Novartis AG 6-K 2006
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SECURITIES AND EXCHANGE COMMISSION
REPORT OF FOREIGN PRIVATE ISSUER
Report on Form 6-K dated February 8, 2006
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Novartis AG publishes its Annual Report for 2005
We want to discover, develop and successfully market innovative products to cure diseases, to ease suffering and to enhance the quality of life.
We also want to provide a shareholder return that reflects outstanding performance and to adequately reward those who invest ideas and work in our company.
Record results with double-digit net sales and operating income growth in 2005. Group net sales up 14% (+13% in local currencies) and operating income advances 10% as strong performances in all divisions are partially offset by acquisition-related costs.
Novartis continues to outpace competitors, gaining market share. Net sales rise 10% (+9% lc) based on excellent performances from strategic products. Operating income advances 12% as margin improves 0.7 percentage points to 29.7% of net sales.
Transformational year with acquisitions of Hexal and Eon Labs to make Sandoz a world leader in generics. Both businesses performed well and exceeded expectations with sales rising 54% (+54% lc).
Focus on strategic brands and new product launches drives growth. Net sales climb 8% (+8% lc), also supported by contribution from the North American OTC business of Bristol-Myers Squibb, acquired in 2005. Operating income advances 5%.
A total of 76 compounds in one of the industry's most promising pipelines. Key late-stage successes in 2005 include approval of Exjade and positive new data for Galvus (type 2 diabetes), Rasilez (hypertension) and FTY720 (multiple sclerosis).
Increase in the number and quality of compounds in early-stage development. The Novartis Institutes for BioMedical Research (NIBR) are exploring molecular pathways that may be shared by various diseases as an organizing concept.
In 2005, Novartis contributes USD 696 million worth of medicines through access-to-medicines programs for patients in need.
A dividend increase to CHF 1.15 per share (+10%) will be proposed to shareholders, reflecting the strong organic net sales growth and improved profitability.
It gives me particular pleasure in our tenth business year to report another set of record results.
Let me summarize the key 2005 figures:
This good performance reflects our clear and consistent strategy, which is based on innovation and achieving a leading position in the healthcare sector. Ultimately, however, the key factors in our success are the skills and commitment of our associates, and I would like to thank them for their contribution.
Pharmaceuticals remains our biggest and most profitable business. Particularly strong growth was posted by the Cardiovascular and Oncology franchises, thanks to the class-leading products Diovan (used to control hypertension) and Gleevec/Glivec (for the treatment of chronic myeloid leukemia). Overall, the division once again successfully increased its market share last year. With a total of 76 projects in clinical development, we have a full, innovative and promising pipeline. But in spite ofor precisely because ofour current success, we need to keep a sharp eye on the market evolution.
Three fundamental trends are boosting demand for healthcare services and medicines:
In line with changes in the population's standard of living and lifestyles, these countries are also experiencing increasing incidence of chronic cardiovascular disease, diabetes, cancer and respiratory illness. In China alone, it is estimated that more than 160 million patients suffer from hypertension and more than 20 million have diabetes. In addition, the demand for effective treatments is outpacing economic growth: while the Chinese economy grew by 9.8% in 2005, sales of pharmaceuticals leapt by 22.5%. In India, some 35% of the population currently has access to essential drugs, and the proportion is expected to increase to 80% by 2020.
Counteracting the effects of these growth drivers, however, are various negative trends, notably government price controls, with mandatory discounts, competitive pricing pressures, parallel imports from low-wage countries, and increasingly stringent regulatory requirements. Cost containment measures introduced by governments include the promotion of generics, which over the next few years will show double-digit expansion worldwidein contrast to market growth for patent-protected medicines, which will be in the mid to high single-digit range.
In light of these developments, Novartis has set its strategic direction as follows:
These, precisely, were the priorities that we pursued in 2005. The Pharmaceuticals Division further expanded its research operations, and this process will continue in the coming year. For our generics business, the acquisition of Hexal and Eon Labs represented not only a geographical expansion but a substantial reinforcement and reinvigoration. In the US and Germanythe most important generics marketswe have secured a leading position, and gained access to a rich pipeline and new technologies. The incorporation of a dynamic entrepreneurial culture is also having beneficial effects. Sales are growing rapidly, integration is proceeding according to plan, and the team is highly motivated. Also pending is the outright acquisition of Chiron, a company in which we have held a minority stake since 1995. While Chiron's pharmaceutical operations can be integrated into our own and its diagnostics unit has posted strong growth, its vaccines business suffered a serious decline as a result of significant quality problems in production. Accordingly, we have decided to bring our quality assurance expertise to bear and are planning strategic expansion of the vaccines business through appropriate investments.
Last year also saw the strengthening of our OTC Business Unit through the acquisition of the North American Consumer Medicines business of Bristol-Myers Squibb (BMS). This move has consolidated our position not only in a key market but also in the analgesics segment, where BMS was a major player with its Excedrin® brand.
Through organic growth and acquisitions in the course of 2005, we thus further expanded our operations in the healthcare sector, paving the way for additional sustained growth and at the same time spreading risks more widely.
What is ultimately essential, of course, is not only strategic decision-making but progress on the operational front. The gains in market share achieved by Pharmaceuticals have already been mentioned above. There was a further rise in the proportion of sales generated by products that will continue to enjoy patent protection for an extended period of time.
The first approval worldwide was granted last year by the US FDA for Exjade, the breakthrough oral iron chelator. Iron overload, mainly occurring as a result of frequent blood transfusions, previously required continuous infusion therapy, which was especially burdensome for children and adolescents. Exjade now substantially facilitates treatment for this group of patients in particular.
In Europe, the regulatory authorities granted marketing clearance for Xolair (for the treatment of severe allergic asthma) and Aclasta (for Paget's disease).
Of the 76 projects currently in clinical development, 50 are already in late-stage trials.
One product I mentioned in last year's letter was Galvus (LAF237, vildagliptin)the first of a new class of oral antidiabetic agents known as incretin enhancers. In the meantime, positive data have been reported from the most recent large-scale (Phase III) clinical trials. This new drug can be combined with several other antidiabetic agents, including insulin, or used alone. Another encouraging finding is that patients treated with Galvus showed no weight gainin contrast to most other oral antidiabetics. The first regulatory filing for this product is planned in the US for the first half of 2006.
Also successful were the clinical trials for Rasilez (SPP100, aliskiren), the first in a new antihypertensive class called renin inhibitors. In these studies, Rasilez showed excellent tolerability and provided sustained 24-hour blood pressure control, thus also offering protection against dangerous early morning surges.
Further observation of patients with multiple sclerosis who were treated with FTY720a novel, experimental immunomodulatorsubstantiated the positive Phase II data. During treatment with this agent, inflammatory lesions in the brain resolved more rapidly, and relapse rates were significantly reduced over a 12-month follow-up period. However, these findings will need to be confirmed in additional studies before registration can be envisaged.
Unfortunately, the trial data for PTK787an agent designed to block new blood vessel formation (angiogenesis) in tumorsfell short of expectations. The course of disease was only improved in one subgroup of patients with colorectal cancer who received this treatment. Whether this compound can ever be registered remains to be seen.
Clinical development of pitavastatin, a cholesterol-lowering compound licensed-in some years ago, has been terminated, as it proved less effective than had been hoped. We are thus reminded that while R&D is often fortunate enough to achieve breakthroughs that decisively improve the lives of thousands of patients, it is never immune to costly setbacks.
