Is Novartis' Strategy a Winning One?

Shares in Novartis (NYSE: NVS  ) have underperformed the S&P 500 over the last five years, with the company's bottom-line also disappointing investors. Indeed, over the period, net profit has increased from $8.2 billion in 2008 to $9.3 billion in 2013, which equates to an annualized growth rate of under 3%.

During that time the company, under the leadership of Daniel Vasella, diversified its operations to include vaccines and generic drugs. The thinking was that the company would be better insulated from the peaks and troughs of the pharmaceutical industry, where patent expiry can cause sales to plummet.

With Daniel Vasella having recently been replaced as chairman by Joerg Reinhardt, Novartis is seeking a new direction. Is the new strategy set to be a winning one?

Patent expiry
As with many of its pharmaceutical peers, Novartis' list of blockbuster drugs is undergoing a number of patent losses. For instance, breast cancer drug Femara, has faced generic competition since 2011 when its active ingredient, letrozole, saw its patent expire in the US and in major European countries. Its sales fell by 12% to $384 million in 2013. In addition, patents protecting the Sandostatin LAR formulation, the long-acting version of Sandostatin (which represents the majority of Sandostatin sales), expire in 2014 and beyond in the U.S., but expired in July 2010 in key markets outside the U.S. Sandostatin was Novartis' fifth biggest selling drug in 2013, with nearly $1.6 billion of sales.

Seeking growth
Therefore, the previous strategy to diversify the business away from pharmaceuticals to include generics and vaccines seemed like a logical one. However, in an attempt to stimulate growth, new management is apparently seeking to divest (or pursue joint ventures) with Novartis' over the counter drugs, animal health and vaccines businesses. Indeed, the first action to reduce the size of Novartis' offering took place in November 2013, when it sold its blood-transfusion diagnostics business to Spanish company Grifols for around $1.7 billion.

The main reason for the potential divestments is that Novartis' new management is focused on building businesses where it can achieve scale and, more importantly, generate growth to counter the effects of patent expiration. This strategy seems to be somewhat similar to that currently being pursued by Johnson & Johnson (NYSE: JNJ  ) , with is focusing on building its divisions that are set to experience above-average growth, while those that are deemed slower growth are divested. The most recent example of this was the sale of Johnson & Johnson's blood testing unit to Carlyle Group, a private equity firm, for just over $4 billion in January 2014.

Of course, Novartis remains very much focused on pharmaceuticals, with the division accounting for 56% of total sales in 2013. Therefore, even if it were to scale back its other divisions, it would likely remain more highly diversified than sector peer Bristol-Myers Squibb (NYSE: BMY  ) . Although Bristol-Myers is also moving away from being a producer of mass-market drugs toward being a more nimble, specialist, niche player, it will continue to remain focused on pharmaceuticals. A major step that Bristol-Myers Squibb took recently toward reaching this goal was the sale of its share of the diabetes joint alliance with AstraZeneca for $2.7 billion, which will allow the capital to be reinvested in the company's research and development spend to stimulate its drug pipeline.

A logical strategy
While the potential changes at Novartis may appear to be significant, they may be less important than at first sight. For instance, the consumer health division (which includes animal health and over the counter medicines) accounted for only around 7% of sales in 2013. Indeed, despite previous management's desire to diversify, Novartis remains highly dependent upon its pharmaceutical pipeline to stimulate future growth.

Therefore, while a strategy shift may mean less stability in future (as the company relies to a greater extent on the ups and downs of pharmaceuticals for sales), it may not end up being the sea change that it appears to be. As a result, it seems as though new management's new strategy is logical and could turn out to be a winning one. Focusing resources on countering the patent expirations that have the potential to be the biggest drag on growth could mean that shares deliver an improved performance in future.

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