Value and Later-Stage Principal Investing Blog: Analysis and Recommendation for Novo Nordisk

Recommendation: Long
Diabetes Care Pure Play Franchise Serving as a’Wide Moat Cash Compounding Machine’ w/ Bullet Proof Balance Sheet and Exceptional Profitability

Nova Nortis

Associated Financial Valuation Model:

Click Here

Thesis

RECOMMENDATION: I recommend initiating a LONG position in the American Depository Receipt (‘ADRs’) Class B common shares of Novo Nordisk A/S (NYSE:NVO). The Company is a classic ‘wide moat, cash compounding machine’ with a durable competitive advantage – as seen by a > 70.0% ROIC – in the pharmaceutical space with multiple inherent barriers to entry. Based on my FY2017 earnings estimate, Unlevered Free Cash Flow intrinsic valuation, and Dividend Discount Model, I recommend setting a FY2018 price target estimate of ~ $60.00 per share, representing a 23.0%+ upside from the current price (i.e. ‘margin of safety’).

COMPANY: Novo Nordisk is a global healthcare company and a world leader in diabetes care. Novo Nordisk was formed in 1989 by a merger of two Danish companies, Nordisk Gentofte A/S and Novo Industri A/S. Novo Nordisk A/S core operations from the beginning was the production and sale of insulin for the treatment of diabetes. Novo Nordisk’s R&D activities utilize biotechnological methods based on genetic engineering, advanced protein chemistry and protein engineering. The focus of the Company’s R&D is on therapeutic proteins within diabetes, obesity, haemophilia and growth disorders. Diabetes and obesity care are Novo Nordisk largest business segments and constitute ~ 80.0% of total sales. Headquartered in Denmark, Novo Nordisk employs approximately 42,500 employees in 75 countries and markets its products in more than 180 countries.

Investment Thesis:

  • INVESTMENT THESIS #1 – Excellent Capital Allocation Policy & Return on Capital Employed: Novo Nordisk guiding principle is to return all excess capital back to shareholders; Novo Nordisk has consistently increased payout ratio and cash dividends paid over prior 5 years. The Company has amazing Return on Equity (‘ROE’) profile of > 84.0%+ with practically ZERO debt (i.e. ‘bullet proof’ Balance Sheet). Novo Nordisk has a VERY tangible durable competitive advantage (i.e. ‘economic moat’ factor) as can be seen by its > 77.0%+ Return on Invested Capital profile. The Company has VERY strong pricing power as can be seen by its consistently high > 80.0%+ Gross Profit Margins. Furthermore, the core operations are VERY profitable as Novo Nordisk has generated > 40.0%+ Operating Profit margins consistently. Dividends have consistently been increased and there is an approximately 10+ year record of consistent positive trend in Diluted Earnings per Share (‘EPS’). The Company has exhibited superior EPS growth, achieving a 11.4% CAGR from FY 2017 thru FY 2020 (versus an 8.0% average EPS CAGR for the industry sector). Novo Nordisk has very opportunistically initiated a regular share repurchase program and has a very amazing Free Cash Flow conversation rate (i.e. Unlevered Free Cash Flow consistently is above 40.0% as a percentage of Total Revenues).

 

  • Consensus View: Novo Nordisk will no longer be able to dominate the branded insulin market as its competitors – Eli Lilly and Sanofi – have competing drugs which will take away substantial market share from Novo Nordisk traditional diabetes franchise. Furthermore, generic insulin products entering the market will erode the Company diabetes franchise.

 

  • Variant Perspective: The diabetes / branded insulin market is primarily an oligopoly with three main competitors to Novo Nordisk: (1) Merck; (2) Eli Lilly; and (3) Sanofi. However, Novo Nordisk three competitors are NOT exclusively focused on diabetes care and only derive part of their total revenues from this segment, whereas Novo Nordisk is a PURE PLAY focused on primarily diabetes care franchise. The branded insulin market that Novo Nordisk dominates has for decades had ‘generics’ (which are called ‘biosimilar analogs’) yet the inherent barriers to industry around the synthetic branded insulin market economic business model ensure that excess returns will be generated by Novo market leadership diabetes care franchise.

 

INVESTMENT THESIS #2 – GLP-1 Based Drugs in USA Still a Growth Market: In the United States, GLP-1 based drugs is a very rapidly growth market, which has been growing at a 20.0% to 30.0% CAGR for some time now. Diabetes as a health crisis is expected to grow exponentially and is considered an ‘invisible’ pandemic. Not only is the number of patients treated by Novo branded insulin expected to increase at a double-digit CAGR rate, but there is expected to be a massive exponential increase in diabetes in the Non-Western continents worldwide.