Access to medicine and drugs for needy patients, particularly in developing countries, remains an important concern. There is little public awareness of the fact that, since the UN Millennium Development Goals were proclaimed in 2000, multinational pharmaceutical companies have entered into more than 126 partnerships for the benefit of patients in developing nations. As a result of these initiatives, over 540 million treatments, worth in excess of USD 4.4 billion, have been provided to needy patients. These figures relate only to long-term programs and do not include assistance to patients in industrialized nations or disaster relief. Last year, taking all pro bono contributions into account, the total aid provided for patients in need by Novartis alone amounted to USD 696 million, with 6.5 million patients being treated. The main element of this commitment was the donation of medicines for the treatment of leprosy, malaria, tuberculosis and chronic myeloid leukemia. On top of humanitarian considerations, this aid produces substantial economic benefits, as it may enable patients to start work again and support themselves and their families.
The pharmaceutical industry's commitment to patients in developing countries exceeds that of any other industry sector worldwide. But it cannot succeed single-handedly. There is a fundamental need for effective action by governments that are primarily concerned with the welfare of their citizens, as well as for partnerships with international organizations and civil society.
The company's tenth year of operations provides me with the opportunity for a brief review. In 1995, Ciba and Sandoz with a combined headcount of 134 000 posted total sales of around USD 27 billion (using today's currency translation rates); in 2005, with just over 91 000 employees, sales reached USD 32 billion. In the initial postmerger years, spin-offs and disposals removed almost 50% of the 1995 total sales and a corresponding number of employees. This transformed the business portfolio dramatically.
While the healthcare sector accounted for only 46% of total sales a decade ago, this proportion has now risen to more than 90%. In just 10 years, Novartis has transformed itself from a widely diversified conglomerate into a focused leading healthcare company. During this 10-year period, net income increased from USD 3.17 billion to USD 6.1 billion (+92%), of course not taking into account revenues or profits from divested companies.
The Novartis brand has also been successfully established worldwide, ranking among the 50 best global brands according to Business Week. The company also enjoys an excellent reputation: in 2005, Novartis was listed among the world's 50 most respected companies by the Financial Times and Barron's, and it also featured in Fortune magazine's list of the world's 50 most admired companies. A key point of interest to investors is the total shareholder return (TSR). Taking spin-offs into account, the annual TSR averaged 12.7%, outperforming both the SMI (by 2.1 percentage points) and the MSCI Pharmaceutical Index (by 2.6 percentage points).
I would like to take this opportunity to thank everyone whose efforts and ideas have contributed to the success of Novartis. In particular, I would like to mention Professor Helmut Sihler, Vice Chairman of the Board of Directors and independent Lead Director, who has played a vital role in shaping our company's success since its creation. As a man of exceptional intelligence and experience, he has influenced our deliberations and decisions with keen business acumen and excellent judgment, without ever neglecting the importance of human relations. Professor Sihler will retire from the Board at the forthcoming Annual General Meeting. In his capacity as independent Lead Director, he will be succeeded by Professor Ulrich Lehner, who will additionally serve, together with Hans-Joerg Rudloff, as Vice Chairman of the Board of Directors.
I am confident that Novartis will remain successful in the future despite any possible setbacks. Sound foundations are provided by our clear strategywith significant investments in world-class research yielding innovative products and our determination to invest in growth segments of the healthcare sector. The skills, integrity and commitment of our associates, management and Board of Directors can be trusted, giving us the ability to act rapidly, flexibly and with circumspection. Naturally, we also hope for a little luck, which occasionally is needed.
I wish to thank you, our Novartis shareholders, for your loyalty and your confidence in us.
Novartis is a world leader in offering medicines to protect health, cure disease and improve well-being. Our goal is to discover, develop and successfully market innovative products to treat patients, ease suffering and enhance the quality of life.
Novartis is the only company with leadership positions in both patented and generic pharmaceuticals. We are strengthening our medicine-based portfolio, which is focused on strategic growth platforms in innovation driven pharmaceuticals, high-quality and low-cost generics and leading self-medication OTC brands.
Novartis is currently organized into three Divisions:
A fourth DivisionVaccines & Diagnosticsis planned to be created after the acquisition of Chiron Corporation. This acquisition, which is expected to be completed during the first half of 2006, provides Novartis entry into the dynamic human vaccines market.
Important market share gains in 2005 as Novartis outpaces the competition through focus on innovative medicines that address needs of patients worldwide, especially in cardiovascular disease and oncology.
Double-digit net sales growth of 10% (+9% lc) to USD 20.3 billion, supported by dynamic performances from many products.
Operating income rises faster than net sales, advancing 12% to USD 6.0 billion as the operating margin improves 0.7 percentage points to 29.7% of net sales, reflecting productivity gains in all areas.
Cardiovascular and Oncology franchises are the key growth drivers, delivering dynamic performances in challenging markets, particularly from Diovan and Lotrel for hypertension as well as Gleevec/Glivec, Femara and Zometa for the treatment of cancer.
Novartis leads the industry with 14 new product approvals in the US since 2000, with key approvals in 2005 for the iron chelator Exjade; Femara, in a new indication for helping women with hormone-sensitive breast cancer; and Xolair in Europe, for treatment of severe allergic asthma.
Impressive new data in 2005 for three late-stage compounds with significant sales potential, preparing submissions in 2006 for Galvus (type 2 diabetes) and Rasilez (hypertension) as well as the start of Phase III trials for FTY720 (multiple sclerosis).
The Novartis pipeline holds a broad stream of promising future products, with 50 projects in Phase II and beyond as of December 2005, including both new molecular entities and additional indications or formulations for marketed products.
GLOSSARY OF TERMS:
Sandoz is a world leader in generics through acquisitions of Hexal and Eon Labs. Ranked No. 2 worldwide based on net sales with global operations and leading positions in key markets.
Net sales surge 54% in 2005 to USD 4.7 billion, bolstered by USD 1.4 billion contribution from Hexal and Eon Labs.
Operating income advances 30% to USD 342 million, benefiting from a strong underlying business performance. Hexal and Eon Labs are performing well and exceeding expectations, leading to a net operating income contribution of USD 7 million.
Rich pipeline in the US and Europe with more than 70 new product submissions in 2005, many of which are for difficult-to-make generics. Sandoz is currently working on more than 600 projects, covering many of the major generic opportunities in the next few years.
Novartis is committed to achieving the annual synergies target of USD 200 million expected within three years of closing. Both acquisitions are expected to be accretive to Group net income no later than the second half of 2006.
Driving growth through focus on strategic brands and the needs of customers and consumers.
Net sales climb 8% (+8% lc) to USD 7.3 billion, driven by strong performance in OTC, in part from the acquisition of the North American OTC business of Bristol-Myers Squibb in 2005. Operating income rises 5% to USD 1.1 billion, based on investments in strategic brands and acquisition-related costs.
OTC, ranked the "Best European OTC Company of the Year" for the second consecutive year, expands US presence through BMS acquisition in US, including well-known Excedrin® to enter the analgesics market.
Animal Health benefiting from the strong performance of companion animal brands as well as the rejuvenation of established brands for farm animals.
Strong sales growth in Medical Nutrition outpacing the market in all regions, especially Asia and Latin America.
Gerber, the leading baby nutrition company in the Americas, driving growth with launch of innovative toddler products in the US.
