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Novartis AG (NYSE:NVS)

Goldman Sachs Healthcare Conference Call

June 11, 2014, 12:20 pm ET

Executives

Harry Kirsch - Member of the Management Board, Chief Financial Officer

Analysts

Keyur Parekh - Goldman Sachs

Keyur Parekh - Goldman Sachs

Good morning, and thank you for joining us. My name is Keyur Parekh and I cover Novartis for Goldman Sachs. Harry. Thank you so much for joining us. Really appreciate it. I am sure you all have a lot of questions, but if you want to make some introductory comments and then we can take it straight to Q&A from there. It has been an exciting first half of the year from a Novartis perspective.

Harry Kirsch

Yes. Great. Thank you, and thanks for coming this morning. My pleasure to be here and as Keyur says, the last few months were exciting. On April 22, we announced a conclusion of all portfolio review, which since last summer, we announced that we are looking at our three of our six divisions. The three smaller divisions, vaccines as well as animal health and OTC.

And then, in the end of April, we announced two deals. One with GSK and one with Lilly. To Lilly, we divest our animal health business for $5.4 billion. And then a three corner deal with GSK, where we divest vaccines, excluding the flu business. We did a joint venture on consumer care. We created a $10 billion consumer care company and we acquired the GSK oncology products out of business cost upon closure and now the priority of the company is to make sure we close as quickly as possible.

We make sure our business is, of course, on track. And from there help maybe shape the company and a still diversified company, but more focused and upon closure of these deals I think we are more focused. We have improved all financial strength and profile and focused on driving these three leading businesses as we go forward.

But maybe I stop here and see if there are questions from you or the colleagues.

Question-and-Answer Session

Keyur Parekh - Goldman Sachs

Sure. So let me start off with a big picture strategy question which is, given what you have announced and I realize that they will perhaps take some time to get it executed on, but given the portfolio restructuring that you announced, is there more to be done on that end or do you think you are very happy with where you are and everything incremental is likely to be much smaller and add-ons in nature?

Harry Kirsch

So I see this structure of the company was proceed over the next five to ten years. So we have set our stuff like this. As you say, we have to go through the regulatory process. The closure has to happen, which we expect to happen in the first half of next year. So of course, the teams of all three companies are working with priority on that, getting the (inaudible) filings going and then close quickly. And in terms of, we are still in the process of selling the flu business, which we have cast out from the vaccine to maximize the value. And then we have a world leading pharmaceutical business, that's Sandoz, generics as well as with Alcon and all of those three of them are $10 billion plus businesses, pharma $30 billion plus businesses and all of them on number one and number two position.

So that is the shape we go forward with and our capital allocation strategy remains the same, which is investing in attractive organic opportunities. Second, a strong and growing dividend. Third, bolt-on acquisitions and bolt-on, we look at per year $2 billion to $5 billion. So it would be smaller pieces, strengthening the three continuing strong divisions. And then, fourth of the capital allocation, the share buyback with excess cash. So we have not touched. We keep going with our $5 billion share buyback program, which we announced at the end of last year.

Keyur Parekh - Goldman Sachs

So if you take those divisions separately and stock with Pharma, given the way you have just based your positions across this broader portfolio, is it logical to think about potential for pruning or enhancing therapeutic areas within pharma areas where you are not number one, two or three? Or do you think, so for example, diabetes, do you think that's an area where feel the waters, building up scale, you are happy with what you are? Or do you think you need a broader portfolio to be a real player in that?

Harry Kirsch

So I think it is important to just step back to say, in the Pharma division, we have three areas, oncology, then specialty where several growth platforms are emerging, including heart failure as well as specialty dermatology and then also primary care. Now within primary care, diabetes is a very attractive field. We have Galvus, which is growing very nicely. Of course, we always will have to have more, but we are not thinking about carving out here more or divesting at all. If we find bolt-on opportunities, also I think we have to do across our Pharma business more early, around the Peri-PoC space, in-licensing deals. There we keep strengthening.

Keyur Parekh - Goldman Sachs

Talking about oncology, clearly the last couple of years, immunotherapy has been really exciting. Novartis has been relatively behind the pack when it comes to the first generation of immunotherapies. If we just kind of think about your positioning there and what you need to do there?

