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Novartis: ‘Extraordinary’ effect - Views on News from Equitymaster

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Novartis: ‘Extraordinary’ effect
Oct 30, 2006

Performance summary
Novartis has announced mixed results for the second quarter and half year ended September 2006. Performance at the topline level was staid and was largely driven by its OTC and pharmaceutical businesses. Operating margins improved sharply mainly due to a considerable reduction in purchase of finished goods and other expenditure. Bottomline has declined due to extraordinary income received in 2QFY06, which was not received this quarter. Excluding this impact, bottomline growth has been significant.

Financial performance: A snapshot
(Rs m) 2QFY06 2QFY07 Change 1HFY06 1HFY07 Change
Net sales 1,228 1,294 5.4% 2,829 2,697 -4.7%
Expenditure 1,138 1,093 -3.9% 2,303 2,206 -4.2%
Operating profit (EBDITA) 90 201 122.8% 526 491 -6.6%
EBDITA margin (%) 7.3% 15.5%   18.6% 18.2%  
Other income 66 89 34.8% 152 203 33.3%
Interest (net) 21 1 -93.8% 22 3 -87.4%
Depreciation (12) 7   (8) 14  
Profit before tax 147 282 91.6% 664 677 2.0%
Tax 140 103 -26.6% 284 241 -15.1%
Extraordinary item 268 -   268 -  
Profit after tax/(loss) 275 179 -35.1% 648 436 -32.7%
Net profit margin (%) 22.4% 13.8%   22.9% 16.2%  
No. of shares (m) 32.0 32.0   32.0 32.0  
Diluted earnings per share (Rs)*         27.1  
Price to earnings ratio (x)*         16.7  
(* 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 2QFY07?
Staid revenue growth: Revenues during the quarter grew by a lacklustre 5% YoY, which was largely driven by its pharmaceuticals (up 9% YoY), constituting 71% of revenues and OTC segments (up 37% YoY), accounting for 15% of revenues. For the half-year period, the pharmaceuticals segment reported a 4% YoY decline in revenues due to one of its key products ‘Tegrital’ being subject to significant price control. Revenues from the generics segment declined by a considerable 39% YoY and 33% YoY during 2QFY07 and 1HFY07 respectively, as the company opted not to participate in the low margin tender business in the anti-TB segment. The OTC segment, however, was the strongest performer of the lot clocking a decent 15% YoY growth during 1HFY07, which was attributed mainly to successful calcium variant launches.

Segmental performance
(Rs m) 2QFY06 2QFY07 Change 1HFY06 1HFY07 Change
Pharmaceuticals 813 886 9.0% 1,974 1,900 -3.7%
PBIT margin (%) 20.3% 19.7%   27.0% 21.6%  
Generics 179 109 -39.1% 331 221 -33.2%
PBIT margin (%) 22.0% 27.4%   34.4% 32.7%  
OTC 142 194 36.8% 348 401 15.1%
PBIT margin (%) 11.6% 11.2%   16.0% 17.7%  
Animal health 94 104 11.1% 177 174 -1.2%
PBIT margin (%) 16.8% 11.0%   17.9% 8.0%  
Total revenues 1,228 1,294 5.4% 2,829 2,697 -4.7%
Total PBIT margin (%) 19.2% 18.4%   26.0% 21.1%  

Operating margins improve: Margins expanded from 7.3% in 2QFY06 to 15.5% in 2QFY07 during the quarter largely due to a fall in purchase of finished goods and other expenditure. Advertisement and selling expenses (as a percentage of sales), however, increased during the quarter, which could be attributed to the promotion of its brands in the OTC segment. 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) 2QFY06 2QFY07 1HFY06 1HFY07
(Increase)/ decrease in stock 3.7% 5.6% 2.9% 4.3%
Raw material consumption 3.0% 3.8% 1.6% 3.9%
Staff cost 8.7% 9.8% 8.3% 9.7%
Purchase of finished goods 49.0% 36.5% 46.1% 36.8%
Advertisement and sales promotion 6.2% 8.7% 5.5% 7.9%
Other expenditure 22.1% 20.1% 17.0% 19.3%

‘Extraordinary’ impact: Sharp expansion in operating margins coupled with higher other income contributed to the robust 92% YoY growth in profit before tax. Despite this, net profits declined by 35% YoY during the quarter. This was the result of extraordinary income that Novartis received in 2QFY06 (from the sale of the Goregaon property), which was absent this quarter. Excluding this impact, the bottomline growth has been significant. Lower tax outgo has also played a part in contributing to this growth.

Quarterly trend
(%) 1QFY06 2QFY06 3QFY06 4QFY06 1QFY07 2QFY07
Net sales growth 21.5% -2.1% 2.3% 32.4% -12.4% 5.4%
Operating profit margin 27.2% 7.3% 15.5% 11.5% 20.7% 15.5%
Net profit margin 23.2% 22.4% 16.7% 19.1% 18.3% 13.8%

What to expect?
At the current price of Rs 453, the stock is trading at a price to earnings multiple of 13.9 times our estimated FY08 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 segment to witness pressure going forward owing to the difficult pricing environment in the anti-TB segment. While we are positive about the growth prospects of the company, considering the volatility in Novartis’ performance over the last five years, our preferred plays on a relative basis are Pfizer and Aventis in the MNC pharma space.

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