#4 Novo Nordisk - Financials, Risks and Opportunities

Finally! This is the 4th newsletter and last on Novo Nordisk. Let’s summarize what have I covered on previous newsletters:

1. Novo Nordisk - Changing Diabetes: on the first newsletter I tried to provide an overview of the diabetes and obesity problem and the new available treatments.

2. Novo Nordisk - Business Breakdown: on the second newsletter I went over the company’s history, business model and segments.

3. Novo Nordisk - Management, subsidiaries and competence: on this 3rd newsletter I covered some topics usually overlooked such as the ownership structure, management incentives and subsidiaries. I also described which competitive advantages hold the company’s moat.

Today I will cover its financials and also go through its Q3 earnings report, released back on the 2nd of November, to evaluate if the qualitative analysis is backed by the fundamentals.

DISCLAIMER: This article is not a recommendation to buy or sell any financial instrument, the content is educational and my personal opinion. Each person has to make his own analysis. Any action or decision you take as a result of viewing this article is your sole responsibility.

Income statement

Let’s start on with the income statement. When I look at a company I like to check the revenue and income growth as well as the margins. If we compare Novo Nordisk against its diabetes and obesity care peers - see figure 1 - we can see the company has the largest 5-year revenue CAGR (13.07%), larger gross margin (stable over 83% last 5 years) which can be explained by the Novo Nordisk’s vertical integration, and largest operating margin.

Regarding operating expenses, it can be noted they grow revenues faster than SGA expenses (almost 1.5% CAGR over the last 5 years).

R&D expenses grew similarly to revenue, representing around 12-13%. This is a very low R&D expense for a pharmaceutical company. The reason behind its that the dividend Novo Nordisk pays out to Novo Holdings is then reinvested in R&D partnership and initiatives by Novo Nordisk Foundation or in building a larger life sciences ecosystem by Novo Holdings.

In figure 3 it can be observed, operating margin is stable around 42-43%. EBIT & EBITDA are comparable, showing a low capital intensity of the business. By approximating Depreciation and Amortization as EBITDA - EBIT, I get that DA costs ranged between 3.5 - 8% of the gross profit during the last 5 years.

However, the pharmaceutical industry is an industry know-how intensive where intangible assets are critical. This makes it necessary to capitalize the R&D to really see the capital intensity of the business. By doing the adjustment, I get that the DA costs ranged between 6 - 16%, substantially more intensive than initially assessed.

The net profit margin is excellent. 50% larger than its closest competitor. 10-year EPS growth is also the largest vs competitors. However, 5-year one, even still good, its the smallest. This difference might be caused by Novo Nordisk exploiting GLP-1 treatments for longer than its peers.

Balance sheet

Novo Nordisk has a strong balance sheet. The company uses leverage due to its huge capacity of increasing sales and generating profit. From annual report 2022 the following information can be extracted:

• Debt-to-equity ratio → 2.22 (at 2023.09.30)

• Net debt-to-shareholders equity ratio→ 1.72 (at 2023.09.30)

• Equity-to-assets ratio → 0.31

• LT-debt-to-net earnings ratio → 0.66

• ST-debt-to-EBITDA ratio → 1.47

• Interest coverage → 47.3.

• Goodwill-to-assets ratio → 0.19 (at 2023.09.30)

During 2023 the company has not reduced debt, but has grown its total liabilities at the same pace as revenue grows (approx 30%).

Note that the Goodwill to assets ratio increased during the previous couple of years due to acquisitions. It is still on healthy levels and reducing after peaking in 2022.

Capital allocation

The company has very little CAPEX expenditures. The CAPEX expenses accounted for less than 6% during the last 5 years period. However, as Novo Nordisk is a pharmaceutical company it needs to spend yearly a share of its profit in R&D activities to keep the business running and to develop new business lines for the future. Hence I have capitalize the R&D to calculate and adjust ROIC and ROCE.

As it can be observed from figure 5, company returns are extraordinary. ROE>70% (leverage favorable impact), ROA>20% consistently, adjusted ROIC>35% and adjusted ROCE>60%. The decrease trend observed in previous years might be due to new facilities building which are not in full operation. It is important to mention that the company is able to redeploy around 50 - 60% of its adjusted NOPAT. The need of building capacity for the growing demand in the GLP-1 segment since 2019 has led to an aggressive expansion, temporarily depleting the returns.

Novo Nordisk also pays a dividend - 50% payout ratio - which has increased at a 10% CAGR las 5 year .