Harry Kirsch

So, overall, certainly we have, I would say, a leading portfolio of targeted therapies. We do a lot of combination trials and we also believe that targeted therapies will continue to be the backbone of cancer therapy. Now we recognize the importance of immunotherapy and we have just done a relatively early exposition with CoStim, and we will talk about it more in our Investor Day next week, which has helped us to catch up and to close a bit of the gap on the immunotherapy or to the next wave beyond PD1s, PDL1s. So certainly that is important, but we believe the targeted therapies continue to be a cornerstone and that combination with immunotherapies are important.

Keyur Parekh - Goldman Sachs

Well, one of the areas that we have got the most number of questions on just relates to the portfolio realignment is the evaluation of the oncology businesses that you bought from Glaxo. So to be extent that you can help us think about what we might be missing as it relates to either the growth outlook or the margin outlook for those businesses, that would be very helpful.

Harry Kirsch

Yes, of course. I didn't get so many questions on the other parts over here, as we clearly understood maybe and of course in oncology the six products from GSK, when you look at it, what it generated in 2013 is about $1.6 billion in sales with about 25% margin. Oncology margins, and that's the first point of the reconciliation through maybe what is missing. Oncology margins at least double than 25%, sort of at 50%, 60% can be achieved. I think that is the combination of several of these products are in launch mode, so sales ramp-up, as well as that in several areas we have synergies, lung cancer or another areas where we can leverage also our infrastructure and expertise. We believe we have better access given that we have number two oncology business with more than $11 billion of sales. We have better QOL [ph] cancer center access than GSK and I think that is the spirit of the overall transaction that we have basically found a win-win situation and the smaller businesses have joined bigger businesses and create global leaders. So that's number one, the margin part.

Number two, I have also modeled actually the below endless consensus, our acquisition model and the endless consensus for 2018 for the GSK product that we acquire $3.8 billion. And the other important information is that the patent goes beyond 2018, what we have patent until 2023. The BRAF and the MEK inhibitors until 2028, 2029. So end of next decade. So the peak sales keep going beyond 2018 and achieved in 2023 according to our modeling. So that's the second piece. And besides the sales uptake, the margin, the long patent protection and then the third element is also that we have a tax benefits of about $2 billion NPV.

Keyur Parekh - Goldman Sachs

Just moving away from oncology for a minute. One of the most exciting growth opportunities for Novartis is the potential heart failure franchise both, with LCZ as well as relatively short PDF, hopefully for Serelaxin. Can you help us think about what the organization needs to do from a ramping up perspective to be able to launch those products successfully and how do you see their opportunities?

Harry Kirsch

Yes. So certainly we are excited and we also looking forward to seeing the data on the LCZ trials for chronic heart failure. As you probably recall, that trial has been stopped from the external data monitoring committee early end of March because of overwhelming positive data and to make sure that patients get access earlier. But of course, we have to be also careful that we don't get too excited before we ourselves see the data and then can present this data early September at European cardiologists congress. And of course how a good this data is will also tell us more about the size of the opportunity. There have been some reports that this will be the biggest product of Novartis and I think that is (inaudible) that is possible, but it depends totally on the data that we will get end of August, early September.

Now in terms of the organizational size, of course, we make sure that we have the right investment plans in place. But we have quite a heritage in cardiovascular diseases, with cardiologist and from that standpoint we have a lot of experience in our also commercial and medical team to penetrate, to make sure that doctors and patients have quick access and understand the benefits.

The other benefit we have is that we are not only in specialty but also in primary care. And either with hypertension, with diabetes and there we have in most places all resources in place to maximize the opportunity. In the U.S., we have to see, you may know earlier this year, we have restructured and downsized our primary care field for the U.S. from about 1,000 to 500, roughly. So the 500 in U.S. is roughly one line or one footprint, which could be added up in case needed to maximize the opportunity. But I would say the incremental cost to maximize the value is very limited.

Keyur Parekh - Goldman Sachs

Are there any audience questions, please raise your hands. Amanda?

