008:

American Depository Receipts:

Novartis AG is traded on the NYSE in the form of an American Depository Receipt. The process for admitting a foreign stock to trade in the United States is done using American Depository Receipts (ADRs). “Under this arrangement foreign shares are deposited with a U.S. bank, which in turn issues ADRs in the name of the foreign company. To avoid unusual share prices, ADRs may represent a combination of several foreign shares (Pearson pg 78).” In the

case of Novartis AG, their depository bank is JPMorgan Chase Bank in New York City. Currently, there are approximately 2.27 billion shares outstanding. In the United States there are around 450 foreign companies that are traded on the NYSE in this format.

SWOT Analysis:

Strengths within Novartis AG begin with its “Forward” initiative as mentioned previously. This program is designed to simplify working processes and decision making by eliminating layers and concentrating on core activities. Focusing on health related emerging markets such as vaccines for meningitis is an example of a core activity that highlights the managements vow to target diseases where new drugs are needed, in the smaller niche areas of medicine. Novartis AG has been creating a broad drug pipeline, it is one of the largest in its industry, in both number of new drugs and health issues that those drugs target. There are close to 50 new drugs that are in final stages and should come onto the market within the next 5 years. Three examples include Aclasta for osteoporosis, Galvus for diabetes and Rasilez for hypertension. Menveo is a candidate vaccine for meningitis at this time. Novartis AG test results show the 90% of children given Menveo developed resistance against four strains of meningitis, a positive indicator for the vaccines marketplace potential. The estimated market size for meningitis vaccines are roughly $1 billion dollars per year. (Wikinvest.com NVS)

Weaknesses within Novartis AG are found in Sandoz (generic pharmaceuticals), and the Vaccines & Diagnostic Tools that are operating in competitive markets, especially the U.S., where they already have low margins. An increase in competition could decrease the profitability of these divisions. Also, large transactions (acquisitions) by the Novartis AG management team would be questionable at this time. At present, the majority of their near term cash flow is committed to the Alcon deal as previously mentioned. There are several drug candidates in Phase III of the drug development pipeline including QAB149 (COPD/asthma), FTY720 (multiple sclerosis), and MenVeo (meningitis) that are expected to significantly contribute to the growth prospects of Novartis AG. If any of these drugs in the current product pipeline were to fail it could damage sentiment and reduce the projected valuation of Novartis AG. (JPM Euro Equity Research Report, Nov. 09)

Opportunities for Novartis AG include benefiting from current H1N1 vaccine demand. Celtura is their most recent H1N1 vaccine to gain approval in Germany. Fluvirin is their current vaccine being marketed in the United States. H1N1 could affect up to 2 billion people globally according to the World Health Organization. In 2009 Novartis AG Q4 sales could be boosted by as much as 700 million dollars in revenue due to H1N1 vaccine demand. The demand assumption is based on 100 million H1N1 doses being produced and distributed leading to a total of 1 billion dollars in sales. Optimistically, there may be orders for up to 200 million doses leading to a revenue forecast between 2 and 3 billion dollars, if global demand increases though the flu season. Novartis AG also finds opportunities by continuing to target customers in the generic drug, eye care product, and therapeutic vaccine categories. External collaborations have

been part of the Novartis business strategy with the addition of units like Hexal, Eon Labs, and Chiron. Lastly, their generic drug business is expected to grow as many name brand drugs will continue to come off patent. (JPM Euro Equity Research Report, Nov. 09)

Threats for Novartis include the integration risks associated with the newly acquired business units as there are many moving parts. Approximately, 17 billion dollars of new debt may need to be raised in 2010 in order to initiate step 2 of the Alcon acquisition from Nestle NA. The upside potential of this acqsition could result in up to 6% EPS growth by year 2012. Other threats include governmental regulatory issues such as the United States FDA failing to approve the Novartis AG drug Galvus in July of 2008. Setbacks of this nature have adverse consequences on potential revenue streams for the company. Emerging markets for Novartis AG include a focus on China, Russia, and Brazil, to name a few. China is their first priority where government investment should reveal market growth of 20% in the next 3 years. Russia has a healthcare reform package called “Pharma 2020” that should result in market growth of over 15% in the next few years. Again, both China and Russia are cause for concern from a healthcare policy perspective. The future revenue potential in both areas should be considered alongside their historical political climate and draconian governmental characteristics. Another threat facing Novartis AG is that they are the only European pharmaceutical company that combines the role of CEO and chairman of the board, this sort of conflicting management role may be a threat to management’s ability to objectively implement business strategy going forward. Lastly, the foreign exchange rate between the U.S. Dollar and the Swiss Franc needs mention. Novartis AG is located in Switzerland and any adverse currency movements would be cause for concern to investors. (JPM Euro Equity Research Report, Nov. 09)

