valuflash novo nordisk - valuanalysis2016/11/02 · novo’s economic rent, and therefore economic...

1 | THE OPINIONLESS ANALYST WRITES ABOUT… NOVO NORDISK

November 2nd, 2016

ValuFlash Novo Nordisk: A New Entry Point?

Last week’s news from Novo is a

reminder of the violent power

battle happening in the US Pharma

sector between the manufacturers

and the Healthcare providers. Even

well managed Novo could not protect

itself from this vicious struggle.

As a result, Novo’s valuation is

now at its most attractive for

years. We believe that paying less

than 25x normalised net FCF for a

global franchise is a good strategy for

investors (we have tested it

extensively), and at DKK 240, the shares trade on 24.5x. However, current investors

have lost 40% from the peak and the onus is on the management to mitigate this

disaster: they will need to demonstrate that their franchise is not a melting ice cube.

Novo’s economic rent, and therefore economic franchise, has peaked. The

market now assumes a future steep fade to well below the 16% mark (ratio of FCF to

economic assets), which is what we calculate to be a “normalised” level for Novo.

Management now need to prove that this line can be defended successfully.

Investors have less of a problem with Novo’s unit sales growth. But, as a result,

we show that the valuation largely depends on this variable now. The way out is for

management to stabilise the rent that they clip and harness the underlying volume

growth of their market. There could even be, on that basis, a substantial valuation

upside of nearly 20%.

Novo’s management need to review the firm’s level of financial leverage, too.

100% of capital invested is financed by equity, which is going to be too flat a structure

to compensate investors for the permanent loss of cash flow (DKK 6bn to 8bn, we

think) that the firm has suffered.

.


1. A Severe Reminder

We have always been impressed by Novo’s meticulous and efficient management.

The past story of the firm can be told in not so many words by the following chart,

which depicts in our view a company with a rather clear competitive advantage

(defined as a stable or growing “economic rent”, or FCF yield on economic assets):

NOVO’S OPERATING RENT

(ACCOUNTING DATA FROM S&P CAPITAL IQ, ECONOMIC ADJUSTMENTS FROM VALUANALYSIS)

We suspect that Novo’s current investors could not care less about the past at the

moment. Yet the past is relevant here, because the formidable franchise that Novo

has built over the past decade is what is at stake now. In other words, is the

dramatic results publication of last week announcing the heat wave that is going to

melt the ice cube, or is it a “reset” of expectations, partly driven by the US pricing

situation and the advent of a new CEO?

1.1 The Extent of the Damage

We calculate that this latest report announces a potential but likely permanent loss

of cash flow of ca DKK 6bn to DKK 8bn per annum. This shortfall cannot to be totally

unexpected; prior to last week’s report, the shares had been under constant and

visible pressure since they reached the DKK 400 mark. The surprise would have

been to see Novo being immune to the violent price pressures in the US, and the

on-going shift of pricing power from the pharmaceutical manufacturers to the

healthcare providers, who can decide which product they can use and reimburse

and at what price.

How we get to a DKK 6bn to DKK 8bn shortfall

Novo expects revenues to reach approximately DKK 114bn in 2016, an increase of

“5 to 6%”. LTM revenues to end September 2016 are DDK 111bn. We have built a


pro forma FY 2015 and FY 2016 revenue line applying the worst case sales growth

of Q2 2016 in each region to FY 2015. This yields a worst case pro forma revenue

line of DKK 105bn for FY 2016. Using last reported gross margin and tax rate, we

arrive at an estimated pro forma loss of cash flow of DKK 6bn, had the challenging

market conditions applied throughout 2015 and 2016. Note that given the negative

base effect, a higher revenue growth for 2016 will increase the CF shortfall, which

prompts us to put it in this DKK 6bn to DKK 8bn range.

There is, indisputably, an initial loss of value attached to this change of level, which

we put at roughly DKK 100bn. “Roughly” because it depends on which discount rate

investors are using, and which tax treatment they assume on this loss of cash flow.

More importantly, we see three reasons why investors should not give up on Novo’s

long term story, and why we anticipate a possible entry point for new investors at

or below the DKK 240 mark per share.

1.2 The Three Reasons to Look at Novo Now

We argue that a potential (but likely) permanent loss of DKK 6bn to DKK 8bn of

annual cash flow:

Should not impede Novo’s ability to fund the protection of its franchise

Does not fall below our previously calculated “normalised” level

Does not deteriorate the valuation further, everything else being equal. In fact,

for the first time in years, the shares now trade within our preferred boundary

of 25x net normalised free cash flow.

