With Novartis (NYSE: NVS ) in the midst of a business transformation process and management projecting significant improvements, investors are a little less interested in quarterly results for the time being. Results for the second quarter were OK, but sluggish growth in Pharma highlights the importance of good clinical data on LCZ696 in heart failure and progress over the next 12 months in the immuno-oncology portfolio.
The Street is pretty bullish on these shares, though the performance on a year-to-date basis has been more middle of the road between the likes of Merck (NYSE: MRK ) , Bristol-Myers (NYSE: BMY ) , Pfizer, and Roche. It would seem that a lot of optimism on LCZ696 and margin improvements is getting worked into the shares and while stronger-than-expected data on LCZ696 and/or the immuno-oncology portfolio would be well-received, I think investors already expect more from Novartis than virtually any other Big Pharma company.
A slight miss isn't a major problem ... yet
Novartis reported OK second quarter results, as sales and operating profits were slightly below expectations on a "core" basis and would have been a little weaker still if the discontinued operations (including the vaccine business being transferred to GlaxoSmithKline) had been included.
Revenue rose 2% on a constant currency basis, with Pharma up 1%, Alcon up 4%, and Sandoz up 4%. Consumer (which is going into a JV w/ Glaxo) was up 5%, while Vaccines were down 14%. Within Pharma, Glivec remains the revenue leader, with sales up 1% to $1.2 billion, while Gilenya was the fastest-growing major drug (up 29% to $606 million).
Gross margin declined a point from last year, but operating income rose 6%. Pharma led the way with 8% operating profit growth, while Sandoz saw profits up 3% and Alcon profits rose 2%. All told, this was a pretty solid result for Pharma from a margin perspective and a strong performance for Alcon, helped by a lower mix of equipment in the sales. Sandoz was relatively disappointing though not to a large degree.
Will LCZ696 deliver?
Investors and analysts were pleasantly surprised when the PARADIGM-HF study was halted early due to surprisingly good efficacy. The history of clinical development of heart failure drugs has been rather poor and this good news has raised hopes that LCZ696, a combination of Diovan and a neprilsyin inhibitor, can be one of the few drugs to show meaningful benefit and take advantage of what should be a multibillion-dollar market.
Given that the target for the PARADIGM-HF study was a 15% reduction in mortality, an early halt for positive efficacy would suggest a significantly better benefit – perhaps north of 25%. While there are around 11 million people in the U.S. and Europe with congestive heart failure, around half of those have reduced ejection fraction and would be likely candidates for this drug. At a price of $3,500/year (in line with Bayer's Xarelto), that would be a market opportunity in excess of $18 billion.
Not all of the 5.5 million or so patients with reduced ejection fraction will be in that patient pool (about two-thirds are/will be treated with drug therapy) and the actual annual price may be lower, but this is still a very large opportunity for Novartis. I would think that Novartis will need to show a 30% or better improvement in mortality to really maximize its potential and the effective price may be lower, but 50% share of the two-thirds getting drug treatment and a $2,000/yr ASP is still a $3.6 billion opportunity.
Right now analysts are estimating $1.5 billion in 2018 sales. Remember that most analysts use risk-adjusted numbers in the models so "$1.5 billion" can really mean something closer to $2.5 billion. All that said, it would seem that the market is already pricing in more than $3 billion in sales, so Novartis really does need to deliver good data on August 31.
Late to the immuno-oncology game, but this is a long race
Other than its CART-19 platform, Novartis had been seen as a laggard in the immuno-oncology field behind the likes of Bristol-Myers, Merck, and Roche. The acquisition earlier this year of CoStim changes that perception to some extent. With CoStim, Novartis gains opportunities in PD-L1/PD-1 as well as less crowded opportunities (for now, at least) like LAG-3 and TIM-3.
The immuno-oncology story is going to play out over a decade or more, and this is why I've been a little skeptical about the hype over the programs at Bristol-Myers and Merck; just as almost every Big Pharma eventually had a statin, there will be many immuno-oncology competitors. With that, taking an early lead may be exciting for shareholders, but likely won't mean much in terms of durable market share. Novartis is behind, but the company appears to be taking a broader approach to the market, more akin to Roche in at least some respects, and that may ultimately be a better strategy compared to Bristol-Myers' early mover advantage and Merck's partnering strategy.
The bottom line
Unless investors are prepared to use a very low discount rate, Novartis's share price already seems to factor in expectations for close to double-digit annual FCF growth for the next decade. That is one of the largest/strongest growth expectations in Big Pharma. It's not impossible – congestive heart failure, immuno-oncology, combo therapy for breast cancer, and smart contact lenses could all be huge opportunities – but it's not exactly a conservative expectation. What's more, management has been fairly aggressive in projecting significant margin improvements in the coming years (despite the need to invest in immuno-oncology and, presumably, support an LCZ696 launch). Add it all up and Novartis really has its work cut out to deliver results strong enough to exceed these elevated expectations.
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