By The Valuentum Team
Novartis' (NYSE:NVS) stock has been under pressure the past few months, but performance isn't as poor as the market is making it out to be. During its second quarter, for example, results released July 19, the company's revenue came in flat but growth in Gilenya and Cosentyx were solid, and the gains offset much of the generic impact from Gleevac. Core operating income fell 4% on a constant-currency basis, but free cash flow growth was solid, advancing 22% to $2.5 billion (free cash flow is up 10% through the first six months of 2016, to ~$3.9 billion). That net sales are to be "broadly in line with prior year" on a constant-currency basis isn't all that bad either, in our view.
Novartis isn't just giving it lip service when it says that its drug pipeline is "consistently rated as having one of the industry's most respected...with more than 200 projects in clinical development." The company's pipeline is simply a sight to see, in our view, and we think readers should have a look. It can be downloaded in full detail here. We continue to monitor the company's priorities for 2016, including its efforts to improve performance at Alcon and capture synergies. Opthalmology remains a very attractive healthcare segment, and the market is large and highly profitable, with estimates of its size at $40+ billion annually in the US alone. We're also not overlooking Novartis' dividend growth track record either (see below). The company has a lot of great things going for it. Let's dig in.
Image Source: Novartis, page 49
Novartis's Investment Considerations
• Novartis provides innovative healthcare solutions. It offers a diversified portfolio to meet the needs of patients and societies via innovative medicines, eye care, cost-saving generic pharmaceuticals, preventive vaccines, and over-the-counter products. The firm was founded in 1895 and is headquartered in Basel, Switzerland.
• Part of Novartis' strategy is to capture crossdivisional synergies. The firm is in the process of scaling up 5 global service centers in Mexico City, Mexico; Prague, Czech Republic; Dublin, Ireland; Hyderabad, India; and Kuala Lumpur, Malaysia.
• Novartis is engaged in a portfolio transformation. The firm will focus on businesses with innovation power and global scale -- pharma, eye care and generics. Its transaction with GSK (NYSE:GSK) includes acquiring the firm's oncology products, divesting vaccines (excluding flu), and creating a Consumer Healthcare joint venture. The firm has also divested its animal health operations to Eli Lilly (NYSE:LLY).
• The portfolio transformation should result in significantly improved profitability on modestly lower sales. We like the strengthening of Novartis' oncology business, as GSK's oncology products have immediately complemented its portfolio. The transformation appears to be on track; total oncology sales grew 24% in 2015.
• Novartis also plans to overhaul Alcon, its eye care division, which operates in a large and profitable market of ~$40 billion that is expected to continue to grow. According to estimates, 80% of the population has a treatable eye condition.
Economic Profit Analysis
"In business, I look for economic castles protected by unbreachable moats." - Warren Buffett
In the world of investing, no other saying is more widespread. The teachings of Warren Buffett have become a favorite among individual investors, having been adopted by money-management firms and sell-side firms alike in order to better connect with their clients and readers who have been 'under siege' by the topic in recent years. The phrase 'economic moat' - or sustainable competitive advantage - has simply become ubiquitous in the investment world and has lost much of its significance and meaning along the way.
The pioneer of the 'economic moat' concept is Michael Mauboussin, and his work at Credit Suisse in 2002 has paved the way for widespread application of the medieval nomenclature across a broad swath of investment frameworks. He states that sustainable value creation is rare and sustainable competitive advantages are even 'more rare' (given that a firm must perform not only better than its cost of capital but also better than its peer group to achieve both). The widely accepted view within the investment community is that at some point in the future, competitive forces will erode a firm's competitive advantages and drive return on new invested capital (RONIC) to a company's cost of capital. This very dynamic is embedded within the framework of the three-stage discounted cash-flow model we use at Valuentum, where we fade a company's RONIC at the end of Stage I to its WACC at the end of Stage II.
The concept of an economic moat - or sustainable competitive advantages - focuses purely on thesustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does notconsider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not. Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.
Image Source: Valuentum; EVA is trademarked by Stern Stewart & Co
The problem with using solely an economic moat framework to assess businesses becomes readily apparent in the above example. Though moaty firms are durable and sustainable businesses, they may not be the best value-generators for shareholders. To business owners, this issue is very clear. Business owners want to maximize shareholder value - and a firm's competitive advantage assessment may be independent of that view. Business owners want to generate the most economic value.