CIBA Vision continues successful global launch of O2OPTIX contact lens.
Professor Mark Fishman, M.D., moves easily between two worldsthe laboratory bench, as a researcher specializing in developmental genetics, and the bedside of patients, as a practicing cardiologist and former Chief of Cardiology at Massachusetts General Hospital.
As President of the Novartis Institutes for Biomedical Research (NIBR) since 2002, Dr. Fishman has fostered the perspective of a physician-scientist in the company's labs around the world. "The whole drug discovery process at Novartis today is permeated with medical thinkingour focus is the individual patient with true unmet medical need," he says.
To sharpen that patient focus, NIBR and colleagues from Development have established a Translational Medicine teamexperienced physician-scientists recruited from academia as well as industry. Each member of the Translational Medicine group represents one of NIBR's disease areasand helps to bridge the gap between basic science and clinical medicine in that field, with the goal of delivering more new medicines.
The increasing emphasis on translational medicine underscores a broader trend at Novartis, where the traditional segregation of research and development is giving way to integrated "exploratory research," spanning from the most fundamental biological knowledge, to early clinical trials. The push for integration has led to a new immersion in patient-centric concerns for research scientists. "Today at NIBR the exploratory phase of research doesn't end when a compound enters developmentwe have to show that it actually works in some patients," says Trevor Mundel, M.D., Head of Exploratory Clinical Development.
It seems to be paying off. Graeme Bilbe, head of NIBR's Neuroscience Disease Area, says there is intense interaction between research, development and translational medicine staff today. "Physicians working in early clinical development get involved in a project much sooner than they used to. And we talk with them all the time to take advantage of their knowledge of disease and clinical practice," Dr. Bilbe adds.
The focal point of this interaction is the "proof-of-concept" clinical trial. The hallowed, sequential model of drug development is being reshuffled, moving toxicology and other tests of a new compound earlier in the process. This sets the stage for studies in a small number of patients.
"It forces our scientists to work in a new way," Dr. Fishman says. "From the very beginning, as they do fundamental biology, scientists must think carefully about which patients most likely will benefit from the new medicine, and how we can establish, expeditiously, whether the medicine is safe and effective."
As a consequence, uncommon but well-defined diseases may be used to provide the first clear, preliminary readouts on new Novartis drugs. This is in distinction to the past, when evaluation of efficacy often began with trials in the more heterogeneous patient population that ultimately might use the medicine.
"We believe that studies in well-defined diseases expedite the transition of a new medicine to and through early clinical trials," Dr. Fishman says. "We examine a new medicine in the right patients quickly and nimbly, and decide whether the drug works and is likely to be safe. Then, once we thoroughly understand the mechanism, we can extend testing of the drug to more complex diseases, with broader populations, where the results of proof-of-concept studies often are less clear because only a subset of patients are likely to respond well."
There are initial signs that the new research paradigm is accelerating discovery of new medicines and their advancement to early clinical trials. In addition, there is the salutary possibility that these proof-of-concept studies might expedite treatment of some rarer and neglected diseases.
In an article last year in the journal Nature, Fishman and NIBR colleague Jeffery Porter wrote: "Historically, pharmaceutical companies have not concentrated on these [rare genetic] diseases. Yet the development of therapies for such patients would not only serve a medical needbut often could be readily extrapolated to a wide population." The rationale is that such trials help to pinpoint which subsets of the broader, more heterogeneous population might benefit.
Fine-tuning NIBR's research model extends back to the earliest stage of drug discoverytarget identificationwhere scientists increasingly look to fundamental signaling pathways for openings to disrupt disease. In their Nature article, Dr. Fishman and Dr. Porter described how a few dozen of these signaling pathways, conserved throughout most of the animal kingdom, control many of the basic cellular functions of life.
These pathways propagate signals that activate genes and thus affect a cell's behavior, such as its ability to grow or to differentiate. "Perturbation of the essential processes driven by these pathways is the cause of many diseases such as diabetes and heart disease," Drs. Fishman and Porter added.
To be sure, most pathways are interconnected, and a vast amount of biological research remains to be done before all nodes are unraveled and identifiedand the roles of the pathways in complex diseases fully understood. However, novel insights into pathway biology have already contributed to several discovery programs under way at Novartis.
One of NIBR's most exciting proof-of-concept studies in 2005 involved ACZ885, a monoclonal antibody targeting interleukin-1 beta (IL-1 beta). IL-1 beta is a cytokine, a key weapon in the body's immune system defenses. Excessive production of IL-1 beta is believed to play a major role in diseases ranging from rheumatoid arthritis and asthma to chronic obstructive pulmonary disease (COPD)as well as certain rare genetic disorders.
ACZ885 binds IL-1 beta circulating in the blood, neutralizing its action and shutting down further production of the cytokine, thereby alleviating inflammatory symptoms.
"IL-1 is part of the body's immediate immune response against infectionwith a broad range of biological effects," says Hermann Gram, Preclinical Research leader for ACZ885 and a senior NIBR investigator in rheumatoid arthritis research in Basel, Switzerland. "Whenever something disturbs the [immune] system, then this IL-1 response kicks in and since it's so potent, with such diverse effects on gene expression, it has to be controlled by the body very well," Dr. Gram adds.
There are two versions of the IL-1 proteincalled alpha and beta, respectively. Each is produced and cleared so rapidly from the body that the proteins are exceptionally difficult to locate and measure. While IL-1 alpha and the IL-1 receptor were targets already under investigation by pharmaceutical companies, Novartis scientists bucked conventional wisdom by choosing IL-1 beta as their primary target for discovery of new drugs to treat inflammatory diseases.
At the time ACZ885 entered development, Novartis planned to look at asthma and COPD, and then go into rheumatoid arthritis. "But we didn't have any idea of which subsets of patients to target in those diseases," Dr. Mundel says. "We just started small studies and hoped for the best."
However, Tim Wright, M.D., Head of Translational Medicine for NIBR's Immunology group, proposed another indication unfamiliar to most of his colleagues.
Muckle-Wells syndrome is a rare, inherited disease caused by mutations in a gene, leading to elevated levels of IL-1. Symptoms of the disorder range from itching skin rashes and daily fevers to conjunctivitis and swollen joints. But because Muckle-Wells is so well-defined, and driven by a single defect, it seemed ideal for a proof-of-concept study with ACZ885.
Yet only a few hundred people worldwide are believed to suffer from MuckleWells syndrome, so recruiting patients was a major challenge. Dr. Wright and Vienna-based NIBR colleague Thomas Jung, M.D., managed to track down a European physician eager to try the new medicine.
For almost two decades, Professor Philip Hawkins at London's Royal Free and University College Medical School has labored in the field of amyloidosis, a disorder where waxy protein fibers become lodged in the liver, kidneys and other organs. Amyloidosis is a potentially fatal complication of Muckle-Wells syndrome, and Professor Hawkins eventually became a world authority on both disorders.
His lab was a leader in the race to track down the gene which in its mutated, defective form causes Muckle-Wells. After reading publications by Professor Hawkins, NIBR researchers approached him about a possible collaboration. He agreed, and the proof-of-concept study for ACZ885 began in early 2005.
"We gave the anti-IL-1 beta antibody to four patients, all of whom responded instantly to the first injection," Professor Hawkins says."And their median duration of response was something like six months.
It's an amazing thing for these people, who had been sick virtually every day of their lives."
