KDNY - Novartis Buys Chinook: M&A To Drive Future Growth

2023-06-12 16:13:12 ET

Summary

• Novartis announced the acquisition of Chinook Therapeutics for $3.5 billion, boosting its pipeline and expanding into the kidney disease market.
• The deal can be paid for with around three months' worth of Novartis' free cash generation, and the company does not need to issue any equity to finance the acquisition.
• Novartis could deliver total annual returns in the 8% range if it can grow its earnings per share by around 4%-5% in the long run, considering its deep pipeline, M&A, and buybacks.

Article Thesis

Swiss pharma giant Novartis ( NVS )( OTCPK:NVSEF ) announced that it will acquire kidney disease drug developer Chinook Therapeutics ( KDNY ). The target rallied on the news, as a major takeover premium is being paid, but the deal could also make sense for Novartis, as this boosts its pipeline, which should improve the long-term growth outlook.

What Happened?

Novartis, one of the largest pharma companies in the world, announced that it will acquire Chinook Therapeutics in a deal that values the target at $3.5 billion. At the time of writing, Chinook Therapeutics is up 58%, which can be attributed to the fact that Novartis offered a hefty takeover premium of more than 60%. Chinook is still trading slightly below the $40 takeover price, despite the jump its shares have experienced on the takeover news.

On top of the $40 per share, Novartis could pay up to $4 per share over the coming years, depending on whether Chinook will achieve a range of goals. This includes development milestones for Chinook's most important asset atrasentan .

While the deal is huge news for shareholders of Chinook Therapeutics, the $3.5 billion deal price is not overly large for Novartis - the company generated more than $13 billion of free cash flow over the last four quarters, meaning the takeover can be paid for with around three months' worth of NVS' free cash generation. Not surprisingly, Novartis does not need to issue any equity to finance this deal, thus there's no dilution investors have to worry about. In fact, Novartis ended the last quarter with around $15 billion in cash and equivalents, thus the company could pay for several deals of this size in a short period of time.

The Chinook Takeover Boosts Novartis' Pipeline

Novartis is one of the largest pharma companies in the world, thus it naturally is active in different therapeutic areas. It also owns a deep pipeline with a wide range of drug candidates. Some of these are new developments, in other cases, Novartis seeks to get drugs approved for additional indications while already selling the same drug in other indications.

Novartis' pipeline includes candidates in areas such as solid tumors, hematology, immunology, neuroscience, and many more. In total, the company has 48 phase III studies in place right now, as can be seen on its website here . A pharma company with a large and established business such as Novartis needs a deep pipeline, of course, as existing drugs that have been on the market for years go off patent from time to time. While sales for off-patent drugs do not drop to zero immediately, they generally decline over time, thus these revenues have to be replaced via a combination of the following factors:

- Increasing the price of its products, thereby generating higher revenue per patient.

- Increasing the number of patients on the company's medication for existing products, e.g. by increased marketing spending or by entering new geographic markets.

- Adding new product lines, either via the introduction of new drugs or by receiving approvals for existing drugs in additional indications.

The last point is highly important, and M&A helps. While Novartis would sport a sizeable pipeline even without any takeovers, M&A can add to a company's growth potential. Importantly, pharma companies also can use M&A in order to boost their presence in markets that are deemed attractive (by the company's management), but where the company's in-house expertise is lacking or where its own development efforts have not resulted in attractive products.

Chinook Therapeutics is focused on kidney diseases, which is not a huge therapeutic area for Novartis yet. In recent years, Novartis generated the vast majority of its revenue and profit in other areas. The company's most recent quarterly report includes the following statement (emphasis by author):

We have a clear focus on five core therapeutic areas ( cardiovascular, immunology, neuroscience, solid tumors and hematology ), with multiple significant in-market and pipeline assets in each of these areas, that address high disease burden and have substantial growth potential.

Novartis thus has not had a big presence in Chinook Therapeutics' focus area so far, but it looks like management deems this an attractive market to expand into. Precedence Research reports that the global nephrology (kidney disease) market size was $16 billion last year, and it forecasts that this market will grow at a mid-single-digit rate through the early 2030s. This is thus a sizable market with considerable growth over the next decade, although it should be noted that sales forecasts may turn out too high or too low eventually. Still, it seems highly likely to me that the global nephrology market will expand considerably in the long run - aging populations in many industrial countries will result in rising overall healthcare spending, and at the same time, more and more people in high-growth markets such as China and India can afford effective treatments for themselves.

Chinook Therapeutics does not have any drugs on the market so far, but that holds true for many smaller pharma companies. A major pharma company taking over a development-stage pharma company is relatively common, and it makes sense for both parties: The acquirer gets an attractive pipeline asset without spending gigantic sums of money - just a couple of months' worth of cash flow in this case. At the same time, the acquired company benefits from increased funding and the acquirer's expertise when it comes to the regulatory process, and, eventually, commercialization of the drug once approved. A global giant such as Novartis can leverage the sales potential of a drug (once approved) a lot faster and more efficiently compared to a small pharma company that has not established itself globally yet. Such deals thus oftentimes make sense for both involved parties, although there is, of course, still some risk for the acquirer - it's possible that the acquired company's pipeline assets turn out to not perform as well as expected, and in a worst-case scenario, no drug will be approved. The good news is that this would still be easily stomached for a company such as Novartis - the worst-case scenario of spending $3.5 billion without getting any new drug out of this deal is not a company-threatening event at all.

Chinook Therapeutics' lead agent, atrasentan , is being evaluated for the treatment of IgA Nephropathy. There are competing drugs on the market, such as Calliditas Therapeutics' Tarpeyo, which was the first IgAN treatment to receive approval in the US. But since Tarpeyo was approved not too long ago, it's not too late to enter this market with a new drug. It's expected that this market will expand significantly in the coming years, and it seems likely that more than one company can make money selling an IgAN treatment. With NVS' global presence and established wide sales network, commercializing atrasentan would not be too hard - if the drug candidate performs well and receives approvals.

Is Novartis A Good Investment?

Large pharma companies with wide and diversified operations generally don't grow very fast, but they still generate solid growth via a combination of benefiting from overall market growth and the impact of M&A - which is common in the pharma world.

NVS has delivered compelling business growth in recent quarters, as core operating profit grew by a strong 15% during the first quarter. Growth will not always be this high, but luckily, 15% annual profit growth isn't needed to make NVS a solid investment.

The company trades at 14x this year's expected net profit, which is not a very demanding valuation. NVS also offers a dividend yield of 3.5% at current prices. When we assume that the valuation will not change too much in the long run and that the dividend payout ratio will roughly stay the same as it is today, then NVS could deliver total annual returns in the 8% range if it's able to grow its earnings per share by around 4%-5% in the long run. That seems like a very achievable target, I believe, considering the long-term market tailwinds for the healthcare industry, NVS' deep pipeline, its M&A, and its buybacks.

Novartis will not make anyone rich in a short period of time, and it doesn't promise the growth potential of AI stocks. But it has a solid growth outlook and could provide compelling risk-adjusted returns in the long run. Since shares are up considerably from recent lows, and since they currently trade close to the 52-week high, it could make sense to wait for a better buying opportunity, however. Shares are up more than 30% since we recommended them last fall - waiting for an equally good buying opportunity could boost investors' returns.

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