Amanda Lynam - Goldman Sachs

Thank you. Amanda Lynam, Goldman Sachs. Harry, you have previously structured M&A deals to protect your AA rating and you have talked about the importance of that rating in the past. Can you articulate for us why it is important for you to keep it and update us on your thoughts about, as you move forward, capital allocation and how it will be structured around that rating? Thank you.

Harry Kirsch

Yes. Thank you. We have, by the way, for the first time last year, we have formalized the AA as our target rating. Before the Alcon acquisition, Novartis was always cash positive and AAA rated. So we have made clear end of last year that that's the reasonable level of debt from our point of view, will be part of the balance sheet. We are right now AA minus rated and we are comfortable with this rating. I think overall, most of the peer group is also in that range, but I think a strong balance sheet, but leveraging debt is important.

So for example, we also have issued a $4 billion bond earlier this year at, I would say, very good rates, which also increased our average finance maturity. We were the most shorted finance pharma company, and now we are back in to the average with our peer group. So that rating comfortably allows also to take advantage of market opportunities, but also to continue with our capital allocation strategy, where a strong and growing dividends, bolt-on M&A deals and share buybacks with excess cash will continue to be very important to us.

So from that standpoint, I think also that net cash out of these deals we announced end of April is between $6 billion and $7.5 billion, we can comfortably finance with our commercial paper programs. So financing costs are also very low. Thank you.

Keyur Parekh - Goldman Sachs

Just going back of Pharma and talking about Gilenya and your success there. Can you just help us think about what the next best for this franchise are, in sense of potential for growing competition there and how do you see the impact from a generic Copaxone, if there was going to be one any time soon?

Harry Kirsch

We expect that Gilenya continues to grow. I think many people speculated what happens when Tecfidera gets launch in U.S. and we have demonstrated we can continue to grow. I think overall the MS market is a very attractive market. The outlook is around $16 billion for total market and when you think about that the overall region, it will probably be around 50% of that or more. You can comfortably see that Gilenya keeps growing.

And of course. U.S. we grow a little bit less than ex-U.S., well that's okay. It also has to do with managing the first six dose observation, a protocol which is easier outside of U.S. given the initiations happening more in the hospital setting and given the high efficacy. And once you are over the first six dose observation, a low side effect profile and patients stay very long on Gilenya.

So we see continued growth there. We have also a pipeline behind it. And of course we always look for opportunity to strengthen that pipeline. So (inaudible) there was a market we see as very attractive.

Keyur Parekh - Goldman Sachs

And if we take step back, there has been subtle change in the pricing environment in the U.S. over the last 12 or 24 months, perhaps not as much of an impact in the waters, given your portfolio as you have seen on some of your peers, but it seems like the industry more broadly is moving from being a price maker to being a little bit of a price taker, given the pressures you have seen from the PBMs and things like that. What do you think it is that the industry can do to gain that pricing power back? And how do you see that back, I believe, all over the next 24 or 36 months?

Harry Kirsch

Yes. So overall if I step back in for U.S. pricing and then go back to the U.S. So overall the pricing environment for the company has been relatively neutral. Basically some price decreases which have been in the last three, four years, mid single-digit price decline in Europe and then the biannual price decline in Japan around mid single-digit again has been offset by price increases mainly in U.S. So I think I would say that's a positive. We are neutral on pricing over several years throughout the economic crisis. And we see also that we have an advantage on that because of our very innovative portfolio compared to other competitors and the less innovative products get hit usually harder by price actions, not everywhere but in geography that's the case.

So that leaves me now to U.S. I think going forward in our planning we don't assume much net pricing upside in the U.S., if anything because I think that at a certain point of time, we have to be careful on this in terms of the planning assumption. Now on the other hand, I think innovation is the answer, as always. I think the U.S. as well as other innovative healthcare systems will ensure that there is enough financing for innovative products and that is so important. That's why we invest a lot in R&D. Invest close to $10 billion in Pharma last year, 22.5% of R&D to make sure we stay leading edge of innovation that we can also make sure we have very good biomarkers and companion diagnostics to find the right patient population and then also be able to demonstrate the significant healthcare outcomes and benefits to the respective healthcare systems.

So I think innovation is the answer and that's also what we see that our innovative portfolio, we are much, much less victim to pricing actions. And if we can take also appropriate pricing for innovative medicines.