At the same time, the proof-of-concept study answered key scientific questions, including which target was most important in Muckle-Wells syndrome. "The partnership with Novartis has worked very wellI think other companies can learn something from this," Professor Hawkins says.
There still is much to be done to prove convincingly that ACZ885 is safe and effective in a larger population of patients. Additionally, it is a challenge to extrapolate from the population of patients with this rare syndrome to more common inflammatory disorders.
For all the success of ACZ885 in Muckle-Wells, Dr. Mundel insists that NIBR won't become doctrinaire "and demand that every single program run according to this model. There probably won't be a well-defined human genetic disease to use as a clinical assay for every one of our molecular targets," he adds. "On the other hand, every time we've looked, we've actually found a rare disease that nobody seems to have known about."
In 2006, the dynamic Cardiovascular and Metabolism Business Franchise at Novartis plans to submit regulatory applications for three important new therapies.
Building on the broad range of indications for our flagship antihypertensive Diovan, Novartis plans to seek regulatory approval in 2006 for Exforge, a fixed-dose combination of Diovan and amlodipine. An important evolution for the Diovan family, the new combination provides best-in-class blood pressure reduction through once-daily treatment with a single pill.
The other two filings expected from the Cardiovascular/Metabolism franchise concern pioneering compounds, with the potential to revolutionize treatment of hypertension and type 2 diabetes, respectively.
Rasilez (aliskiren) is a renin inhibitor for treatment of high blood pressure. Renin inhibitors are the first new antihypertensive class introduced in more than a decade. Rasilez offers patients strong, sustained, 24-hour blood pressure control, additional efficacy without interactions when used with other drugs, and placebo-like tolerability within the expected dose range.
Galvus (vildagliptin) is a potentially first-in-class oral agent to treat dysfunction of pancreatic islet cells, one of the key causes of type 2 diabetes. Galvus lowers blood glucose effectivelywithout weight gain and other side effects associated with many oral antidiabetic agents. Moreover, Galvus could potentially modify disease progression through its beneficial effect on insulin-producing islet cells, which gradually wear out as type 2 diabetes progresses.
"Both Rasilez and Galvus could become mega-blockbusters," says Thomas Ebeling, Head of the Novartis Pharmaceuticals Division. "Our objective is to make Rasilez the new gold standard in the treatment of hypertension and a cornerstone therapy which every patient should have on board." Galvus, Mr. Ebeling adds, "offers patients with type 2 diabetes sustained efficacy and good tolerability through an exciting mechanism of action that is already recognized by the scientific community."
The prevalence of hypertension and type 2 diabetes is increasing rapidly in both the developing and developed worlds. According to projections by the World Health Organization, cardiovascular disease will be the number one disease burden globally by 2020. Yet most patients with hypertension, type 2 diabetes or dyslipidemia aren't being treated optimally despite the availability of many therapies in the market today.
The use of combination therapies is becoming increasingly common, reflecting US national guidelines which state that a majority of patients with high blood pressure will require two or more antihypertensive drugs to achieve effective control.
"With the increasing prevalence of hypertension and diabetes, cardiovascular disease is the number one challenge that all of us face as physicians," says Professor Victor Dzau, M.D., the James B. Duke Professor of Medicine and Director of Molecular and Genomic Vascular Biology at Duke University.
More than a decade ago, Professor Dzau proposed the concept of the cardiovascular continuum, establishing the role of the renin-angiotensin-aldosterone system (RAAS) in progression of cardiovascular disease from hypertension, through endothelial dysfunction, vascular disease and heart attack, to heart failure and death.
Today there is a growing recognition that patients who have one form of cardiovascular disease, such as hypertension, have a likelihood of also suffering from dyslipidemia or type 2 diabetes. This increases the need for an industry leader like Novartis to offer a broad portfolio of safe and effective treatments for each disorder.
"More than 80% of cardiovascular patients have two or more of those conditions, and we believe that in the future physicians will have to look across multiple disease parameters and really start to assess, diagnose and treat global risk," says Kurt Graves, Chief Marketing Officer and Head of General Medicines for the Pharmaceuticals Division. "The majority of patients are not at goal and not compliant. Both innovative monotherapies and fixed combinations are needed to really make a big impact on the lives of people with cardiovascular and metabolic disease."
DIOVAN: POWERFUL EFFICACY
Diovan continues to grow dynamically from its position of global leadership among angiotensin-receptor blockers (ARBs). During 2005, worldwide net sales of Diovan climbed 19% to USD 3.7 billion, fueled by powerful efficacy as well as regulatory approvals for a growing number of indications.
The multiple indications for Diovanunmatched by any other ARBreflect an aggressive mega-trial program involving more than 50 000 patients across the cardiovascular continuum. FDA approval last year of Diovan to reduce the risk of cardiovascular death in post-myocardial infarction patients was based on the results of VALIANT, one of the biggest long-term studies ever conducted among people who have suffered heart attacks.
Approvals by nearly 80 countries for use of Diovan to treat people with heart failure are based on the positive findings of Val-HeFT, a study involving more than 5 000 patients.
One of the exciting findings from VALUE, an outcomes trial involving more than 15 000 patients, was the suggestion that Diovan may offer benefit in lowering the incidence of new-onset diabetes in patients at high cardiovascular risk. Further valuable data are expected from NAVIGATOR, the biggest outcomes trial yet conducted on the prevention of cardiovascular disease and type 2 diabetes in patients with impaired glucose tolerance.
Clinical trials testing Exforge involved more than 5 000 patients. Data disclosed by Novartis at a research and development update in London in late 2005 showed that more than 90% of patients treated with the combination had a positive response. Certain side effects, such as edema, were mitigated and compliance also improved, enhancing protection among patients receiving the fixed-dose combination compared to those given the individual components alone.
"Sadly, the evidence shows that patients don't take their medicine in the optimal way, particularly treatments for long-term conditions," says Mary Baker, MBE, President of the European Federation of Neurological Associations. "By putting two medicines together in a fixed-dose combination, you've got a chance of managing the whole condition in a better way."
Successful registration studies represent essential, initial steps, demonstrating the safety and efficacy required to earn regulatory approval. "But to really maximize the value of our exciting new medicines, we have to invest in outcomes studies that will demonstrate concrete clinical benefits for patients over the long term and help shape medical practice in the future," says Ameet Nathwani, M.D., Head of Clinical Development and Medical Affairs at the Cardiovascular and Metabolism Business Franchise.
"The mega-trial program helped build Diovan into a blockbuster," he adds. "We intend to apply our experience to realize the full potential of our new cardiometabolic medicines in similar outcomes studies."
RASILEZ: CORNERSTONE TREATMENT
Though renin, a key enzyme released by the kidney, was discovered more than a century ago, therapies to control its activity have long been sought. Rasilez is the first renin inhibitor to successfully complete the pivotal round of clinical testing required to qualify for regulatory approval.
Renin activates RAAS, a complex chemical system that regulates blood pressure in the body. Medicines blocking the RAASincluding ACE inhibitors and ARBshave led to some of the biggest advances in treatment of hypertension. However, their modes of action also lead to compensatory rises in plasma renin activity (PRA), which elevates blood pressure and can limit the benefits of therapy.
Rasilez acts in a novel way by targeting the RAAS at its point of activationrenin. That mechanism optimizes RAAS suppression and reduces PRA, potentially leading to unique therapeutic benefits.