Valuation

A simple DCF model was used to estimate the valuation of the company. The assumptions considered are:

• Revenue growth → Until year 2 included, 35% yearly revenue growth will be considered, aligned with current growth. After that, the impact of Elli Lilly’s candidates and a more mature market might slow down the revenue growth. I have then considered a 25% revenue growth from year 3 onwards.

• FCF margin → 25%. Current FCF margin its around 30%. Tax increase and customer negotiating power might slightly reduce the profitability of the company.

• WACC → 15%. 6% risk-free rate + 3% inflation + 6% risk premium.

• Terminal growth → 4%. Insulin, obesity and cardiovascular diseases have remarkable tailwinds. I estimate a larger growth than global GDP.

DCF model shows the stock is overvalued right now (683.9DKK per share). At current price, assuming they can mainain a 30% FCF margin (instead of 25% used in the model), a 12.5% return could be expected.

Risk and opportunities

Opportunities

1. Approval for the use of GLP-1 treatments on other diseases.

   Novo Nordisk is currently investigating GLP-1 application to other diseases like Alzheimer, cardiovascular diseases and renal diseases among others. Getting approval on any of these areas would unlock a new business segment.

2. Enhancing operational efficiency

   Pharmaceutical industry is not as optimized as the petrochemical industry, there is still room for process improvement. Digitalization, data analytics, implementation of lean manufacturing initiatives and even the introduction of AI might reduce COGS and operating expenses.

Risks

I will only cover company specific risks because there are risks common to the whole pharmaceutical industry, such as the data protection reduction in the EU, that will equally affect all the players.

1. Regulatory risks.

   It could be the case that GLP-1 is proven unsafe (or at least one of its applications or administration forms) leading to losing its marketable license and potential fines and reputation loss of the company. An example would be when Acomplia - Sanofi’s weight loss drug - was retired from the market in 2008 due to evidence supporting its risks to mental health and suicide risk. Recent studies have pointed to GLP-1 impacting dopamine paths.

   In my opinion, the risk exists but a situation like Victoza’s controversy is plausible - evidence of increasing pancreas cancer risk was found but Victoza was not retired from the market because its benefits outweigh the risks - but unlikely as data shows every generation of GLP-1 are safer and easier to tolerate by patients.

2. Technological risks.

   Better weight loss treatment could be developed. Sanofi’s Acomplia was based on Cannabinoid Type 1 receptors (CB1) for example. Also, it is under investigation the potential application of cell gene therapy to cure diabete.

   I think Novo Nordisk does a good job ensuring its leading position regarding technology and patents as its vertical integration and critical technology proprietary rights.

3. Supply issues

   The company could have problems along the supply chain as they have reported on the rare diseases segment. This could lead to market share loss , and even their dominant position on the GLP-1 market.

   The market is a duopoly where demand is so high that I don’t think a temporary shortage would damage any of the players.

4. Company culture dilution

   Novo Nordisk is a company with a strong nordic culture, Danish to be more accurate. The global expansion and maintenace of a larger workforce might lead to company values loss and dilution.

   I think this would be the most likely pre-morten scenario. However, it will be a slow process.

5. Management incompetence

   Compensation does not align management and shareholders incentives. However, Lars Fruergaard has moved up the ranks of Novo Nordisk during 30 years. Since he was appointed as CEO in 2017, he has been increasing his position in the company every year, accounting for a remarkable share of his own net worth.

   Moreover, in his own words he recognizes that the extraordinary performance of the company nowadays is thanks to the previous executive team work, time when research was initiated and business plans for them were drafted. Hence, Lars Fruergaard performance will probably have an impact on the future drug segments.

Thesis wrap-up and conclusion

Novo Nordisk is an extraordinary company whose investment thesis has little flaws. Let’s sum up the main key points of the thesis:

1. Oligopolistic industry segment with strong tailwinds, barriers of entry, switching costs (psychological) and a business model which ensures recurring revenue.

2. Proprietary technology, vertical integration, scale, distribution network and ecosystem of companies.

3. Management incentives only reward growth. The operations are very profitable but the allocation of capital for dividend could be improved.

4. Strong balance sheet despite the use of leverage.

5. Opportunity to develop new treatments and, consequently, new markets.

6. Low terminal value risk.

7. Current share price is reasonable.

Considering all the exposure above I think Novo Nordisk offers a compelling investment case.

DISCLAIMER: This article is not a recommendation to buy or sell any financial instrument, the content is educational and my personal opinion. Each person has to make his own analysis. Any action or decision you take as a result of viewing this article is your sole responsibility.

And this is the end of the Novo Nordisk 4th newsletter (and last) of the saga. Although, I will continue following the company news and latest updates.

Stay tuned @SiemprePulpo