Keyur Parekh - Goldman Sachs

Given what we have seen on some of the other launches in the U.S. respiratory market, does that make you see it as a bigger opportunity for Novartis? Or does that make you step back and rethink the U.S. opportunity?

Harry Kirsch

Yes, I think two elements have to come together. First, we have to see our data of our LABA/LAMA combination which is June quarter for this year. The second one is to analyze the situation. So some of the competitors didn't have much success and they have to analyze what are the reasons for this. A lot of this analysis and the data and the strength we have from our compound, we will make a decision what we do with on the respiratory LABA/LAMA situation in the U.S.

Keyur Parekh - Goldman Sachs

But as we think about what it is that we know today, are all options on the table? Have you ruled out certain options?

Harry Kirsch

All options are on the table and we continue to believe that we have the right product. With the right commercial team, it can be very successful. Ex-U.S., the same thing. Many people didn't believe that we would be able to launch, for example, the LABA/LAMA combination ex-U.S., mainly Europe at this point in time. And we have done it very successfully even though we have strong competition. And we have done also with very limited, if any, incremental resource because we are very present in (inaudible).

Keyur Parekh - Goldman Sachs

All right. Moving away from your revenue line for a bit. Can you help us think about what, I guess the portfolio transformation gives you a slightly higher starting point from a margin perspective, but how should we think about the margin evolution for the broader group over the next three to five years? If you can talk about the pushes and pulls around the impact from Diovan U.S. monotherapy as and when that goes? And then Gleevec?

Harry Kirsch

Okay. So I think first of all, as we have shown when we announced the deals, the signature end of April, upon conclusion of the deals, our core operating income margin in 2013 would have moved up by 250 basis points. I just use the 2013 pro forma data to have any speculation about a future just as how would have that been as of January 2013, this would have happened. So that's 250 core margin basis points improvement upon closure.

Then the second piece, we announced also on our (inaudible) that we have created Novartis business services. So for the first time, the company is now delivering or will deliver services in a consistent way for all the business whilst historically every division had full-fledged standalone even back office services. That I don't expect short-term, big savings, but mid-term certainly efficiency gains from that change in the operating model.

Then each of the divisions, I strongly believe, have opportunities to increase margins and of course it was the backdrop of some generic division, but pharma with the increased mix to more specialty in oncology, as well as, I mentioned R&D spend of 22.5% last year was very high. We see the R&D spend mid-term as it was over the past, more around 20% of sales. More M&A efficiency by shifting to more specialty product.

Then in Sandoz, of course, key is that we take the opportunity of the loss of exclusivity of more than $50 billion of sales from the Biologics with our biosimilar program. Now it is happening 2016, 2017, 2018, according to our forecast when these LOEs happen, but there is certainly an investment, which is already in the P&L of the Sandoz generic division that is will allow us to tap into that significant potential.

And then on Alcon, it is a bit different story. Alcon is already at the 35% margin and they are rolling out their surgical equipment suite, which has a bit lower gross margin and still the target of Alcon is grow the topline more attractively and not eroding the margin. But I think at a 35% margin, if you become too greedy, one has to ensure to do the right investments to keep that very attractive business growing at a higher rate.

Keyur Parekh - Goldman Sachs

Talking about Sandoz for a bit. I know there has been a lot of investment into R&D and specially the complex generics of biosimilars and respiratory that Novartis has done over the last three to five years and you had meaningful success with Lovenox, but haven't seen that replicated elsewhere. How should we think about your appetite for further investments into those fields without seeing a near-term return on those?

Harry Kirsch

As I mentioned, the key is, we have now eight Phase 3 programs in biologics and biosimilar, from six biologics. So it's a significant investment, which is already embedded in the P&L of Sandoz. Sandoz has right now a core margin of 17%. So the rest of the business is carrying this. We are also shifting more and more toward difficult to make our oncology injectables, respiratory specialist generics which also have higher margin. So I think from a margin expansion standpoint, I see that mainly happening when more meaningful in terms of size biosimilars launches would happen which is 2016, 2017.

