Novartis – A Reality Check…

Graham H Campbell, Joint Manager of the TB Saracen Global Income & Growth Fund, on the pitfalls of compromising management credibility in the eyes of investors…

As investors, we are frequently searching for fragments of information that confirm or disprove our investment thesis.  It largely condenses into the following question: “Are management actions consistent with perceived strategy?”

Saracen Fund Managers has long been a supporter of Novartis.   Our investment case was based on the attractive pharmaceutical pipeline, growth in generic drug use and positive demographics surrounding eyecare.  The initial purchase into TB Saracen Global Income & Growth was attractive and we have achieved a return of over 60% in share price terms (plus dividends and currency) on our initial investment.

Novartis has more strategic issues than most.  For some time, management has considered selling off the Alcon eye-care business (decision now expected 1st Half 2019), it also has a minority position in OTC medicines with GSK and a shareholding in Roche, valued around $13bn.   These positions provide optionality.

In addition, while the company is not alone in stripping out some large and recurring costs, such as restructuring and legal expenses to their calculation of ‘Core’ earnings, the variance between both measures is considerable.  In turn, we do our best to re-adjust to reflect a more accurate measure of performance and future cash flows.  The company also enjoys a very low tax charge of around 15%.  Joe JIminez, the current Chief Executive, has decided to step down a year earlier than expected to make way for Vas Narasimham, the current Global Head of Drug Development.

It has been a good few years since I read “Barbarians at the Gate: The fall of RJR Nabisco” by Bryan Burrough and John Helyar.  I remember being amazed by the corporate excesses of the times and in particular the 10 private jets that formed the RJR Air Force!  I assumed these days were long gone and vanity projects of this type were now solely the indulgences of private ventures by billionaires and oligarchs.

While there has been more focus by management on improving the manufacturing and technology platforms of the business, it would appear that it has not been equally applied to all operations.  Page 247 of Novartis’s Annual Report 2016 has the following disclosures for ownership of Spanish business.  The pertinent entry is the final one: Abadia Retuerta (The hotel is pictured above).

Spain Share /
paid-in capital
Equity
interest %
Novartis Farmaceutica S.A. Barcelona EUR 63.0m 100
Alcon Cusi S.A., El Masnou / Barcelona EUR 11.6m 100
Sandox Farmaceutica S.A., Aravaca / Madrid EUR 270,450 100
Sandoz Industrial Products S.A.,
       Les Franqueses del Valles / Barcelona EUR 9.3m 100
Abadia Retuerta S.A., Sardon de Duero / Valladolid EUR 6.0m 100

 

Further information on the business can be found on the Abadia Retuerta website and a review from The Telegraph

In summary, there are considerable strategic uncertainties facing Novartis at a time where underlying operating performance has been disappointing.  The valuation is firmly in Hold territory on our ‘clean’ numbers.  The ownership and investment in non-core assets such as a luxury hotel and winery, may not appear significant from a business the size of Novartis, which has revenues of around $49bn.  Nevertheless, it dents management credibility and our confidence that management is sufficiently aligned with all shareholders.  When the incoming CEO manages to re-assess the strategy, all may become clear and our concerns will dissipate.  However, the team here invest with conviction and frankly, we don’t feel that conviction with Novartis at present. We have Sold the shares and reinvested the proceeds elsewhere in the sector.

 

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