"The role that renin plays in end-organ damage has been debated for years," says Professor Morris Brown, Head of Clinical Pharmacology at the University of Cambridge (UK) and Addenbrooke's Hospital, and President of the British Hypertension Society. "By blocking renin production in tissues, a renin inhibitor may be able to attain the elusive goal of organ protection beyond blood pressure control."
In clinical trials involving more than 8 000 patients, Rasilez has demonstrated strong blood pressure efficacy as monotherapy and in combination with hydrochlorothiazide, a member of the diuretic class of antihypertensives. Rasilez showed consistent blood pressure lowering across all studies, indicating very effective RAAS blockade through renin inhibition. The new medicine also was well-tolerated, with adverse events comparable to placebo both as monotherapy and in combinations within the expected dose range.
Clinical studies with once-daily dosing also confirmed that Rasilez delivers sustained 24-hour blood pressure control. That's particularly important for patients because blood pressure drops during night sleepbut rises again in a substantial surge shortly before waking in the morning. "The time of these surges is when most ambulances and emergency rooms get busy with coronary events," says James Shannon, M.D., Head of Development at the Pharmaceuticals Division.
In studies, Rasilez maintained consistent blood pressure control through that morning surge. Blood pressure lowering at the end of the 24-hour treatment period was up to 98% of the effect at the beginning of the period. "It doesn't get any better than that," Dr. Shannon adds.
Another distinguishing characteristic of Rasilez is that blood pressure doesn't immediately return to normal whenever treatment is stopped or forgotten. In studies, blood pressure did not return to pre-treatment levels for up to four weeks after drug withdrawal, avoiding the rebound rises in blood pressure that are seen with some other antihypertensive medicines.
Novartis plans to file a regulatory application for Rasilez with the FDA early in 2006. In most countries in Europe, however, the submission will be filed during the fourth quarter, following completion of additional requirements from European Union health authorities.
Still, as Professor Brown and others suggest, the full promise of renin inhibition and Rasilez extends beyond blood pressure loweringto the possibility that targeted renin inhibition will translate into improved end-organ protection. The organ protection hypothesis is scientifically based on the differing effects antihypertensives have on PRA levels.
ACE inhibitors, ARBs, diuretics and other classes of antihypertensive medicines raise levels of plasma renin activity at the same time that they lower blood pressure. The fact that elevated PRA contributes to high blood pressure hints at the self-induced limitations of these therapies. Treatment with Rasilez lowers both PRA and blood pressure. The potential long-term impact of decreasing PRA remains a key topic of interest, which Novartis will address in an ambitious mega-trial program.
In the first round of this program (2006-07), the benefits of reducing PRA with Rasilez will be assessed in patients with renal disease, type 2 diabetes, heart failure and those with previous heart attacks, using surrogate markers of target-organ protection. In parallel with these surrogate marker studies, Novartis will begin a series of outcome studies assessing the long-term benefits of renin inhibition in treatment of patients with a variety of cardiovascular diseases to reflect actual patients' health conditions. Those long-term studies are expected to deliver results between 2011 and 2013.
"There is a growing body of evidence suggesting that PRA is an independent risk factor in cardiovascular and renal disease," Mr. Graves says. "Rasilez is the first drug that can be used with any existing therapy to reduce PRA and optimize RAAS suppression, and we believe it will prove to be a better treatment for cardiovascular protection."
Rasilez has been tested with a variety of other medicines commonly used by patients with high blood pressure. Such combinations proved to be very safe and did not lead to any undesirable interaction effects. At the same time, combinations with other antihypertensives demonstrated the benefits of adding Rasilez. In addition to trials of the Rasilez/hydrochlorothiazide combination therapy, Novartis is exploring a combination of Rasilez with Diovan. Results from studies of Diovan/Rasilez are expected during the second half of 2006.
Professor Peter Sever of Imperial College in London says, "Because of a very favorable safety profile and unique and complementary mechanism of action, Rasilez is an ideal component for combination therapy. While it works very well alone, in combination it can make other agents better. Most patients I see now need combinations. And with more stringent treatment guidelines, we need new agents that control blood pressure differently. Rasilez is a great new treatment option."
GALVUS: EXCITING PROMISE
Galvus belongs to a new class of oral agents developed to treat pancreatic islet dysfunction (PID), one of the major causes of type 2 diabetes. Galvus offers more patients with type 2 diabetes the ability to achieve and maintain optimal blood glucose levels, with the potential to slow disease progression and ultimately prevent the onset of type 2 diabetes in new patients. Because of its novel mechanism of action, Galvus isn't associated with unwanted side effects such as weight gain or hypoglycemia (abnormally low levels of sugar in the blood). And clinical studies have shown that Galvus is suitable for all types of type 2 diabetes patients.
The World Health Organization has declared type 2 diabetes a worldwide epidemic of crisis proportions, with an estimated 170 million people afflicted, leading to more than 3 million deaths per year. Alarmingly, the WHO expects prevalence to double by 2025.
Underscoring the limitations of current therapies, only about one in five patients with type 2 diabetes is treated optimally today. Two of every three patients fail to reach their glucose goals, and the same proportion is no longer compliant with treatment 12 months after beginning therapy.
That rising disease burden is being driven by underlying predisposition to islet cell dysfunctiona flaw in human biology that leaves millions of people around the world particularly vulnerable to the effects of a sedentary lifestyle and modern dietand ultimately to type 2 diabetes.
Normally, blood glucose is maintained at optimal levels by an exquisite balance between two hormonesinsulin and glucagon. Both are secreted from specific cells in a region of the pancreas known as the pancreatic islet. Insulin is secreted by islet "beta cells"glucagon by "alpha cells."
Insulin and glucagon work in tandembut have opposite effects. Insulin removes sugar from the blood, through uptake by muscles and tissues where the glucose is stored. Glucagon, by contrast, releases sugar into the blood to feed the body's energy requirements. The net effect of the interplay between these two hormones is to maintain normal blood glucose levels in healthy individuals.
While back-up systems exist for the function of most regulatory systems in the body, insulin is alone in its ability to lower blood glucose. "Once beta cells start failing, a person is in troublethere is nothing else that can compensate," says Dr. Nathwani.
Unfortunately, a large proportion of people have an underlying predisposition to islet cell dysfunction. Once an environmental factor like obesity triggers insulin resistance, the pancreas is forced to churn out more and more insulin to compensate.
"In about 30% of people with insulin resistance, the islet cells of the pancreas just can't keep up that pace. It simply gets progressively weakerand both the function and the mass of beta cells steadily diminish," Dr. Nathwani adds.
Eventually, the fine balance between insulin and glucagon is disrupted. As insulin secretion dwindles, the usual check-and-balance on glucagon weakens. Alpha cells are unleashed to flood glucagon into the blood and drive up glucose levels, the hallmark of type 2 diabetes.
The novel mechanism of action of Galvustargeting both insulin and glucagon secretion from the pancreatic islet cellis different from any oral antidiabetic agent available today. "It's important to point out that the neglected alpha cell plays an equally critical role in both the evolution leading to diabetes and in its progression," Dr. Nathwani says.
Moreover, the novel mechanism enables Galvus to stimulate insulin production only when it's needed mostwhen blood glucose levels are high. And because Galvus responds selectively to fluctuations in glucose and glucagon levels, the drug isn't associated with unwanted side effects. Clinical studies have shown that Galvus is suitable for all groups of type 2 diabetes patients, as monotherapy or in combination with other treatments.