How we assess Novo’s cash flow

We define gross cash flow as cash flow before spending on economic capital.

Because we capitalise some P&L items (such as R&D or operating leases, for

instance), these expenses are considered capital consumption and not a P&L

operating cost anymore. The following table shows how we get to the 2015 figure:

ECONOMIC GROSS CASH FLOW (IN DKK M)

2015 % Total

Adjusted Gross CFO 38 341 74%

Lease-exp. taxed at 20% 635 1%

Intang-exp. taxed at 20% 12951 25%

Total 51927 100%


Lower down the cash flow statement, we look at both operating and net FCF by

calculating and deducting two levels of capital consumption: the “maintenance

level” (which gives operating FCF) and the “economic level” (which gives net FCF).

Maintenance Capex is the minimum spending that a company could afford to

spend to “stay in the game”, or maintain its competitive advantage. It is best


approximated by the economic depreciation of gross assets, as per the Hotelling

economic depreciation model, pictured below.

NOVO’S GROSS ECONOMIC ASSETS (LEFT) & ECONOMIC DEPRECIATION (RIGHT) (IN DKK M)


Because Novo Nordisk has accumulated capital at an historical 10% p.a. clip, the

proportion of “young assets” is high (average economic age is 4 to 5 years). This

means that net economic assets are more than 50% of the gross value.

Correspondingly, economic depreciation, which is not linear, is still small. The chart

above suggests a figure of ca DKK 9bn. This would mean a level of operating FCF

pre the profit warning of some DKK 43bn (DKK 52bn minus DKK 9bn).

That said, operating FCF is not the ideal benchmark of a firm’s underlying economic

rent in industries where competitive pressures are high and asset lives are

shrinking (as in the pharma industry). We believe that Novo will need to spend

much more than DKK 9bn per year to grow and maintain its economic capital. A

better approximation of Novo’s economic rent might be its net FCF yield, calculated

by deducting all “economic capital spending” from gross cash flow:

NET FREE CASH FLOW (IN DKK M)

2015 % Total

Gross Economic Cash Flow 51 927

Tot. Capital Consumption 18 843 100%

o.w. Intang.-exp. 12 951 68.7%

o.w. CAPEX 5 224 27.7%

Total Net FCF 33 084

Permanent loss (assumed) 8 000

Revised net FCF 25 084

VA Normalised net FCF 24 321



The previous table supports the view that a permanent loss of DKK 6bn to DKK 8bn

of cash flow will not impede the company’s ability to fund its growth in - and

replacement of - economic capital, at the same growth rate as before. Furthermore,

there will be enough funds to stick to the same distribution policy as before. We

calculate that share buy backs and dividends consume on average DKK 25bn per

annum. This is likely to translate into a distribution ratio close to 100% of FCF. But

100% of assets are currently financed by equity, and the company has therefore

access to an untapped and rather large reserve of debt funding, should it find it

necessary to increase its funding resources. We believe that some financial

leverage would help compensate for this year’s severe loss of substance.

The use and usefulness of normalised FCF

The previous table also carries another important piece of information, we think.

Generally, we prefer to value companies on the basis of their normalised level of

FCF, an application of Ben Graham’s margin of safety. There is nothing particularly

fancy about our normalisation process. We tend to normalise over the last four

years, with one of the four observations being a rolling accumulation of the last

twelve months. The weightings that we apply to these 4 data points may vary

according to the cash flow cycle of the firms. In the case of Novo, we have used a

simple arithmetic weighting of 4 x 25%.

Crucially, the previous table shows that the expected drop (of ca DKK 8bn) does not

make the new net FCF level fall outside of the normalised one. The numbers are

quite close now (this is probably a coincidence) but New Novo is still DKK 750m

better off than VA’s calculated normalised level of net FCF.

An Entry point within sight?

If investors are following our argument so far, and accept that a normalised level

of ca DKK 24bn of net FCF is reasonably representative of the firm’s cash generation

potential, the remaining issue is the multiple at which this level should trigger an

investment.

