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Novartis: Still no respite!

May 25, 2005

Performance Summary
MNC pharma company, Novartis, recently announced dismal 4QFY05 and FY05 results. In 4QFY05, while the topline of the company registered a 23% YoY decline, chiefly due to uncertainties over VAT and MRP based excise, bottomline fell 98% YoY on the back of high expenditure. For the full year, topline dipped 7% YoY while bottomline recorded a 43% YoY fall aided by a higher tax outgo. But for this outgo, the decline in the profitability would have been much lower.

(Rs m) 4QFY04 4QFY05 Change FY04 FY05 Change
Net sales 1,023 791 -22.7% 5,049 4,715 -6.6%
Expenditure 942 882 -6.3% 4,310 4,009 -7.0%
Operating profit (EBDITA) 82 (91)   739 706 -4.4%
EBDITA margin (%) 8.0% -11.5%   14.6% 15.0%  
Other income 210 174 -17.1% 581 394 -32.2%
Interest (net) 3 3 -9.7% 9 8  
Depreciation 16 13 -18.9% 132 52 -60.3%
Profit before tax 273 67 -75.4% 1,180 1,040 -11.8%
Tax 64 63 -2.6% 42 389 828.9%
Profit after tax/(loss) 209 5 -97.8% 1,138 651 -42.8%
Net profit margin (%) 20.4% 0.6%   22.5% 13.8%  
No. of shares (m) 32.0 32.0   32.0 32.0  
Diluted earnings per share (Rs)* 26.1 0.6   35.6 20.4  
Price to earnings ratio (x)         23.5  
(* annualised)            

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 back up which is dedicated towards research work and has consistently introduced new products in different therapeutic segments. However, it has a no manufacturing operations in India and all the products that Novartis sells are either out-sourced from the local producer or imported from the parent company. Thus, this company should be seen as a trading company rather than a drug manufacturing company. This puts a question mark on the company's seriousness about the Indian market.

What has driven performance in FY05?
VAT affects revenues: The revenues for 4QFY05 fell by 23% YoY on account of reduced offtake from its retail distribution chain due to VAT uncertainties. Consequently, the impact was also reflected in the revenues for FY05, which recorded a fall of 7% YoY. As far as the performance of the segments is concerned, the OTC segment, which clocked a 10% YoY growth in FY05 revenues, was the only saving grace for the company. The other segments registered a decline in revenues. Animal health sales dipped 23% YoY, primarily due to the discontinuation of an ‘organophosphorous' compound. Despite the 7% YoY decline in revenues of the generics business, the margins of this segment considerably improved, which is attributed to lower depreciation post impairment of the company's assets at Mahad. The pharmaceutical business also witnessed a 7% YoY drop in revenues largely due to reduction in the prices of its anti-TB products.

Cost breakup
(% sales) 4QFY04 4QFY05 FY04 FY05
(Increase)/ decrease in stock -0.04% -29.3% 4.6% -3.1%
Raw material consumption 4.7% 7.4% 3.2% 5.3%
Staff cost 10.6% 14.9% 8.9% 9.7%
Purchase of finished goods 49.0% 77.8% 43.8% 45.4%
Other expenditure 27.8% 40.8% 24.8% 27.7%

Margins under pressure: Margins continued to face the heat propelled by lacklustre sales and a steep rise in raw material costs, staff costs and other expenditure. Staff costs (as a percentage of sales) rose by 430 basis points in 4QFY05, as the company incurred VRS expenditure to the tune of Rs 5.3 m. The focus of the company on trading activity was very apparent during the quarter as well as the year, which was reflected in the sharp increase in the purchase of finished goods. Lower offtake also escalated this ratio.

Segmental performance
(Rs m) 4QFY04 4QFY05 Change FY04 FY05 Change % contribution to
FY05 sales
Revenues-Pharmaceutical 631 460 -27.2% 3,104 2,890 -6.9% 61.3%
PBIT margin 18.6% 3.2%   22.8% 22.6%    
Revenues-Generics 264 204 -22.7% 1,094 1,015 -7.2% 21.5%
PBIT margin -1.6% -7.3%   -0.3% 10.6%    
Revenues-OTC 75 80 6.4% 475 521 9.7% 11.0%
PBIT margin -31.9% -47.1%   4.4% 5.6%    
Revenues-Animal health 54 48 -11.4% 377 289 -23.3% 6.1%
PBIT margin 6.7% -14.0%   14.5% 13.3%    
Total revenues 1,023 791   5,049 4,715   100.0%
Total PBIT margin (%) 9.1% -5.7%   15.4% 17.6%    

Consequently bottomline blues: Bottomline for the year fell by 43% YoY aided by decline in revenues, lower other income as well as higher tax outgo. It must be noted that in the previous year, the company's tax incidence was net of a deferred tax credit for the impairment of bulk drug fixed assets, whereas in this fiscal the tax included a deferred tax charge of Rs 70 m relating to the discontinuing of the bulk drug business effective 1 April 2005. This resulted in a boost in the tax outgo, deflating the bottomline picture.

Over the quarters…
The decline in revenue growth during the last few quarters continues to be a cause for concern. Though the OTC segment will continue to log in decent growth, the chief contributor to the topline i.e. Pharmaceuticals and generics (together they contributed nearly 83% to revenues) continue to display pressure, which is a concern. Despite the improving trend in margins during the previous quarters, a sharp decline was witnessed in 4QFY05 primarily due to a combination of reduced sales and escalating costs.

What to expect?
At Rs 478, the stock is trading at 23.5 times its FY05 earnings. The management has declared a dividend of Rs 10 per share (dividend yield of 2.1%). The company has recently sold its unviable ‘Rifampicin' bulk drug business and this move is expected to help improve its operational efficiency going forward. The company is a leading multinational pharma company with some strong brands. Historically, the valuations of this company have been at a discount to its MNC peers like Glaxo for reasons such as lower penetration in the markets and absence of manufacturing activity. Initiatives taken to increase penetration in Tier 2 and Tier 3 markets are likely to augur well for the company. Also, with the new patent regime the company will be in position to launch new-patented products in the Indian markets giving a further growth avenue for the company. Novartis is pretty clear about launching new products and is revamping its operations for the same. However, till that time Novartis will be seen as a trading company and will get a lower valuation compared to top MNC pharma companies.

In our view, Novartis is at a cusp. Though FY05 has not been a good year for the company and we suspect FY06 too will not be something extraordinary, we believe its restructuring and increasing of product folio will start taking concrete shape by FY07. We will be downgrading our numbers for FY06 for the company. But we also believe that as a strong MNC pharma company, Novartis AG can ill afford not to concentrate on the Indian markets in light of the new patent regime. That will be the guiding light for investors over the long term.

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