What the market is missing on this “pioneering” global pharma company

Impressive cash flow underpinned by diversified in-market assets and an underappreciated mid-stage pipeline is just part of the appeal of the global healthcare company Novartis, said Magellan Financial Group portfolio manager John Wylie in a recent interview.

The real jewel in the crown is the company’s R&D business, the innovative medicines franchise that comprises around 85% of group earnings. In the following interview, part of the Magellan Minutes investment insight series, Wylie delves into the reasons why Novartis has been a long-term holding of Magellan. He also touches on some of the risks, including how the company is positioned in the face of potential structural changes to US drug pricing.

Transcript

Jennifer Herbert: Hello and welcome to the fourth edition of our investment insight series, Magellan Minutes. Unfortunately, due to COVID, we found ourselves broadcasting via Zoom yet again. The challenging times continue, but we are hopeful that we back in the studio again very soon. My name is Jennifer Herbert Key Account Manager of Magellan. And in this session, I'll be talking with John Wylie, Head of Healthcare and Portfolio Manager. We'll be discussing Magellan's investment thesis on Novartis, the US political risk overhang to the health care sector, and how recent innovations around early cancer detection could translate into investment opportunities. Now, the obvious topic which is missing from this list is a coronavirus update. But for that, I would like to direct you to our December podcast 'In the know' where Hamish Douglass interviews leading epidemiologist Dr. Michael Osterholm on the status of the virus. You can find the podcast on our website, and I highly recommend you take some time to listen. Now John, hello and welcome.

John Wylie: It's great to be here, Jen. And I'm very excited to do this in person soon.

Jennifer: John, let's start by discussing one of our healthcare stocks currently in our portfolio. Novartis has been a holding of ours for some time now. Perhaps you will give us an update on the stock and talk it through the investment thesis.

John: Certainly, Jen. Well, Novartis is one of the world's leading pharmaceutical companies, and it is a stock that we have patiently held in the Magellan Global Fund for some time. Over the last few years, Novartis has executed a series of sensible divestments on fair terms. That means the business is now a function of only two key segments. The first, which accounts for about 85 percent of Novartis’s earnings and is the sole focus really of our investment thesis is Novartis’s innovative medicines franchise. That business is Novartis R&D engine, and it derives its cash flows from in-market assets across approximately six key therapeutic areas. The second part of Novartis's business is called Sandoz. It is a generics manufacturing business, it's a leading global generics business with appropriate scale in most products, especially biosimilars, where it's got uniquely differentiated capabilities. But that asset is subject to being restructured, spun off to shareholders or perhaps sold over the next few years, and isn't a core component of our Novartis valuation or investment thesis. So with respect to the innovative medicines piece. We find the cash flows that fall out of Novartis's innovative medicines franchise incredibly interesting from a portfolio perspective. Pharmaceutical cash flows are not correlated to macroeconomic events, nor are they correlated to the same economic forces that can drive earnings up or down in other portfolio companies. So the uncorrelated nature of those pharmaceutical cash flows is rather attractive from a portfolio construction perspective, and that makes Novartis a valuable contributor to the defensive component of the global fund's portfolio. 

In the earliest stages of the pandemic, Novartis was a beneficiary of the virus catalyzed uncertainty as consumers and hospitals pulled forward purchases of important medicines. As the pandemic dragged on and lockdowns proved to be globally more persistent, 

Novartis wasn't a beneficiary because people weren't able to see their physician and get access to important new medicines to treat chronic underlying conditions and so forth. So while Novartis's base of recurring revenue was un-impacted by the pandemic, some of the growth optionality from important new best in class therapies was was adversely impacted to a small extent. We were always happy to look through that, but that was a source of some valuation uncertainty in the very near term. The other piece is the political risk overhang, which perhaps we can address separately. We're relatively comfortable on that risk as well. And then with respect to what we think the market's missing. 

With respect to Novartis's current valuation, we would argue that a conservative assessment of Novartis’s in market assets almost entirely justifies the current enterprise value of the business. 

