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NOVARTIS
COMPANY UPDATE: Prospects for 2004 HEALTHCARE - Drugs & Pharmaceuticals

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EQUITY RESEARCH UNITED STATES OF AMERICA Ryan Wannemacher

Email: rwannema@mail.smu.edu

SELL
April 2, 2004

Dont do DRUGS.
INVESTMENT THESIS

Kanaiya Kapadia
Email: kkapadia@mail.smu.edu

Benjamin Q. Luong
Email: luong_benji@hotmail.com

Miranda Peters
Email: mpeters@mail.smu.edu

FINANCIAL STATISTICS
Price: $42.48 (as of April 2, 2004)
Symbol | Exchange: NVS | NYSE 52-Week Range: $34.13 - $47.83 Market Cap: $109.27 billion Shares Outstanding: 2.47 billion Relative Price-to-Earnings (P/E): 1.15 Forward P/E: 16.7 Trailing P/E: 23.52 (Stock) vs. 28.19 (Industry) PEG Ratio: 1.54 (Stock) vs. 1.24 (Industry) Return on Assets (ROA): 12.5% Return on Equity (ROE): 16.2% Total Debt-to-Equity (D/E): 0.15 Current Ratio: 2.46 Annual Dividend: 0.70 Dividend Yield: 1.55%

The market consensus expectations for Novartis are fairly low. The growth that most people are predicting is consistent with typical expectations of a value company, with a consensus revenue growth at 8% a year. There are some factors which could contribute to the revenue growth dipping below 8%. They are expecting big things from two new drugs, Zelmac and Xolair. If these drugs do not live up to their billing, it could have an adverse affect on the companies expectations. Zelmac is a drug to help relieve chronic constipation. If approved for use in chronic constipation, (Zelmac) would be the rst treatment not only to improve bowel frequency but also to provide relief of multiple symptoms to patients, said John Johanson, MD, MSC, lead investigator and Clinical Associate Professor of Medicine at the University of Illinois College of Medicine in Rockford. This advance would be welcomed by the medical community because there is a need for additional therapies that are effective and well tolerated. Xolair is a drug for chronic asthma. From a business model standpoint, Novartis strategy of developing drugs that are comfort drugs is a sound one. Both Zelmac and Xolair are medications that will need to be taken continuously over a persons lifetime. This bolsters another trait of a value company more stable cash ow. However. there are some drawbacks to that business model. By not going for the homerun ball, they will not experience huge gains, but they will be more consistent gains. The largest cost to any drug manufacturer is Research and Development (R&D). Novartis has done a good job of controlling R&D. They have kept it constant at about 15% of revenues. This is par with the industry average. If Novartis does not get the return on their R&D that they expect, then it would force them to either increase R&D or see their revenues drop. Either way, the percentages that they are spending to achieve the same revenue stream will increase, causing a decrease in free cash ow. Novartis, similar to other drug companies, carries a lot of cash, $13 billion in cash and short term securities. This allows them to be very agile in the business world. They are also not held down with a lot of debt. Their debt-toequity ratio is only about .15 and their cash-to-debt ratio is a very healthy 2.5. In this case, we feel that they could support some more debt, and we think that it could have a positive effect on their stock price. The weak point from the ratio analysis is the P/E ratio. It is fairly high at about 18.6 (see Exhibit 1). There are some much lower P/E ratios in the drug manufacturing industry. Their growth rates over the past 3 and 5 years have been meager at best. We expect this to continue with a conservative average growth rate of 8% into the future. Possible merger in the works. There has been some talk of a merger with French drug company, Aventis. Novartis has said that they are not opposed to a merger; however, they will not going to do anything that does not make logical sense. We think that this behavior shows that management is realistic, is aware of their situation, and understands what affects the success of their company.

Instrinic Value: $42.35

COMPANY PROFILE
Novartis AG, formed in December 1996, operates in its core businesses of pharmaceuticals and consumer health, which includes generics, over-the-counter (OTC) self-medication, animal health, medical nutrition, infant and baby foods and products, as well as eyecare products. The Company is organized into two divisions, pharmaceuticals and consumer health. In 2002, the consumer health division was reorganized to include the generics, OTC self-medication, animal health, medical nutrition, infant and baby and CIBA Vision business units. In May 2003, Novartis acquired Idenix Pharmaceuticals, Inc., a biopharmaceutical company engaged in the discovery and development of drugs for the treatment of human viral and other infectious diseases. Also in May 2003, the Company acquired the incontinence drug Enablex from Pzer Inc. Reuters Novartis is also mostly well known for its launch of Ritalin LA (methylphenidate).

