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By Erik Kobayashi-Solomon | 01-15-2010 01:15 PM

Behind the Bullish Take on Our Top Pharma Pick

A large generics business and niche pipeline keep Novartis ahead of the curve.

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor of Morningstar's OptionInvestor and today it's my great pleasure to welcome Damien Conover. Damien is a strategist and the editor of "The Healthcare Observer" newsletter. Damien, thanks a lot for coming.

Damien Conover: Thanks for having me, Erik.

Kobayashi-Solomon: I know it's busy for you, about ready to come out with another issue, right?

Conover: Right, yeah. Our next issue is looking at M&A. There's a tremendous amount of opportunity in the pharmaceutical sector for M&A, and so we're spotlighting our take on which companies we think will be gobbled up next.

Kobayashi-Solomon: Boy, it sounds fascinating. But today, what I wanted to do is talk to you about Novartis. A couple of weeks ago, right when the news that Novartis was going to take voting control of Alcon over, I wrote a QuickShot idea putting our subscribers into a bullish position in Novartis.

I know that you have liked Novartis for a long time and I wonder why? What's the good about Novartis?

Conover: Right. Right now Novartis is probably our top pick in the pharmaceutical industry, and there are a couple of reasons behind that. But let's focus first on the generics business within Novartis.

So, Novartis is primarily known for its branded products, but they also have the second-largest generics business in the world with its division called Sandoz. We think the generics industry is very well positioned coming out of U.S. health-care reform as well as a huge tailwind of products losing exclusivity over the next several years.

However, to get a pure play generics firm, you have to pay up quite a bit in the multiple.

Kobayashi-Solomon: These are like Ranbaxy?

Conover: Ranbaxy, Teva, Watson, these are companies that have much higher P/Es than Novartis.

Kobayashi-Solomon: It's already priced in, in other words.

Conover: Exactly. Versus Novartis, you get a huge exposure to the generics business at a much cheaper multiple.

Kobayashi-Solomon: Oh, that is interesting.

Conover: On top of that, we like its branded drug division. This is really the engine that drives Novartis, and we like it for a couple of different reasons. One, it doesn't have the massive patent exposure that some of the other firms have.

While it is facing the patent loss on Diovan in the next couple of years, really outside of that, it's a relatively clean product portfolio in regards to patents.

Kobayashi-Solomon: Ah, interesting.

Conover: And then if we shift towards the pipeline, we think Novartis is way ahead of the curve in what it's going after. And what I mean by that is a lot of pharmaceutical companies stayed with the primary care indications with their pipeline.

Novartis is going after the niche indications, meaning these are niche diseases, not a lot of drugs out there. That means to bring these drugs through the FDA, there's a lot less risk of the FDA rejecting it, because there just aren't a lot of drugs out there for those different types of diseases.

Kobayashi-Solomon: I see.

Conover: So, well ahead of the curve with its pipeline, pretty solid baseline of products, and not going to be losing a lot of products to patent losses.

Kobayashi-Solomon: Is it fair to say that their new strategy is not to hit one or two big blockbusters, but actually have some singles and doubles in the niche markets? Is that right?

Conover: Yeah, I think that's fair. The only thing that I would say is that a lot of these areas that look like they're singles and doubles turn out to be home runs because you have such powerful pricing power in these areas.

So managed care isn't as resistant to say, "Hey, for this niche indication, we're going to say you can't price it at this level." However, for cardiovascular disease drugs, they're going to say, "Hey, we're not going to reimburse at this level." So the pricing power is really in Novartis' court. What were areas that looked like singles and doubles could potentially turn out to be home runs.

Kobayashi-Solomon: So what they lose in volume they actually gain in profitability.

Conover: Yeah, exactly.

Kobayashi-Solomon: Very interesting. Let's turn for a second to the Alcon transaction, the Alcon acquisition. You've talked about the generic side of their portfolio and also this niche indication part of their portfolio. How does Alcon fit in? Why does this transaction make sense for Novartis?

Conover: Novartis, besides those areas that we talked about, also has a vision product line, but it's primarily lens solution and lens products. So contact lenses are really where Novartis has been with the ophthalmology. It also has a few products in its drug lineup that treat ophthalmology indications as well.

By bringing in Alcon, it brings in a whole host of other ophthalmology products and drugs. So there's a nice overlap there, so a lot of the marketing that Novartis has already been doing on the ophthalmology front can be leveraged and there can be a synergy with the Alcon business.

The company has put forward an estimate of $300 million in annual cost savings synergies with a full acquisition of Alcon. From our analysis, that seems like a low-ball number, and we think we could get much higher than that.

So we think it makes sense from a cost-synergy standpoint as well as this is a line that should have very high growth rates. So some of the other divisions of Novartis are slowing a little bit--they still have decent growth rates--but ophthalmology should have very, very strong growth over the next several years.

Kobayashi-Solomon: So really ophthalmology being the engine of growth for Novartis, and then the drugs lines being their cash cows, in other words.

Conover: Yeah, to a large extent.

Kobayashi-Solomon: I see. One thing that I wondered as well, is what this deal portends for the rest of the pharmaceutical industry? We talked about J&J before. Is this a shift towards the J&J style of having some pharma exposure and having some over-the-counter exposure, let's say?

Conover: I think so. I think right now you're seeing a market where if you're a diversified pharmaceutical company, you have a little bit higher multiple. The investment community is more comfortable with the less volatility that you offer than if you were a very focused pharmaceutical company with the volatility of losing the patents.

So I think the market's rewarding those types of companies. I see companies going down that pathway. GlaxoSmithKline, Abbott, even Pfizer to a smaller extent. So you're seeing these companies trying to branch out a little bit to get more diversified, get less volatility.

Also, with the recent acquisition of Chattem by Sanofi-Aventis, that's another example where you see a branded pharmaceutical firm reaching out of the branded drug space and try to get a little bit more diversified.

I think this is just another chapter that we're going down that will see this trend continue.

Kobayashi-Solomon: Boy, you've really got me interested in reading the next edition of "The Healthcare Observer" now.

Conover: Oh, absolutely. We're going to touch on those topics as well as highlight the targets that we think will be gobbled up by big pharma.

Kobayashi-Solomon: Sounds great. Damien, thanks for coming today. I sure appreciate it.

Conover: Thanks for having me, Erik.

Kobayashi-Solomon: And thank you for joining us. Please stop by the Morningstar OptionInvestor website where we have many more option investing ideas.

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