 

  • Consensus View: Negotiating power of Buyers [i.e. Pharmacy Benefit Managers (‘PBM’)] due to M&A consolidation will continue to pressure Net Listing Prices of insulin drugs in North America region – with N. America constituting ~ 50.0% of total worldwide revenues – thus compressing overall profitability and operating profit margins. Sell-side equity research analyst sentiment is that drug pricing will continue to experience erosion (based on Q3 FY 2017 earnings conference call statements made by management). Specifically, drug compounds Levemir and Tresiba are under pricing pressure in USA, and sales of latter (i.e. Tresiba) were 17.0% below consensus expectations and sales of former drug (i.e. Levemir) were 10.0% below consensus expectations.
  • Variant Perspective: Novo Nordisk has positioned itself for further future growth by focusing on its International Operations segment, as the diabetes pandemic is no longer a ‘developed world’ crisis. Hence while the existing diabetes global market is a VERY large Total Addressable Market (‘TAM’), it is expected to CONTINUE to be a growth industry over the decades. The Company did an internal restructuring and now consists of two business regions: International Operations and North America. Novo Nordisk already has a very strong foothold in the USA diabetes care market (i.e. as seen by a strong and stable market share position); however, future growth will consist of International regions, such as very highly populated nations such as India and China. Novo is leading the way with on-the-ground operations in China region. China and India represent the largest populated nations, and number of potential future diabetic patients can surpass even North America, which itself constitutes approximately 50.0% of Novo Nordisk total consolidated revenues.

Company Segments:

  • SEGMENT #1 – Diabetes:

  • Diabetes care is Novo Nordisk largest business segment, accounting for approximately 80% of the Company total sales

  • Currently 415 million people are living with diabetes, and the number is expected to increase to 642 million by 2040; 193 million people with diabetes have not yet been diagnosed and are untreated

  • The Total Addressable Market (‘TAM’) for diabetes care is estimated at 450 billion Danish kroner, and Novo Nordisk’s market share is approximately 27% of global market

  • Novo Nordisk R&D efforts in diabetes are all focused on ‘protein-based products’ (i.e. insulin and GLP-1), with a 40% market share in insulin and 60% market share in GLP-1 drugs

  • Currently Novo Nordisk has 7+ active compounds in various stages of FDA clinical trials within the Diabetes segment pipeline of drugs

  • SEGMENT #2 – Obesity:

  • Obesity business segment is correlated with the risk of developing diabetes

  • Obesity is a pandemic crisis with more than 600 million adults having clinical obesity (i.e. Body Mass Index > 30); however, only 10 million people receive pharmacological treatment for obesity (since there are few treatments and medical insurance reimbursement is very limited for such treatment)

  • In FY 2015 Novo Nordisk entered the obesity market with a drug called Saxenda; in FY2016, Saxenda has gained a market share of 35% in the USA market

  • Currently Novo Nordisk has 6+ active compounds in various stages of FDA clinical trials within the Obesity segment pipeline of drugs

  • SEGMENT #3 — Haemophilia:

  • Haemophilia is a bleeding disorder that prevents blood from clotting

  • The Total Addressable Market (‘TAM’) for this disease is estimated at 493,000 people worldwide; the global pharmaceutical market has a value of 64 billion Danish kroner

  • Currently Novo Nordisk has 3+ active compounds in various stages of FDA clinical trials within the Haemophilia segment pipeline of drugs

  • SEGMENT #4 – Growth Hormone:

  • The Total Addressable Market (‘TAM’) for growth hormone deficiency is estimated at 18 billion Danish kroner

  • Novo Nordisk has been active in this market for four decades

  • Novo Nordisk drug Norditropin is the market leader with a 37% market share

  • Currently Novo Nordisk has 1+ active compounds in various stages of FDA clinical trials within the Growth Hormone segment pipeline of drugs

Industry Dynamic:

