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Novartis: ‘Generic’ blues! - Views on News from Equitymaster
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Novartis: ‘Generic’ blues!
Oct 22, 2005

Performance Summary
Novartis announced its results for the second quarter and half year ended September 2005 late yesterday. While the poor performance of both its divisions - pharmaceutical and generics - contributed to the decline in revenues, a significant rise in expenses led to a sharp contraction in margins. However, a spurt in other income saved the bottomline for the company, which rose 27% YoY.

(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Net sales 1,254 1,228 -2.1% 2,572 2,829 10.0%
Expenditure 1,009 1,138 12.8% 2,067 2,303 11.4%
Operating profit (EBDITA) 245 90 -63.2% 505 526 4.1%
EBDITA margin (%) 19.6% 7.3%   19.6% 18.6%  
Other income 96 334 246.7% 163 421 158.3%
Interest (net) 2 21 1135.3% 3 22 619.4%
Depreciation 13 (12)   26 (8)  
Profit before tax 327 415 27.0% 639 932 46.0%
Tax 110 140 27.5% 210 284 35.2%
Profit after tax/(loss) 217 275 26.7% 429 648 51.3%
Net profit margin (%) 17.3% 22.4%   16.7% 22.9%  
No. of shares (m) 32.0 32.0   32.0 32.0  
Diluted earnings per share (Rs)*       13.4 20.3  
Price to earnings ratio (x)         24.1  
(* 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 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 2QFY06?
Revenues slide: After a robust 22% YoY growth in revenues in 1QFY06, Novartis’ revenues dipped in 2QFY06 by 2% YoY. As far as its business segments are concerned, the pharmaceutical division proved to be a dampener as it managed to clock a mere 3% YoY growth. Further, the generics business continued to remain under pressure and declined 35% YoY on the back of the absence of contribution from its ‘Rifampicin’ bulk drug business, which was sold off during 4QFY05, and de-growth witnessed in the anti-TB business. Both the OTC and the animal healthcare segments continued to log in strong growth rates at 24% YoY and 27% YoY respectively. For the half year, the performance was much better with revenues growing at 10% YoY. This was on the back of a strong 22% YoY growth in the topline in 1QFY06, chiefly led by the pharmaceutical division, which had grown by 40% YoY during the first quarter.

Segmental performance
(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Pharmaceutical 790 813 3.0% 1621 1974 21.7%
PBIT margin (%) 27.7% 20.3%   26.9% 27.0%  
Generics 275 179 -35.0% 556 331 -40.4%
PBIT margin (%) 11.8% 22.0%   13.0% 34.4%  
OTC 115 142 23.8% 257 348 35.4%
PBIT margin (%) 10.6% 11.6%   10.7% 16.0%  
Animal health 74 94 26.5% 139 177 27.4%
PBIT margin (%) 4.0% 16.8%   10.9% 17.9%  
Total revenues 1,254 1,228   2,572 2,829  
Total PBIT margin (%) 21.2% 19.2%   21.4% 26.0%  

Sharp margin contraction: Margins remained largely under pressure in 2QFY06 owing to a rise in other expenditure (up 400 basis points as % of net sales). Besides this, the focus of the company on trading activity was apparent during the quarter, which was reflected in a steep rise in the purchase of finished goods (up 530 basis points as % of sales). The company, however, managed to keep its employee costs under control.

Cost break-up
(% sales) 2QFY05 2QFY06 1HFY05 1HFY06
(Increase)/ decrease in stock -1.5% 3.7% 1.8% 2.9%
Raw material consumption 4.8% 3.0% 4.8% 1.6%
Staff cost 9.1% 8.7% 9.2% 8.3%
Purchase of finished goods 43.7% 49.0% 40.7% 46.1%
Other expenditure 24.3% 28.3% 23.9% 22.6%

Bottomline cushion: A sharp spurt in other income helped in not only preventing the bottomline from registering a steep fall in profits but rather aided it to register a 27% YoY growth during the quarter. The other income 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. Just to put things in perspective, if one were to ignore this amount, the profits would have been lower by 97% YoY!

Over the last few quarters: There has been an inconsistency in Novartis’ performance over the last couple of quarters. While VAT related concerns affected the company in 4QFY05, a dismal show put up by the pharmaceutical and generics segment has impacted topline in 2QFY06. After maintaining margins over 15%, they have actually been rather volatile in the last three quarters.

What to expect?
At the current price of Rs 488, the stock is trading at a price to earnings multiple of 18.2 times our estimated CY07 earnings, which is at the higher end of our valuation spectrum. The company recently sold its ‘Rifampicin’ business, which is expected to increase the operational efficiency going forward. Initiatives taken to increase penetration in Tier 2 and Tier 3 markets (smaller towns) 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 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.

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