Drug Pipeline – Core Pharmaceuticals:

Novartis has 138 compounds under development with many of them in late stage development. Below is a graph showing the names, peak sales year, and patent year expiry for the core drivers of the Novartis AG pipeline. Hypertension drugs account for 12% of the equity value of the pipeline at this point. Patent expiration for Diovan, the largest component of these hypertension drugs, occurs in year 2012. In order to bolster the impending decrease in Diovan demand, Novartis AG is launching a new group of drugs targeting a variety of health issues. As shown above, some of these include Tasigna, Lucentis, Exjade, and Galvus. Tasigna is approved for leukemia treatment in the United States; it competes against Bristol-Myer Squibb’s drug Sprycel in this market. Chronic myeloid leukemia (CML) is a cancer of the white blood cells. It is a form of leukemia where there is an increase and unregulated growth of cells in the bone marrow and the accumulation of these cells in the blood. CML represents about 15-20% of all cases of adult leukemia in Western populations. Tasigna has projected peak sales in year 2014 and patent expiry in year 2015. Galvus has been approved in the EU as an oral treatment for patients with type 2 diabetes. Galvus has projected peak sales during year 2015 and patent expiration in year 2021. Top branded pharmaceutical drugs for Novartis AG account for 46% (almost half) of the firm’s equity value at this time. (JPM Euro Equity Research Report, Nov. 09)

European Pharma Competitors:

There are five large capitalization European Pharma firms as shown on the above chart. They include AstraZeneca, GlaxoSmithKline, Novartis, Roche, and Sanofi-Aventis. Novartis AG is the second largest behind Roche. The estimated adjusted EPS for years 2009 – 2013 place Novartis in the second position behind Roche for this category as well. The estimated adjusted price to earnings ratio for year 2009 – 2011 show Novartis AG moving from second to third. This movement may be based on analyst predictions for a strong earnings environment versus a slower upward trend for the Novartis stock price in this time period. (JPM Euro Equity Research Report, Nov. 09)

Industry Trends:

For the first time in decades, the branded pharmaceutical sales could see a decline this year (net advantage). The past decade has seen fewer drugs come to market thanks to patent expiration, potential blockbusters not making it out of trial stages, and a boom in the generic business. In 2009, approximately $24B in branded sales will be lost to generic competition, up from $18B in 2008 (net advantage). This number is expected to increase to $33B in 2010 (net advantage). This has been one of the driving reasons for the wild merger activity in branded pharmaceuticals over the past year. Pfizer, Merck, and Roche all improved their pipelines by merging with Wyeth, Schering-Plough, and Genentech respectively. Novartis is in good shape compared to the other branded pharmaceutical companies. Along with having no drugs coming off-line during the next few years, Novartis also boasts one of the healthiest pipelines in the business. Two more new molecule filings are expected to take place in the 4th quarter 2009 and four new molecule filings in 2010. This year, there have been three new molecule filings approved by the FDA, including an H1N1 vaccine (Novartis.com).

Government Spending/Legislation:

Aside from the defense sub-sector, no other industry is more affected by government spending than healthcare. Each year, the Centers for Medicare & Medicaid Services release estimates of health care spending by sector. Spending on pharmaceuticals has slowed from an impressive rate of 12.4% per year from 1990-2003 (7% was the overall rate of growth for health care spending) to 6.7% in 2007 (net advantage). In 2007, total US domestic expenditures for prescription drugs was $227.5B and in 2008, that number was estimated to be $235.4B (net advantage). With the passage of the Medicare Part D, government spending has increased as a percentage of funding for pharmaceuticals. In 2006, federal, state, and local funding represented 34% of spending on retail pharmaceuticals in the US, compared to just 17% in 1990 (net advantage). This change

over time explains the drastic price inflation for both the CPI-drugs and the PPI-specific drug products.

Spending on Medicare and Medicaid continues to be a large part of the US budget, with Medicare consuming $432B in 2007 (41% of total spending) and Medicaid $338B (net advantage). The large increase in Medicare spending also comes from Medicare Part D; 6.5 million elderly now can get their prescription drugs from Medicare as opposed to Medicaid (Medicare pays a higher rate).

