Pharma_Valuation_ETH

Valuation

Methodology &

Case Studies

Karl Heinz Koch

Content

Valuation Methodologies - An Overview

3

Static Valuation Methodologies (Pros and Cons)

4-8

Dynamic Valuation Methodologies (Pros and Cons)

9

Vontobel Pharma Valuation ("Net Portfolio Add-On Potential")

10-21

Case Studies:

- Special Situations (i.e. Roche, Novartis)

22-39

Valuation Overview

Static

Dynamic

Geared

(e.g. P/E,

P/CF)

De-Geared

(e.g. EV/x)

Discounted

Cash Flow

(DCF)

Economic

Value Added

(EVA)

P/E rel.,

PEG

EV/x rel.,

EV/x/g

Static "Geared" Valuation Methods (1)

Price per share relative to Earnings per share, the so-called "PER"

Pros:

"Simple" (no adjustments needed)

Widely used because they are "simple"

Cons:

Misleading due to lack of comparability

Different accounting philosophies (shareholder focus versus tax

authorities)

Gearing affects P/E ratios (PER)

USD million Company A Company B

Market Capitalisation 100 50

Level of debt 0 50

Cost of debt (interest rate p.a.) 12% 12%

Earnings before interests and taxes (EBIT) 10 10

Net interest 0 6

Pre-tax profit (PTP) 10 4

Taxes (@ 35%) 3.5 1.4

Net profit 6.5 2.6

Static "Geared" Valuation Methods (2)

Price per share relative to Cash Flow per share, so-called "P/CF"

Pros:

More accurate cross-company comparability within a sector (assuming similar capital structures)

More accurate assessment of "cash" operating performance

Cons:

Not as widely used due to lack of information that spots "cash" from "non-cash" items

Insufficiently accounts for minority interests, capital requirements and is even more sensitive to "gearing" than a PER

Static "De-Geared" Valuation Methods (1)

Enterprise Value (EV) relative to "Revenues" per share

Pros:

Values assets of a company by looking at the whole enterprise (hence the term "enterprise value") independent of the capital structure of the company (which is different from just looking at "equity" in the case of geared valuation methods); (known as Proposition 1 by Miller and Modigliani)

Allows for a distinction between a company's "core" and "non-core" assets (widely used by so-called "company raiders")

Cons:

Imperfections of markets mean that companies are not always able to

restructure their balance sheet at will or at negligible cost

Strong assumptions built into EV methodology: tax neutrality between

Static "De-Geared" Valuation Methods (2)

Enterprise Value (EV) = Market Capitalisation + Value of net debt

(average for the year) - Estimated Value of "non-core" assets

Pros:

Removes the often significant distortion due to different capital structures

Allows to value individual businesses

Cons:

Not as widely used due to adjustments needed ("can not be easily commanded on traditional financial services such as Bloomberg")

Sometimes difficult assumptions needed to value non-core businesses

Dynamic Valuation Method - DCF

Discounted Cash Flow Model

Pros:

Allows valuation of companies with no near-term sustainable cash flow streams (or even loss making companies, i.e. biotechnology)

Appropriate for businesses with discretionary cost structures and long

product cycles, such as pharmaceuticals

Cons:

A large part of the NPV is driven by the growth rates in the terminal

value which are difficult to predict

Many businesses do not lend themselves to the long-term predictions

needed for a DCF model (though pharmaceutical and biotechnology companies do)

Vontobel Pharmaceutical Valuation Model based on

Relative Valuation Multiples for Pharmaceuticals

0 5 10 15 20 25 A Z N Sa n o fi P fi ze r L u n d b e ck _GSK W ye th N o va rt is B M S L il ly M e rc k I n c. SG P M e rc k K G aA _JNJ R o ch e A b b o tt N o vo M u lt ip le ( x)

PER 2008 EV/EBITDA 2008 EV/Sales 2008

PER Median 12.2x

+10x

Large Variances in Relative Valuation Multiples

-6 -4 -2 0 2 4 6 8 10 12 A Z N Sa n o fi P fi ze r L u n d b e ck G SK W ye th N o va rt is B M S L il ly M e rc k I n c. SG P M e rc k K G aA _JNJ R o ch e A b b o tt N o vo M u lt ip le ( x)

Why Has Valuation Analysis Been Poor in the Past?