CHART A : Stock Chart

Source: Morningstar.com

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BUSINESS MODEL
The Major Drug Manufacturing and Pharmaceuticals sub-sector of the health care sector is marked by high margins despite large research and development costs. The largest driver of earnings for any given company in this sector is its ability to remain innovative and revolutionary. As a result these companies must always be forward looking. The companies in this sector often carry a very large amount of cash. They generate very large amounts of cash ow, and with an aging population they seem to only be growing.

OVERALL MARKET PERSPECTIVE

Gradually, medical progress has been expensive, and healthcare still represents the largest sector of the U.S. economy. In 1940, the United States spent $4 billion on health care. In 1998, health care costs have skyrocketed to $1.1 trillion, almost $4,094 per person. Further, this health care cost accounted for approximately 13.5% of the gross domestic product (GDP) or one-seventh of the U.S. total output. Total U.S. health care costs are projected to increase from $1.31 trillion in 2000 to $2.17 trillion in 2008, averaging a 6.8% increase per year. Health care spending in terms of GDP is expected to increase from 14% in 2000 to 16.2% in 2008. According to Plunkett Research, rising drugs costs amply contribute to the soaring health care costs. Since 1995, the price of drugs has been increasing more than 10% annually and has surpassed $110 billion annually. Most importantly, a large percentage of the U.S. population will also be aging. Baby boomers of 1946 to 1964 will reach retirement age and this retiring population will increase sharply. Intuitively, the percentage of the working population will fall. Consequently, demand for medical care, long-term care facilities, drugs, improved technology, and other medical services will eventually skyrocket. As a benet, these services will increase life expectancy age, but prolonging age will add to health care costs. In addition to health care spending, the number of people drawing Social Security benets will rise sharply. Intense pressure will be tightly placed on government budgets. Increases in taxes will result unless the government cuts the level of these services. Nothing about health care expenditures indicates that any decrease will occur anytime soon. According to Plunkett Research, the state of the health care industry will have recurring themes during the rst half of the 21st century: 1) Increase in ineffective utilization of Managed Care enterprises (HMOs, PPOs, etc.) 2) Loss of autonomy for both physicians & patients 3) Backlash against HMOs (Patients Rights) 4) The rise and fall of various types of physicians organizations 5) Vast number of uninsured and underinsured Americans 15.5% of Americans have no health coverage (42.6 million adults & 14 million children)
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6) HMOs dump Medicare & Medicaid investments while the cost of senior care balloons 7) Utilization Review (seeking effective means of cost control) 8) Use of minimally invasive surgery (loss of business in operating rooms) 9) Alternate site care (Home health care) 10) Advanced imaging techniques 11) Biotech and advanced pharmaceuticals use grows while costs soar 12) Advanced information technology and medical records 13) The Internet (a shift of access of knowledge from the physician to patient) 14) M&A of health care companies rise in consolidation 15) New Medicare Rx legislation $400 billion budget over 10year period to cover elderly; boost pharmaceutical sales 16) Loss of patent protection in the next four years 17) Rx to OTC drug conversion to boost non-prescription sales Additionally, the drug market is one of the worlds most protable markets in terms of prot margin. For instance, lifestyle drugs alone economically and socially have been transforming the $98 billion U.S. pharmaceutical market. With the forefront of the biotech era, biotechnology is expected to produce up to of all new drugs in the future. The outlook for technology will mostly encompass regenerative medicine, transgenics (use of organ and tissues grown in lab animals for human transplant), neo-organs, the human genome project, enhanced gene therapy, new drug delivery methods, new technology in hospital systems, support and services, nanotechnology and advanced in cancer research, diagnostic imaging and monitoring, laboratory testing, and surgery.

VALUATION
We calculated an intrinsic value based on an average, revenue growth of 8% a year in-line with market consensus estimates. In our discounted free cash ow (DFCF) model, we assumed that their prot margin would remain constant as well as their other major cost drivers, such as Research and Development. We also assumed that their line item percentages in their income statement for 2003 would remain the same throughout forecasted years (see Exhibit 2). Based on our analysis of Novartis, we determined that it is a good company, but slightly overvalued. With a Weighted Average Cost of Capital (WACC) of 7.35% and a Terminal Growth percentage of 4%, we feel Novartis is fairly valued at $42.35. Exhibit 4 depicts a sensitivity analysis of the possible intrinsic values of the rm depending on the variability in WACC and Terminal Growth numbers. On a positive side, we do not necessarily see serious detrimental behaviors that could adversely affect their nancial condition because it has a lot of room on the upside. However, we feel that Novartis will not be able to achieve the returns consistent with the expectations of the Ann Rife Cox portfolio for 2004. Growth in the rm will remain either relatively constant or will slowly grow over time (see Chart A). Consequently, we recommend a sell of our position in Novartis.
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DFCF MODEL ASSUMPTIONS

We made several assumptions that will serve as inputs into our DFCF model for simplicity purposes.

