Novartis Stock Downgraded: 3 Things You Need to Know

By Markets Fool.com

With its stock down 26% in 52 weeks, German pharmaceutical giant Novartis is looking cheap and winning fans on Wall Street. But Leerink Partners is not one of them.

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According to data from S&P Global Market Intelligence, 16 out of 34 analysts polled rate Novartis a buy, while only three analysts recommend selling the stock. This morning, however, Leerink Partners moved one step closer to joining the sell camp.

The news
In a note released Wednesday, Leerink announced it is removing its outperform rating from Novartis stock, and downgrading the shares to market perform. The analyst also slashed $13 off of its price target for the stock, cutting its estimate for Novartis to $85.


Novartis reported strong profits in 2015 -- but Leerink is no longer a fan. Image source: Novartis.

Here are three reasons why.

Thing No. 1: Survey says...
According to the ratings watchers at StreetInsider.com, the catalyst for Leerink's move today was a "59 physician MEDACorp Heart Failure (HF) survey" that Leerink conducted, the results of which convinced the analyst that there are "multiple adoption barriers" that could prevent the success Novartis's twice-daily Entrestodrug, which is designed to prevent heart failure. (One imagines that the drug's cost -- about $4,500 a year -- is one such barrier).

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Thing No. 2: Irrational exuberance
Novartis fans have high hopes for Entresto. With analysts projecting sales of as much as $6 billion annually by 2023, the drug could turn out to be a blockbuster -- or not. According to Leerink, the results of its MEDACorp survey, combined with what the analyst is seeing in "the drug's early trajectory" in the market, and certain "clinical issues," has Leerink thinking Entresto won't be nearly as big a deal as everyone else seems to believe it will be.

In fact, Leerink goes so far as to call the consensus estimates for Entresto sales "unrealistic."

Thing No. 3: Bad news for the stock price
Leerink is accordingly projecting "overall EPS forecasts ... well below consensus" levels of $8.60 per share earnings in 2023, on sales of $65.7 billion.

We don't know precisely what Leerink is projecting -- and to be honest, we wouldn't have much confidence in any estimates anyone posited for a stock's earnings seven years into the future. But whatever the magic numbers are, Leerink doesn't see them being good enough for Novartis stock to either "beat the market or its large pharma peers."

And one more thing...
Unfortunately for owners of Novartis stock, the numbers we see today support that thesis. Consider: If we put guesses about "2023" aside for the moment, and focus just on the facts on the ground, Novartis stock currently sells for 10.2 times earnings, pays a 3.8% dividend yield, and is projected to grow earnings at 7.1% annually over the next five years. That all adds up to a total return of 10.9% on the 10.2 P/E stock -- not a bad bargain at first glance.

There are two problems with that analysis, though. First, it doesn't take account of Novartis's large debt load -- currently $16.6 billion net of cash. Second, it overlooks the fact that Novartis's relatively low P/E ratio is based on a net income number that vastly overstates the stock's true cash profitability.

Last year, Novartis reported net income of $17.8 billion. But as the company's cash flow statement reveals, actual free cash flow production was only $9.5 billion. Put another way, for every $1 in "profit" that Novartis reported, the company actually generated only $0.53 in real cash profits.

Put even simpler: Novartis isn't as cheap as it looks.

What to do now?
So how can an investor sidestep these issues, and perhaps buy a pharmaceutical stock that's a bit cheaper? One possibility is to look for stocks than generate more free cash flow than they report as net income. With a P/E ratio of 27.5, Pfizer (NYSE: PFE), for example, looks more expensive than Novartis at first glance. But S&P Globaldata show that Pfizer generated $13.1 billion in positive free cash flow last year -- nearly twice its reported $7 billion "net income."

On the other hand, just like Novartis, Pfizer carries a large debt load. Is it possible we can find a better stock, that generates superior free cash flow, and does it without taking on a boatload of debt? It is: At 19.8 times earnings, Johnson & Johnson is cheaper than Pfizer, and unlike either Pfizer or Novartis, Johnson & Johnson carries net cash -- $18.5 billion worth -- on its balance sheet. Johnson & Johnson also generates more free cash flow ($15.8 billion) than it reports as net income on its income statement ($15.4 billion). Both these factors make Johnson & Johnson cheaper than it looks.

Now, to be clear, I'm not recommending that you rush right out and buy Pfizer stock, or Johnson & Johnson, either -- or even that you sell your Novartis shares. I'm just highlighting the dangers of looking at Novartis' low P/E ratio, its good growth rate, and strong dividend yield, and concluding the stock is automatically a buy. As Leerink has pointed out, the obvious answer isn't always the right one.

And Novartis isn't an obvious buy anymore.

The article Novartis Stock Downgraded: 3 Things You Need to Know originally appeared on Fool.com.

Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 288 out of more than 75,000 rated members.The Motley Fool owns shares of and recommends Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.