An Interview With Harry Kirsch, CFO of Novartis

Novartis (NVS 1.93%), one of the world's largest and most diversified pharmaceutical companies, made headlines recently after announcing multibillion dollar deals with peers GlaxoSmithKline and Eli Lilly. These deals will strengthen Novartis' oncology portfolio and change several aspects of its business.

To gain more insight into Novartis' long-term strategy, Max Macaluso, The Motley Fool's health care bureau chief, spoke with Novartis' Chief Financial Officer, Harry Kirsch.

A full transcript follows the video below.

Max Macaluso: Hi, I'm Max Macaluso, the health care bureau chief at The Motley Fool, and joining me today is Mr. Harry Kirsch, CFO of Novartis. Mr. Kirsch, thank you very much for joining us today.

Harry Kirsch: Thank you very much for having me.

Macaluso: Mr. Kirsch, you joined Novartis in 2003. I'm curious, how has the pharmaceutical industry changed in the last 10 years plus, and how has Novartis adapted to these changes?

Kirsch: I think it's a very relevant question. Certainly for me, being now more than 10 years with the company, it's very good to step back and look at the big changes.

Of course, when I joined Novartis I was also looking at the pipeline and the strength of innovation. I think the key changes that I have seen is that, in the industry, companies that keep trying on marginal innovation have difficulty.

Companies that can create breakthrough therapies, as well as really going after the unmet medical needs, have advantages because, in the increasingly difficult health care financial environment -- and we have felt this especially during the 2008 to '12 time frame, behind the financial economic crisis -- of course only really innovative medicines and health care solutions can command respective premium pricing.

I think that is what has changed mainly -- that successful companies, including Novartis, have shifted their focus early enough to really breakthrough innovation and going after unmet medical needs, rather than chasing the next incremental benefit of existing therapies.

Macaluso: Let's continue talking a little bit about innovation. I recently had the pleasure of talking with Bernard Munos. He's the founder of the InnoThink Center for Research in Biomedical Innovation. He's also a consultant to the big pharma industry.

He's been very impressed with Novartis' culture of innovation, so I'm curious; going along with your last point, how does Novartis incentivize scientists to go after really breakthrough medications?

Kirsch: You would have to ask also Mark Fishman, our head of research, or Tim Wright, our head of development around this. But certainly the culture that has been created is really to make sure that all the researchers and the multifunctional teams look for unmet medical needs. How can we help patients? Also going after, maybe orphan drug indications -- not only chasing the next big blockbuster, but really go where there's a big medical need.

That passion and, overall, the culture for innovation and also pathways approach, really has helped to move the culture of innovation ahead at Novartis.

I think our track record of more than 200 programs in our pipeline, and the clinical development of 144 of these programs in the pharmaceutical division, are impressive. By now we have four breakthrough designations from the FDA.

Of course, one can never be satisfied, but that culture of going after unmet medical needs and after pathways -- and not immediately, very early on, looking for the financial benefits, which are very hard to forecast.

That's maybe one thing I can add as the CFO as I grew up through the operations. In the early days, maybe 10, 15, 20 years ago, probably we tried to forecast too early. One thing you can be almost sure of is that, in the early stages of development, nobody knows how much a certain medicine will deliver, in terms of sales profit.

But what we know is if there are unmet medical needs; will it solve a health care problem or not?

We have several examples -- like Gleevec and other products -- where then all of a sudden a huge market expands and, besides doing good and having great medicines, also the financial rewards come, that are of course needed in a high investment industry like pharma and health care.

Macaluso: You touched on several interesting things there. First, going after blockbuster drugs, which is common in the industry. Also, another challenge over the last few years, really throughout the whole industry, has been the patent cliff. Virtually every company has been hit by this. Of course, every company has a different strategy to prevent another patent cliff, or to just mitigate the effects of it. What has Novartis' strategy been over the last few years?

Kirsch: This is also a very timely question, because when I, almost 11 years ago, joined the company, everybody knew that in 2011, '12, and '13, Diovan -- basically our biggest product, that had peak sales of more than $6 billion -- would go off patent.

It's not a cliff -- it's more of a slide -- but still, over two or three years, losing the majority of $6.5 billion is a challenge. The key answer has been really, how to step change innovation, how to drive that culture of innovation internally, but also be very open about external collaboration. That's the second pillar, and the third one is emerging markets growth.

We've already discussed number one, which is driving internal innovation and attracting great researchers and developers. The second one is to be very open and be a partner of choice for BD&L -- business development and licensing -- deals.

Several of our current growth drivers and blockbusters have been in-licensed, and that's a testimony that we have been very successful in that area. A lot of innovation, of course, for any pharma company, is happening outside of that pharma company. That's an important piece of the success as well.

Thirdly, also making sure that we do not only focus on the Western markets, but also go after needs in the emerging markets. There, we had very good success. For example, last year we grew 10% in constant currency in the emerging markets -- our sales -- led by China, with more than 20% growth, were also very successful.

But I think, in summary, all three things accelerate further -- breakthrough innovation; number two, very active on in-licensing, recognizing a lot of good innovations wherever those are happening outside of the company and be the partner of choice; and thirdly, look also about emerging market opportunities.

Macaluso: Let's shift gears a little bit and talk about a recent deal that Novartis entered with GlaxoSmithKline. It's quite a complex deal, that has many moving parts, but it's fundamentally changing Novartis' business, and also its drug portfolio.

