Novartis AG ($SWX:NOVN) is one of those companies in Europe with a very long and rich history. If you don’t know the company that well, then initially you might think that this is a relatively new company because it only exists in its current form since 1996.

Just as a background, Novartis was created through a merger of Ciba-Geigy and Sandoz, both from Basel (Switzerland) with a history dating back to the 19th century. Novartis is still based in Basel and located on just a 3 kilometer distance from probably its largest rival and competitor: Roche Holding AG ($SWX:ROG).

I think it’s fair to say that Novartis can be considered the European equivalent of US companies like IBM and 3M whom also spot a very long history. All of them are predating the second world war and have reinvented themselves continuously as society and the world evolved.

This is also what makes Novartis so special, because its earliest predecessor started out as a chemicals and dyes trading company back in 1758 and nowadays Novartis is one of the leading pharmaceutical companies in the industry. Based on 2019 revenues, Novartis is the 4th largest pharmaceutical company by revenue in the world only trailing Pfizer (3rd), Roche (2nd) and Johnson & Johnson (1st).

In 2019, Novartis had a total revenue of 47.5 billion USD (+9%). This is excluding 7 billion USD revenue from eye-care products after the recent spin-off of Alcon ($SWX:ALC) was completed in April 2019. However, EPS declined slightly with 6% compared to 2018 numbers.

Novartis key revenue drivers for 2019 have been the extraordinary sales growth of Cosentyx (+714 mln | +28%) and Entresto (+698 mln | +71%). Cosentyx is a popular medicine to treat plaque psoriasis, psoriatic arthritis and ankylosing spondylitis. Entresto is a popular prescription medicine to reduce the risk of death and hospitalization in people with certain types of chronic heart failure.

As you can see in the below overview, also their established products have seen steady growth and this is a very powerful sign for a company like Novartis. Hence why I believe that this company is firing on all cylinders!

The last 2 years have also brought a set of portfolio adjustments. Most notably the spin off of Alcon ($SWX:ALC) and the purchase of the Medicines Company. This makes analyzing their consolidated FY 2019 results also a bit harder.

In my opinion Novartis has a strong moat, like other pharmaceuticals with a diverse portfolio, because it isn’t easy to just copy their business model. Their medicines are typically for quite some time protected by patents and those medicines earn enough cash-flow which can be reinvested in R&D. This keeps strengthening their portfolio and keeps the snowball rolling into the next decade.

Lately they have also been giving special focus to China. I believe that this is very smart and this can be considered to be another strong catalyst for the upcoming 5 years.

While management has a very strong focus on growing their portfolio quite aggressively including their focus on China, they are also very conscious that future earnings growth can also be achieved on the cost side.

I like this very much, because it’s very easy for management to loosen up and not worry that much about operational excellence today, but the fact that they continue to focus on margin expansion means to me that they are trying to grow their sales and at the same time become a “LEANer” enterprise.

This is a typical example of maximizing earnings, something that shareholders should appreciate very much.

To conclude this introduction, to me Novartis seems to be a very good company with a lot of future prospects for strong earnings-growth. But does this mean that it is also a good stock to own?

Let’s have a brief look into their financial quality, dividend quality, management integrity and valuation.

Financial Quality

Financial quality to me in simple terms means whether they have a sound balance sheet, can easily cover their interest payments and have a strong stable cash-flow growth.

Let’s have a look at their balance sheet. Novartis reported their FY 2019 earnings on the 28th of January 2020, so the information at hand is still pretty recent.

Their debt/equity ratio is ~53% (29 BLN / 55 BLN), which is OK. because it means that they are financing at least half of its growth using equity rather than leverage. I am not going to judge on a 3% difference (ideally < 50%).

Their Interest Coverage is 10.7 (9.086 MLN / 850 MLN) which is a very good sign (ideally > 3). Effectively it means that Novartis has more than enough profit to cover their interest expenses.

Both metrics tell me that they have a very sound balance sheet which should prevent them getting straight-away in financial trouble when they would face some headwinds.

Let’s also briefly look at their recent free-cash-flow (FCF) growth. They grew their free-cash-flow compared to 2018 with 3.7% and over the last 5 years with an average of 4.3%. This is OK, but I would like to see it grow with mid- to high-single digits.

FCF growth is important for me, because it ensures the ability to continue growing future dividends.

