SMU |COX
NOVARTIS
SM
SCHOOL
OF BUSINESS
ANN RIFE COX ENDOWMENT FUND
EQUITY RESEARCH
UNITED STATES OF AMERICA
Ryan Wannemacher
Email: rwannema@mail.smu.edu
Kanaiya Kapadia
Email: kkapadia@mail.smu.edu
Benjamin Q. Luong
Email: luong_benji@hotmail.com
Miranda Peters
Email: mpeters@mail.smu.edu
FINANCIAL STATISTICS
Price: $42.48 (as of April 2, 2004)
Symbol | Exchange: NVS | NYSE
52-Week Range: $34.13 - $47.83
Market Cap: $109.27 billion
Shares Outstanding: 2.47 billion
Relative Price-to-Earnings (P/E): 1.15
Forward P/E: 16.7
Trailing P/E: 23.52 (Stock) vs. 28.19 (Industry)
PEG Ratio: 1.54 (Stock) vs. 1.24 (Industry)
Return on Assets (ROA): 12.5%
Return on Equity (ROE): 16.2%
Total Debt-to-Equity (D/E): 0.15
Current Ratio: 2.46
Annual Dividend: 0.70
Dividend Yield: 1.55%
Instrinic Value: $42.35
COMPANY PROFILE
“Novartis AG, formed in December 1996, operates in
its core businesses of pharmaceuticals and consumer
health, which includes generics, over-the-counter
(OTC) self-medication, animal health, medical
nutrition, infant and baby foods and products, as well
as eyecare products. The Company is organized into
two divisions, pharmaceuticals and consumer health.
In 2002, the consumer health division was reorganized
to include the generics, OTC self-medication, animal
health, medical nutrition, infant and baby and CIBA
Vision business units. In May 2003, Novartis acquired
Idenix Pharmaceuticals, Inc., a biopharmaceutical
company engaged in the discovery and development
of drugs for the treatment of human viral and other
infectious diseases. Also in May 2003, the Company
acquired the incontinence drug Enablex from Pfizer
Inc.” – Reuters
Novartis is also mostly well known for its launch of
Ritalin LA (methylphenidate).
PAGE 1
COMPANY UPDATE: Prospects for 2004
HEALTHCARE - Drugs & Pharmaceuticals
SELL
April 2, 2004
“Don’t do DRUGS.”
INVESTMENT THESIS
The market consensus expectations for Novartis are fairly low. The growth that most
people are predicting is consistent with typical expectations of a value company, with a
consensus revenue growth at 8% a year. There are some factors which could contribute to
the revenue growth dipping below 8%. They are expecting big things from two new drugs,
Zelmac and Xolair. If these drugs do not live up to their billing, it could have an adverse
affect on the companies expectations. Zelmac is a drug to help relieve chronic constipation.
“If approved for use in chronic constipation, (Zelmac) would be the first treatment not only
to improve bowel frequency but also to provide relief of multiple symptoms to patients,” said
John Johanson, MD, MSC, lead investigator and Clinical Associate Professor of Medicine at
the University of Illinois College of Medicine in Rockford. “This advance would be welcomed
by the medical community because there is a need for additional therapies that are effective
and well tolerated.” Xolair is a drug for chronic asthma. From a business model standpoint,
Novartis’ strategy of developing drugs that are comfort drugs is a sound one. Both Zelmac and
Xolair are medications that will need to be taken continuously over a person’s lifetime. This
bolsters another trait of a value company — more stable cash flow. However. there are some
drawbacks to that business model. By not going for the homerun ball, they will not experience
huge gains, but they will be more consistent gains.
The largest cost to any drug manufacturer is Research and Development (R&D).
Novartis has done a good job of controlling R&D. They have kept it constant at about 15%
of revenues. This is par with the industry average. If Novartis does not get the return on their
R&D that they expect, then it would force them to either increase R&D or see their revenues
drop. Either way, the percentages that they are spending to achieve the same revenue stream
will increase, causing a decrease in free cash flow. Novartis, similar to other drug companies,
carries a lot of cash, $13 billion in cash and short term securities. This allows them to be very
agile in the business world. They are also not held down with a lot of debt. Their debt-to-