Relative Earnings Multiples (geared or de-geared) Can Be Misleading

because:

Much of a stock's value is driven by future drug revenues, which are difficult to predict accurately

A. they tend to penalize innovative companies since they are the ones that

have to absorb the high cost of large-scale clinical studies and market introduction;

B. they favor companies that lack new product flow, not least as profitability

measures tend to rise in the short term due to a lack of (product) investment opportunities

Furthermore, relative valuation multiples do not take into account important

quality differences because "growth is not simply growth" and only

sustainable growth driven by new products determines valuations in the sector.

Patent losses - The Only Certainty

0% 10% 20% 30% 40% 50% 60% Roch e (inc . pro p. D NA) _Bayer SGP Abbo tt Wye th Merc k & Co. Nova rtis Novo Nor disk Eli L illy _AZN _GSK _BMS Pfize r Sano fi-Av enti s JNJ g e n e ri c e xp o su re a s % o f sa le s

The Difference is in The Balance

0% 20% 40% 60% 80% Roch e (i nc. p rop. DNA ) Baye r SGP Abbo tt Wye th Mer ck & Co. Nova rtis Novo Nor disk Eli L illy _AZN _GSK Sano fi-Av enti s BMS _Pfizer JNJ g e n e ri c e xp o su re v s p ip e li n e p o te n ti al ( as % o f sa le s)

Winners And Losers ... Broadly Speaking (Phase 1-3)

Net portfolio "add-on" potential (pipeline potential - generic exposure)

-30% -20% -10% 0% 10% 20% 30% 40% 50% Nova rtis Roch e (inc . pro p. D NA) GSK _Bayer SGP Mer ck & Co. Wye th Novo Nor disk AZN BMS Eli L illy Abbo tt Sano fi-Av enti s JNJ Pfiz er % o f 2 0 0 6 s al e s

Winners And Losers ... Strictly Speaking (Phase 3)

Net portfolio "add-on" potential (pipeline potential - generic exposure)

-40% -30% -20% -10% 0% 10% 20% 30% 40% Nova rtis Roch e (i ncl. Prop DNA ) GSK SGP Baye r Mer ck & Co. Novo Nor disk BMS Wye th Abbo tt Eli L illy _AZN _JNJ Sano fi-av entis _Pfizer % o f 2 0 0 6 s al e s

Big Pharmaceuticals - An Industry Fallen From Grace

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 1996 1998 2000 2002 2004 2006 2008E 2010E

3-Phase DCF Model - FCF Growth EU Universe

6% 4% -5% 0% -2% 2% 3% 0% 2% 0% 3% 3% 3% 3% 3% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0%

Novartis Roche Sanofi-aventis GlaxoSmithKline AstraZeneca 1st phase 2nd phase terminal

Healthcare Continuum - Risk Perceptions

Biotech

Big Pharma

Assessing Quality of Growth - Appropriate Discount Rate

Low risk (++)/High risk (--) ++ + 0 -

--Premium/Discount per quality

characteristic -0.40% -0.20% 0.00% 0.20% 0.40%

++ (significantly better than sector)

+ (better than sector

average) 0 (sector average)

- (w orse than sector average)

-- (significantly w orse than sector) Pipeline Potential or Portfolio

Replacement Rate (Sum of probability-w eighted peak sales of all pipeline projects expressed as % of current sales)

> 50% 40% - 50% 30% - 40% 20% - 30% 0% - 20%

Generic Exposure or Portfolio Rate at Risk (Sum of all sales losing patent protection in the coming 5 years expressed as % of sales)

10% 10% - 20% 20% - 30% 30% - 50% above 50%

Increm ental potential of base portfolio (Sales of the underlying base portfolio - not new , not at generic risk - as % of current sales)