Finally I am also looking at the credit score from the credit rating agencies to cross-check my analysis. Moody’s has reaffirmed Novartis last November with a credit-rating of A1, which is a pretty good rating.

All in all, Novartis seems to have a strong balance sheet supported by decent Free-Cash-Flow growth.

Dividend Quality

Needless to say, but as a dividend growth investor I have a very strong interest in understanding the ability of the company to keep paying growing dividends.

This is why I analyze the quality of the dividend. Dividend quality in simple terms means for me a good starting yield, combined with solid dividend growth and a payout ratio which is healthy and should prevent a dividend to be cut when facing headwinds.

Novartis has just announced a dividend of 2.95 CHF, which currently spots a 3.10% dividend yield (ideally > 2.75%). It is also a 4% increase compared to last year.

I have not found a clear dividend policy written down in their investor relations section on the website, but I think it’s safe to say that management intends to continuously grow the dividend. This is exactly what they have been doing since 1996, the year that Novartis was created in its current form.

The dividend growth over the last 5 years has been rather low with an average of 1.8%. I prefer to see this rather around the 6%, especially in a bull-market like this, because I will need such dividend income growth to support my Financial Independence and Retire Early (FIRE) plans.

The EPS payout ratio is 56% (2.95/5.28) and the FCF payout ratio is 52% (2.95/5.71). Both payout ratios are good, because ideally I generally prefer to see a payout ratio below 60%.

Maybe this is also the reason why the dividend growth has been rather low in the last several years. Management seems to prioritize a healthy balance sheet over excessive shareholder return, because the 5 year average FCF grow has been in the low-single digits and they payout ratio is already pretty decent. To a conservative income investor this doesn’t justify high-single digit dividend growth.

I actually like a financially conservative management approach, because as a dividend growth investor I want them to first of all focus on growing the business in a sustainable manner so that dividend can grow as a result of that.

As discussed earlier, Novartis is firing on all cylinders and the company guidance is to grow its earnings in high-single digits or low-double digits. This should provide Novartis ample room to grow its dividend going forward and hopefully next year with at least high-single digits as well.

Management Quality

This topic is maybe less analytical, but as investors we put a lot of faith in the captain that is steering the ship. Therefore I find it important to understand them a bit as well, because their quality and trustworthiness is important in the direction of the company.

Since 1 February 2018, Novartis is headed by Vasant Narasimhan. Mr Narasimhan is known as a digital-savvy CEO who understands what the impact of big data is on the future of Pharma.

In one of the recent articles that I read he was mentioning the learnings that Novartis was taking regarding Data Science. Effectively it came down to the fact that they need to clean-up and prepare their internal systems in a consistent way to be able to start leveraging data science capabilities, because so far it has been tough and pretty disappointing.

When I read that, he won already several credits with me, because I know quite a bit about IT and big data and I am glad that I hear a CEO talking about this in a vulnerable and no-bullshit way. For me this means that he is probably objective in his actions and I think that this limits confirmation-bias for past actions and believes.

I found the following interview pretty good to get a feeling of what kind of CEO he is: how to be a boss in an unbossed company

Well it’s good to get a feeling about the CEO, I also find it important to look at the hard facts by checking out the US violation tracker.

Just to set the record straight: it’s almost impossible to find a global company without any violations. Therefore I tend to more look at the competitive landscape and from there it’s clear that Novartis as a company shows a pretty good integrity. For instance, Johnson & Johnson had an almost 3 times higher amount in fines.

Last but not least, looking at recent spin-offs and acquisitions then I am also coming to the conclusion that the track record of Novartis from the last few years is a bit mixed and still needs time to proof whether it brought substantial shareholder value.

The spin-off of Alcon had a net positive result for shareholders and as an independent company Alcon can now proof that it’s able to grow faster than under the parent.

However, when looking at its most recent acquisitions, then I am not so optimistic yet. Avexis was purchased for 8.7 BLN back in 2018 and one of their main gene-therapies in their portfolio delivered ~361 MLN in sales last year. Novartis is expecting a lot from their expertise, but I would like to see more accretive earnings already.

Having said that, I am quite optimistic that Novartis has the right CEO to lead them into the next decade which I think will be defined by Personalised Healthcare driven by new insights and the abilities that big data and data science enable in this space. This CEO gets that.