equity ratio is only about .15 and their cash-to-debt ratio is a very healthy 2.5. In this case, we
feel that they could support some more debt, and we think that it could have a positive effect
on their stock price.
The weak point from the ratio analysis is the P/E ratio. It is fairly high at about 18.6 (see
Exhibit 1). There are some much lower P/E ratios in the drug manufacturing industry. Their
growth rates over the past 3 and 5 years have been meager at best. We expect this to continue
with a conservative average growth rate of 8% into the future.
Possible merger in the works. There has been some talk of a merger with French drug
company, Aventis. Novartis has said that they are not opposed to a merger; however, they
will not going to do anything that does not make logical sense. We think that this behavior
shows that management is realistic, is aware of their situation, and understands what affects
the success of their company.
CHART A : Stock Chart
Source: Morningstar.com
SOUTHERN METHODIST UNIVERSITY
BUSINESS MODEL
The Major Drug Manufacturing and Pharmaceuticals sub-sector
of the health care sector is marked by high margins despite large
research and development costs. The largest driver of earnings for
any given company in this sector is its ability to remain innovative
and revolutionary. As a result these companies must always be
forward looking. The companies in this sector often carry a very
large amount of cash. They generate very large amounts of cash
flow, and with an aging population they seem to only be growing.
OVERALL MARKET PERSPECTIVE
Gradually, medical progress has been expensive, and healthcare
still represents the largest sector of the U.S. economy. In 1940,
the United States spent $4 billion on health care. In 1998, health
care costs have skyrocketed to $1.1 trillion, almost $4,094 per
person. Further, this health care cost accounted for approximately
13.5% of the gross domestic product (GDP) or one-seventh of
the U.S. total output. Total U.S. health care costs are projected
to increase from $1.31 trillion in 2000 to $2.17 trillion in 2008,
averaging a 6.8% increase per year. Health care spending in terms
of GDP is expected to increase from 14% in 2000 to 16.2% in
2008. According to Plunkett Research, rising drugs costs amply
contribute to the soaring health care costs. Since 1995, the price
of drugs has been increasing more than 10% annually and has
surpassed $110 billion annually.
Most importantly, a large percentage of the U.S. population
will also be aging. Baby boomers of 1946 to 1964 will reach
retirement age and this retiring population will increase sharply.
Intuitively, the percentage of the working population will fall.
Consequently, demand for medical care, long-term care facilities,
drugs, improved technology, and other medical services will
eventually skyrocket. As a benefit, these services will increase
life expectancy age, but prolonging age will add to health care
costs. In addition to health care spending, the number of people
drawing Social Security benefits will rise sharply. Intense pressure
will be tightly placed on government budgets. Increases in taxes
will result unless the government cuts the level of these services.
Nothing about health care expenditures indicates that any decrease
will occur anytime soon.
According to Plunkett Research, the state of the health care
industry will have recurring themes during the first half of the 21st
century:
1) Increase in ineffective utilization of Managed Care
enterprises (HMOs, PPOs, etc.)
2) Loss of autonomy for both physicians & patients
3) Backlash against HMOs (“Patients Rights”)
4) The rise and fall of various types of physicians’ organizations
5) Vast number of uninsured and underinsured Americans –
15.5% of Americans have no health coverage (42.6
million adults & 14 million children)
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NVS | PAGE 2
6) HMOs dump Medicare & Medicaid investments while the
cost of senior care balloons
7) Utilization Review (seeking effective means of cost control)