Our long-held view is that investors should not pay more than 25x normalised Net

FCF for any stock. At zero growth (i.e. as a multiple of operating FCF), the correct

multiple should be the inverse of the long term real return on equity investments,

which we put at between 5% (20x) and 6% (16.7x). Taking growth into consideration,

i.e. as a multiple of net FCF, the multiple should be higher, and our tests of a

systematic investment at or below 25x show a relatively stable pattern of

outperformance (see the following chart). This hurdle appears to be a good

compromise between a value discipline and the necessity to allow growth stocks

into a diversified portfolio.

Prior to Friday 28th October, Novo was trading on 27x normalised net FCF, a

relatively low level for this stock, already putting the shares back on our radar.

Following the sharp movement in the share price, the corresponding multiple is

now between 24x and 25x, a putative buy signal for us.


SYSTEMATIC INVESTMENT IN “LOW MULTIPLES” (<25X NORM.NET FCF) VS REST OF THE MARKET



2. New Novo, same Franchise?

Having acknowledged the optical attractiveness of Novo’s new multiples, we

propose to check, as an Opinionless Analyst, what kind of precise expectations are

now embedded in its share price. These are not forecasts but market-implied

assumptions extracted from the valuation. Of course there are many ways in which

a future stream of free cash flow can match this valuation, but surprisingly few that

actually “make sense”, given the history of the firm.

2.1 Novo’s Implicit Competitive Advantage

Investors have taken on board the new message by pricing a step-change in the

immediate expected profitability of the group. Over the longer run, we also note

that the market now expects a relatively steep decline below the historical 16%

mark (of normalised net FCF). These implicit profiles are definitively not forecasts.

By construction, the market assumes “going concern” and therefore discounts over

very long periods; what looks like a precipitous fade on the chart is in fact beyond

most people’s immediate time horizon. In this case, the time horizon is roughly four

investment cycles (four times the economic life of the firm), or 45 years. After that,

there is no more economic franchise, says the market.

NOVO’S IMPLICIT FADING RENT AT DKK 240 PER SHARE


The anticipated growth rate is less affected, it seems. It looks like investors in

aggregate believe that Novo can achieve 8% in its market (historically, 10%). They

price a gentle fade only in this rate of accumulation, to 5% over many years.


2.2 Novo’s Three Sources of Value

The chart below shows an Intrinsic Value breakdown based on the implicit profiles

of point 2.1. The Three Sources of Value are Replacement (Novo’s net economic

asset base, its “book value” in accounting speak), Franchise and Growth.

NOVO’S THREE SOURCES OF VALUE (IN DKK M)


This chart makes it clear that investors are predominantly concerned by pricing, in

that the fading rent profile seen in the previous chart, expressed here as the

Franchise Value, corresponds only to 30% of market value, which is a small number

for a global franchise. The Growth Value, as a result, contributes the most to the

market value. This is logical as no one has questioned the long-term rate of growth

of diabetes products in the world. But this is a strong signal to management and

investors alike: unit sales growth is what is now primarily underpinning this

valuation. As explained in 2.1, the underlying assumption is a growth rate starting

at 8% and fading to 5% over time, which does not look extravagant.

An alternative presentation1 calculates Franchise Value with a constant (not fading)

yield (16%) over the same finite life (the “competitive advantage period”, here 45

years, or roughly four investment cycles), after which there is no more value

creation, and therefore no more economic franchise. The comparison is not

without merits, because it allows to quantify the upside if Novo can sustain its

competitive position and defend its 16% rent over a few investment cycles (in the

jargon: “if Novo can beat the fade”). There is no escaping from the fact that this is a

high number (ergo it is likely to attract more attacks), but we can see a number of

reasons why Novo’s management might pull it off:

1 Naturally, all models give the same Net Present Value and the Enterprise Value remains unchanged


They have access to a very sizeable amount of financial resources, should they

decide to leverage their balance sheet

They have a number one or number two position in their key markets, with some

sporadic dominant positions above 30% market share.

NOVO’S THREE SOURCES OF VALUE WITH CONSTANT RENT (16%) (IN DKK M)


The main difference in this new configuration is a much larger Franchise Value,

which increases from DKK 175.7bn to DKK 300bn, because the rent does not “fade”

anymore. As a result, the residual Growth Value does not become a very

demanding hurdle. We estimate (the precise calculation is nearly impossible) that

DKK 134bn is equivalent to a growth rate below 5% per annum, probably 1% below

the long-term potential of Novo’s markets. This would mean that Novo would lose

10% of its market share in the next decade, an assumption for which we don’t

clearly see tangible signs despite the difficulties in the US market. Thus, we can

estimate the upside potential to be in the region of DKK 120bn (DKK 257.5bn –

implicit Growth Value fading from 8% to 5% - minus DKK 134bn –implicit Growth

Value below 5%), or 18% at current levels. Needless to say, the company will need

to demonstrate (and investors will need to believe it) its ability to fight and sustain

its 16% rent.