This leads into the current health care debate. With no bill in place, there is much uncertainty in pharmaceuticals, even for a European based firm. By looking at the House version of the bill and the proposals brought forth in the Senate, we have some idea of how this legislation will affect Novartis. In the House bill, the pharmaceutical companies have agreed to pay $80B over ten years to help cover the cost of legislation. The House also passed a sure to be contested amendment that the HHS Secretary can negotiate drug prices on behalf of Medicare and Medicaid patients. We expect this part of the legislation to be removed by the Senate as the Bio-Pharma lobby will be strongly fighting this proposal. Eventually, we believe the final plan will instead include the increased rebate pharmaceutical manufacturers give to Medicaid reimbursements (23% up from the current 15.1%). One similarity that we know to be in favor on both sides of Congress is setting a period of 12 years for market exclusivity for novel biologics. This could be a boon to Novartis, as they began collaborating with the German Biotech firm MorphoSys in 2007 (Novartis.com). This combination has already seen benefits after producing biologics such as Xolair ($218M YTD sales) and Lucentis ($858M YTD sales) (Novartis.com). While there is a lot of risk and a lot of uncertainty, we believe that Novartis is well insulated from potential legislative pit-falls due to: Novartis is 8th in US sales in 2008, $8B behind US leader Pfizer, Novartis already has a generic division (Sandoz), and a biologic division (MorphoSyS), placing them in areas that are favored by the legislation (think margin of safety), and finally, the companies’ strategy focuses on areas of medicine that need drugs and are based in science, making them more likely to gain approval from government regulators. Since 2000, Novartis has had the most drugs approved by the FDA.

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Novartis Financial analysis:

Income Statement

When looking at the key ratios for Novartis, most of them are below those of their key European competitors, such as AstraZeneca. Novartis is not a weaker company due to these lower ratios. Due to the diversification of their business into: generics, vaccines, and consumer health products; the company turns a profit in lower margin industries, which explains why their key ratios are lower. Beginning with their gross margin, Novartis has consistently posted a gross margin above 70% since the turn of the century. In 2008, the gross margin for the company was a healthy 73.1% and in the third quarter of this year, the margin stood at 73.85% vs. 74.52% a year earlier (Novartis.com). Looking at one of Novartis’ main competitors, AstraZeneca posted a gross margin of 79.1% in 2008 (Morningstar.com). When we break down the four business units of Novartis this quarter, we get a different story. For the third quarter 2009, AstraZeneca posted a gross margin of 84.9% (azn.com). The four divisions of Novartis posted the following gross margins over the same quarter: Sandoz (47.75%), Vaccine (44.77%), Consumer Health (65.9%), Branded Pharma (83.4%) (Novartis.com). When we separate out the pharmaceutical division, we find that Novartis matches up with AstraZeneca and other branded pharmaceutical companies in most regards. Novartis is currently spending around the industry average for R&D as a percent of sales. The industry usually finds itself between 14-18%, while Novartis is at 16.46% for the third quarter and 16.98% YTD (Novartis.com). The percent spent on R&D is impressive considering that Novartis has approximately 3x as many drugs in late stage trials than other firms (JPMorgan). For branded pharmaceuticals, the average operating margin is 31% in 2007. The branded pharmaceutical unit of Novartis was close to that number (30.45% third quarter), but the remaining divisions of the company lower the group’s operating margin compared to industry averages. Operating margins for Novartis in 2008 were 21%; the ratio has stayed in a range between 17.1% and 24.3% over the last ten years (Morningstar.com). Compared to our test case,

AstraZeneca (39.07% third quarter operating margin), Novartis’ operating margin looks weak. However, AstraZeneca is number three in US sales for 2008 at $16.3B while Novartis was at $12.4B (net advantage). Furthermore, Novartis spends a much higher percentage in its pipeline because it has the most products ready to come online during the next five years and since the late stage trials are the most expensive, Novartis is spending $5.3B on R&D YTD while a company like AstraZeneca, whose pipeline is not as robust, is only spending $3B (nvs.com, azn.com).

