Model Portfolio rmcduff:RMG1

A Category Killer Next Generation Insulin

Novo-Nordisk (NVO-NYSE: $53.51)

Shares outstanding (fully diluted as of 09/30/08: 618.6 million.
Total liabilities- short term cash as of 09/30/08: $1.68 billion.
Enterprise Value: $34.78 billion.

Revenue forecast for 2008: $9.1 billion.
Revenue forecast for 2009 $10.1 billion.

EBITDA margin forecast for 2008: 30%
EBITDA margin forecast for 2009: 32%

EBITDA estimate for 2008: $2.7 billion.
EBITDA estimate for 2009: $3.2 billion.

In an investment world plagued with companies reporting earnings disappointments, reduced guidance or balance sheet blowups due to credit markets, it is refreshing to find world class companies that have INCREASED their guidance. Novo Nordisk is one of just a handful of firms on a global basis to have done so.

http://biz.yahoo.com/ap/081030/earns_novo_nordisk.html?.v=2

Novo Nordisk is the world leader in diabetes pharmaceuticals

NVO has a 52% market share of the worldwide insulin market. This market share has been growing consistently over time. The firm has worked diligently to produce better and safer insulins over the past 20 years, which have been well received by patients. The company has demonstrated considerable success in the modern insulin market as of late, capturing a 44% global market share of this fast growing market. The diabetes division accounted for 73.5% of total revenues in the first 9 months of 2008

Major global competitors include Eli Lilly and Sanofi Aventis.

The firm also has considerable strengths in hormone therapies and haemophilia pharmaceuticals

Novo produces human growth hormones and coagulation products. Revenues continue to grow at double digit rates.

Novo has a superb balance sheet

Using the conventional model that is employed by analysts at most firms, NVO would be considered completely debt free and carry a liquid balance of 1.7 billion US.

http://www.novonordisk.com/images/investors/reports/interim_reports/2008/PR081030_9M_UK.pdf

Analysts generally lump all short term assets into models employed at major brokerage firms, when producing their Enterprise Value (EV) estimates. My valuation models are more stringent. I consider inventory to be a permanent part of the capital structure. Without inventory, a company cannot produce any product. A failure to include inventory in investment analysis represents an admission that a business is not a "going concern".

My EV calculations only include true "cash and short term assets" and exclude inventory, accounts receivable and marketable securities. As we are all now intimately aware, marketable securities sometime become "unmarketable".

Using my model, NVO reported net liabilities of $1.68 billion on 09/30/08. This works out to be less than 9 months of 2008 operating cash flow.

The firm has a near term diabetes product in the pipeline, with blockbuster potential

Liraglutide may be approved by the FDA as early as 2009. This drug is designed to compete with an Eli-Lilly/Amylin Pharmaceuticals product known as Byetta. According to comprehensive phase 3 testing, Liraglutide has the potential to become the industry standard in this newer class of diabetes compounds. Adverse side effects are much less pronounced in Liraglutide than Byetta, and patient tolerance is considerably higher. Novo does not factor in any revenues from this drug in 2009 revenue estimates.

Of greater interest is a "Category Killer" insulin now heading for phase III trials

NN5401 and NN1250 have the indications to completely redefine the conventional treatment of diabetes. Novo had kept this development under wraps until quite recently. Now, it appears that management is highly confident of their potential to better the lives of diabetics globally. These two innovative, next generation insulins will commence phase 3 testing in the latter half of 2009. Both are long lasting insulins (more than 24 hours), and appear to be both safe and very well tolerated. Instead of daily injections, patients would only require 3 injections per week.

Novo is the only company worldwide, with a new generation of insulin in full clinical development. Now that details are more fully disclosed, it appears that NVO might have caught Eli Lilly and Sanofi Aventis napping. Either of these products may serve to completely change the dynamics of the marketplace. If approved, NN5401 and NN1250 could steal enormous market share from competing products.

The global market for conventional insulins (modern and human) is estimated to be larger than $11.2 billion, and is growing at almost double digit annual rates. While NN5401 and NN1250 would cannibalize Novo's own sales, commercialization of either of these insulins could potentially add incremental sales by at least 10% per annum, commencing in 2012.

In terms of market potential, a 3 injection per week insulin, considered much safer than conventional products, with weight loss potential, would reshape the playing field. Novo appears to have as much as a 5 year window over potential competition. If successful, these insulin's could hit the market as early as 2012. While this sounds ridiculous, the potential exists for Novo to capture 100% of the remaining market share

A game changing drug could also be a game changer for Novo investors

At a 7% annual growth rate for conventional diabetes products, the market share that Novo does not have, may grow to $7.4 billion in five years. The operating margins on insulin sales approach 76%. EBITDA margins for this division approach 40%.

Total market share could add an incremental $3 billion of EBITDA for Novo shareholders by 2016. Novo's current product portfolio seems to offer the potential for 15% annual EBITDA growth, for some years to come. Commercialization of NN5401 or NN1250 would make NVO the fastest growing large cap pharmaceutical firm on the planet.

In ten years, if either insulin is approved, NVO appears to offer "five bagger" potential from here.

Unlike many peers, Novo carries little pharmaceutical liability

If a drug does not have the potential to be an industry standard, NOVO management won't run it through the clinical trial basis. The firm also has no reservation about scrapping drugs in the early testing phase. This has been proven again. In the most recent quarter, a promising compound was dropped.

When a drug company cancels a research project in the testing phase, this results in an immediate expense against the current years earnings. This is generally punished by analysts. Perversely, legal settlements are often considered to be "one time" items, and are therefore ignored by analysts.

NVO has demonstrated that it is willing to take the ethical high road. Accordingly, the company's litigation docket is the lightest of any major pharmaceutical firm that I follow.

On a historic basis, the shares are inexpensive

Novo is a quiet global success story. According to Yahoo, only 2 Wall street firms now report on NVO. Yet, in the past five years, investors have almost tripled their investment value, when dividends are added to the total return. That said, the shares are presently selling at the same EV/EBITDA ratio as in 2003. This is because the company's sales and EBITDA have grown proportionately.

Eli Lilly and/or Sanofi-Aventis may ultimately be forced to launch a takeover bid

I don't normally comment on the potential for takeover with any stock, as they seldom come to fruition.

In the short term, potential commercialization of Liraglutide appears to place Lilly at a clear disadvantage. In the mid term, NN5401 and NN1250, if successful, could totally destroy the high profit insulin franchises of Novo's competitors. Lilly, in particular, has lost considerable market share in the past decade. Without a competitive product, the only defense against a category killer, is a high cost friendly takeover.