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Novartis: Follows its peers
Jul 27, 2006

Performance summary
Novartis has announced a poor set of numbers for the first quarter ended June 2006. The subdued performance at the topline level can be attributed to the high base effect of 1QFY06, which had seen strong sales. This was due to re-stocking by retailers post the implementation of VAT from April 2005 and has impacted almost all pharma companies during this quarter. A sharp shrinkage in operating margins coupled with decline in revenues led to the bottomline falling at a much faster pace than the topline.

Financial performance: A snapshot
(Rs m) 1QFY06 1QFY07 Change
Net sales 1,601 1,403 -12.4%
Expenditure 1,166 1,113 -4.5%
Operating profit (EBDITA) 436 290 -33.4%
EBDITA margin (%) 27.2% 20.7%  
Other income 86 114 32.1%
Interest (net) 1 2 15.4%
Depreciation 4 7 86.1%
Profit before tax 517 396 -23.5%
Tax 144 138 -3.9%
Profit after tax/(loss) 373 257 -31.0%
Net profit margin (%) 23.3% 18.3%  
No. of shares (m) 32.0 32.0  
Diluted earnings per share (Rs)*   30.1  
Price to earnings ratio (x)*   13.7  
(* on a trailing 12-months basis)      

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 the 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 1QFY07?
High base effect affects revenues: Revenues during the quarter declined by over 12% YoY on the back of the high base effect of 1QFY06, which was due to re-stocking by retailers post the implementation of VAT from April 2005. This has largely been reflected in the numbers of its pharmaceuticals business (72% of total sales), which reported a 13% YoY decline in revenues (see table below). The OTC business (15% of revenues) performed relatively better than the other segments recording a flat growth in revenues. The generics business (8% of revenues) declined by 26% YoY during the quarter. This business continues to face pressure with the government having imposed price cuts on anti-TB products.

Segmental performance
(Rs m) 1QFY06 1QFY07 Change
Pharmaceuticals 1,160 1,014 -12.6%
PBIT margin (%) 31.8% 23.3%  
Generics 152 112 -26.3%
PBIT margin (%) 48.9% 37.8%  
OTC 206 206 0.2%
PBIT margin (%) 19.1% 23.8%  
Animal health 83 70 -15.2%
PBIT margin (%) 19.2% 3.7%  
Total revenues 1,601 1,403 -12.4%
Total PBIT margin (%) 31.1% 23.5%  

Sharp margin contraction: Margins fell by 650 basis points during the quarter largely due to a steep rise in raw material costs and other expenditure (as percentage of sales). That said, we expect margins to expand going forward, backed by an improved product mix in both its pharmaceuticals and OTC business and also from efficiencies at the operating level.

Cost break-up
(% sales) 1QFY06 1QFY07
(Increase)/ decrease in stock 2.2% 3.2%
Raw material consumption 0.5% 3.9%
Staff cost 8.0% 9.6%
Purchase of finished goods 43.9% 37.0%
Other expenditure 18.2% 25.6%

Reflected in the bottomline: The impact of revenue decline and sharp fall in operating profits was reflected in the bottomline, which fell by 31% YoY. Even a 32% YoY increase in other income could do nothing to arrest the fall in bottomline.

Quarterly trend
(%) 4QFY05 1QFY06 2QFY06 3QFY06 4QFY06 1QFY07
Net sales growth -22.7% 21.5% -2.1% 2.3% 32.4% -12.4%
Operating profit margin -11.5% 27.2% 7.3% 15.5% 11.5% 20.7%
Net profit margin 0.6% 23.2% 22.4% 16.7% 19.1% 18.3%

What to expect?
At the current price of Rs 413, the stock is trading at a price to earnings multiple of 13.7 times its trailing twelve months earnings. Going forward, the pharmaceutical and OTC businesses are expected to be the key growth drivers. The performance of these two segments will largely be driven by new product launches. With the advent of the product patent law in India, Novartis has unveiled plans to launch patented products in India from 2007 onwards. Having said that, we expect the generics business to witness pressure going forward owing to the difficult pricing environment in the anti-TB segment.

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