Novartis' Pharmaceutical Business Faces 2 Major Challenges

Diversified health care giant Novartis (NVS -0.13%) has had a fairly strong year so far, with its stock price outperforming industry peers GlaxoSmithKline (GSK -0.88%), AstraZeneca, Pfizer, and Merck by a wide margin.

Over the past week, Novartis has rallied another 5% to all-time highs following its third-quarter earnings report. Can Novartis keep climbing higher, or are there fundamental vulnerabilities investors should be aware of?

Source: YCharts.

A mixed third quarter
On the surface, Novartis' third-quarter earnings weren't that impressive. Its earnings per share fell 8% year-over-year to $0.91 per share as its revenue edged up 6% to $14.3 billion.

Sources: Company earnings report, author's calculations.

However, if we break down Novartis' revenue by segments, we can see that it posted double-digit growth in generics, which was boosted by its acquisition of skin drug manufacturer Fougera for $1.5 billion, as well as in consumer health care -- a segment where GSK and Johnson & Johnson have reported anemic growth.

An overview of Novartis' pharmaceuticals business
Novartis' pharmaceuticals division posted positive sales growth thanks to strong volume growth and higher pricing. Another positive catalyst was the lack of a generic competitor for its blood pressure treatment Diovan, which lost patent protection last year. Diovan was Novartis' second top-selling drug last year with sales of $4.4 billion in sales last year.

Looking forward, Novartis' pharmaceutical segment has positive growth catalysts, such as positive phase 3 data for its new psoriasis drug secukinumab and a breakthrough designation for its pipeline candidate BYM338 as a treatment for sporadic inclusion body myositis.

The rest of Novartis' pharmaceutical portfolio is a highly diversified one, with eight key drugs -- Gilenya, Afinitor, Tasigna, Galvus, Xolair, Arcapta Neohaler, Seebri Breezhaler, and Jakavi -- accounting for 39% of the segment's total sales, a 28% increase from the prior year quarter.

These rapidly growing drugs the key to Novartis' future, but they could also face two major challenges.

Challenge No. 1: Gilenya could be taken out by Tecfidera
First and foremost, Novartis' multiple sclerosis treatment Gilenya, which accounted for 7% of the pharmaceutical segment's revenue, should not be considered a new pillar of guaranteed growth.

Although U.S. sales of Gilenya soared 44% year-over-year to $273 million and 90% in the rest of the world to $245 million, the drug now faces a formidable competitor -- Biogen Idec's (BIIB -1.53%) Tecfidera, which was approved by the FDA in March.

Tecfidera, like Gilenya, is an orally administered treatment for MS. There are currently only three orally administered MS treatments on the market -- Gilenya, Sanofi's (SNY 0.68%) Aubagio, and Tecfidera. All other leading MS treatments, such as Teva Pharmaceutical's Copaxone and Biogen's Avonex, are injected.

However, Gilenya and Aubagio's side effect and risk profiles compare poorly to Tecfidera's.

Sources: FDA, company and industry websites.

In addition, Gilenya caused 15 deaths in patients with cardiovascular conditions, which prompted a full safety review in the EU and the U.S. last year. In July, another patient taking Gilenya developed a rare viral inflammation of the brain, which caused another FDA investigation.

Biogen's Tecfidera, by comparison, has a much milder side effect profile. Biogen also released interim data this month that showed that patients taking Tecfidera for at least four years showed no new problems.

In its first full quarter of sales, Tecfidera generated $192 million in sales for Biogen -- which indicates that it could catch up to Gilenya very quickly.

Challenge No. 2: GSK could threaten Novartis' respiratory portfolio
Three drugs that Novartis is counting on for future growth are respiratory ones.

The Arcapta (Onbrez) Neohaler and Seebri Breezhaler are used to treat COPD (chronic obstructive pulmonary disease), and Xolair treats asthma. The Arcapta Neohaler is approved in three major markets -- the EU, Japan, and the U.S.

Seebri is only approved in the EU and the U.S. Novartis recently gained approval for a third COPD treatment, the Ultibro Breezhaler, in the EU and Japan.

That high concentration on respiratory treatments puts the company on a collision course with GSK, which also has two potential blockbuster COPD treatments in its portfolio co-developed with Theravance (NASDAQ: THRX) -- Breo Ellipta (known as Revlar Ellipta in overseas markets) and Anoro Ellipta.

Breo Ellipta has been approved in the U.S. and Japan, and Anoro Ellipta was recommended for approval by an FDA advisory panel in September. Revlar Ellipta also received a favorable opinion from the European Medicines Agency's Committee for Medicinal Products for Human Use, which bodes well for a future approval.

Neither product has been launched yet, but GSK is counting on the success of these treatments to offset the eventual loss of patent exclusivity for its top-selling asthma medication, Advair, which generated $8.1 billion in sales last year.

Therefore, Novartis' new treatments could face competitive pressure over the next year as Breo Ellipta and Anoro Ellipta enter the market.

The Foolish bottom line
Although these vulnerabilities in Novartis' pharmaceuticals business won't be enough to bring the house down, investors should keep a close eye on recent developments at Biogen and GSK, which could alter Novartis' outlook considerably.

However, if Novartis continues concentrating on growing its generics and consumer health care businesses, the segments could easily help offset losses or unstable growth from its pharmaceuticals business.