Before moving on, let's clarify one concept. The trajectory of a firm's economic value creation (or the blue and red areas in the graph above) is not equivalent to the trajectory of a firm's stock price. A firm's valuation, which is used to identify stock mispricings, already embeds the future economic value creation, as it is a function of 'earnings before interest,' which itself is the primary driver behind future free cash flows to the firm (enterprise cash flows) - or that which we use in our valuation framework at Valuentum. Said differently, the above graph shows pure economic value-creation, or in other words, the spread between a firm's return on invested capital and its cost of capital. It's possible, though unlikely, that the stock price volatility of the no-moat stock above can be less than that of the moaty stock. I say this to drive home the differences between stock price volatility, which is based on expectations revisions, and economic profit volatility, which is based on fundamental business dynamics.
Regarding a moaty firm's or a no-moat firm's stock price, if the firm is fairly valued, the stock will already reflect its respective forecasted economic profit trajectory. As Moubaussin puts it in his paper, under a scenario where the equity is fairly priced, investors should expect a risk-adjusted market return. The value of fairly-priced moaty stocks, which tend to be less risky, will advance at a lower annual pace than the value of fairly-priced no-moat stocks due in part to the lower risk-adjusted discount rate applied to their respective future free cash flow stream. Generally speaking, a firm's intrinsic value will advance at the annual pace of its corresponding discount rate less its dividend yield. Since moaty firms generally have lower discount rates and pay dividends, the pace at which their fair values increase in any given year will trail that of a no-moat firm, assuming the future forecasts are accurate. Intrinsic value estimates are never static.
What we are after as investors, as Moubassin states in his paper, is anticipating revisions in expectations of financial performance. Is a no-moat's economic value trajectory correctly priced in? Is a wide moat's economic value trajectory overvalued? Is a no-moat firm's economic value trajectory undervalued? The economic moat concept is less important to the valuation and global investment framework than the actual future economic value stream of each individual company. In Valuentum parlance, this means that we're looking for companies in the global investment universe that have mispriced future economic value streams (i.e. stocks that are underpriced relative to their discounted future free cash flows and net balance sheet impacts) and are just starting to have their 'expectations revised' by market participants (i.e. their equities are just starting to be purchased). We call these stocks Valuentum stocks - underpriced stocks that are just starting to go up.
The sustainability and duration of a firm's economic value creation - or its competitive advantage period - tells us little about a company's economic castle, or the magnitude of the value creation that it is expected to deliver to shareholders. Though a focus on economic moats is important to Warren Buffett's process, identifying "economic castles," or those that will deliver the most value to shareholders may be equally, if not, more important to an investor's process. We are keeping the horse before the cart.
Valuentum's Economic Castle rating assumes that 'economic profit' (as measured by ROIC less WACC) is the primary factor in assessing the value that a company generates for shareholders. Whereas an economic moat assessment evaluates a firm on the basis of the sustainability and durability of its economic value creation stream, Valuentum's Economic Castle rating evaluates a firm on the basis of the magnitude of the economic profit that it will deliver to shareholders (as measured by its ROIC-less-WACC spread). Firms with the best Valuentum Economic Castle™ ratings are poised to generate the most economic value for shareholders, regardless of their competitive positions.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. Novartis' 3-year historical return on invested capital (without goodwill) is 17.8%, which is above the estimate of its cost of capital of 10.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Novartis' free cash flow margin has averaged about 17.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Novartis, cash flow from operations decreased about 10% from levels registered two years ago, while capital expenditures fell about 2% over the same time period.
We think Novartis is worth $80 per share with a fair value range of $64.00 - $96.00.
The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 2.7% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -4.3%.
Our model reflects a 5-year projected average operating margin of 30.3%, which is above Novartis's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.7% for the next 15 years and 3% in perpetuity. For Novartis, we use a 10.3% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $80 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Novartis. We think the firm is attractive below $64 per share (the green line), but quite expensive above $96 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Novartis' fair value at this point in time to be about $80 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Novartis' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $99 per share in Year 3 represents our existing fair value per share of $80 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.