Denmark is famous for producing bacon - lots of bacon. In fact, with a pig population of 18.9 million (in 2011), there are more than three times as many pigs as there are people in Denmark, so there's plenty enough of the stuff to go around. But while the Danes are busy handing out bits of porky goodness with one hand, they're even busier handing out insulin with the other. Not-so-famously, Denmark is also home to Novo Nordisk (NYSE:NVO), the world's largest player in the diabetes care market. With the share price up more than 20% year-to-date, Novo Nordisk has now surpassed GlaxoSmithKline (NYSE:GSK) in market capitalization.
The short story about earnings
Over the past ten years, Novo Nordisk's annualized growth rate of earnings has been nearly 21%. Over the past five years, it has been closer to 25%. The impressive constancy of this growth is evident in the plot below:
This invites us to speculate about Novo Nordisk's future earnings. A simple linear regression of earnings in the last five years forecasts EPS (TTM) of 16 DKK at the end of Q2 in 2019:
Assuming that the P/E ratio remains around the 5-year average level, this corresponds to a price per share of 418 DKK, which in turn gives us an annualized rate of return just short of 11%, excluding dividends.
The long-term plot above, however, looks more exponential than linear. An exponential regression of earnings in the last ten years gives us a forecasted EPS of 27 DKK in Q2 in 2019, which in turn corresponds to a share price of 710 DKK or an annualized rate of return of 23%, excluding dividends:
If we include a dividend of around 1.1% per year (corresponding to Novo Nordisk's historical dividend yield), these estimated rates of return start to look attractive to the sensible long-term investor. The immediate question, however, is which estimate should we believe and why?
The long story about earnings
Simply extrapolating regressions of earnings - linear or exponential - without any context is neither very scientific nor informative. For all we know so far, Novo Nordisk's earnings could nosedive in the next quarter, never to return to the current trend. On the other hand, this mere possibility does not invalidate our estimates. Barring freak occurrences and events, we assume that the past is our best guide to the future, and thus we look to the history of both the company and the market to determine whether the current trends are likely to persist in the future.
Novo Nordisk's earnings growth is the result of both expansion and internal optimization. While revenue in 2013 was just over three times the revenue ten years prior, net profit was more than five times its 2003 level. The company has managed to nearly double its operating margin to 37.7% over this 10-year period. There is little reason to think that such high margins are a fluke or temporary trend, as Novo Nordisk has just raised insulin prices in the face of increasing demand.
With no long-term debt or other creditors knocking on the door, total liabilities covered one-and-a-half times by current assets and plenty of cash on hand there is no reason to believe that the company's financial situation will take a turn for the worse if current market conditions persist. This raises the question: what are the current market conditions?
The World Health Organisation (WHO) calls diabetes a 'global epidemic'. According to the Center for Decease Control, the number of Americans with diagnosed diabetes nearly quadrupled from 1980 to 2011 In 1998, WHO estimated that 300 million people worldwide would have diabetes in 2025, but the current number of diabetics worldwide already stands at 347 million. Predictions about the future prevalence of diabetes abound, and the forecasts differ. However there can be little doubt that the number of people with diabetes in the world has been and is rising, both in developing and developed countries. This means that, barring an extraordinary scientific breakthrough, the demand for diabetes care will continue to increase significantly in the foreseeable future.
Given the data, then, it seems unlikely that Novo Nordisk's earnings in the future should suddenly take a permanent nosedive on the basis of market conditions or the company's financial condition. But which estimate should we believe then - the linear or the exponential? Consider that if future earnings will be linear in time, then this implies a decreasing growth rate of earnings. In a growing diabetes care market, this in turn would imply that Novo Nordisk's market share would decline. There are two reasons why this is implausible: first, there is plenty of room for the company to grow in the current market. While Novo Nordisk is currently the largest player in the insulin market, it still supplies less than half of the insulin on the market. This means that there is still plenty of market share to be won from competitors. Second, for Novo Nordisk's two main competitors - Sanofi (NYSE:SNY) and Lilly (NYSE:LLY) - insulin is only one part of the portfolio. Novo Nordisk is the only large market player dedicated purely to providing products for the diabetes care market. This makes the Novo Nordisk operation much more focused and it means that the company's earnings stay in the market in the form of marketing and research expenses. For these reasons, we believe that the estimate from the exponential regression is likely to be the more reliable prediction of the two.
There is nevertheless one major risk currently associated with Novo Nordisk, namely the pending decision of the United States Food and Drug Administration (FDA) about Novo Nordisk's newest ultra-long lasting insulin product, Tresiba. The product has already been rolled out in key markets such as EU and Japan, with significant market shares already captured. But the drug still lacks the approval of the mighty FDA. If Tresiba is approved by the FDA in the United States, this will massively accelerate growth, but this possibility goes hand-in-hand with the huge blow it would be to earnings (and the investor sentiment) if the drug is not approved. The fact remains, however, that the relevant authorities in the European Union, Canada, Mexico, Switzerland, Norway and Japan have all approved Tresiba on the basis previous clinical trials. We expect the FDA to do the same once Novo Nordisk's current extended trials are concluded.
Of course, real earnings will depend on a number of other uncertain factors, and the real result will almost certainly be somewhere in between our two estimates rather than an exact fit. However, we believe that the available data makes the higher end of that range the most plausible, i.e. we believe that an annualized rate of return nearing 24-25% is the most plausible for the next five years. Given the margin of safety indicated in the above analysis, this makes Novo Nordisk an attractive investment for the sensible long-term investor.
Disclosure: The author is long NVO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.