Balance Sheet

The philosophy at Novartis seems to be that if the firm does not already have what they want inside the company, they will go out and purchase it because they have the cash to do so. In making many smaller purchases recently, the company has used all cash in these deals and continues to hold an extremely low debt/equity ratio. Between 1999 and 2008, the ratio has ranged from 0.01 to 0.10. We like that Novartis has little debt. For their 2010 purchase of the remaining 52% of Alcon, they will be able to take on debt if needed in order to finish the deal. Already, the company has begun to take on more debt for this deal; the company issued bonds in 2009 first in the US, worth $5B, and then in Europe, worth almost $3B US (Novartis.com). This has raised the firm’s debt/equity ratio from .18 in the second quarter to .70 in the third quarter 2009. The company remains substantially liquid though, with a 2008 current ratio of 1.27. While this is the lowest in ten years, we feel that this decline is due to the focus on having more debt on the books. This ratio is in no trouble of dropping below 1 anytime soon as the current ratio for quarter two was 1.77 and 1.7 ending September 30th. Due to the diversified business model, Novartis posts a lower than average ROE. At 18%, the average ROE for pharmaceuticals is the highest amongst all industries. In 2008, Novartis posted an ROE of 16.47%, a decline from their ten year high of 26% in 2007 and the lowest ROE in a decade (Morningstar.com). The 26% ROE in 2007 was due to the sale of Gerber to Nestle for $5.5B leading to a 71% increase in net income in 2007.

Growth Rates:

Growth

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 latest Qtr

Revenue Growth

Year over Year (12.1%) 8.9% (12.7%) 20.8% 6.6% 13.6% 15.2% 13.0% 6.0% 9.3% (2.3%)

3-Year Average --- --- (5.8%) 4.8% 4.0% 13.5% 11.7% 13.9% 11.3% 9.4% ---

5-Year Average --- --- --- --- 1.5% 6.9% 8.0% 13.8% 10.8% 11.4% ---

Operating Income

Year over Year (14.4%) 6.0% (9.9%) 29.5% 3.8% 11.0% 5.6% 15.1% (14.7%) 32.2% (3.9%)

3-Year Average --- --- (6.5%) 7.3% 6.6% 14.3% 6.8% 10.5% 1.2% 9.1% ---

5-Year Average --- --- --- --- 1.9% 7.4% 7.3% 12.6% 3.6% 8.8% ---

EPS

Year over Year (3.6%) 117.3% --- 25.4% (2.6%) 17.0% 12.0% 13.0% (5.4%) 27.1% ---

3-Year Average --- --- 487.0% 540.7% 390.3% 12.6% 8.5% 14.0% 6.2% 10.8% ---

5-Year Average --- --- --- --- 201.0% 212.8% 174.0% 12.6% 6.4% 12.2% ---

Valuation:

Based on the Equity DDM model from Bloomberg for Novartis AG we project a theoretical stock price of 66.34 dollars. The stock is currently trading near the 53 dollar level, which is a 25% lower difference. This theoretical price is based on a 13% earnings growth rate between year 1 and year 2 as well as a subsequent growth rate of 8% between year 2 and year 3, with a

long term growth rate of 6%. The implied growth rate result is 3.3% based on these calculations, a conservative number in our view.

Fear & Greed:

Greed

• Business strategy of four divisions gives Novartis a more consistent revenue stream • New R&D focus is “regulator friendly” • Best pipeline of all pharmaceuticals (138 molecular compounds under development) • 50 molecular compounds in late stage development • Good management • No drugs coming off patent during OFG • Pay dividend at the beginning of April • Only 39-40% exposure to US, already moving into developing world • Three drugs approved by the FDA in 2009, four seeking approval in 2010 • Swine Flu Vaccine orders will give a one-time boost to top line

Fear

• Negative outcome with healthcare reform • Management making too many purchases too quickly • Branded pharmaceutical unit focused on the future, not necessarily during OFG • Integration of business units • Weaker patent protection in the developing world • Generic competition • Declining industry sales • Failure to move new molecular entities to market • Recession leading to fewer prescriptions of branded drugs

Overall Analysis:

In taking a different approach, Novartis has positioned itself to become an even more dominant pharmaceutical company over the next decade. By changing its R&D approach, Dr. Vasella has potentially created the future model for all pharmaceutical companies during a period of declining sales and few blockbuster segments left to develop. By focusing on the science of medicine as opposed to the bottom line, Novartis has created the best pipeline in the industry with 138 new molecular entities, 3-4x the industry average. Furthermore, Novartis has approximately 50 molecules in late stage development that should hopefully be hitting the market within the next five years.