Mr. Kirsch, let's start by talking about the acquisition of GlaxoSmithKline's oncology business. Why is this an area that Novartis is keen to expand?

Kirsch: Maybe let me give you a short overview, before I dive into the different pieces, and also step back and say what has been our strategy. When we step back, the executive team -- Joseph Jimenez and with our board -- we certainly looked at, what are the next 10 years? What do we expect from the health care industry?

Certainly, there will be quite some changes coming up, and also there will be further payer pressure, given the aging population which is, at first I would call it a great thing for health care and pharmaceuticals. On the other hand, we believe also this will reward mainly companies who are innovative, and are thriving and leading businesses with global scale.

As we stepped back and then announced somewhere last year that we're doing a portfolio review because we had, and we have, three leading businesses -- pharmaceuticals, including oncology; Alcon in eye care; and Sandoz, our generic arm -- all of these businesses are number or number two. They have $10 billion or more; like pharma, more than $30 billion in sales.

These are businesses at global scale, leading. But then we had three other very good businesses, but more subscale -- vaccines, over the counter products (OTC), as well as animal health.

Then, in discussions with other pharma companies who also have subscale assets, we thought that it would really be good to strengthen one or two of our businesses, as well as creating leading businesses for our subscale businesses, and to potentially other companies.

I would call this the targeted, or precision M&A approach, which I personally like much better than the big merger/acquisition approaches, because in the end it creates, from my standpoint, a clearly win/win situation.

Then we jump now into maybe the different parts of the deal.

We acquired GSK's oncology products and clinical trials on these products, strengthening further our oncology and pharma business. On the other hand, upon closing we divested our vaccines business, excluding flu, to GSK where they have a leading business. Then created a joint venture on consumer health, which will have the combined sales of about $10 billion. Many synergies are to be expected here, be it on the top line as well as on the bottom line.

Those are the three elements of the deal that we have signed with GSK. Then we have divested our animal health business to Eli Lilly for $5.4 billion.

Those are the four pieces of, as I mentioned before, what I call a "targeted M&A" approach, which I believe will create very good win/win situations for all companies involved.

Macaluso: Right, that's an excellent overview.

Looking more deeply into the joint venture with Glaxo, I'm curious, what's the advantage of keeping a joint venture, versus just selling off that unit?

Kirsch: First of all, we believe in the attractive future of the OTC consumer health business, so we'd like to be part of it. On the other hand, as you may know, our consumer and animal health business had some quality issues three years ago and we were still recovering, which is expressed in our relatively low margins of the OTC business.

It was about 10% profit margin in 2013, and from that standpoint, we were looking for opportunities to maximize shareholder value, but in of a recovering business.

When you look at the profit share the OTC business had in 2013, of that joint venture, and now we have the ownership, after signing, of 36.5% of this combined $10 billion consumer health business. This gives us basically a complete recovery value, as well as a significant share of the significant synergies we are expecting.

We felt, and we have of course benchmarked this as well, that this is creating far more shareholder value than a straight divestiture, for example, as an alternative.

Macaluso: I also have a question about the animal health deal. In the traditional big pharma model, it's really relied on animal health to provide a source of more stable cash flow to help fund some of the riskier R&D projects, so why divest from this business?

Kirsch: Our animal health is a fundamentally good business. However, in our hands it is a bit more than subscale. It's $1 billion of sales. It operates on a worldwide basis and, for that, $1 billion is very small, and from a profit standpoint, it's breaking even right now.

When looking at potential different opportunities, the most value-creating solution was that our animal health team and products would join Eli Lilly and further strengthen their leading animal health business, fundamentally creating better value being a part of a leading business, rather than staying subcritical and not returning enough shareholder value.

Macaluso: Just looking at Novartis' businesses, today, what do you think the company's biggest opportunity is, if you were to pinpoint just one?

Kirsch: I think our biggest opportunity is to continue to drive our culture of innovation, on the one hand -- that will fuel growth. At the same time, also capture productivity benefits.

Now, this I strongly believe is best done by managing leading businesses with global scale. That's I think what this portfolio -- and the conclusion of our portfolio review -- we are creating these three leading businesses, all of them with investments and very significant innovation opportunities.

Also, once we close these transitions, we really have transformed our company into a much more profitable, more focused, and financially stronger portfolio, on top of innovation, growth, and productivity opportunities.

Macaluso: One last question; we're quickly approaching the end of the first half of 2014, so what are the expectations for Novartis for the rest of this year?

Kirsch: As you know, we have given our outlook and have reconfirmed our outlook of low- to mid-single-digit rates growth in 2014, and core operating income in constant currencies growing ahead of that, so margin accretion in constant currencies.

We are basically working through the last part of our Diovan patent situation so we expect, together with some smaller products, more than $2 billion of generic impact. Underlying growth is in the high single digits, but we are working through that.

At the same time, we are innovating and we have a very good new flow. You may have seen also that one very promising trial of LCZ for chronic heart failure has been stopped early. While it's too early to get too excited -- data will come out in September -- there is a strong new flow coming, as well as the underlying sales growth.

It's promising, given that we have a strong in-market launch portfolio that can more than offset the generic impact.

Macaluso: Once again, Harry Kirsch, chief financial officer of Novartis. Mr. Kirsch, thank you very much for joining us today.

Kirsch: Thank you very much for having me. Bye-bye.