  • INDUSTRY DYNAMIC #1 – Pricing of Drugs: In the United States, there are several deductions that need to be made to get from the gross listing price of the drug to the net price that consumers pay. The first definition is the List Price, which is set by the manufacturer of the drug compound. The people that have to pay the list price include patients without insurance and patience with a high insurance deductible. From the list price, there are three different deductions that are made to get to the Net Price, which represents the drug manufacturer realized price for the drug sold. The Net Price more closely represents the actual company sales revenues. The first deduction is Rebates / Discounts, which represent payments to Pharmacy Benefit Managers (‘PBM’) and insurance companies to ensure placement on drug formularies. The second deduction consists of Wholesaler Fees, which represents payments to wholesalers to support stocking and distributions of medicate throughout the entire supply chain. The final deduction to the list price consists of additional Price Concessions, which consist of coupons and co-payment fees and administrative fees to PMS. For Novo Nordisk, the Net Price year over year increases have been in the mid-single digit percentage.
  • INDUSTRY DYNAMIC #2 – Challenging USA Market Conditions: FY2016 was a very difficult year for Novo Nordisk, primarily for its North American operations. The challenging business environment in the United States was due to several factors: (1) a wave of M&A consolidation among Pharmacy Benefit Managers (‘PBMs’) – the main purchasers of medicine – caused increased threat from buyers negotiation powers to offer larger rebates off the listing price of drugs. Despite these headwinds in North America, Pharmacy Benefit Manager formularies continue to categorize Novo Nordisk branded insulin products as a ‘Group 2’ products, which serves as an inherent ‘economic moat’ in the form of (1) high patient switching costs; and (2) brand equity in the mind of doctors and pharmacies.

Catalysts:

  • CATALYST #1 – Expected USA Approval of Semaglutide (aka ‘Sema’) in Q4’FY17: Based on the R&D initiatives of Novo Nordisk and the SUSTAIN 7 study results, Sema has shown superior reduction in HbA1c and weight loss. Based on the study, this new diabetes drug compound has shown to be superior based on retinal disease and cardiovascular (CV) side effects. Sema has relatively recently

    received a unanimous 16 to 0 vote in favor of the drug labeling by the FDA. As of the current time, it also seems that Sema is the ONLY GLP-1 compound to receive favorable CV labeling by the FDA.

  • CATALYST #2 – Collapse in Share Price between FY2015 to FY2016: Novo Nordisk share price collapsed by 36.3% between its FY2015 closing price of DKK 399.90 and Dec. 30 , 2016 closing price of DKK 254.70.

  • CATALYST #3 — Patent ‘Cliff’ for NovoLog/NovoRapid & NovoLog Mix/NovoMix: Total sales for NovoLog / NovoRapid diabetes drug compound were DKK 19,945 million in FY2016. The patent protection for the drug compound has expired back in FY2014 in the United States. North American (i.e. USA) constituted 56.0% of the total worldwide sales revenue from this drug. The formulation patent for this drug compound is expected to expire in June 2017 in all major markets. Furthermore, total sales of NovoLog Mix / NovoMix diabetes drug compound were DKK 10,482 million in FY2016. Of this total worldwide revenue, 20.0% of total sales were derived from North America. The formulation patent for this diabetes drug compound is expected to expire in the United States in December 2017. However, despite the patent cliff for these two diabetes drug compounds approaching in Dec. 2017, management has disclosed that there are NO biosimilar versions are currently being tested in clinical trials in EU, North America, and Japan. Novo Nordisk has a very robust diabetes drug compound pipeline and regularly spends approximately 12% to 14% of Total Sales on Research & Development. Despite the patent expiration on these two drugs, the Company has three new diabetes compounds for treatment of both Type 1 and Type 2 diabetes, which have all passed FDA Phase III clinical trials already, and will come ‘online’ soon and have future patent protection thru FY 2031.

Valuation:

  • A full 3 statement Operating Model was created for the purposes of conducting an intrinsic fundamental valuation for Novo Nordisk. Furthermore, in the quantitative valuation section of the Company analysis, three different intrinsic valuation methodologies have been employed to ‘triangulate’ on a range of true ‘intrinsic value’ per share: (1) an Unlevered Free Cash Flow analysis (i.e. Free Cash Flow to Firm); (2) a Levered Free Cash Flow analysis (i.e. Free Cash Flow to Equity Investors); and (3) a Dividend Discount Model (i.e. ‘DDM’).
  • P/E vs peers: On a relative valuation basis, Novo Nordisk is trading at a more attractive level than its main competitors Eli Lilly and Sanofi. Specifically, as of the current date Novo Nordisk is trading at a TTM P/E multiple of 20.8x, whereas Eli Lilly trades at a TTM P/E multiple of 40.4x, Sanofi trades at a TTM P/E multiple of 21.2x. For comparison purposes, overall industry TTM P/E multiple is 31.9x and the sector overall TTM P/E multiple is 35.2x.