Therefore, shareholders at the current price are getting access to Novartis deep pipeline of early, mid and later stage IP almost for free, and they're also gaining access to significant option value that's embedded in Novartis gene cell and nuclear medicine platforms without paying a premium for access to that incredibly promising and early technology. Where Novartis is the global pioneer in the commercialization of those technologies and almost certainly the best acquirer of new IP to bolt on to the global manufacturing networks that underpin those technologies.

Jennifer: And John, you mentioned the US political risk overhang. Can we just go back to that for a moment? I'm really interested in how Magellan's framing that US political risk overhang over the healthcare sector.

John: Certainly, Jen, it's a very important issue for the broader sector, and therefore it's important to have a view on the likelihood and materiality of potential legislative change in America when allocating capital to global pharmaceutical companies. And that's important because the US is the primary driver of profitability for any globally diversified pharmaceutical company. Novartis is an exception to that because Novartis only derives approximately 40 percent of its revenue from America. So it's partially insulated from a structural change to U.S. drug prices. But nonetheless, it's important to have a view on whether structural change to how Americans pay for drugs is imminent in that context. Both Democrats and Republicans have sought to introduce legislation to recut how America pays for drugs for quite some time. With any new legislation, the fundamental question in our mind is, does that new legislation pose a structural risk to America's role as the buyer of first resort, buying new innovation at a full but fair price? 

It's no secret that America pays more for drugs than every other developed market in the world, and some of that premium may compress a little bit. 

But what's most important is that the U.S. remains the buyer of first resort for that innovation because that role underwrites really expensive and risky early stage development programs. The legislation that's being proposed by President Biden and his administration is of some concern, but doesn't go anywhere near enough to pose a risk to structurally re-cutting the economic model for US pharma companies. And Novartis in particular, has almost no exposure to the limited price negotiation framework that's been proposed. Nor would they be materially impacted by the proposed annual inflation cap and the rethink of who pays the excess inside various medical insurance policies purchased by elderly Americans isn't expected to have a meaningful impact on Novartis, either.

Jennifer: Finally, on what is quite an exciting note, I understand that there's been some interesting innovations recently that may allow an earlier diagnosis of cancer. Does that translate into any potential investment opportunities?

John: It's a fascinating space Jen, so genomic sequencing has evolved from the first sequencing of a human genome in the 1990s at a cost of arguably billions of dollars to a technology that now costs perhaps only a thousand dollars to have your personal genome sequenced. And that's almost certain to fall to a couple of hundred dollars over the next year or so. So that reduction in the cost of being able to sequence your genome and derive a whole load of really clinically relevant information from that process is incredibly valuable. And the utility from this technology, until the last few years, had been mostly derived by academics doing really interesting research. And the reduction in the cost of accessing this technology means that the tools that have fallen out of that research endeavor are now available to you and I, when we're talking to our doctor and managing our health. 

So as the cost of genomic sequencing has come down so materially and the clinical applications have been subject to genuine innovation, we've unlocked a whole lot of interesting applications around risk assessment for genetic diseases for young or even unborn children to cancer treatment. 

That's better optimized for the nature of the mutations in your cancer as you progress along that pathway to now a point where perhaps we can even screen populations for cancer, perhaps even via a simple blood test such that we can find cancer early when it's in its most treatable form. And this is all derived from improved access to genomic sequencing technology, as well as some very, very complicated IP around the early detection of cancer via blood tests. Untangling who owns the right parts of that IP portfolio, who has the best strategy to bring that technology to market and what the ultimate size of the market will be? There's no question we're talking about tens of billions of dollars a year of revenue here for these indications at scale. But who the winners will be are important investment questions. It's something where we've invested a significant amount of time to map out that universe and best understand what the risks and opportunities are for a number of prospective investments. And I'm excited to come back to you and the team with an update on that in due course.

Jennifer Herbert [00:11:43] Wow, the wonders of modern medicine, John, thank you so much for sharing your insights with us today and thank you to everyone for watching. If you have any questions, please don't hesitate to contact one of the Magellan distribution team and feel free to share this update with clients or colleagues as you see fit. Take care and stay safe. 

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