Novo Nordisk Has One of the Widest Moats in Health Care

I have a soft spot for companies with the combination of a wide economic moat (a very strong competitive advantage), a positive moat trend (the competitive position is improving over time), and exemplary stewardship (management that excels at strategic execution and capital allocation).  Novo Nordisk (NVO) is just such a company, and I recently purchased it for Morningstar StockInvestor's real-money Hare portfolio. I think Novo Nordisk has one of the widest moats in healthcare, with many favorable dynamics beyond just patent protection defending the firm's profits from the competition.

The World's Premier Diabetes Drugmaker
With more than 85 years of history and about a 50% share of the global insulin market by volume, Novo Nordisk is the leader of the attractive diabetes drug niche. Prevalence of the disease has been steadily increasing, with aging populations, unhealthy diets, and increasingly sedentary lifestyles. None of these secular trends shows any sign of slowing. The total market for diabetes care grew 10% annually over the past decade, and Novo Nordisk has been steadily improving its market share.

Diabetes is a chronic disease. There are two main forms: Type 1, where the body fails to produce insulin altogether, and Type 2, where the body steadily becomes resistant to insulin. Insulin is a hormone necessary to remove glucose from the blood, where it becomes toxic if allowed to accumulate. With careful management, it is possible to live for decades with diabetes. However, unmanaged diabetes can result in all sorts of complications, such as nerve damage, cardiovascular problems, and kidney failure.

Because diabetes is so common, it accounts for a disproportionate share of health-care costs--some $250 billion annually in the U.S. alone. Importantly, the incentives of health-care payers and diabetes drugmakers are somewhat aligned, since it is much cheaper to manage the disease with drugs than it is to treat all the complications of uncontrolled diabetes.

There are other favorable characteristics to diabetes drugs. They are often prescribed by primary care physicians, and effective marketing and education are both expensive and essential. Various drugs can have a different effect on blood sugar levels, so once a patient's disease is well-controlled on a particular regimen, doctors and patients hesitate to switch brands. As pharmaceuticals go, insulin is also relatively inexpensive, but consumed in large volumes--which means manufacturing scale plays an unusually important role. As a biologic drug, generic insulin isn't yet available in the United States, but even in international markets where Novo competes with generics the company tends to maintain a dominant market share. In other words, while Novo Nordisk's primary advantage is its intellectual property, the wide moat is bolstered by economies of scale, branding, and switching costs.

Innovation in Diabetes Drugs
Insulin is the ultimate diabetes treatment. Type 1 diabetics need insulin to survive, and sooner or later most Type 2 diabetics will need insulin, too. However, insulin has a number of drawbacks: It requires a painful injection, often multiple times per day; it can cause patients to gain weight, when obesity is already an issue among many Type 2 diabetics; and if patients take too much, they can die from hypoglycemia.

The past decade has witnessed significant innovation in diabetes care. Within insulin, the market has been shifting away from older human insulins and toward modern insulin analogs. The modern insulins either last longer, act quicker, or some combination of these, which helps diabetics more closely imitate the body's natural activity. Modern insulins also happen to be significantly more expensive. There has been innovation in delivery mechanisms as well, with Novo increasingly selling insulin in convenient prefilled pens that eliminate the need for a vial and syringe. Novo has a full pipeline of next-generation insulins, including oral insulins still at a relatively early stage of development.

The downsides to insulin have also resulted in the emergence of other classes of diabetes drugs, in particular DPP-4 inhibitors such as  Merck's (MRK) Januvia and GLP-1 analogs like Novo's Victoza. Novo has focused on the GLP-1 class because it does the best job of imitating the body's natural behavior: releasing insulin only when needed, without a serious risk of hypoglycemia. Victoza has the added benefit of causing mild weight loss. Victoza seems to have overcome some early safety concerns about pancreatitis and is on pace for more than $2 billion of sales this year. For the most part, these new therapies have tended to result in earlier treatment of a greater number of patients, rather than cannibalizing insulin sales.

Modern insulins and Victoza are Novo Nordisk's two big growth drivers, with sales up 16% and 36% in the most recent quarter, respectively. Over the past three years, the company achieved 15% annual sales growth and 25% annual operating income growth. Our model calls for sales growth to slow to 8% and operating income growth to slow to 11% annually over the next five years. Share repurchases generally enable Novo to grow earnings per share a few percentage points faster than operating income.

Risks
Of course, Novo Nordisk is not without risk. The most important patents on its modern insulin franchise expire around 2017, and it is likely that there will be a regulatory pathway for approval of generic biologics in the U.S. by then. However, we haven't modeled a decline in sales following the patent expirations, as we usually do for drug manufacturers. We're counting on all the other unique dynamics in the insulin market--the challenge of marketing to primary care physicians, the need for scale in manufacturing, patient switching costs--to prevent generic competitors from seriously eroding Novo's market share.

Part of Novo's strategy is to constantly roll out new insulin innovations that extend its patent and branding advantages. However, the company recently received a regulatory setback when the U.S. Food and Drug Administration requested additional cardiovascular safety data before it can approve Novo's next-generation insulins Tresiba and Ryzodeg. While we still expect these drugs to be approved eventually, the FDA's request will delay launch by at least a few years, perhaps creating an opening for competitors.

Of course, the secular growth in the diabetes market isn't exactly a secret, and many other drug companies are attempting to encroach on Novo's turf. For example,  Bristol-Myers' (BMY) and  AstraZeneca's (AZN) Bydureon has a similar mechanism of action to Victoza, but only requires an injection once per week. Novo has its own once-weekly version of Victoza in development, but it is a couple of years behind Bydureon.

Valuation
Novo Nordisk is trading for a better than 20% discount to Morningstar's $212 fair value estimate. At around 20 times expected earnings for this year, Novo isn't screamingly cheap, but its valuation is in line with historical norms and can be justified by the company's growth outlook. Overall, I think this is a fair price to pay for a company of exceptionally high quality.

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