Novo Nordisk (NVO-NYSE, $33.62) Warns for 2017

Novo Nordisk reported fiscal 2016 results. Net profits increased by 9% and revenue grew by 6%. However, the operating margin fell by 2.5% to 43.3% of sales.

For 2017, Novo anticipates a revenue decline of as much as 1%, which will be the first year in memory, if realized, to produce a decline. Operating margins are also forecast to decline in the range of 2%-3% in 2017.

The issues facing Novo Nordisk are twofold and they are material. In the United States, product shipment volumes are largely determined by inclusion into the formularies of the pharmacy benefit management companies (PBM). The pharmaceutical industry sells their products largely to these third parties, which then distribute the drugs to retailers and end-users. To many observers, this author included, PBMs represent something more odious than a gate-keeper; they add many percentage points to the cost of drugs and have added a layer of complexity to a system that is already overly complex. PBMs have forced drug companies, in certain cases, to increase list prices of popular drugs but then extract steep volume discounts for inclusion into the distribution network. This arcane setup permits the PBM to keep a much higher percentage of the net drug sale price as percentage holdbacks are based upon gross sales. Accordingly, PBMs are keeping, in some cases, almost all of drug price increases for themselves, while pharmacy companies earn less, even in the face of rising prices and increasing volumes. This was the case for Novo Nordisk in 2016.

Secondly, a foreign drug manufacturer has NO allies whatsoever in the current Trump led republican government of America. This author believes that PBMs (some of which are publicly traded, many are wholly owned subsidiaries of publicly traded health insurance companies) are gouging consumers. This gouging has been obscured through effective deflection away from PBM pricing practises and onto the manufacturers of drugs. As American owned companies, the PBMs have the full backing of the current administration and there is no reason to assume that any meaningful change will take place to limit the price setting power of these gatekeepers for 2017. Novo Nordisk, as a Danish company, has no alternative but to accept the system as such; the PBMS take the price increases for themselves, NOVO will ship more volumes and profits should still decline.

What compounds a bad business environment is the possibility of some punitive measures by the American government. As a foreign company, NVO is fully exposed to the headwinds of a more hostile government determined to protect American companies. Domestic producers of insulin and insulin type products in America exist but the global market is largely carved up between Novo (Danish) and Sanofi (French). Should the US seek to punish the foreign dominance through regulatory action, import taxes, fines, etc. there is little that can be done and the effects would be disastrous for NVO shareholders.

The global large cap portfolio prefers to own businesses with high EBITDA margins, secular tailwinds and that operate as monopolies or oligopolies. Until now, Novo Nordisk was a business with all of those characteristics. The sector features a tailwind which is a persistent global increase in diabetes. Until now, EBITDA margins at NVO were growing year over year. Until now, the industry was effectively a duopoly. However, with the recent business forecast, a determination that the US government is hostile to foreign companies and a growing risk of some punitive action that may be taken against NVO; there is little clarity ahead for shareholder of Novo Nordisk. PBMs may seek to extract further discounts in 2017 and beyond, from any foreign manufacturer of drugs, in order to pocket the difference for themselves rather than pass savings onto consumers. The American government may choose to impose a blanket import tax, which is essentially an access fee to be able to sell to the US market. A 10% access tax would hit the profits of NVO, Sanofi and other foreign manufacturers extremely hard.

It is highly doubtful that there will be ANY pleasant headline news for NVO in 2017. According to NVO management, margins and revenues could fall, and they should be taken at their word. Therefore, the large cap portfolio is closing its position in Novo; this position was recently reopened after a two year absence. Accepting a modest loss is the reality of a thesis did not fully take into account the predatory pricing of PBMs and their effects upon the corporate profitability of NVO. It was an atypical misjudgement and the funds will be reallocated elsewhere.

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