Novo Nordisk (NVO): Overvalued Pharma That Should Be Rotated Here

Author’s Note: This is the shorter version of an article posted on iREIT on Alpha on April 18th 2022.

Novo Nordisk (NVO) is the sort of pharma business you want to own – at the right price. This is a dominant player in top international fields of medicine. The company is the largest player in Diabetes medicine/treatment and controls over 30% of the global market, including a massive 44% of the global insulin market.

This company has absolutely superb return metrics, sector-leading margins, and a very efficient asset strategy that’s allowed for some superb returns throughout the past few years.

I invested large amounts of money years ago – but I’ve since then rotated most of it into cheaper businesses.

Here is why.

Novo Nordisk – What the company is and does

As mentioned, Novo Nordisk is a global leader in the care of Diabetes. Diabetes is around 80% of sales for the company in one way or another, even if it does have other treatment areas. These other treatment areas include hemophilia care, growth disorders, and obesity, each making up between 4-8% of company sales.

The company is a global controller of around 30% of the diabetes market. This market is somewhat complex, but Novo Nordisk owns 30% of the main market and has a 40-50% market share in the diabetes sub-market, such as GLP-1 and insulin.

Novo Nordisk has stellar credit and is rated AA- by S&P Global with similar ratings across the board. The company is not a high sort of dividend payor, coming in at a historical 1-2%. Dividends are not why you buy Novo Nordisk – safety, growth, and exposure to appealing markets are your target when you start investing here.

Novo Nordisk is owned 28.1% by the Novo Nordisk Foundation, which owns voting-class strong sharers that amount to 76.7% of the voting rights, meaning a majority decision-making power in the company. Other strong shareholders are BlackRock (BLK), Vanguard, and the Norwegian State.

It can be said that 1990-2020 was a superb time to be in diabetes investments because the global rate of diabetes has been skyrocketing during these past decades. This is not the case for the next decade or two – at least not in terms of overall expectations. Expectations are for the diabetes market to essentially normalize more, and dial down growth to around 1-2%. The expectation is also for the demand for Insulin to flatten/drop somewhat, while oral diabetes drugs are set to grow perhaps somewhat more. (Source: Alpha Value, MedJournal)

The market is also seeing increased competition and pressure, as we get more and more competition in the form of both insulin- as well as non-insulin-based medications. Stiff competition for Novo Nordisk comes from Eli Lilly (LLY) and Boehringer Ingelheim, which is German and not publicly listed. Their respective drugs Jardiance and Trulicity are leading sales, and are already pushing out Novo Nordisk drugs from the #1 spot. This is not to say that Novo hasn’t been fighting back, with releases of Ozempic that’s led to continued market leadership in the sub-category of GLP-1. While undercutting Novo and Sanofi (which suspended all R&D for diabetes), Eli Lilly has more than 10 compounds in different phases of clinical trials, Novo’s presence across the drug classes and exploring additional diabetes-related treatment areas justifies the Danish drugmaker’s continued top slot. The point is not to make Novo Nordisk seem in danger, but to point out that competition is increasing – and the competition has the financial muscles to do what they want.

The pricing for Insulin is under massive, global pressure and this is likely to continue. The USA is a huge market for Novo, with over 45% of sales. Recent presidential cycles in 2020-2022 have focused on starting to pressure the prices on some of these medications. Despite the companies already offering discounted refills, the pressures in this segment are definitely here to stay. Besides pricing, competition has intensified via Eli Lilly’s competition through its aforementioned GLP-1 candidate Trulicity, which has been in the market since 2014 and is taking market share (primarily new patients) from Novo’s Victoza (2010 US approval).

These pricing/competitive concerns are also what forced, as mentioned Sanofi (SNY) to suspend its R&D completely in the diabetes space.

Novo Nordisk’s fundamental upside has always been managing its products and their lifecycle very effectively. The company has a slew of legacy insulin products that have faced headwinds during the recent years, resulting in the top positions being passed to even more modern and innovative products which have been able to make up for the price erosion of legacy insulin.

Novo Nordisk, in addition to advancing its research efforts on diabetes, has been active in the associated and fast-growing obesity market, with Saxenda. This medication controls a staggering 65% of the global market for Obesity, a market with a TAM of $1.5B of 650M people. Only 15M of them is being treated, meaning this is a massive opportunity, and the company expects the number of patients to increase by 10M until 2025.