  • Target price calculation – DCF (‘FCFF’): Novo Nordisk was valued primarily on an intrinsic valuation basis (as opposed to a relative valuation basis). A flat 10.0% discount rate was assumed (as a conservative discount rate estimate) and a nominal perpetuity growth rate of 3.5%. Unlevered Free Cash Flow (i.e. Free Cash Flow to Firm) was calculated based on full 3-statement Operating Model. Unlevered Free Cash Flow was projected thru FY 2021 (in local Danish kroner currency), and the Terminal Value (‘TV’) was calculated based on the Exit EBITDA method, using an Enterprise Value / EBITDA exit multiple of 12.5x (note: as a relative basis of comparison, Eli Lilly is currently trading at a EV/EBITDA = 16.2x and Sanofi trades at a EV/EBITDA = 11.1x), resulting in a value for Enterprise Value. Net Debt was backed out to get to an Implied Equity Valuation, which based on a Fully Diluted Shares Outstanding {‘FDSO’) basis, resulting in a DKK 389.47 value per share, which converted back to $USD at the FX Exchange rate (as of the valuation date), resulting in a per share value of ~ $60.00+ per ADR class B shares. This represents a 23.9% upside from the Novo Nordisk current share price of $49.76 (as of the valuation date of the analysis).

  • Figures 3 thru 5 below show the summary valuation results of the three intrinsic valuation methodologies utilized to triangulate on an estimated intrinsic valuation range for the Novo Nordisk ADR class-B common shares: [NOTE: SEE EXHIBITS IN FORMATTED PDF WRITE UP]

Risks:

  • RISK FACTOR #1 – Diabetes Business Concentration Risk: Novo Nordisk represents a ‘pure play’ investment in diabetes care within the pharmaceutical industry. Approximately 80.0% of the Company total revenues is derived from this one single diabetes care segment. This sole focus is both a strength of Novo Nordisk diabetes franchise, as well as a potential risk factor. Pharma companies are trying to work to discover a cure for human diabetes, which would severely impact Novo Nordisk future earnings power ability. However, despite this potential risk, the Company senior management is constantly spending a very large proportion of revenues on R&D initiatives so that Novo Nordisk can be ahead of the market in innovation such that it can reinvent itself and pivot its existing business model to fit any future business conditions within the synthetic branded insulin market.
  • RISK FACTOR #2 – Unexpected Generic Drug Competition: Biosimilar analog products for branded insulin have been available for years. Insulin must be stored in liquid form and has a short shelf life. The global supply chain logistics of shipping and handling for insulin serves as a barrier to entry as insulin needs to be shipped in small glass containers. Hence despite patent protection for Novo branded insulin, unlike traditional pharmaceutical drug companies, generics really do NOT pose as a risk to branded insulin, even after patent expiration. There are high ‘customer switching costs’ associated with changing a doctor approved diabetes insulin regiment, and the pharmacy formulary list categorization of Novo branded insulin as a ‘Group 2’ preferred and recommended brand for treating diabetes.

Exhibits – Additional Information

Q3 2017 EARNINGS CONFERENCE CALL:

  • Revenues were DKK 26,614 mm, -2.7% less vs. consensus estimate at DKK 27,738 mm
  • Sales growth came from diabetes and obesity care segment, with main growth drivers being Tresiba growing 118% and Victoza growing 15% (in local currency)

  • Q3 FY2017 sales results were weaker that guidance provided by management, but Operating Expense reductions were better than anticipated and Operating Income guidance was higher than consensus estimates

  • IFRS Diluted EPS was DKK 12.03

  • YTD FY2017 Management Guidance:

    • Revenues growth rate (in local currency) = 2.0% — 3.0% (vs. 1.0% to 3.0% previous guidance by management)

    • Gross Profit Margin range: 6%

    • FY2017 Operating Profit growth guidance of 3.0% to 6.0% (vs. 1.0% to 5.0% previous guidance by management)

    • FY2018 guidance of low to mid-single digit growth in both sales and operating profit

  • Call commentary:
    • Majority of growth derived from International Operations segment and from sales of diabetes and obesity care segment drugs

    • Key drivers of sales growth are sales of (1) Tresiba; (2) Victoza; and (3) Saxenda

Major Shareholders:

  • Novo Nordisk A/S consists of two classes of common shares: A-shares and B-shares, each with different voting rights. The A-shares have 200 votes per share; the B-shares have 20 votes per share. All of the A-shares with the super-voting privileges are held by Novo A/S, a wholly-owned subsidiary of Novo Nordisk Foundation. As of FY2016, the A-shares represent ~ 73.0% of the total votes exercisable.

Management Team:

  • Novo Nordisk A/S is led by a stable management team with very long tenures at the Company. Former President and CEO Lars Rebien Sørensen retired in September 2016 and the Board promoted Lars Fruergaard Jørgensen to the CEO role. Mr. Jørgensen has been with the company for over 26 years and was previously in the role of VP of Corporate Development prior to being promoted to Chief Executive Officer.

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