Jamie Ross, Fund Manager of Henderson EuroTrust, provides a snapshot of the typical analysis on every company considered for the portfolio. In this case, he explains the rationale behind the inclusion of the Danish pharmaceutical company Novo Nordisk.
When considering an investment for the Henderson EuroTrust portfolio, we tend not to focus on market noise or any technical factors. What we are trying to establish is whether the company is a good one or not. This is a key part of the research process. There tend to be many features that most good companies have in common, but multiple characteristics and features will be unique to each one. By undertaking detailed analysis of the 50 or 60 companies we have on our radar (a portfolio of around 40 positions and a watch list of 10-20 names), we are able to not only assess their quality but also determine whether it is the right time to invest.
What does Novo Nordisk do?
Based in Denmark but very much a global business, Novo Nordisk has for more than 90 years been focused largely on one therapeutic area – diabetes care. The business started in the 1920s with the merger of two Danish companies that sold insulin, which at the time had just been discovered and was, as such, a novel product.
Novo has since grown into a globally recognised pharmaceutical business but, crucially, its attention has remained on diabetes care and related categories. This laser-sharp focus has been a significant reason for the company’s long-term success.
Novo generates around 85% of its revenues from diabetes care, with its efforts recently shifting from insulin – which is finally becoming commodified – to a new category of diabetes drugs called GLP-1. Novo is a clear leader in the GLP-1 category and has produced a daily injectable product called Victoza and a weekly called Ozempic. It is in the process of developing oral semaglutide, which is yet to be given a brand name. These GLP-1 products tend to come earlier in the treatment cascade for diabetes and, as well as controlling blood sugar levels, have important secondary benefits to cardiovascular health and weight control, vital for diabetes patients.
Does Novo generate strong return on invested capital (ROIC)?
Novo’s gross margins (total revenue minus the cost of goods sold) are exceptionally high at more than 80% and are expected by the company to hold at these levels. The strong gross margin is driven by the company’s powerful position as market leader and the attractive demand dynamics in the industry – demographic changes are driving higher rates of diabetes globally).
The strong supply-side and demand-side characteristics combine to create pricing power for Novo. It spends around 26% of sales on selling and distribution costs (SG&A) and another 13% on research and development (R&D). With only 3-4% of sales spend on admin, Novo generates an exceptionally high EBIT (earnings before interest and tax) margin of around 42%. We believe this is sustainable, largely due to its efficient and focused R&D department.
In terms of invested capital, most is tied up in working capital and fixed assets. The company has very few intangibles and essentially no goodwill – they have not been big acquirers of businesses, a feature of the company that really appeals to us. Overall, with exceptionally high margins and below-average capital employed in the business, Novo has exceptionally strong ROIC of above 60% on our numbers. This will be a truly exceptional investment if these levels can be sustained.
What are the risks to the business and to this ROIC profile?
While we view the singular focus of the company on diabetes as a positive, it does bring its risks. For example, Novo is far more exposed to someone else developing an alternative to one of its key products than a company whose product suite is far more diversified. Plus, if Novo was to fall behind on innovation and R&D success, then its earnings power and ROIC characteristics could come under material pressure. Pharmaceutical products are exposed to patent cliffs and therefore constantly need to be developing new products to replace their off-patent products.
Another risk lies in the company’s exposure to governments as customers, especially in the US. Large customers generally bring bargaining power, especially if the product they are buying is not unique. Novo has traditionally fended off this bargaining power by selling innovative products but it is a risk factor we must constantly monitor.
Novo is also at risk of losing talent, especially in its R&D team. We would highlight Mads Thomsen, who heads up R&D, as being one of the key individuals that Novo must retain.
Finally, as with other high-quality companies, the high valuation Novo trades on means that any doubts from the market about its ability to deliver on targets could see the share price underperform. So, the valuation itself adds risk to the investment case.
Is there scope for growth?
There are several reasons for us to feel confident in the future growth profile of Novo. First, as briefly mentioned, demographic changes continue to drive a growing diabetic patient population. There are many factors at play here but ageing populations and increasingly poor diets – including the so-called Westernisation of some Asian countries’ eating habits – are two of the most important drivers.
Growth will also occur via market share gains. Novo has some of the best products in the industry and this is driving share gains. The ongoing rapid update of Ozempic in the US is the best example of this at present.
Finally, we see a very interesting long-term opportunity in Novo developing drugs focused on weight loss. Weight loss has been a positive side-effect of some of Novo’s recent products and the company is in the process of trying to harness these properties into a specific product. Given the huge demand and need for an effective weight loss product, this could be a significant future growth driver not reflected in the current share price.
We have held Novo for a relatively long time and fully intend for it to remain a core long-term holding for the strategy. Our analysis will continue to focus on the long-term drivers of growth and any potential risk factors that could challenge its attractive ROIC profile.
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