> 36% 26% - 35% 16% - 25% 0% - 15% < 0%

Therapeutic Leadership (Franchise strengths indicating high sustainability of future cash flow s - Minimum 10% in USD 10 bn+ market segment)

3 leadership positions 2 leadership positions 1 leadership position No leadership according to LODH definition, but among

top 5 in 2 or more areas No notable therapeutic franchise strength Geographical Exposure (% of

revenues in the profitable and higher grow th US market) > 60% US revenues US revenues of 45% - 60% US revenues of 30% - 45% US revenues of 15% - 30% US revenues of 0% - 15% Business Diversification (% of

revenues derived from prescription medicines (not vaccines, not blood plasma) 100% Rx revenues 75% - 99% Rx revenues 50% - 74% Rx revenues 25% - 49% Rx revenues < 25% Rx revenues TOTAL COMPANY-SPECIFIC RISK

(PREMIUM (-)/ DISCOUNT (+) (Negative risk premium is a bonus and increases the value by low ering the overall discount rate (Rf + Rm). Positive risk premium low ers the value by raising the overall discount rate)

Aggregate of premium quality characteristics on discount rate -2.4% -1.2% Aggregate of average quality on discount rate 0% 1.2% Aggregate of discount quality characteristics on discount rate 2.4%

Novartis relative to MSCI Euro Pharma Index

27/2/08 2000 2001 2002 2003 2004 2005 2006 2007 2008 45 50 55 60 65 70 75 80 NOVARTIS 'R'

REL.PERF. TO DRUGS EURO

Source: DATASTREAM

-20%

-30%

Novartis Branded Rx Outperforms a Declining Industry

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 1996 1998 2000 2002 2004 2006 2008E 2010E

A Bird's View

Cost Phase Return Phase

P ip e li n e D ru g s N e w D ru g s ? Stars Cash Cows Dogs Myfortic Certican Enablex EPO Tekturna Eucreas Aclast a Diovan Lotrel Lescol _Neoral Voltaren FTY720 (MS) Lamisil Elidel Famvir Clozaril Tegretol Trileptal Exelon Stalevo QAB 149 Miacalcic Zometa Gleevec Femara Exjade Sandostatin LAR Visudyne Exforge Foradil Xolair Market Share G ro w th Sebivo Lucentis RAD ACZ Tasigna NVA AGO Tekt. FDC SOM albuf Mycograb QAB FDC Men B AS LBH Optaflu Zelnorm Menveo Aurograb AEB071 LBQ

Structurally Sound ...

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Risk adjusted pipeline potential as % of 2007 sales Generic risk as % of 2007 sales Incremental potential of base portfolio as % of 2007 sales (2007-12) Others Zometa Lamisil Lucentis Aclasta Eucreas (G) QAB149 Tekturna Diovan FTY720 Trileptal Lotrel agomelatine Exforge Tasigna Femara agomelatine

New Product Cycle - "Show Me The Money"

0 5,000 10,000 15,000 20,000

2002 2004 2006 2008E 2010E 2012E

Sa le s in U SD m n

Annual sales of drugs losing patents Annual sales of new drugs

Valuation And Earnings Discrepancy

7217 55896 1253 22320 1013 16357 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% EBIT EV EB IT v s EV c o n tr ib u ti o n