A comprehensive program of clinical trials involving more than 3 000 patients has documented that Galvus reduces glycosylated hemoglobin (HbA1c), a key marker of blood glucose, in a clinically meaningful manner both as monotherapy and in combination with other antidiabetic agents such as metformin. Control of HbA1c was maintained for more than a year in these studies.
Its mechanism of action makes Galvus an attractive candidate for use in combination with metformin, the current gold standard of therapy for type 2 diabetes. "By using Galvus in combination with agents that address insulin resistance, such as metformin, we will be able to tackle both causes of type 2 diabetes for the first time," says Professor Bo Ahren, M.D., Dean of the Faculty of Medicine at Lund University.
Mechanistic studies in an extensive testing program are exploring the potential of this mechanism of action. Significantly, data from animal studies suggest that through its beneficial effect on islet cells, Galvus may have an effect on disease progression and potentially also prevention. Data from mechanistic studies conducted to date have shown that Galvus increases mass of beta cells and at the same time reduces cell death.
"Galvus clearly has a strong safety, tolerability and dosing profile versus some of the other new treatments that are entering the type 2 diabetes category," says Mr. Graves. "We think we have a breakthrough therapy that can revolutionize the treatment of pancreatic islet cell dysfunction, and by doing that we'll get more patents to their target goals and modify the course of the disease long-term."
Two major brandsGlivec(1) and Zometaalready are blockbusters and a third, Femara, is also expected to exceed peak annual net sales of a billion dollars. A deep pipeline of compounds in development promises to improve and extend the lives of cancer patients through three therapeutic approaches: highly targeted treatments, advanced or improved cytotoxics, and supportive therapies.
In addition, both in-market and development compounds are being tested in an expanding program of combination therapies against major tumor types. "We believe that the competitive focus in the world of oncology is changingfrom an old-fashioned model where companies built their base on single molecules with single mechanisms of action, to broadly diversified franchises covering multiple technology platforms," says David Epstein, Head, Business Unit Oncology at the Novartis Pharmaceuticals Division. "Putting proprietary combinations into the market will be key to further extending the lives of patients."
TARGETED THERAPIES: GLIVEC AND AMN107
Novartis pioneered the field of targeted therapies with Glivec, the breakthrough treatment for chronic myeloid leukemia (CML), gastrointestinal stromal tumors (GIST), and other types of rare tumors. The benefits of that discovery are still being extended to patients with other diseases driven by Glivec-sensitive targets. At the same time, Novartis scientists are developing AMN107, a new compound being studied for patients intolerant of Glivec or no longer effectively treated because of resistance.
Discovered by scientists at the Novartis Institutes for Biomedical Research, AMN107 was specifically designed to be a highly selective inhibitor of Bcr-Abl, the abnormal protein responsible for excessive production of white blood cells in CML. Building on expertise accumulated during the Glivec program, development of AMN107 has progressed rapidly. The new medicine was synthesized in August 2002 and entered Phase I clinical trials only 21 months laterless than half the pharmaceutical-industry average of 74 months from synthesis to start of Phase I studies.
In preclinical studies, AMN107 was shown to be active against wild-type, or non-mutant Bcr-Abl, as well as 32 of 33 Bcr-Abl mutations most frequently associated with varying degrees of resistance to Glivec. In a multi-center study, more than 90% of Glivec-resistant patients with chronic-phase CML achieved hematological responses. In the same study, hematological responses of over 70% have been seen after treatment with AMN107 in some groups with accelerated phase and blast crisis CML. Cytogenetic response rates were also impressive at 53% of chronic-phase patients.
The Phase I trial of AMN107 featured a novel, flexible design, extending the treatment of patients not yet responding at initial, low dose levels, compared to conventional clinical trials of anticancer medicines. This innovative design was particularly attractive for patients who had failed treatment with Glivecand lacked adequate alternatives.
Normally, Phase I trials proceed by enrolling a few patients at a specific dose level, and evaluating safety of the compound at that dose. Then the initial cohort exits the study and a new group of patients begins treatment at an elevated, preset dose. Gradually, dosage reaches a level where physicians would expect to see clear clinical activity.
Novartis and investigators conducting the AMN107 study agreed that even after treatment failure at starting doses, participants would be allowed to escalate to the next dose of AMN107 that had been shown to be safeand continue treatment.
"Rapid dose escalation was important for patients with this kind of disease because it tends to progress rapidly," says Oliver Ottmann, M.D., Head of the Molecular Therapy Section at J.W. Goethe University in Frankfurt, Germany, and a principal investigator for the initial Phase I study of AMN107, as well as a Phase II trial currently in progress. Some patients enrolled in the Phase I study have benefited from treatment for more than 18 months and are continuing to receive AMN107, Dr. Ottmann adds.
The randomized Phase II study is currently under way at more than 60 centers in Asia, Europe, Canada and the US, testing the safety and efficacy of AMN107 in treatment of adult patientsat all three stages of CMLwho are intolerant of Glivec, or failed to respond to therapy. The Phase II trial also is testing AMN107 in treatment of patients with Philadelphia-chromosome-positive acute lymphoblastic leukemia (ALL) and two other malignancies.
At the same time, a Phase I study of AMN107 is also under way in treatment of GIST patients who have developed resistance to Glivec.
It is also expected that in 2006, patients treated with AMN107 will be incorporated into an ongoing Phase III study comparing two doses of Glivec in treatment of newly diagnosed CML patients. "It's unusual for a company to sponsor a head-to-head study comparing two of its own drugs," says Alessandro Riva, M.D., Head of Oncology Development. "But at the end of this study, we'll have definitive data enabling physicians to provide the best treatment for CML patients."
Meanwhile, ongoing research continues to identify new diseasesand additional groups of patientswho can benefit from Glivec. In two new clinical trials, Novartis is testing a combination of Glivec with hydroxyurea in the treatment of newly diagnosed glioblastoma multiforme, as well as in patients who have failed to respond to previous therapy.
The Glivec/hydroxyurea combination was first tested in a small study by Gregor Dresemann, M.D., an oncologist at Franz-Hospital Duelmen, in Duelmen, Germany. Though Glivec previously had shown modest activity against glioblastoma as monotherapy, Dr. Dresemann found that the combination with hydroxyureaa well-known anticancer agentled to positive responses or stabilization of disease in more than half of the 30 patients he treated. The positive results were confirmed in a later study at Duke University Medical Center.
A Phase III trial of Glivec with hydroxyurea in glioblastoma patients who had failed previous treatment is under way in Germany, while a second Phase III study, testing the combination in newly diagnosed glioblastoma patients, began at Duke Medical Center this year. "Despite all the challenges of developing a brain cancer therapy, when you have this tantalizing data, how can you not try?" Mr. Epstein says. "We simply have to get the answer."
Separately, Novartis has submitted applications to regulatory authorities around the world, seeking approval for use of Glivec in the treatment of a cluster of rare conditions where the drug has shown exceptional efficacybut hasn't completed the conventional marathon of clinical trials. (See page 55.)
For all the potential of targeted anticancer therapies, cytotoxic medicines will remain an important component of cancer care in the near- to medium-term, used either as monotherapy or in combination treatments. Cytotoxics work by attacking rapidly dividing cancer cellsbut that efficacy traditionally has come at the cost of severe side effects.
Novartis has two promising cytotoxics in early- to mid-stage clinical trials that offer major advantages in both safety and efficacy. EPO906 belongs to the family of epothilones, a class of antibiotic compounds discovered in soil bacteria that work by inhibiting cell division.