8) Use of minimally invasive surgery (loss of business in
operating rooms)
9) Alternate site care (Home health care)
10) Advanced imaging techniques
11) Biotech and advanced pharmaceuticals use grows while
costs soar
12) Advanced information technology and medical records
13) The Internet (a shift of access of knowledge from the
physician to patient)
14) M&A of health care companies – rise in consolidation
15) New Medicare Rx legislation – $400 billion budget over 10-
year period to cover elderly; boost pharmaceutical sales
16) Loss of patent protection in the next four years
17) Rx to OTC drug conversion to boost non-prescription sales
Additionally, the drug market is one of the world’s most profitable
markets in terms of profit margin. For instance, “lifestyle drugs”
alone economically and socially have been transforming the $98
billion U.S. pharmaceutical market. With the forefront of the
biotech era, biotechnology is expected to produce up to ½ of all
new drugs in the future. The outlook for technology will mostly
encompass regenerative medicine, transgenics (use of organ and
tissues grown in lab animals for human transplant), neo-organs,
the human genome project, enhanced gene therapy, new drug
delivery methods, new technology in hospital systems, support
and services, nanotechnology and advanced in cancer research,
diagnostic imaging and monitoring, laboratory testing, and
surgery.
VALUATION
We calculated an intrinsic value based on an average, revenue
growth of 8% a year — in-line with market consensus estimates.
In our discounted free cash flow (DFCF) model, we assumed that
their profit margin would remain constant as well as their other
major cost drivers, such as Research and Development. We also
assumed that their line item percentages in their income statement
for 2003 would remain the same throughout forecasted years (see
Exhibit 2). Based on our analysis of Novartis, we determined that
it is a good company, but slightly overvalued. With a Weighted
Average Cost of Capital (WACC) of 7.35% and a Terminal
Growth percentage of 4%, we feel Novartis is fairly valued at
$42.35. Exhibit 4 depicts a sensitivity analysis of the possible
intrinsic values of the firm depending on the variability in WACC
and Terminal Growth numbers. On a positive side, we do not
necessarily see serious detrimental behaviors that could adversely
affect their financial condition because it has a lot of room on
the upside. However, we feel that Novartis will not be able to
achieve the returns consistent with the expectations of the Ann
Rife Cox portfolio for 2004. Growth in the firm will remain either
relatively constant or will slowly grow over time (see Chart A).
Consequently, we recommend a sell of our position in Novartis.
ANN RIFE COX ENDOWMENT FUND
SOUTHERN METHODIST UNIVERSITY
DFCF MODEL ASSUMPTIONS
We made several assumptions that will serve as inputs into our
DFCF model for simplicity purposes.
Capital Expenditures-to-Depreciation ratio
Using Novartis’ 2003 financial figures, we arrived at a ra-
tio of .9589 and assumed this ratio remained constant for purposes
of growing capital expenditures throughout forecasted years.
Revenue growth %
Market consensus estimates revenue growth of 8%; how-
ever, we forecasted 10% revenue growth for the years 2005, 2006,
and 2007 because Novartis will be able to recognize returns on
investments (ROI) from their new drugs that will be coming out of
Phase II and final Phase III clinical trials. We then conservatively
reduced revenue growth for the remaining years. Further, Chart B
and C indicate breakdowns and distributions in sales earnings.
Depreciation
Using Novartis’ 2003 financial figures, we arrived at
5.65% (see Exhibit 2 - Key Percentages) and assumed this per-
centage remained constant for purposes of growing depreciation
throughout forecasted years. We also derived depreciation-to-
book assets of 4.4%.
Debt Interest Rate %
We calculated the debt interest rate to be based on a
spread from a AAA bond rating. An interest rate of 4.1% seems
to be consistent with interest expense (as a % of revenue) in 2003.