Back-Integrated Sum-of-Parts (SOP) Valuation

in million USD 2007 2008E

Novartis share price (in CHF) 50.8 50.8

Novartis share price in USD (Fx: 1.0) 50 50

Number of shares (diluted) * 2330 2287

Market Capitalisation 116500 114350

Net Cash * 7400 11457

Cash value of Roche equity holding (in USD) 11193 11193

Roche bearer share price (in CHF) 210 210

Nbe of Roche bearer shares owned by Novartis 53.3 53.3

Enterprise Value (EV) 97907 91700

Sandoz (generics) sales 7169 7972

Mean peer EV/Sales multiple 2.8x 2.6x

Implied EV (Sandoz) 20073 20726

Consumer Health (OTC, animal, vision) sales 5426 5842

Mean peer EV/Sales multiple 3.2x 3.0x

Implied EV (Consumer Health) 17363 17526

Corporate overhead EBITDA >638 >468

Mean peer EV/cost 5.0x 5.0x

Implied EV (Corporate overhead) >3190 >2340

Implied EV of Pharmaceuticals & Vaccines 63661 55788

Pharmaceutical sales 24025 25277

Vaccines (& Diagnostics) sales 1452 1646

Total Pharmaceuticals & Vaccines/Dx sales 25477 26923

Pharmaceutical EBITDA 7688 8368

Vaccine (& Diagnostics) EBITDA 448 485

Total Pharmaceutical and Vaccine/Dx EBITDA 8136 8853 Implied Pharmaceuticals & Vaccine/Dx EV/Sales (x) 2.5x 2.1x

Mean peer sector EV/Sales multiple 3.5x 2.8x

Discount Novartis versus peers 828% 826%

Implied Pharmaceuticals & Vaccine EV/EBITDA (x) 7.8x 6.3x

Mean peer sector EV/EBITDA multiple 11.5x 8.5x

Novartis - A Takeover Target?

44 -24 6.5x 6.3x -30 -20 -10 0 10 20 30 40 50 Novartis Pfizer

Big Pharma's Pain is Generic's Gain

0% 5% 10% 15% 20% 25% 1996 1998 2000 2002 2004 2006 2008E 2010E

Due To Potential "Conflict of Interest"

-5% 0% 5% 10% 15% 20% 25% 1996 1998 2000 2002 2004 2006 2008E 2010E

Roche NVES relative to MSCI European Pharmaceuticals

2002 2003 2004 2005 2006 2007 2008 60 80 100 120 140 160 180 200 220 240 260 ROCHE HOLDINGS GSH. Rel to MSCI Pharma

Roche Rx Substantially Outperforms Peers

0% 5% 10% 15% 20% 25% 30% 1996 1998 2000 2002 2004 2006 2008E 2010E

Substantially Scalable...

Cost Phase Return Phase

P ip el in e D ru g s N ew D ru g s Mircera EPO (ex-US) CellCept Rocephin Accutane Viracept/ Fortovase Xenical Kytril Herceptin (ex-US)/Jap) Xeloda Mabthera (ex-US/Jap) Fuzeon Pegasys Bonviva "Stars" "Cash Cows" "Dogs" Tarceva (ex.-US) Market Share G ro w th Dilatrend Avastin (ex.-US/Jap) Pertuzumab (ex-US) Actemra (RA) Bondronat Tamiflu Valcyte R1658 (dyslipidemia) "Pipeline" ocrelizumab (ex-US) R1626 (HepC) R1583 (diabetes) HPV16

Structurally Sound ...

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Risk adjusted pipeline potential as % of 2007

sales

Generic risk as % of 2007 sales

Increm ental potential of base portfolio as % of 2007 sales (2007-12) NeoRecorm on Mircera Other CellCept Dilatrend DNA Avastin DNA Roche Actem ra M/ocralizum ab

New Product Cycle - "Show Me The Money"

-5,000 0 5,000 10,000 15,000 20,000

2002 2003E 2004 2005 2006E 2007E 2008E 2009E 2010E

S a le s i n C H F m n

Annual sales of drugs losing patents Annual sales of new drugs

Back-Integrated Sum-of-Parts (SOP) Valuation

Price Nbe of shares Market Cap

Roche NVES + Bearer

NVES 191 699 133509

Bearer 210 160 33616

Total in CHF mn 167125

Genentech (DNA) (in USD) 81 1070 86670

FX 1.0 DNA in CHF mn 86670 Roche ownership (56%) 48535 Chugai (Japan) 1087 551 598937 Fx 1.01 Chugai in CHF mn 5930 Roche ownership (51%) 3024

