How Innovation In Europe And China Is Helping Novartis Over Its Patent Cliff

 7/19/2012Novartis managed to beat Wall Street analysts' forecast in the second quarter even as it faced the loss of U.S. patent protection on the hypertension pill Diovan, long its top-seller. "This is right in the thick of the Diovan patent expiration," says chief executive Joseph Jimenez. "As we come out of 2012 and midway through 2013, I think we'll position the company for some good growth."Adjusted earnings per share were still down 7% to $1.38 per share. Sales for the quarter fell 4% from a year ago to $14.3 billion, but the company says that, adjusting for currency changes, sales were actually up 1%.Jimenez continues to say that Novartis, based in Basel, Switzerland, will be able to weather the storm thanks to the innovative drugs it is developing and the fact that it is in several non-pharmaceutical businesses. Prescription drugs now represent only 50% of Novartis' sales, with the generic unit Sandoz, the eye care division Alcon, and its over-the-counter and vaccines businesses comprising the rest of the growth. Manufacturing woes: In addition to the Diovan patent expiration, Jimenez is facing two sets of manufacturing problems that are dragging on both sales and earnings. Sandoz is working to improve quality at there different plants after receiving warning letters from the FDA. The over-the-counter division has started producing Excedrin, a headache medicine, and Sentinel, an animal health product, again but won't be ready to ship again until the fourth quarter, later than Novartis had forecast. Perrigo, a rival in the over-the-counter space that makes store brands, could benefit, according to Christopher Schott at J.P. Morgan.Growth in China: Sales in China were a bright spot, up 23%. As laid out in a recent report from IMS Health, emerging markets like China are the growth area that could take the overall global drug market, including generics, from $950 billion now to $1.2 trillion in 2016. But big drug companies could sit out this boom because these markets will be dominated by small, local generic drug makers. Many large pharmaceutical firms are trying to make so-called "branded" generics in these markets, where a brand name for a blood pressure pill or cholesterol drug comes to command a premium price.Jimenez says he's not going to rely on the branded generics strategy. He's finding that China wants to create a market for branded, innovative drugs, and says that Novartis' growth there is due to its branded treatments for chronic obstructive pulmonary disease (COPD), caused by cigarette smoking, and Lucentis, for macular degeneration, a leading cause of blindness. He says he expects the branded generics to be squeezed on price while innovative drugs benefit. Just as Novartis set up its research headquarters in Cambridge, Mass., when the U.S. was the key to growing a pharmaceutical company, it is now building a research lab in Shanghai, with many researchers already in China in temporary headquarters. New drugs: Jimenez says what he is most excited about is the launch of several new drugs. Affinitor, approved for kidney cancer, just received a European clearance as a treatment for advanced breast cancer and may soon get approval from the U.S. Food and Drug Administration. That's great news for the 200,000 women who get diagnosed with the disease each year, Jimenez says, and could by itself make Affinitor a $1 billion drug. He's also very excited about Novartis' COPD drugs getting cleared in Europe; it is about two years behind in the U.S. He is waiting on European approval for Bexsero, a meningitis vaccine that could make the vaccine division less dependent on the seasonal flu shot business.Jimenez also talked up a new psoriasis drug that may have fewer side effects than competitors and two cancer drugs against PI-3 kinase drugs for different solid tumor cancers. Relaxin, a treatment for acute heart failure, is a huge opportunity, but no medicine has proved successful in acute heart failure in a decade or more. "That's why, externally, nobody's counting on it," he says.Focus on innovation: Novartis has launched more drugs over the past 10 or 15 years than any other drug company, although not all have been successful. Jimenez says that the company has benefited from being focused on research more than marketing, a direct contrast with many other drug firms. (AstraZeneca, where Jimenez was once a board member, springs to mind as the epitome of a more marketing based company; until recently, so was Pfizer.)"We allocate spending based on the level of unmet medical need as opposed to how big we think the market size is," says Jimenez. "When you're developing you can make a lot of false negatives based on how big is this market?" That means that insurers and governments are more willing to pay a premium price, especially if the drug is targeted to a specific population because the disease is rare or there is a diagnostic test. If he were running a more marketing-focused firm, he says, "things would be different."Joe's Job: Right now, though, investors don't want to hear about Novartis' past innovations, or even new approvals. They want the manufacturing problems fixed, the patent storm weathered, and a clear plan for what happens when Gleevec, for leukemia, arguably the most important drug of the past 15 years, goes generic, which could happen as soon as 2015. Right now, Novartis trades at 10 times next year's earnings, about the same as Pfizer and slightly less than Merck. Novartis shares are down 8% over the past twelve months, but have been essentially range bound since September.