Their mode of action is similar to a successful class of anticancer medicines known as taxanes. Interest in epothilones has been fueled by preclinical experiments showing potential efficacy against cell lines insensitive, or resistant, to treatment with taxanes.
In clinical studies, EPO906 has shown an acceptable safety profile as well as promising preliminary results in treatment of patients with ovarian cancer who previously had failed treatment including a taxane. A Phase III clinical trial is now under way testing EPO906 in treatment of ovarian cancer. Phase II trials in other tumor types are also being started.
Another promising cytotoxic compound is gimatecan, an oral topoisomerase inhibitor in development for treatment of solid tumors. Topoisomerases are an important class of enzymes that regulate processes underlying cell growth, replication and division. Current topoisomerase inhibitors are potent, but may cause severe diarrhea as a side effect. In initial studies with gimatecan, activity was shown in several different tumor types and diarrhea was infrequent.
Supportive therapies may improve patients' quality of lifeas well as their ability to live longer. The latest addition to the Novartis Oncology portfolio is Exjade, an "iron chelator" used to remove excess iron that is a serious complication of regular blood transfusions.
In November, the US Food and Drug Administration approved Exjadethe first and only once-daily iron chelatorfor the treatment of chronic iron overload due to blood transfusions, in adults and children aged two and older. Switzerland also has approved Exjade. Priority reviews are under way in Canada, Australia and New Zealand and additional regulatory submissions have been made around the world.
As many as 250 000 people worldwide are believed to receive frequent blood transfusions to treat anemias caused by cancers such as myelodysplastic syndrome, as well as thalassemia and sickle-cell disease. Of these, as many as 100 000 are likely iron overloaded. However many do not yet receive iron-chelation therapy, reflecting the burdensome and unwieldy administration of the previous gold standard treatment Desferalalso from Novartis.
While Desferal requires infusions via a portable pump for up to 12 hours a day, five to seven days per week, Exjade is a dispersible tablet administered once daily. The approval of Exjade is expected to greatly enhance the acceptance of iron chelation therapy, especially for children.
"Exjade will allow these patients to be chelatedreducing the chances that they will go on to have the complications of excess iron, which may include liver damage and cardiac death," Mr. Epstein says.
Hepatitis B is one of the most common infectious diseases in the world and a growing global health problem.
The World Health Organization estimates that more than 350 million people are chronically infected with the hepatitis B virus (HBV). More than one million deaths result each year due to chronic hepatitis B.
Persistently elevated viral loads are associated with progression of hepatitis Band increased risk of complications, such as liver cancer. As a result of these complications, hepatitis B is the second-leading known cause of cancer worldwide, after tobacco.
Novartis is focusing on unmet patient needs in developing treatments for hepatitis Bas well as for hepatitis C, another devastating liver diseasethrough formation of the new Infectious Diseases, Transplantation and Immunology Business Unit (IDTI).
"Our vision is to be a world leader in both hepatitis B and hepatitis C," says William Hinshaw, Head of Infectious Disease Marketing and Development at IDTI. "We are building a portfolio of innovative medicines, including oral therapies, with complementary mechanisms of action that potentially could be used in combination."
Novartis has advanced its pipeline rapidly by forging collaborations with a pair of dynamic biotechnology firms. Promising compounds against both hepatitis B and hepatitis C have reached advanced stages of clinical testing.
Late last year, a regulatory application was filed in the US for LDT600 (telbivudine), one of the most potent next-generation therapies that provides rapid and profound viral suppression with a favorable safety and convenient dosing profile. Additional regulatory filings for LDT600 in other major markets will follow in 2006.
To better understand the burdens of the disease on people infected with chronic HBV, the LDT600 brand team has conducted thousands of interviews with physicians and patients over the past three years.
According to patients, chronic hepatitis B affects virtually every aspect of their daily livesand at the same time overshadows future plans like a dark cloud. "Life as I knew it was overeverything I was planning for and hoping for had gone," one female patient said, describing her initial reaction after being diagnosed with hepatitis B.
Another mother, infected with chronic HBV, admitted that for fear of spreading the infection, she no longer kisses her baby daughter in areas she could touch and put in her mouth"only behind her neck or on her toes."
Such comments underscore a lack of basic knowledge about hepatitis B that is widespread among patientsbut even more acute among the general public. Many countries, particularly in Asia, have begun mobilizing their health-care systems to increase understanding about the diseaseand diminish discrimination that has deprived many people infected with HBV of access to higher education, or chances of a good job. Nevertheless, much remains to be done to fully dispel the traditional stigma associated with HBV infection.
"Hepatitis B is a social issuenot just a medical one," says Professor Jia Jidong, M.D., Director of the Liver Research Center at the Capital University of Medical Sciences in Beijing Friendship Hospital.
"Most people don't understand the route of transmissionthrough contaminated blood or from an infected mother to her infant," Professor Jia says. "We are trying to decrease the public's fear of infection by explaining that hepatitis B isn't transmitted by ordinary daily lifeby sharing an office, a dormitory or even a computer."
Major progress has been achieved during the past decade, he adds, "and China clearly is moving in the right directionbut it will take time. We still lack an optimal therapy that would enable us to manage patients effectively, with a very good safety profile. We need more choice."
Professor Jia was the principal investigator in China for GLOBE, the biggest international hepatitis B registration trial to date, which compared LDT600 with the current standard of care, lamivudine. "We found LDT600 to be both a very safe and very powerful agent," he says. "I think LDT600 could play an important role in the management of hepatitis B in clinical practice in the future."
Results from GLOBE, a Phase III study involving more than 1 300 patients from 20 countries, showed that patients treated for one year with LDT600 had a statistically superior response on all evaluable virologic markers to patients receiving lamivudine.
Patients treated with LDT600 achieved statistically superior viral suppression, which resulted in significantly more achieving clearance of detectable virus, compared to patients treated with lamivudine.
Viral suppression, a clinically meaningful reduction in the level of circulating virus, usually measured by blood levels of HBV DNA, reduces the risk of disease progression and is a primary goal in treatment of hepatitis B. The GLOBE trial also demonstrated that after one year of treatment, the highest rates of clinical-efficacy outcomes are associated with maximal reduction of HBV levels early in the course of therapy.
Patients receiving LDT600 showed significantly less viral resistance and less treatment failure, compared to patients receiving lamivudine at one year. In addition, the 52-week results from GLOBE support a favorable overall safety profile for LDT600. The low rate of adverse events was similar between patients treated with LDT600 and lamivudine.
The positive, one-year GLOBE results were the basis of the US regulatory filing last year and will be included in additional filings during 2006. GLOBE will continue for another year and the two-year results will evaluate the longer-term efficacy and safety of LDT600.
LDT600 belongs to the nucleoside-analogue category of antiviral medicines. Natural nucleosides serve as building blocks of human and viral DNA; analogues, or synthetic versions of nucleosides, target viral polymerase and work by crippling replication of HBV.
By contrast to other nucleoside analogues, LDT600 has a unique mechanism of action that targets a late stage of viral replication. And while studies so far have concentrated on LDT600 as monotherapy, some physicians believe the new medicine could become the cornerstone of safe and effective combination therapy.
