#5 Novo Nordisk - The Other Side of the Story

During the last months I have dedicated up to four newsletter to explain the potential of Novo Nordisk as a company to develop within the diabetes and obesity market.

The hype for the GLP-1 space is huge among the investing community, creating echo chambers which make it quite challenging to contrast one’s own bullish thesis against others which provide rationales on why risks might be larger than what they look. I couldn’t find a thesis against the company myself!

Hence, in today’s newsletter I am playing Devil’s advocate. I don’t think there is a scenario where a short thesis is plausible. Although, current expectations in the stock bull case might be too inflated.

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.

Base case - Which are the expectations?

Firstly, I think we need to analyze the market expectations of the business. Let’s start with the price, during the last 3 months the stock has been trading in the range of 650 - 720 DKK per share, being the PE ratio in the range 40 - 45. The PE ratio has doubled since 2019, when it was around 20. What has changed during that time? What is the current price discounting? How have investors valued the business to consider that price (at least temporarily) fair?

Every financial asset is valued based on the present value of its future cash flows. Michael Mauboussin, in his article “The Math of Value and Growth. Growth, Return on Capital, and the discount rate”, breaks down this definition of cash flow into three parts: opportunity economics, value creation and barriers of entry in the form of competitive advantages.

Opportunity economics

Since 2019, Novo Nordisk has opened two new markets with lage TAMs, the oral diabetes and the obesity treatment using GLP-1 drugs. 537 million people were estimated to have diabetes in 2021 and it is expected to reach 784 million of patients by 2045. Novo Nordisk reported in 2022 that more than 50% of its GLP-1 related revenue is currently generated by oral GLP-1 treatments. Meanwhile, the opportunity the obesity segment presents is even larger. Nowadays, only 2% out of 650 million people affected nowadays are being treated with medication and it is expected to impact 25% of world population in 2035 (roughly 2250 million patients).

Summarizing, these markets have strong tailwinds and are expected to be dominated by very few players in the years to come due to the barriers of entry they present.

Value creation

In general, the pharma and biotech industry use very cheap raw materials to create high value added products which are needed in small amounts by adding value through their know-how. For example a patient taking Rybelsus 7mg would need 2.55 grams of semaglutide per year.

The company not only has the opportunity to incredibly grow its earnings but also to do it at a return larger than the cost of capital, leveraging their proprietary technology and specialized knowledge.

Competitive advantages

The industry in which Novo Nordisk operates has large barriers of entry in the form of the proprietary technology required and regulatory constraints governing it. Moreover, Novo Nordisk scale and vertical integration also improves its competitive positioning.

This apparent wide moat leads to a demanding valuation in terms of PE ratio. The PE ratio captures investors’ expectation regarding the company’s competitive positioning durability and serves as a proxy for its large terminal value.

DCF model

DCF is useful to understand what is the market discounting in the company. The assumptions I have used for mine are the following ones:

1. WACC → 15%. Reasonable for a company with such great prospects and plausible to be what investors are expecting considering current hype.

2. g → 4%. Larger than global GDP growth which is again reasonable.

3. FCF margin → 30%. In line with the last 5-year period FCF margin.

4. Revenue growth → 35% CAGR. 2023 revenue growth.

Putting these four assumptions together, the DCF model (see Figure 1) returns approximately the stock price Novo Nordisk is currently trading, meaning investors expect a flawless execution of the business from now on and comparable to (what will likely be) its best year in history.

Spotlighting the Flaws

The GLP-1 macrotrend is so strong that investors tend to minimize or even ignore (passively or actively) the flaws of the company. Having established the base case we should now explore them.

People & culture

Novo Nordisk is known for its exceptional company culture, embedded in Danish and Scandinavian culture. This dinstinctive culture was developed during Novo Nordisk’s third CEO tenure, Mads Øvlisen, and it is lived and maintained by every employee until today.

The company currently has over 52000 employees all over the world, being more than 50% based in Denmark. Most of the expansions announced announced for the current decade are taking place in the Copenhagen area. There are two considerations to make:

1. Copenhagen area (known as Hovedstaden region in Denmark) is a pole of the life sciences industry. A large amount of life-science companies are also expanding (either because they supply/support Novo Nordisk). Employee retention will become more challenging, salaries migth rise at a higher pace. A good analogy might be the competitive landscape professionals and companies face in Silicon Valley (Copenahgen area is in fact known as Medicon Valley).

2. Any company under ambitious expansion programmes provides its employees new opportunities. Hence the employees performance might suffer as their focus shifts to promotions and participating in the next big thing.

It is well known the case of Google, where a great company culture was eroded by the business growth and corporate structure evolution. Hence, Novo Nordisk has a analogue situtation ahead regarding its company’s culture preservation.