FUNDAMENTALS ANALYSIS (see Exhibit 1)

Sales and Net Income
Novartis ranks 3rd in sales and net income among our choice of comparable companies (see Chart B and C for Novartis sales breakdown). While Novartis have sustained their position, other drug manufacturers have shown much better growth prospects and increased competitiveness.

Capital Expenditures-to-Depreciation ratio

Using Novartis 2003 nancial gures, we arrived at a ratio of .9589 and assumed this ratio remained constant for purposes of growing capital expenditures throughout forecasted years.

Earnings per Share (EPS) Revenue growth %

Market consensus estimates revenue growth of 8%; however, we forecasted 10% revenue growth for the years 2005, 2006, and 2007 because Novartis will be able to recognize returns on investments (ROI) from their new drugs that will be coming out of Phase II and nal Phase III clinical trials. We then conservatively reduced revenue growth for the remaining years. Further, Chart B and C indicate breakdowns and distributions in sales earnings.

Once again, Novartis ranks 3rd in EPS among our choice of comparable companies. Next Fiscal Year (NFY) prospects shows attractive growth for all comparables. Eli Lilly seems to show the greatest prospect in EPS growth of 17.7%.

Financial Ratios

Depreciation
Using Novartis 2003 nancial gures, we arrived at 5.65% (see Exhibit 2 - Key Percentages) and assumed this percentage remained constant for purposes of growing depreciation throughout forecasted years. We also derived depreciation-tobook assets of 4.4%.

Debt Interest Rate %

We calculated the debt interest rate to be based on a spread from a AAA bond rating. An interest rate of 4.1% seems to be consistent with interest expense (as a % of revenue) in 2003. We also used this gure to calculate interest expense in forecasted years.

Pzer steps into the 1st position with the highest Last Fiscal Year (LFY) gross margin of 87.5% while Novartis achieves a gross margin of 76.5%. However, Novartis maintained an EBITDA gross margin of 27%, shy under Pzers EBITDA gross margin of 36.4%. Return on Equity (ROE) is mediocre at 16.2% while Eli Lilly has a well-above average ROE of 26.1%. According to Yahoo!, the Industry indicates a trailing twelve months (TTM) ROE of 20.01%. Return on Assets (ROA) is moderate at 12.5% in terms of measuring protability. TTM ROA for the Industry is determined to be at 9.01%. Asset Turnover (in terms of how well assets are used to produce revenues) for Novartis does not look impressive at 0.46 when compared against other drug manufacturers. Current ratio is very high at 2.46, indicating that Novartis is very liquid.

Growth
Historical 3-year growth rate seems to look unattractive at -0.05% while other drug manufacturers have achieved positive growth. Projected ROE NFY for Novartis at 16% is extremely low among others. Yet, Novartis projected growth in EPS in 5 years is expected to be at a modest 13.1%.

Tax rate
We used a fair tax rate of 20% for 2003. We kept this gure constant throughout forecasted years.

Key Percentages for 2003

Percentages for each line item indicate as percentage of revenue. These percentages were used to forecast line items in forecasted years (see Exhibit 2).

Risk
Debt does not seem to be a risk factor for Novartis considering they carry a hefty load of cash at $13,967.8 million.

Beta
We arrived at a beta equity of the rm of 0.84 from Valueline (see Exhibit 3).

Valuation
Current Fiscal Year (CFY) Price-to-Earnings (P/E) is fairly high at 18.6 while NFY P/E also remains high at 16.7. Also, Relative P/E is high at 1.15. Additionally, Novartis PEG ratio is high at 1.54 when compared to the Industrys 1.24 PEG ratio. In summary, Novartis is expensive, and because the P/E ratio is high, the market seems to be more willing to pay for each dollar of annual earnings. Further, Novartis P/E is slightly higher than the aggregate P/E ratios, indicating that the Company is a slightly more expensive than the norm.

Weighted Average Cost of Capital (WACC)

With our inputs, we calculated the WACC to be 7.35% for the levered rm (see Exhibit 3).

Terminal Growth %
We used 4% as a terminal growth input to determine the intrinsic value of the company (see Exhibit 4).

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EXHIBIT 1 : Comparable Company Analysis

Rex Thompson P/E Aggregate Ratio (Thompson PEAR) The Thompson PEAR method is determined using the sum of the all comparables market capitalization and the sum of the each comparables common shares times their EPS.

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EXHIBIT 2 : Projected Financials

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EXHIBIT 2 : Projected Financials (continued)

CHART B : Sales Breakdown by Patent Products

Source: Company Reports

CHART C : Sales Breakdown

Source: Company Reports

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EXHIBIT 3 : Risk and Required Return

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EXHIBIT 4 : Free Cash Flow - Sensitivity Analysis

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