The company is also pushing into entirely new treatment areas such as cardiovascular, non-alcoholic steatohepatitis, chronic kidney, and Alzheimer’s.

These pushes are clear signs that management is acknowledging that being the market-dominating force for Diabetes is no longer enough for the growth that investors have come to associate with long-term investing in Novo Nordisk.

In terms of Sales, Diabetes makes up around 94% of total revenues, with biopharmaceutical sales making up 6%. The company’s emerging market exposure is low at 10%, with the largest FX exposure in dollars. The largest market is EU and NA, which make up over 60% of total sales together, with China making up around 11.4% of sales.

Novo Nordisk has historically shown exceptional ability to withstand pricing pressure, NVO manages operating margins of over 43%, with peers closer to 24% – and this is despite NVO spending 6% less as a percentage of sales than competitors on R&D. The near-term margins seem safe at least. Another massive advantage is selling 50% of its products in dollars, which means that NVO is a major beneficiary of a strong USD.

Novo Nordisk has also not outsourced its production to China. The group has a total of 16 manufacturing sites across the US, Brazil, France, China, Russia, and Japan, but the main manufacturing is carried out in Denmark, where it has seven plants. No drug manufacturing is allowed to occur in China, only filling and packing. Moreover, despite running a highly commoditized business, the group has done well to keep its SG&A expenses in check over the years – an average of 29% of sales compared to around 33% for its peers.

In closing, Novo Nordisk carries some of the largest shareholder returns in the entire sector, and with a ~70% annual RoE, the company carries superb returns as a result of excellent margins and superb asset rotation (158% vs. 57% for peers).

As mentioned, the dividend is on the low side but has shown very impressive growth over time.

So, overall, this is a foundationally great company if bought at the right price and under the right sort of circumstances.

Novo Nordisk Risks

Novo Nordisk of course also has some risks inherent to the business. Some of them I’ve already touched on, and the company’s strategy has shifted, reflecting some of them.

Pricing pressure in legacy insulin and diabetes drugs is a major problem for Novo Nordisk. This is especially true for emerging markets where the company’s products, to a larger extent, are included in hospital-based bulk-purchasing programs due to the national healthcare systems. This ensures a consistent sort of margin pressure across the company’s entire bottom line.

The company also has technology concentration to a degree that might impact the future. Both the pipeline and marketed drugs that Nordisk focuses on use glucagon-like-peptide-1 as their hormone/focus, which means that the company might suffer from overexposure here compared to other potential technologies.

Perhaps the most worrying factor though, is that when it comes to other treatment areas, Novo Nordisk might lack the expertise and punch to really challenge some of the primary peers here. This is especially true for Haemophilia, with already-apparent competition being frequent here, from Roche and other peers such as Biomarin (BMRN).

However, aside from these smaller facts, I do see no significant fundamental risks to Novo Nordisk. To put it in positive terms, Novo Nordisk is “too good” to face much from other directions here.

Novo Nordisk management deserves all the credit in the world for delivering top-notch results year. after year. after year. However, many analysts shifted to a cautious stance on the Danish giant due to inflated multiples and its single technology focus.

Let’s look at that valuation.

Novo Nordisk – Valuation

When it comes to valuing Novo Nordisk, I use three methods for evaluating company performance and forecasts.

When it comes to DCF, we assume a 4-6% EBITDA growth rate due to increased penetration of GLP-1 products. R&D costs go up quicker and higher than historically due to the company’s increased and more diversified pipeline of products. A 4-6% growth rate in EBITDA is actually below the historical norm, but I believe this more accurately reflects the company’s current position and forecasts, as legacy insulin products are set to continue their decline.

The new crop of drugs and products for Novo Nordisk will be subject to more intense competition than its legacy products. I assume a 4% CapEx growth compared to the 4-6% EBITDA growth. This puts my estimates well below my analyst peers, which focus on a 2.5-3.5% CapEx growth, but I like being more conservative and allowing for more setbacks than others.

The resulting DCF on a WACC of 6.84% with a cost of debt of 3.15% is a range between 690-740 DKK/share. This is, quite obviously, well below the current share price if we average it out to around 715-720 DKK/share.

