NVSEF - Novartis: Healthy Results

Summary

• Novartis reported revenues and earnings that were down year over year.
• Currency rate movements were responsible for that, however, Novartis' underlying performance was pretty solid.
• The company offers a nice dividend yield and should be able to deliver very solid returns in the long run.

Article Thesis

Novartis AG ( NVS ) reported its third-quarter earnings results that saw revenues decline on a year-over-year basis when denominated in US dollars. That can be attributed to the US dollar's strength, however, as Novartis' underlying results were very solid in constant currencies. Right now, the company is negatively impacted by interest rate movements, but the US dollar will likely not continue to strengthen forever, which is why this near-term headwind for Novartis' results should wane eventually.

The US Dollar's Strength

There are many factors at play when it comes to currency rate movements. Among them are different economic growth rates or macro pictures, differences in interest rates, as well as (perceived) risks when it comes to the likelihood of a financial crisis, etc.

In recent months, thanks to comparatively low energy costs and above-average interest rates, the US dollar has strengthened quite a lot vs. currencies such as the Euro and the Yen, as interest rates are still way lower in the Eurozone and Japan, even though there is above-average inflation there as well.

While the US dollar was equal to €0.8 to €0.9 most of the time over the last five years, it has recently run up quite a lot, becoming even slightly more valuable than the Euro. This is good news for Americans traveling to Europe, but it hurts the revenue performance of companies that have significant European operations, at least when they announce their results in US dollars instead of Euros. Novartis, which is headquartered in Switzerland but does most of its business in the surrounding Eurozone, is one such company with large Euro exposure that reports its results in US dollars.

The recent weakness in the Euro has had a significant negative impact on Novartis' reported results, as we can see in the following screencap:

Essentially, everything has been moving in the right direction on an underlying basis, i.e. when it comes to the actual business performance at Novartis. But exchange rate movements resulted in major headwinds when it comes to reported results, which is why GAAP revenue was down year over year, across both NVO's Innovative Medicines business and its generics medicines business Sandoz that the company plans to IPO next year.

Novartis' Underlying Performance Was Very Healthy

For US-based investors, the revenue decline in their currency isn't good news, but I do believe that the underlying business performance is more important in the long run. When a company manages to grow its business in constant currencies, via the development of new medicines, via increased marketing efforts, and via M&A, then eventually, GAAP results will improve as well, as it seems highly unlikely that currency rates will always move in the wrong direction - at least to me, it seems highly unplausible that the US dollar will continue to strengthen forever (although it may very well do so in the near term).

Novartis managed to grow its revenue by 4% year over year at constant currency rates, which is a solid result for a big, diversified pharma company. Pfizer ( PFE ) is showing stronger growth, but that's due to COVID vaccine sales and Paxlovid sales, neither of which will be long-term growth drivers. In general, big pharma companies do not grow their revenues at very high rates as they have to balance out the revenue losses from drugs that lose patent protection, and since the law of large numbers dictates that maintaining high growth rates is easier for smaller companies than for large, established ones. Pfizer's revenue growth rate prior to the recent COVID spike was less than 4% annually, while Roche ( OTCQX:RHHBY ), another Swiss pharma giant, saw its revenue grow by around 4% a year over the last decade. With a similar underlying growth rate, Novartis thus doesn't have to hide at all, as maintaining growth at that level would be more than sufficient to generate compelling total returns in the long run.

Novartis' earnings per share declined as well on a GAAP basis, but that was again driven by forex rates. In local currencies, earnings per share would have increased compared to the previous year's quarter.

Not Too Much Growth Is Needed For Novartis To Be A Solid Investment

When we assume that currency rates won't move against Novartis forever, I do believe that there's a good chance that the company will deliver very solid returns in the long run. A 4% annual revenue growth rate could be more than enough for attractive annual returns, as there are several more factors at play. First, the company could be able to increase its margins as long as it controls its costs tightly, although that may not be possible at all times.

But earnings per share will likely grow more than revenues in the long run due to another factor - share repurchases. Those make the share count decline over time, which means that company-wide profits are distributed over a smaller number of shares, increasing each remaining share's portion of the total. When a company grows its revenue by 2% a year, for example, and takes out 2% of its shares per year while keeping its margins stable, that would result in 4% annual earnings per share growth.

Novartis currently has a $15 billion share repurchase authorization in place, which covers around 9% of the company's market capitalization at current prices. The company won't spend that much per year, of course, but even if that is spent over several years, it will have a meaningful impact over time. Over the last year, the company's fully diluted share count declined by a little over 2%, thus a 2% annual EPS tailwind from buybacks is far from an aggressive estimate.

Novartis' underlying business will likely continue to experience some growth as well, as global healthcare spending continues to rise, which makes for a positive macro environment for big pharma. Novartis has recently received some positive news regarding its product portfolio, such as iptacopan , which had strong phase III results in paroxysmal nocturnal hemoglobinuria ('PNH'), a rare type of blood cancer. Novartis also has recently gotten approval for Pluvicto for the treatment of prostate cancer in the European Union. Some of Novartis' younger drugs that are already on the market continue to show a very strong performance as well, such as MS therapy Kesimpta, which recorded 170% year-over-year growth during the third quarter.

Novartis also is battling some patent expirations, which is why its older MS therapy Gilenya saw its revenue drop by more than 20% both on a GAAP basis and in constant currencies. But during the third quarter, Novartis was able to more than offset this headwind via the strong performance of other drugs in its portfolio, and that could remain the case as Kesimpta will be taking over Gilenya's spot over time.

Between some business growth and buybacks, I do believe that a 4%-6% annual earnings per share growth rate is very much achievable. When we assume that buybacks will continue at a 2% annual pace, that would require just 2%-4% annual revenue growth in the long run. And thanks to Novartis' generous dividend, a 4% annual earnings per share growth rate would be more than sufficient. At current prices, Novartis' dividend yield is 4.3%, based on an annual dividend of $3.33 per share that's always paid in spring. Currency rate movements could make that number decline next year when denominated in US dollars, as has been the case in 2019 when the dividend was down 3% year over year in US dollars. But even if the dividend were to fall by 10%, the dividend yield would still be very solid, at 3.8%.

Novartis thus has a good chance of delivering 4%-plus annual earnings per share growth, and that's combined with a dividend yield of around 4% right now. All in all, that should allow for annual returns of 8% or more in the long run. That's not going to make anyone rich in a short period of time, but it makes for a very solid return from a low-risk, crisis-proven company that is active in a resilient industry.

The fact that Novartis is currently trading at just 12.8x net profits and at an enterprise value to EBITDA multiple of just 10.2 suggests that Novartis is an inexpensive pick today. In the long run, it thus might benefit from multiple expansion, which would have a positive impact on total returns, all else equal.

Takeaway

Novartis reported third quarter results that didn't look good at first sight, but that was due to adverse currency rate movements. Those will, I believe, not work against the company forever. The underlying business performance was healthy, and Novartis has a serious shareholder return program in place.

Overall, Novartis looks like a solid low-risk, low-volatility pick to me where investors get a dividend yield of around 4% and some share price appreciation potential on top of that.

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