2012-05-31

Novartis Looks Cheap. But...

Pharmaceutical company Novartis (NVS) looks attractive right now from some financial angles. But is Novartis a great company to own going forward? Judging from its history of earnings and dividends, it seems to either lack good management or a defensible business moat. But I'm getting ahead of myself. First, let's look at why it might be cheap.

Why NVS might be cheap: Dividend Growth Model

For the last 12 years (the most data I have available), NVS increased its dividend an annualized 16%. That's an amazing track record!

However, one should be skeptical of this record being achieved in the future -- especially because its earnings have only grown an annualized 7% during this period.

Still, let's assume the current dividend can grow at a 6% clip going forward. If we require a 10% return on our investment, that means that a fair price for NVS is around $62. Given its market price is currently $52, that's a nice discount.

If we instead insist on an 11% return, then the fair price drops to $49. So, the current price is no longer a bargain, but it's close.

Dividend growth model. Source: S&P

Why NVS might be cheap: P/E analysis

Assuming NVS is neither growing nor shrinking, we can assume it will continue to earn what it has earned on average in the last five years.

Averaging the last 5 years earnings we get $3.62 per share. Now apply a P/E multiple of 15x, which is approximately NVS' historical average and the industry's average and also the current market average, then we get a fair price of $54.  Not too far off its current price -- about a 4% discount.

Now, to consider an investment, one must look at how long time shareholders have fared and whether the company has shown good results.

Why NVS may not be such a great company

Let's apply the Buffett test. I attribute this test to Buffett because I first heard this from him, but Ben Graham has written about it on his various books too. The test is very simple: has the stock price of the company shown $1 or more in return for every $1 retained (and not distributed to shareholders)?

In NVS' case this is a big no. Let's look at the numbers, summarized by the table below.

Retained Earnings. Source: Morningstar.

In the last five years, NVS has had about $66B in free cash flows (operating earnings minus capital expenditures). Over the same time, it paid out about $26B in dividends, thus retaining about $40B in earnings. However, what has happened to these $40 billion? They were mostly spent on acquisitions. Have the acquisitions been successful?

Well, let's see: the stock price in the last five years should have grown by 40/2.42 (billion shares outstanding) = $17 per share.

And yet, the stock market doesn't show that growth. In fact, the stock has gone nowhere in the last five years. From 2007 to 2011 the stock went from $59 to $57. Not only that, but NVS also blew most of the $4.6B it had on hand in the beginning of 2007.

But perhaps the market is mispricing the stock now, you ask?

Well, if you believe our analysis above, the current fair price is between $62 and $49. Nowhere close to the implied price of $76 ($59 -- stock price in 2007, five years ago -- plus the $17 it retained).

So what's wrong? Perhaps management is not that capable. Perhaps the acquisitions haven't paid off yet but may in the future. Or maybe the company's business model is just not great.

Maybe the industry is at fault?

Well, maybe. It's a highly competitive industry and highly unpredictable, given the various status of pipelines, patent expiration and generics. Take JNJ for example, which is in the same industry. Its numbers aren't much better: JNJ's stock price hasn't gone anywhere in the last five years, but our calculation would suggest it should have grown by $11 during during these five years (for JNJ, at least, the balance sheet is in better shape and a lot of the retained earnings show up as cash).

Why didn't NVS's number materialize, I can't say. But at a first glance, it signifies either poorly-timed (or poorly-priced) acquisitions or inefficient management, possibly combined with a tough environment for pharmaceutical companies.

Conclusions

NVS looks cheap at these prices and could reward shareholders looking for a growing dividend income. But given its lackluster past in share price growth and poor track record of creating value for each dollar retained, shareholders should not expect significant price increases in the near future. Current shareholders should consider pressing management to increase the dividend, instead of using the cash on malinvestments.

Disclaimers: I own NVS at the time of writing.

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