High-Risk Pipeline Candidates and Limited Options Make Novartis an Iffy Buy Candidate

With the markets as strong as they are, it's getting harder and harder to find solid, undervalued names to add to a portfolio. While Novartis (NYSE: NVS  ) is basically in good shape, investors are already fully on board with the bullish thesis, perhaps even expecting too much from some high-risk/high-reward pipeline programs. I'm also concerned that Novartis has only limited scope or flexibility in making truly transformative moves. Worst of all, though, I believe that the Street is simply too willing to price in low risk to this name, suggesting to me that the capital appreciation potential is not all that great relative to other big pharma names.

Novartis seems in no big hurry to get smaller
Novartis management has been hearing calls to break up the business almost from the quarter after they put it all together, but management seems more inclined to improve the hand they hold rather than sell pieces. True, Novartis sold its blood diagnostics business to Grifols for the not-trivial sum of $1.7 billion, but management seems to be playing it smart with the rest of its portfolio review -- not rejecting the prospect of further sales or restructurings outright (which would antagonize some investors and analysts), but certainly doing nothing to stoke the idea that they feel they must move.

Novartis does have a subscale business in vaccines, and investments into that business have pressured profits recently. I suspect that the company would like to just restructure the business (cutting costs to return to profitability) and see how the new Bexsero vaccine plays out, as some believe this meningitis vaccine could be worth several billion dollars a year in revenue. Failing that, Pfizer (NYSE: PFE  ) would seem to be the best, and maybe only option -- Pfizer has enough scale to make this a worthwhile addition, while GlaxoSmithKline, Sanofi, and Merck would all likely raise regulatory concerns.

Outside of vaccines, animal health is the most likely business to go. The synergies between consumer health and pharma would argue for keeping it, to say nothing of the growth prospects in emerging markets like China. The animal health business would be a much easier sale, and Novartis has reportedly already opened its books to Bayer and others in a sale that could bring in around $4 billion.

Pharma growth may be riskier than some think
There's no doubt that Novartis has some very interesting drugs in late stage filing and/or awaiting approval, and the company said during its recent analyst day that it expects 20 filings and 15 approvals over the next two years. The trouble is that many of the high-potential compounds have real questions attached.

Novartis is the only major drug company outside of Amgen  (NASDAQ: AMGN  ) to really be focusing on heart failure, and the company has two drugs here. Serelaxin has already been filed for acute heart failure, while investors should see phase 3 data on LCZ696 in chronic heart failure in the second quarter of 2014. Together, these two drugs could generate $5 billion or more in sales; heart failure is a critically underserved market, as big pharma has tried and failed for years to develop effective drugs.

Unfortunately, serelaxin's commercial success likely rests on a confirmatory study of survival benefit (RELAX-AHF2) that would read out until 2016 and could very well fail. LCZ696 is also a very high-risk opportunity, as the details of the phase 2 data (including biomarker reduction between weeks four and 36) raise question about its ability to really manage this disease.

Novartis may also be overselling its prospects in dermatology, where I think secukinumab may be hard-pressed to distinguish itself from Johnson & Johnson's Stelara and rival IL-17 compounds from Amgen and Lilly that have looked even stronger in early stage studies.

Where I am more enthusiastic about Novartis is in the oncology business. Novartis may not have quite the heft or reputation in immunotherapy as Roche or Bristol-Myers Squibb, but I think the company's CART-19 compound CTL019 could be something really special in hematological cancers and the CDK4/6 compound LEE011 may well be a very serious challenger to Pfizer's CDK4/6 drug palbociclib, which has wowed in early stage studies in breast cancer.

Blocking-and-tackling always matters
Outside of the "sexy" stuff, Novartis still needs to keep its other operations moving forward. Although Novartis doesn't have much of a position in branded biologics, the company has multiple biosimilar programs in late development. I also think that Alcon is coming along well, with a balanced split between new surgical products, late-stage drug candidates, and capacity additions in the lens business.

There's also likely to be a steady buzz about Novartis buying and selling. Analysts have been speculating about Novartis selling its stake in Roche (NASDAQOTH: RHHBY  )  (about 6% of share capital, but one-third voting control), but that's a tricky proposition. Novartis wants a premium for that voting power, but the most likely buyer (Roche), has no particular need to buy it, and certainly not at a premium, when there are other moves the company can make in pharmaceuticals, diagnostics, and/or life sciences that would actually boost growth and cash flow.

If Novartis can't sell, they could certainly still buy. It sounds like management would be interested in pharma-oriented M&A, particularly in that $3 billion to $5 billion sweetspot.

The bottom line
I'm looking for Novartis to grow revenue at a long term rate of just over 3%, which is actually pretty bullish compared to most sell-side estimates and its big pharma peers. I do also believe that Novartis will manage some restructurings and portfolio transitions that support more effective cash flow generation, leading me to estimate almost 6% long-term free cash flow growth. Discounting that back, I believe Novartis is fully valued, if not modestly overvalued, at today's price.

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