Peers are easier. In the Peer group, I include Roche (OTCQX:RHHBY), Biomarin, Eli Lilly, Sanofi, AstraZeneca (AZN), and Belgian UCB (OTCPK:UCBJY). This peer group averages a P/E of 22.5X, with an EV/EBITDA of around 15.5X and P/B multiples of above 5X. Novo Nordisk does constitute a justification for a premium – around 25-30% to my mind, given its global market dominance of key products, but even with these premium allowances, the company has a 33X+ P/E, a 25X+ EV/EBITDA, and a P/B multiple in the stratosphere. This is coupled with a yield of less than 1.5% compared to a peer average of almost 2.3%.

The peer average does not give us a flattering picture for allowed peer valuations. Based on the premiumized P/E, a valuation higher than 725 DKK is out of the question – even lower with EV/EBITDA. The P/B allowance even with a 35% premium is only 405 DKK/share.

The simple fact is that based on every single valuation method, the company trades at a near chronic premium to any sort of logical valuation. Evaluating NAV is harder since we take blockbuster medications and apply sales multiples – and here things get truly varied when we look at analyst targets. Applying a sector-relevant sales multiple range of 3-10X depending on the life cycle of the drug, analysts get gross asset targets of around DKK1,627B, which fewer commitments and on a per-share basis net of treasury shares comes to less than 710 DKK/share.

Unless you want to start applying higher sales multiples than 10X for Ozempic/Rybelsus and Wegovy/Saxenda, the company’s blockbusters, you’re fresh out of luck in NAV as well.

Any target above a 720 DKK multiple assumes a premium for the company that I’m very uncomfortable with – and would not invest in. That’s why I myself sold the company after waiting around for a long time, at close to 800 DKK some time ago.

S&P global analysts are surprisingly somber with their PT’s for NVO. 24 analyst following the company come to a PT of 720 DKK based on a range of 490 DKK low and 905 DKK high. 16 analysts have the company at hold, underperform or sell. The overvaluation based on S&P Global here is 11% – I sold at around 10%.

The picture I want to deliver to you is very clear.

Novo Nordisk Is overvalued here – at least 10%. That’s the very least we could consider the overvaluation at over 800 DKK per share.

Thesis

While Novo Nordisk remains one of the undoubtedly strongest pharma businesses on earth, that does not mean it has an immunity to challenges or hardships, or valuation concerns.

I’ve mentioned that GLP-1 technology, while being a huge success, also comes as a singular risk in terms of concentration. It’s also very pricey compared to legacy insulin, which could pose challenges in emerging markets with less buying power in the typical consumer.

Also, 2021 outperformance by Novo Nordisk apart from diabetes tailwinds, was driven in large part by one-off discontinuation decisions for discounts to certain hospitals – namely government-designated hospitals in low-income and/or rural communities which receive rebate benefits; resulting in a 2-3% positive sales impact. How this impacts the company’s future sales flow in this area remains to be seen. In addition, Wegovy is seeing supply issues that are impacting first-mover advantage compared to LLY drugs Teriparatide, which is better clinically than Ozempic for both diabetes and obesity.

In the end, the company performs very well – but the margins for error are shrinking as competition increases, and the valuation demanded by the company fails to reflect these inherent risks to NVO, instead giving the appearance of years of LFL historical growth.

I do not believe this to be a realistic case.

Novo Nordisk has a very liquid ADR of 1x trading under NVO. It’s so liquid that I will show the upsides and possible cases here as well.

I believe this visually captures how far out of its normal trading range the company is currently being traded at. I only see one possible result for holding Novo Nordisk at this price – sub-par or negative RoR in the short or medium term.

Even assuming an average P/E premium of over 20x, the company is likely to underperform given the heights it’s currently trading at.

You could make a case, I suppose, for why a 30-36x P/E multiple is fair for Novo. On the basis of my research and everything presented herein, I will state to you in no uncertain terms that I believe such a stance to be wrong/incorrect.

I believe Novo Nordisk will come down from its lofty heights, and normalize closer to 20-25x P/E, at which point savvy valuation investors, such as myself and yourself, potentially can pick it up if our portfolio allows for it.

Until such a time, I am not interested in buying Novo Nordisk – and happy to stay at the sidelines at a “HOLD”.

At 10% overvaluation even to a high conservative PT, I believe Novo Nordisk should be rotated.

My own PT is around 720 DKK, which currently comes to an overvaluation of 11%.