Novo Nordisk – the anatomy of a good company

Jamie Ross, fund manager of Henderson EuroTrust, explains the rationale behind the inclusion of the Danish pharmaceutical company Novo Nordisk in his portfolio.

When considering an investment for the Henderson EuroTrust (LON:HNE) portfolio, we tend not to focus on market ‘noise’ or any technical factors; the main thing we are doing is trying to establish whether what we are looking at is a good company 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 there are myriad characteristics and features to analyse that will be unique to each and every business. 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 companies) we try to ascertain whether a business is a good business and if so, whether now is the right time to be invested or not. In this article we will highlight aspects of our process using one of our portfolio companies, the Danish pharmaceutical company Novo Nordisk (CPH:NOVO-B).

What does the company do?

Based in Denmark, but very much a global business, Novo Nordisk (‘Novo’) has, for over 90 years, been focused largely on one therapeutic area; diabetes care. The business started with the merger of two Danish companies in the 1920s that began to sell insulin, which at the time had just been discovered and was, as such, a novel product. Novo has grown strongly since the 1920s into a globally recognised pharmaceutical business, but crucially, its focus has remained firmly on diabetes care and on closely adjacent categories. I will come back to discuss the return on invested capital (ROIC) characteristics later, but needless to say, this laser-sharp focus has been a significant reason for the company’s long-term success.

Novo still generates around 85% of its revenues from diabetes care, but over recent years, the focus has shifted from insulin, which almost 100 years after it was first produced is finally becoming commoditised, 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, a weekly injectable product called Ozempic and is in the process of developing an orally administered product (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, both of which are very important features for diabetic patients.

Does this company generate strong return on invested capital (ROIC)?

The firm’s gross margins (total revenue minus cost of goods sold) are exceptionally high at over 80% and are expected, by the company, to be able to be held at these levels. The strong gross margin is driven by the company’s very powerful market position (they are market leaders in all that they do) and the very attractive demand dynamics in the industry (demographic changes are driving higher incidence of diabetes on a global basis). The strong supply-side and demand-side characteristics combine to create pricing power for Novo.

Novo spends around 26% of sales on selling and distribution costs (SG&A) and another 13% on research and development costs (R&D). With only around 3-4% of sales spend on administrative costs, Novo is able to generate an exceptionally high EBIT (earnings before interest and tax) margin of around 42%. We believe that this is sustainable, largely due to an 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 little intangibles and essentially no goodwill (it has not been a big acquirer 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 is able to generate exceptionally strong ROIC (above 60% on our numbers). This will be a truly exceptional investment if these levels of ROIC can be sustained over the coming years.

What are the risks to the business and to this ROIC profile?

As explained previously, we view the singular focus of the company on diabetes as a positive for the long-term investment case and ROIC structure. However, this focus does bring its risks. For example, Novo is far more exposed to the risk of someone else developing an alternative to one of its key products than a company such as Roche for example, whose product suite is far more diversified. In addition, if Novo were to fall behind on innovation/R&D success, then you could see the company’s earnings power and ROIC characteristics come under material pressure; pharmaceutical products are exposed to patent ‘cliffs’ and therefore they constantly need to be developing new products in order 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 you are selling them is not unique. Novo has traditionally fended off this bargaining power by selling innovative products, but it is a risk factor that we must constantly monitor. Another key risk with Novo is that it loses talent, especially in its R&D team. We would highlight Mads Thomsen, who heads up the R&D team, as being one of the key individuals that Novo must retain. Finally, as with other high-quality companies, the high valuation that the company trades on means that any doubts from the market about the company’s ability to deliver on its 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 confidence in the future growth profile of the company. First, as briefly mentioned previously, 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 ‘westernisation’ of some Asian countries’ eating habits) are two of the most important drivers. In addition, 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 very positive side effect of some of Novo’s recent products and Novo is in the process of trying to harness these properties into a specifically weight-loss-focused product. Given the huge demand and unmet need for an efficacious weight-loss product, this could be a significant future growth driver that we do not see reflected in the current share price.

Investment decision?

We have held Novo for a relatively long period of time now 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 on any potential risk factors that could challenge the business’ attractive ROIC profile.

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