We also used this figure to calculate interest expense in forecasted
years.
Tax rate
We used a fair tax rate of 20% for 2003. We kept this
figure constant throughout forecasted years.
Key Percentages for 2003
Percentages for each line item indicate as percentage of
revenue. These percentages were used to forecast line items in
forecasted years (see Exhibit 2).
Beta
We arrived at a beta equity of the firm of 0.84 from Val-
ueline (see Exhibit 3).
Weighted Average Cost of Capital (WACC)
With our inputs, we calculated the WACC to be 7.35% for
the levered firm (see Exhibit 3).
Terminal Growth %
We used 4% as a terminal growth input to determine the
intrinsic value of the company (see Exhibit 4).
SMU : COX SCHOOL OF BUSINESS
NVS | PAGE 3
FUNDAMENTALS ANALYSIS (see Exhibit 1)
Sales and Net Income
Novartis ranks 3rd in sales and net income among our
choice of comparable companies (see Chart B and C for Novartis’
sales breakdown). While Novartis have sustained their position,
other drug manufacturers have shown much better growth pros-
pects and increased competitiveness.
Earnings per Share (EPS)
Once again, Novartis ranks 3rd in EPS among our choice
of comparable companies. Next Fiscal Year (NFY) prospects
shows attractive growth for all comparables. Eli Lilly seems to
show the greatest prospect in EPS growth of 17.7%.
Financial Ratios
Pfizer steps into the 1st position with the highest Last Fis-
cal Year (LFY) gross margin of 87.5% while Novartis achieves a
gross margin of 76.5%. However, Novartis maintained an EBIT-
DA gross margin of 27%, shy under Pfizer’s EBITDA gross mar-
gin of 36.4%. Return on Equity (ROE) is mediocre at 16.2% while
Eli Lilly has a well-above average ROE of 26.1%. According to
Yahoo!, the Industry indicates a trailing twelve months (TTM)
ROE of 20.01%. Return on Assets (ROA) is moderate at 12.5%
in terms of measuring profitability. TTM ROA for the Industry is
determined to be at 9.01%. Asset Turnover (in terms of how well
assets are used to produce revenues) for Novartis does not look
impressive at 0.46 when compared against other drug manufactur-
ers. Current ratio is very high at 2.46, indicating that Novartis is
very liquid.
Growth
Historical 3-year growth rate seems to look unattractive
at -0.05% while other drug manufacturers have achieved positive
growth. Projected ROE NFY for Novartis at 16% is extremely low
among others. Yet, Novartis’ projected growth in EPS in 5 years is
expected to be at a modest 13.1%.
Risk
Debt does not seem to be a risk factor for Novartis con-
sidering they carry a hefty load of cash at $13,967.8 million.
Valuation
Current Fiscal Year (CFY) Price-to-Earnings (P/E) is
fairly high at 18.6 while NFY P/E also remains high at 16.7. Also,
Relative P/E is high at 1.15. Additionally, Novartis’ PEG ratio
is high at 1.54 when compared to the Industry’s 1.24 PEG ratio.
In summary, Novartis is expensive, and because the P/E ratio is
high, the market seems to be more willing to pay for each dollar
of annual earnings. Further, Novartis’ P/E is slightly higher than
the aggregate P/E ratios, indicating that the Company is a slightly
more expensive than the norm.
ANN RIFE COX ENDOWMENT FUND
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EXHIBIT 1 : Comparable Company Analysis

Rex Thompson P/E Aggregate Ratio (Thompson PEAR)

The Thompson PEAR method is determined using the sum of the all comparables’ market capitalization and the sum of the each comparables’ common shares times their EPS.

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EXHIBIT 2 : Projected Financials

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EXHIBIT 2 : Projected Financials (continued)

CHART B : Sales Breakdown by Patent Products

Source: Company Reports

CHART C : Sales Breakdown

Source: Company Reports

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EXHIBIT 3 : Risk and Required Return

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EXHIBIT 4 : Free Cash Flow - Sensitivity Analysis

SMU : COX SCHOOL OF BUSINESS ANN RIFE COX ENDOWMENT FUND