NVS: Share of Peer Group R&D Spending Exceeds Share of Peer Group Innovation Produced

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Richard Evans / Scott Hinds / Ryan Baum

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November 19, 2013

NVS: Share of Peer Group R&D Spending Exceeds Share of Peer Group Innovation Produced

  • NVS’ economic returns to R&D spending (yr10 operating income / yr1 R&D) are on par with peers, after recovering over the last decade. This appears to be more a consequence of cost cuts outside the R&D organization than of efficiency gains within R&D
  • Since 1993, NVS’ R&D spend per quality-adjusted patent has averaged $52M, v. $30.5M for the peer group. This ‘unit cost of R&D’ disadvantage for NVS has worsened in the last decade; NVS’ R&D spending has kept pace with peers but its share of innovation has not
  • 80pct of the company’s pre-phase III (aka ‘hidden’) stock of innovation lies across 29 research areas, where NVS holds an average rank of 5th. NVS holds a top 3 rank in 14 of these 29 areas, and ranks first in 3 of these areas
  • NVS’ hidden pipeline contains 5.1pct of the quality-adjusted innovation held by the combined peer group; however the apparent market value of NVS’ hidden pipeline is equal to 11.8pct of the summed market value of all peer companies’ hidden pipelines, implying NVS’ hidden pipeline is roughly 2x overvalued. For NVS’ hidden pipeline to be valued on par with peers, all else held equal its share price would have to decline by roughly 20pct relative to its peers. **These figures were current as of our last hidden pipeline iteration in September of 2013, and will be updated in the iteration to be published this December**

NVS’ R&D spending as a percent of sales is on par with its peer group (Exhibit 1), as are its economic returns to R&D spending (yr10 operating income / yr1 R&D, Exhibit 2) following a period of steady improvement over the last decade

Economic returns to R&D spending measure R&D productivity on an enterprise wide basis, and make no distinction as to whether returns are attributable to operating efficiency within R&D specifically, or to operating efficiencies in the broader non-R&D organization. To estimate R&D-specific operating efficiency, we rely on quality-adjusted patent counts as a standardized measure of innovative output. Measured this way, NVS lags the peer group with respect to the amount of innovation produced per dollar of R&D spending, which implies that operating savings outside of R&D may have offset operating inefficiencies within R&D. Over the last two decades NVS spent roughly $52M of R&D per quality-adjusted US patent granted, versus a peer group average of $30.5M (Exhibit 3). Across this 20 year period, with the exception of 2002 / 2003 NVS has had a consistently higher share of peer group R&D spending than of peer group innovation (Exhibit 4)[1]. Since 2003 NVS’ R&D spending kept pace with the peer group but its share of innovation did not, thus most of NVS’ higher R&D spending per unit of innovation appears to have occurred in the last decade (Exhibit 5)

Narrowing our focus to the company’s phase II and earlier (aka ‘Hidden’) pipeline, we find that 80pct of the company’s ‘hidden’ stock of innovation lies in 29 research areas[2] (Exhibit 6). NVS has an average rank (according to share of quality adjusted innovation) of 5th in these 29 areas, and ranks among the top 3 in 14 of these 29 areas. The company’s stock of pre-phase III innovation is, on average, about 6 months older than peers’, owing largely to a bolus of innovation granted within the last 10 to 15 years (Exhibit 7). The apparent quality[3] of innovation in NVS’ hidden pipeline has lagged the peer group since 1996, with the exception of the three year period from 2000 – 2002 (Exhibit 8)

Looking forward, the company’s share of anticipated grants (based on current filings) is likely to grow considerably (Exhibit 9); this implies NVS’ share of innovation may be recovering off of its 2008 trough (see Exhibit 4 again). If our estimates of NVS’ future grants are accurate, NVS’ hidden pipeline would grow relative to the peer group’s aggregate hidden pipeline (Exhibit 10), though to a point (+/- 7.2pct) still well below NVS’ share peer group R&D spending (currently 10pct)

As of September, the quality-adjusted innovation in NVS’ hidden pipeline represented 5.1pct of the total quality-adjusted innovation in the broader peer group (Exhibit 11, col ‘e’). However the apparent market value of NVS’ hidden pipeline represented 11.8pct (Exhibit 11, col ‘d’) of the summed market value for all peer group companies’ hidden pipelines, implying that NVS’ pipeline was nearly 2x overvalued. As of that date, all else equal NVS’ market capitalization would have had to fall by roughly 20pct for its hidden pipeline to be valued at par to the peer group (Exhibit 12). **These figures were current as of our last hidden pipeline iteration in September of 2013, and will be updated in the iteration to be published this December**

  1. Exhibit 4 compares NVS’ share of R&D spending in a given year to NVS’ share of total quality adjusted innovation granted in a given year. This view gives a better sense of trend than Exhibit 3, which aggregates relative cost of innovation across 20 years into a single figure. Nevertheless two particular limitations of Exhibit 4 should be borne in mind: 1) R&D spending in any given year will be dominated by development spending, whereas the number of quality-adjusted patents granted in that same year have a lot more to do with research spending; and 2) because citations are a crucial component of measuring quality, and because younger patents have had very little time to accrue citations, our measure of quality-adjusted innovation output is much weaker in the most recent years. Accordingly measures of NVS’ share of innovation in 2011 through 2013 will be relatively rough estimates
  2. Research areas are defined here in terms of the World Health Organization’s (WHO) Anatomic, Therapeutic, and Chemical (ATC) classification system. Single research projects can fall into more than one ATC code
  3. To estimate quality, we rely heavily on measures of the rate at which patents accumulate so-called ‘forward’ citations from later-filed patents. Though not reflected in the quality metric in Exhibit 8, we also consider patent age to be a meaningful indicator of quality. In particular, we view ‘hidden pipeline’ patents granted more than 15 years ago as having little if any commercial utility – the simple logic being that patents of this age that are not yet associated with phase III or later assets are unlikely to underpin commercially meaningful projects
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