2.3 Novo and Alternative Investments

For those unconvinced and looking for alternatives to Novo, we have searched our

database for similar rent levels and multiples. If Novo’s proposition is a 16%

economic rent for 25x normalised net FCF, what else can we get for this price?

SAME RENT OR SAME MULTIPLE AS NOVO…

Same Rent for: Same Multiple for:

Shire plc (30.8x) Medtronic (20.0%)

Sino Biopharma (24.9x) General Dynamics (18.7%)

Hikma Pharma. (21.2x) Quest Diagnostics (16.1%)

Pfizer (18.1x) Henkel (15.1%)

Teva Pharma (15.8x)

Galenica (21.2x)


Interestingly but not surprisingly, companies with similar rent levels are primarily

in the Healthcare (broadly defined) sector. On the basis on these numbers only,

Pfizer (especially after the very recent softness in its share price) and Galenica look

the most interesting alternatives. The other way around, Medtronic, a company we

like, tops the list. Note that Sanofi, a major competitor to Novo, also trades on a

similar multiple (23.5x) but delivers a rent almost half that of Novo (8.5%).


GLOSSARY

Competitive Advantage Period (CAP). The period during which a firm can

generate a return (see Rent) above the cost of capital.

Economic Depreciation. The correct way to take into account the obsolescence

of an asset, according to the economist Harold Hotelling. Typically, an asset

produces n cash flows over its economic life and is valued as the net present

value of these cash flows. Depreciation is the recognition of the loss of cash

flow(s) as the asset is ageing, such that, at the end of its life, an equal amount of

capital has been put aside to renew it. If L is the economic life of the asset and d

its cash yield, depreciation in year y is calculated as: 𝐶𝐹𝑦

(1+𝑑)(𝐿−𝑦).

Economic Profits. Cash profits minus the notional cost of capital.

Excess Return. The level of return above the cost of capital.

Fade. The rate of normalisation of the competitive position of the firm, defined as

its level of Rent and growth rate. By construction, an excess return cannot be

assumed to be perpetual, and the market always assumes an eventual

normalisation towards the cost of capital.

Franchise Value. One of the three sources of value, defined as the net present

value of a firm’s sustainable level of Economic Profits over its Competitive

Advantage Period.

Gross economic Capital (GeC). or Gross Economic Assets (GeC). The sum of all

operating capital used by the firm pre-depreciation, including all tangible assets,

capitalised intangible assets and operating leases, Other Long Term Assets (OLTA)

and concession assets.

Growth Value. One of the three sources of value, defined as the residual of:

Market Value minus Replacement Value and Franchise Value.

Intrinsic Value. The sustainable value of a firm, defined as Replacement Value

plus Franchise Value.

Net economic Capital (NeC) or Net Economic Assets. The depreciated value of

GeC, according to the principles of economic depreciation.

Net Free Cash Flow. Gross cash flow minus all capital spending.

Operating Free Cash Flow. Gross cash flow minus maintenance capital spending.

Rent Yield, or “Rent”. The ratio of FCF over Net economic Capital. We refer to it

as “cash yield” or “cash return” as well.

Replacement Value. One of the three sources of value, equal to Net economic

Capital.


Residual Income Model. A valuation framework defining the price of an asset as

the net (depreciated) value of this asset plus the net present value of its

sustainable level of economic profits.

13 | THE OPINIONLESS ANALYST WRITES ABOUT… INGENICO

For more information:

Pascal Costantini

Director

The Clubhouse, 8 St. James's Square

London SW1Y 4JU

(+44) 203 058 2931

[email protected]

Joakim Darras

Director


London SW1Y 4JU

(+44) 20 3058 2933

[email protected]

Diarmid Ogilvy

Director


London SW1Y 4JU

(+44) 203 058 2932

[email protected]

www.valuanalysis.com

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valuflash novo nordisk - valuanalysis2016/11/02 · novo’s economic rent, and therefore economic...

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