Keyur Parekh - Goldman Sachs

And just perhaps this is too detailed a question, but as you walk through the investing decisions behind biosimilar projects, is the assumption that the background or the base molecule is going to be interchangeable with a combination agent as we see the evolving landscape, whether it is Herceptin, whether it's Rituxan, they are all moving to a combination therapy. So is the assumption that your biosimilar versions of those assets would be allowed to use in combination? Or is the assumption that the ex-U.S., ex-European markets are attractive enough to support the investment behind them?

Harry Kirsch

Well, I think overall of course the U.S. and European markets are a key element of the investment case. The other key element is that not too many biosimilars get there when we get there, for quite some while and some competitors have dropped out, which actually, I think confirms to me that we are uniquely positions with, on the one hand for example our oncology team, on the other hand, the generic team to make sure they can design these trials, they have the right discussions with the key regulatory bodies, to make sure that they have high probability of success on the approvability of our trials. And the third one is also the enrollment of patients.

So I think we are uniquely positioned to get these biosimilar trials successfully completed. Then we have to see how the landscape is and what can be done. But in our planning, we certainly assume that not many are there but we also are not assuming we are the only one. That shows us already attractive returns.

Keyur Parekh - Goldman Sachs

And should we start assuming a meaningful contribution from this starting 2016? Or is this still further out?

Harry Kirsch

2017.

Keyur Parekh - Goldman Sachs

Moving on to Alcon. There has been recent commentary and investor feedback that the growth has slowed down a bit. Especially as one looks Alcon pre-2010 where they were delivering. Can you help us think through what might fundamentally be different about that market? Or is this just part of a cyclical process as they have gone through some great expedition, some slowdown in the Capex spending in hospitals?

Harry Kirsch

Yes, I think when you compare the Alcon prior to acquisition to now, it's also different footprint. So because w moved in CIBA Visio into Alcon, which is generally a bit slower growing business and some of the Alcon generics moved to Sandoz . So overall, this change of scope has took away 1.5 points or so of growth but still you we want Alcon to grow high single-digit and not mid single-digit. The last four quarters, Alcon has grown roughly 6% in constant currencies. So not bad, but also not exciting from where we think it should be. So certainly we have to make sure that we roll out the surgical equipment base with excellence and the team is doing that. Hitting the bits to gross margin but we invest in that.

The second piece is that we have to strengthen our pharma pipeline. You mentioned some LOEs. They are impacting there. So we have to strengthen that. There, for example in-licensing deals and so on would be much welcome and we will look for those opportunities.

Then on the vision care, our dailies total one. We sell as much as we can produce. So bring lines up every few months to keep driving the consumption and our sales. What is striking as a bit down there is the vision care solutions which is getting a bit commoditized. So we have to see. But overall we are not happy with the growth. We want to find opportunities.

I am very happy that Jeff George got announced, our Sandoz Division Head, now as the Head of Alcon, who will drive very aggressively the growth and look for opportunities of this excellent business.

Keyur Parekh - Goldman Sachs

So you have got an Investor Day coming up next week. What should we expect from that? And what is the incremental level of visibility we are going to get across the various businesses?

Harry Kirsch

Yes, I think we have changed the format of this. Usually we have more upfront presentations. Joe will give an introduction presentation, but then we will go very quickly into breakout groups where the respective investors and analysts will meet each one hour with the Pharma team including the oncology team but also some of the key team members of David Epstein, for example. Then the same with the NIBR, Mark Fishman and his team will be there. Therefore (inaudible) will certainly see more about CoStim and what we do in immunotherapy, COG-19program and other programs. And then Alcon, Jeff George and his team will be there as well on Sandoz, Richard Francis, who just joined us and his team will be there as well.

This is also reacting a bit to say that usually you talk to group, you talk Pharma and that's kind of it. Giving much more visibility also into Alcon, into Sandoz and then NIBR.

Keyur Parekh - Goldman Sachs

I think we are coming up to time. Are there any audience questions? So with that, Harry, perhaps the most important question of the session, from my perspective, how do you assess Germany chance in the World Cup and how should we think about that?

Harry Kirsch

I think the Germans will be top four, but lose again to Italy and Spain. Thank you very much for that.

Keyur Parekh - Goldman Sachs

Thank you. Okay.

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