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Novartis: Mixed signals! - Views on News from Equitymaster
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Novartis: Mixed signals!
Jan 28, 2006

Performance Summary
Novartis announced its results for the third quarter and nine-month ended December 2005 late yesterday. While the pharmaceutical and over-the-counter (OTC) business performed well during the quarter, the generics business continued to be a drag on the topline. At the same time, a significant rise in expenses led to a sharp contraction in margins. Even a lower tax outgo could not boost the bottomline, which grew by a mere 6% YoY.

Financial performance: A snapshot
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mY06 Change
Net sales 1,352 1,383 2.3% 3,924 4,212 7.3%
Expenditure 1,059 1,168 10.3% 3,126 3,471 11.0%
Operating profit (EBDITA) 293 215 -26.6% 798 741 -7.1%
EBDITA margin (%) 21.6% 15.5%   20.3% 17.6%  
Other income 57 72 26.8% 220 492 124.3%
Interest (net) 2 2 25.0% 5 24 417.0%
Depreciation 13 8   39 (1)  
Profit before tax 334 277 -17.1% 973 1,210 24.3%
Tax 116 47 -60.0% 327 331 1.3%
Profit after tax/(loss) 218 231 5.8% 647 879 35.9%
Net profit margin (%) 16.1% 16.7%   16.5% 20.9%  
No. of shares (m) 32.0 32.0   32.0 32.0  
Diluted earnings per share (Rs)*         27.6  
Price to earnings ratio (x)*         21.1  
(* trailing twelve months)            

What is the company’s business?
Novartis is a leading player in certain therapeutic segments with strong brands like Voveron, Tegrital and Calcium Sandoz. The company has a strong presence in anti-TB, respiratory and anti inflammation segments. Also, it has a very strong parent backup, which is dedicated towards research work and has consistently introduced new products in different therapeutic segments. However, it has no manufacturing operations in India and all the products that Novartis sells are either outsourced from a local producer or imported from the parent company. Thus, this company should be seen as a trading company rather than a drug manufacturing company.

What has driven performance in 3QFY06?
Subdued topline growth: Novartis’ topline for the quarter recorded a marginal 2% YoY growth. However, if one were to look at the segmental performance, the pharmaceutical (68% of 9mFY06 revenues) and OTC (14% of 9mFY06 revenues) divisions logged in good growth rates of 11% YoY and 38% respectively. What really contributed to the staid growth in the topline was the 53% YoY decline in the generics business (11% of 9mFY06 revenues). It must be noted that during the year, the company had sold of its unviable ‘Rifampicin’ business leading to a sharp fall in the revenues from this business. To that extent, the figures of the generics business are not comparable. The performance of the animal health business continued to be volatile. While this business grew by 27% YoY in 2QFY06, it reported a relatively slower 4% YoY growth in 3QFY06.

Segmental performance
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mY06 Change
Pharmaceutical 809 900 11.2% 2,430 2,874 18.2%
PBIT margin (%) 25.0% 16.8%   26.3% 23.8%  
Generics 255 121 -52.6% 811 452 -44.3%
PBIT margin (%) 19.8% 26.0%   15.1% 32.1%  
OTC 184 254 38.0% 441 602 36.5%
PBIT margin (%) 21.4% 22.6%   15.1% 18.8%  
Animal health 103 108 4.3% 242 284 17.5%
PBIT margin (%) 29.0% 10.7%   18.6% 15.2%  
Total revenues 1,352 1,383 2.3% 3,924 4,212  
Total PBIT margin (%) 23.9% 18.2%   22.2% 23.4%  

Sharp margin contraction: Margins remained largely under pressure in 3QFY06 owing to a rise in staff costs (up 220 basis points as % of net sales). The company attributed this rise to the payments of Rs 13.6 m made to employees under VRS. Besides this, Novartis’ focus on trading activity continued during this quarter as well. This was reflected in a steep rise in the purchase of finished goods (up 540 basis points as % of sales). The company however, managed to keep its other costs more or less under control.

Cost break-up
(% sales) 3QFY05 3QFY06 9mFY05 9mY06
(Increase)/ decrease in stock 2.8% 3.0% 2.2% 2.9%
Raw material consumption 5.0% 2.4% 4.9% 1.8%
Staff cost 7.7% 9.9% 8.6% 8.9%
Purchase of finished goods 35.5% 40.9% 38.9% 44.4%
Other expenditure 27.3% 28.1% 25.1% 24.4%

Uninspiring bottomline picture: Slower growth at the topline level coupled with margin contraction percolated down to the bottomline, which grew by 6% YoY. Even a lower tax outgo did nothing to help matters. However, two things need to be noted here. One is the sharp fall in the depreciation charges. This was because the company changed its method of calculating depreciation with retrospective effect from April 1st, 2005. Also, there was a considerable rise in other income as well. This other income for 9mFY06 included Rs 173 m, which Novartis received towards the sale of its Goregaon property as well as Rs 96 m towards inventory damaged due to the heavy rains witnessed in Maharashtra.

Quarterly trend
  3QFY05 4QFY05 1QFY06 2QFY06 3QFY06
Net sales growth (%) -7.0% -22.7% 21.5% -2.1% 2.3%
Operating profit margin (%) 21.6% -11.5% 27.2% 7.3% 15.5%
Net prfofit margin(%) 16.1% 0.6% 23.2% 22.4% 16.7%

What to expect?
At the current price of Rs 583, the stock is trading at a price to earnings multiple of 21.8 times our estimated FY08 earnings, which is at the higher end of our valuation band. The disposal of the ‘Rifampicin’ business (having lower margins) is a step in the right direction and margins are likely to improve. Initiatives taken to increase penetration in Tier-2 and Tier-3 markets (smaller towns) are likely to augur well for the company. The pharmaceutical and OTC businesses are expected to be the key drivers. Also, with the new patent regime, the company will be in position to launch new-patented products from its parent’s portfolio in the Indian markets, which will boost its topline. Novartis plans to launch patented products in India from 2007 onwards. Having said that, the generics business is likely to continue to witness pressure going forward owing to shrinkage in the anti-TB segment and will consequently be a drag on the topline.

It must be noted that the company’s performance has been volatile over the last five years. While we believe that the company will grow at a relatively faster pace over the next couple of years, the stock at the current juncture seems fairly valued.

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