"Equity value" of underlying Roche (CHF mn) 115566 115566 115566 115566

2005 2006 2007 2008E

Net cash owned by Roche (90% of total) 8163 12286 15041 18619 Enterprise value (EV; CHF mn) 107403 103279 100525 96946

2005 2006 2007 2008E

Roche Rx and Dx Sales 23,962 28,101 30,918 32,331

Implied sales multiples 4.5x 3.7x 3.3x 3.0x

Global sector mean 3.8x 3.6x 3.5x 2.8x

Premium (Discount) 18% 2% 87% 7%

Roche Rx and Dx EBITDA 7796 9035 10569 11513

Implied EBITDA multiple 13.8x 11.4x 9.5x 8.4x

Global sector mean 12.6x 11.5x 10.5x 8.5x

Preparing for Life Beyond Pantoprazole...

Cost Phase Return Phase

P ip e li n e d ru g s N e w d ru g s Stars Cash Cow s Dogs Alvesc Bradley Pharm a Tachosil Protonix Market Share G ro w th Om naris Instanyl Im agify Alvesco + LABA FDC Preotac ZyCom b TransMID Angiom ax

Overcoming the Pantoprazole Patent Overhang...

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Risk adjusted pipeline potential as % of 2007

sales

Generic risk as % of 2007 sales

Increm ental potential of base portfolio as % of 2007 sales (2007-12) Others Protonix/ pantoprazole

?

Alvesco + FDC Om naris

Risk Profiling of Nycomed

Risk Grade 5 (low risk) 4 3 2 1 (high risk)

Pipeline Potential (Portfolio replacement rate) 50% or more >= 30% - 50% >= 15% - 30% 0 to 15% 0

(Sum of probability weighted value of

pipeline projects / current sales base) -0.40% -0.20% 0.00% 0.20% 0.40%

Generic Risk (Portfolio rate at risk) <= 10% >= 10% - 20% >= 20% - 30% >= 30% - 50% above 50%

(Sales at risk of losing patents in coming 5

years at 100% / current sales base) -0.40% -0.20% 0.00% 0.20% 0.40%

Incremtental potential of

underlying portfolio > 36% 26% - 35% 16% - 25% 0% - 15% < 0%

(Sales of the underlying product portfolio - not new, not at risk of patent loss - as % of current sales) -0.40% -0.20% 0.00% 0.20% 0.40% Therapeutic Leadership 3 leaderships in therapeutic groups of average size $10bn+ 2 leaderships in therapeutic groups of average size $10bn+ 1 leaderships in therapeutic groups of average size $10bn+ No leadership + among top 10 in 3 therapeutic groups

No leadership and not among top 10 in 3 therapeutic groups at

least

(Based on world market shares and serves as an indicator of a company's success in franchise building, ie., knowledge building)

-0.40% -0.20% 0.00% 0.20% 0.40%

Geographical Exposure US sales of 60% or

more US sales of > 45% US sales of > 30% US sales of > 15% US sales of < 15%

(% of sales (direct and indirect sales) in the fast growing "free" US market)

-0.40% -0.20% 0.00% 0.20% 0.40%

Business Diversification 100% of sales from

prescription drugs > 75% of sales from prescription drugs > 50% of sales from prescription drugs > 25% of sales from prescription drugs < 25% of sales from prescription drugs

Nycomed Be?

4.5% 4.5% 4.5% 4.5% 4.5% 4.50% 4.0% 4.0% 4.0% 4.0% 4.0% 4% -1.0% -0.7% -0.2% -0.3% -0.2% 0.8% 0.56% 0.50% 0.50% 0.75% 0.75% 0.75% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%

Roche (7.5%) AZN (8.3%) Novartis

(8.8%) GSK (8.95%) Sanofi-aventis (8.3%) Nycomed (~10%)

Remember ... Valuation is Not Strictly a Science But More Like an Art !

"Not everything that can be counted counts and not everything that counts can be counted" (Albert Einstein)