Valuation

Now that we have some insights in the company and its financial performance, let’s check if the stock is fairly valued compared to its current stock price of 95.61 CHF per share.

In simple terms, I like to look at the valuation from different angles. The first one is the Price to Earnings and the Free Cash Flow to earnings ratios. These typically give good rule-of-thumb indicators.

Besides that I analyze the fair value of the stock via the dividend discount model and the discounted cash flow method.

• The current Price to Earnings is 18.10
• The current Price to Cash Flow is 16.74

Both ratios makes me optimistic already given the current bull-market. I typically prefer to purchase companies which have for instance a PE ratio lower than 20.

Another way to look at these valuation multiples is to compare it with the S&P 500, which currently spots a 25.43 PE Ratio.

When inserting the variables into my dividend discount model calculation, then the fair price is indicated to be 118 CHF. I assumed a 5% growth rate in dividends going forward and a 7.5% weighted average cost of capital.

A discounted cash flow (DCF) calculation is a bit more difficult to perform and has a higher sensitivity in output based on the variables. But based on my analysis and taking the FY 2019 results into consideration, I believe that the fair value for Novartis is 95.06 CHF based on the DCF.

Looking at both the DDM calculation and the DCF calculation, then the average of the two would make the result of my fair value analysis to be 106.53 CHF.

The above DCF & DDM calculations don’t yet take a margin-of-safety in consideration. A stable company like Novartis I prefer to purchase with a margin of safety of 15%.

That would make my recommended purchase price for the stock 90.55 CHF.

Risks

Before closing out, I would also like to highlight some of the current risks that I consider when owning Novartis AG.

First of all, for me the biggest risk for a negative impact of earnings at this moment time to is the presidential election in the US. Bernie Sanders is a front-runner in the election and if he gets to become the next POTUS, then we can expect a strong push for a single-payer healthcare system in the United States.

Novartis earns 35% of its sales in the United States. As an example, a 20% decline in sales would have a severe impact to its net income and would likely temper future dividend growth.

Secondly, and this is a very typical risk for any pharmaceutical company, is the risk that new R&D will not be successful enough and fails to replace existing products that at a certain time will lose their patents.

Thirdly, the coronavirus will become a pandemic and hinders the supply chain of drug manufacturing and in particular any drugs manufactured in China.

Last but not least, it might be worth having a look at the risks that Novartis identified themselves in the latest annual report (page 5).

Final thoughts

As per the title of this blog post and based on the above analysis, I believe that these are the 5 main reasons to consider initiating a position in Novartis:

1️⃣ The company is currently firing on all cylinders with a whopping 9% sales growth. I feel confident that EPS growth with follow, also based on the company’s guidance.

2️⃣ Novartis has a healthy balance sheet and it has enough room to increase its spending in R&D or further acquire other companies

3️⃣ The dividend is safe and has enough room to grow. Although growth in recent years has been moderate, I see no reason why the company can’t grow the dividend in the upcoming years and above the latest 5 years dividend growth rate.

4️⃣ They seem to have the right CEO at the right moment in time.

5️⃣ My fair value calculation is 106.53 CHF. This provides a margin-of-safety of ~10% based on the current share price of 95.61.

Take in consideration though that the dividend hasn’t been growing that much in the last few years and that it requires the company to execute on their plans as per guidance and as per general expectations.

Having said that, I am considering initiating a small position in Novartis AG if the share price drops to 90.55 CHF.

Notes:
1. Novartis is going ex-dividend on 28 February 2020.
2. Novartis is based in Switzerland. This means a 35% withholding tax-rate on dividends.

DISCLOSURE: I do not own SWX:NOVN, but I might consider initiating a position in the upcoming days if the share price dips to ~90 CHF.

DISCLAIMER: I’m not a certified financial planner/advisor nor a certified financial analyst nor an economist nor a CPA nor an accountant nor a lawyer. I’m not a finance professional through formal education. I’m a person who believes and takes pride in a sense of freedom, satisfaction, fulfillment and empowerment that I get from being financially competent and being conscious managing my personal money. The contents on this blog are for informational and entertainment purposes only and does not constitute financial, accounting, or legal advice. I can’t promise that the information shared on my blog is appropriate for you or anyone else. By reading this blog, you agree to hold me harmless from any ramifications, financial or otherwise, that occur to you as a result of acting on information provided on this blog.

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With best Regards,

— European Dividend Growth Investor