Management & structure

Management incentives are not aligned with shareholders. In the 3rd newsletter of the saga, I explained why despite CEO Lars Fruergaard having a remarkable stake of his net worth in the company, the incentives are only focused on growth but not in efficient capital allocation. Moreover, I don’t find the targets linked to management bonus clearly stated in the remuneration policies they released every year.

In the tracking presented to investors in the 2022 remuneration report it can be observed that a revenue growth target in the Short-Term Incentive Plan of Revenue growth was 8.4% at CER. Quite far from the company’s current performance and expectations. So management will be able to get their bonus without much effort.

Another thing I raised a concern about in that newsletter was the corporate structure. Novo Nordisk majority of voting rights are held by Novo Holdings, the investment vehicle of Novo Nordisk Fonden, which is led by former Novo Nordisk executives.

Even though it has not proved to damage the company yet, I dislike this structure because the Foundation’s objectives is not to generate value for shareholders but to promote scientific knowledge discovery and humanitarian causes. Novo Nordisk Fonden executives shares in Novo Nordisk are not disclosed making the decision-making process concentrated in the hands of few more opaque for investors.

Keep up supply with demand

The obesity market is currently a duopolistic market where the demand is way larger that the supply. However, the situation could lead to patients unable to start or even continue their treatment so FDA included Novo Nordisk semaglutide injections in their drugs shortage list.

At the DCF model, we could see the market is discounting the explosive growth Novo Nordisk is currently experiencing will continue. The drug supply chain system in the USA (which will continue to hold the largest share of the obesity products) is structured in such a way that the pricing power is in the PBMs and insurance companies. Hence, revenue growth will come mainly from increasing the amount of medicines supplied. At a revenue growth rate of 30% per year, it means its supply has to double in 3-4 years.

Designing, building, qualifying and validating a new GMP facility for pharmaceutical production takes twice that time (6-8 years). Where will the revenue growth come from? Novo Nordisk can activate the following levers:

1. Optimization of current processes: biopharmaceutical facilities are usually under optimized compared to a traditional industry like petroleum industries. They are novel differentiated products where competition is not requiring the pharma companies to adjust their processes to get an extra tenth in their margins.

2. Maturation of new (and recently completed) facilities: the performance of any completed facility in the coming years will improve as a natural consequence of business maturity.

3. Normalization of BRD supply: This year revenue from Blood Rare Diseases segment was down due to temporal supply disruptions.

4. Partnership with CMOs: make agreements with contract manufacturing organizations to produce the GLP-1 products for a certain period of time.

Another consideration on the supply side is the largest amount of active drug substance needed for oral formulations (under research, Orforglipron by $LLY) due to the better absorbance of injections vs pills. What behavioural-wise is great for the patients puts more stress on the supply side resources.

Competitors risk

Any market with great prospects of value creation will attract competitors. GLP-1 is no exception. If the diabetes traditional market based on insulin is governed by the oligopoly of Novo Nordisk, Eli Lilly and Sanofi; the GLP-1 space - both for diabetes and obesity - is a duopoly where the latest of the three is not present.

However, more companies are trying to access the GLP-1 space with fourth generation GLP-1 agonists. Some of them are:

• Altimmune: its drug, Pemvidutide, just successfully completed Phase II clinical trials. Its trial (called MOMENTUM) MOMENTUM was a randomized, double-blind, placebo-controlled study over 391 participants and was conducted for 48 weeks. It showed a weight loss between 10-15%.

• Innovent Biologics: Phase III results of its drug, Mazdutide, will be released in January 2024.

• Boehringer Inghelheim & Zealand Pharma: they are developing a GLP-1 & GLP-2, Survodutide, for obesity treatment, currently under Phase III clinical trial. If they are successful it could be submitted for regulatory approval in 2025.

Phase II trials have, a rule of thumb, have a success rate of 50%. On the one hand, Altimmune’s MOMENTUM trial, a success. On the other hand, Pfizer’s dropped Phase II danuglipron clinical trials.

There are also other type of obesity drugs like MGAT2 and CGPR inhibitors which I will not cover as most of the obesity drug market value is in the GLP-1 space.

Conclusion and personal comment

The macrotrend of diabetes and obesity care is a great opportunity due to its oligopolistic characteristics. As I presented in this newsletter the market is discounting all the good and neglecting the potential risks.

Personally, Novo Nordisk is one of the companies in my portfolio which I think has some of the best products, business models and moats for the coming decade. However, there are risks , especially in connection to the culture and management incentives. Hence, considering the cost of opportunity and te margin of safety I require I don’t think the company offers a compelling valuation currently.

Hope you enjoyed this newsletter a little out of the usual research topics but I thought it was quite interesting to put in writing, analyze and learn this memory which at first sight might seem not quite related to the investment world.. Please leave a comment, give it a like and share!

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