2023-06-05 11:46:34 ET
Summary
- Novartis has significantly outperformed the market since my last article and is now a Hold.
- Most of the outperformance is due to multiple expansion.
- Earnings are likely to expand from both blockbuster drug growth and the Sandoz spinoff.
- Novartis is likely to continue to outperform the market but the risk-return profile is not as favorable as 18 months ago.
Background
Since my article 18 months ago , Novartis ( NVS ) has outperformed the overall market by a wide margin. Total return was 34% vs -5.7% for the S&P 500 over the same period.
The article stated that management should buy back shares using the additional cash flow from the Roche ( RHHBY ) stake disposition and higher earnings. Approximately, three weeks after the article was published, management initiated a $15B repurchase program. Over the past 12 months, the company has spent $11B on buybacks. At the time of publishing, Sandoz was under strategic review. In late August of 2022, management announced its divestiture, which is currently scheduled to be completed in 2H 2023. Bloomberg has reported rumors of a private-equity buyout for as much as $25B. This represents about 10% of NVS enterprise value and would yield additional cash to support growth, repurchases, and future acquisitions.
The company posted solid results in 2022 with 8% constant currency Core Operating Income growth. This was the Most Likely scenario for earnings growth in the article and was sufficient to keep the stock price flat while the overall market declined. On March 7 th 2023, shareholders approved additional share repurchases, and this marked the beginning of a spike in the stock price. On March 31 st , the company announced positive results for a Kisqali Phase 3 trial that caused the stock price to increase by 8%. On April 25th, management announced Core Operating Income increased 15% year-over-year in Q1 2023 and increased guidance for 2023 growth to be in the high-single digits from mid-single digits.
Thesis
Despite the outperformance of NVS vs SPY over the past 18 months, the stock is still fairly valued. The continued growth of blockbuster drugs such as Entresto, Kesimpta, and Kisqali should continue to outpace the decline of legacy drugs. As the newer drugs reach maturity, sales, margins, and cash flows should continue to increase. The increased guidance reflects this. Management has avoided overpriced acquisitions, and the increased buyback authorization suggests that capital will continue to be returned to shareholders.
It is possible that increases in future free cash flow will occur just before and during an economic downturn. In particular, the Sandoz divestment should close soon. Depending on the terms of the deal, this could lead to another influx of cash. If funding conditions become tight later this year, NVS could leverage this excess cash to profitably pursue acquisitions and partnerships. These countercyclical advantages make NVS worth holding.
Previous Forecast Evaluation
To evaluate the previous forecast, I used a Continuous Ranked Probability Score (CRPS). A range of possible scores for the forecast is shown below. The lower the score, the better the forecast. The best possible score corresponds with the Most Likely scenario.
The chart below shows the rolling 1-year returns of NVS with the date corresponding to the last day of the period. Until May 2023, the returns remained close to the Most Likely scenario. However, the most recent good news pushed the performance of the stock between the Best Case and Maximum scenarios.
As shown below, the CRPS performance degraded starting in early May and suggests that the forecast needs to be reevaluated.
Key Inputs and Scenarios
Multiple expansion and earnings growth are estimated for five different scenarios: Minimum (0 th percentile), Worst Case (10 th percentile), Most Likely, Best Case (90 th percentile), and Maximum (100 th percentile). Historical data, current data, management estimates, and best guesses underlie the following assumptions.
Base Case: Free cash flow yield of 6.8% over the past twelve months
Multiple Expansion: The lines on the following chart show the forecast multiples over the above scenarios.
Next, the Most Likely scenario is assumed to equal the Base Case. Forecast multiple % changes from the Base Case (Most Likely) are shown in the table below.
Forecast Income Growth
- Minimum: 0% growth
- Worst Case: Low end of management guidance for sales growth of 4%
- Most Likely: Management guidance for Core Operating Income growth ~8%
- Best Case: Management guidance for Innovative Medicines Core Operating Income growth ~12%
- Maximum: 2023 Q1 year-over-year growth of 15%
As with multiple expansion, the Most Likely scenario is assumed to equal the Base Case. Forecast income growth % changes from the Base Case (Most Likely) are shown in the table below.
Forecast Total Return: The total return forecast is the combination of the Base Case, forecast multiple % change from the Base Case, and forecast income growth % change from the Base Case.
Forecast
To create the forecast, the above scenarios are input into software that creates the graph below and calculates the associated statistics. The black values underneath the graph indicate the total return values as shown in the previous table of scenarios. The white percentage values overlaid on the graph correspond to the proportion of the total area under the curve within each colored region. This is the forecast probability of the total return falling within the associated range. For example, the light green region represents a 36% chance that total return is between 7% and 25% over the next year.
Based on the above forecast, the software calculates expected return and risk. The resulting statistics are shown below.
The expected return based on the above analysis is 5.3% and is .5% lower than the initial forecast. Although I still expect NVS to outperform the market, the multiple seems unlikely to expand as much as it has over the past 18 months. Forecast volatility of 15% is significantly higher than the initial forecast of 11%. A large move in either direction seems increasingly likely as the result of either a recession or exceptional earnings. Also, the evaluation of the previous forecast indicated it was too narrow. In contrast to the previous forecast, which was positively skewed, this forecast is nearly symmetrical (skewness is ~0). This reflects my belief that NVS is now fairly valued; whereas, I previously believed it was undervalued and the reward outweighed the risk. This forecast is much closer to approximating the normal distribution and excess kurtosis is also close to zero.
Alpha Calculation
To calculate alpha for NVS, an estimate of beta or correlation to SPY is required. Beta is a little more intuitive than correlations. For example, if the expected excess return of SPY above treasuries is 1% and a stock has a beta of 2, then the expected excess return of the stock is 2%. The chart below shows rolling 90-day estimates of beta for NVS, and the forecasts for the different scenarios.
Correlations can be derived from beta, market volatility, and stock volatility. The previous section forecast NVS volatility to be 15%, and forecast market volatility is assumed to equal the current VIX value of 16%. The chart below shows the rolling 90-day correlations for NVS and SPY and the derived correlations from the beta forecasts. Recently, correlations have trended towards zero since most of the recent NVS stock price gains have resulted from events that are specific to the company. Anomalously, forecast correlations and betas are nearly equal because the forecast stock and market volatilities are close to each other.
Assuming a risk-free rate of 3.6% and expected return of 4% for SPY, the following table displays the resulting forecast alpha for each scenario. Regardless of the scenario, the forecast alpha is nearly constant. This occurs because the expected return for SPY and risk-free rate are nearly equal.
In summary, NVS is still worth holding even after the multiple expansion. It should continue to grow earnings and cash flow regardless of the economic environment. As a result, it is likely to generate alpha over the long term and perform particularly well during a recession.
For further details see:
Novartis: Fair Value After Multiple Expansion