"Combinations are the way to go in the future. But we don't yet know which drugs will have synergistic effects when used togetheror the optimal timing or dosage of various treatments," says Professor Michael Manns, M.D., Chairman of the Center for Internal Medicine at Hanover Medical School (Hanover, Germany) and founder and chairman of the German National Competence Network in Viral Hepatitis (Hep-Net).
"The task ahead is to identify the optimal combination leading to long-term suppression of viral replicationultimately maintained by patients' own immune systems once they are off drugs," Professor Manns adds. "LDT600 is a strong candidate for these future combination therapies because of its strong antiviral efficacy, good safety profile and limited and manageable resistance profile."
Dedicated research and development programs at Novartis are exploring novel, complementary mechanisms of action in both hepatitis B and hepatitis C. Internal research has been bolstered by strategic collaborations with Idenix Pharmaceuticals Inc., based in Cambridge, Massachusetts, and Anadys Pharmaceuticals Inc., based in San Diego, California The collaborations underscore the emergence of Novartis as a development and marketing partner of choice for biotechnology companies.
In 2003, Novartis acquired a majority holding in Idenix, along with a license to co-develop two hepatitis B drug candidates discovered by the US firm. In addition to LDT600, Idenix is developing a compound called LDC300 (valtorcitabine) in a fixed-dose combination with LDT600.
Novartis has an option to license and jointly develop other future Idenix drug candidates, including NMC283, a first-in-class oral agent for hepatitis C. NMC283 is undergoing Phase II trials and is expected to enter Phase III during 2006.
Separately, Novartis and Anadys announced an exclusive co-development agreement last year for ANA975, a compound in early development for the treatment of both hepatitis C and potentially for hepatitis B. ANA975 works through a novel mechanism of action that stimulates the antiviral defenses of the body's innate immune system. In a proof-of-concept study, the active ingredient in ANA975 significantly reduced concentrations of hepatitis C virus (HCV) in a majority of patients treated. ANA975 has completed multiple Phase I studies.
Novartis also holds the exclusive option to license rights from Anadys to ANA380, a compound being co-developed for chronic hepatitis B by Anadys and LG Life Sciences.
The most advanced internal candidate compound from Novartis is NIM811. A novel cyclophilin inhibitor, NIM811 began full-scale clinical development last year as a treatment for chronic hepatitis C.
The World Health Organization estimates that currently 170 million people worldwide are chronically infected with hepatitis C virus. More than 3 million new infections occur each year. Chronic HCV infection generally progresses slowly over decades, inflaming the liver and causing progressive damage that can lead to cirrhosis, liver cancer, liver failure and death. Liver failure related to hepatitis C is the most common cause of liver transplants in the US.
In the US and Western Europe, many patients acquired chronic infections prior to 1992 by exposure to contaminated blood products during surgery or other medical procedures. The rate of new HCV infections has declined but the burden to healthcare systems will remain significant for decades. Complications from hepatitis C killed an estimated 8 000 Americans in 2004 and the figure is expected to triple by 2010.
The current standard of care is pegylated interferon combined with ribavirin, which is administered as a once-weekly treatment over a period of one year. Nevertheless, interferon therapy is far from ideal. More than half of patients with HCV genotype 1the most common form accounting for almost 75% of chronic hepatitis C infections in the US, Europe and Japanfail to respond to interferon therapy.
New-generation nucleoside analogues are targeting this area of unmet medical need in hepatitis C. NMC283the once-daily, RNA-polymerase inhibitor in development by Idenixhas shown promising results in Phase II clinical trials in combination with pegylated interferon.
The flagship compound from AnadysANA975stimulates activity of toll-like receptor 7 (TLR7), a complementary mechanism to direct inhibitors of viral replication, including the nucleoside analogues.
Toll-like receptors are a family of cellular proteins that patrol the cell, recognizing molecular patterns on foreign pathogens and triggering a protective response by the body's innate immune system. The immune system defenses unleash a cascade of the cell's own infection-fighting cytokines, including interferon alpha. By acting on the host cell rather than a viral target, a medicine that stimulates TLR7 might have a lower risk of viral mutations and drug resistance than is typically observed with nucleoside analogues.
"In HCV, we need innovative treatments and completely new drugs," Professor Manns says. "We can cure about 50% of genotype 1 patientsbut at a high cost with high side effects. And we still can't do anything for the other half of people infected with genotype 1. It's an urgent unmet need."
Andreas Rummelt knows that a clear sense of mission is the secret of building successful teams.
One of his favorite examples is a cleaning lady at America's space agency NASA who once told a reporter her job was to put the first man on the moon. Dr. Rummelt was delighted to find the same tenacious focus at German generics giant Hexal AG and its US-based affiliate Eon Labs Inc., which were acquired by Novartis in 2005.
"At Hexal, everybody understands that to be successful, a Hexal product has to be on the market on Day One following patent expiry of the originator medicine," Dr. Rummelt says. "And they live that."
The USD 8 billion purchase of Hexal and Eon Labs reinforces the position of Sandoz as a world leader in generics. The transaction also underscores the importance of generics to the strategic commitment of Novartis to provide patients and physicians the right treatment option, at the right time and the right price.
The primary focus of Novartis remains innovative, patent-protected medicines that address unmet medical need. Sandoz, in turn, provides quality generics as a competitive and affordable alternative once patent protection of the originator compound has expired. And Novartis also develops and markets OTC products that are convenient to buy without a doctor's prescription, and readily available to consumers at pharmacies and other stores.
"Our credibility in discussions with governments and other payers is enhanced by being in generics, as well as innovative medicines," says Daniel Vasella, M.D., Chairman and Chief Executive Officer of Novartis. "Innovative products and generics are interdependent. The role of innovative products is to make generics obsolete. But at the same time, knowing that generics are coming forces branded companies to invest in research and development, and rejuvenate their portfolios. In that sense, generics actually spur innovation."
The aging of populations, combined with rising affluence in emerging economies such as India and China, is increasing demand for drugs and other medical services. This is creating additional costs for governments and other payers. "As a result, penetration of generics will increase in markets around the world, and we see significant opportunities for the future," Dr. Vasella adds.
Indeed, industry analysts project 10% average annual net sales growth for generic products over the next five years, higher than projected growth for patent-protected pharmaceuticals during the same period. Novartis expects net sales at the Sandoz division to double to USD 10 billion by 2010, from pro forma net sales of USD 5 billion in 2004.
The integration of Hexal and Eon Labs has progressed rapidly. The initial agreement was announced in mid-Februarywith regulatory reviews and the tender offer for outstanding shares in Eon Labs completed within five months. Sandoz now employs more than 20 000 people, and the international management team based at the former headquarters of Hexal in Holzkirchen, Germany, includes senior executives from all three predecessor companies.
Along with Dr. Rummelt, Hexal's co-founders Dr. Andreas Struengmann and Dr. Thomas Struengmann are members of the Sandoz Executive Committee. Dr. Andreas Struengmann heads regional operations in Europe and Africa while Dr. Thomas Struengmann heads operations in Germany, the Middle East and the Americas. Dr. Bernhard Hampl, former chief executive of Eon Labs, heads the US operations of Sandoz.
Borrowing best practice from the 1996 merger of Ciba-Geigy AG and Sandoz AG that created Novartis in its current form, Dr. Rummelt and his top management team adopted a "Best of All" principle in the selection of country heads. Along with the Struengmann brothers and Dr. Horst-Uwe Groh, Global Head of Human Resources, Dr. Rummelt visited major countries and met personally with all incumbents.
"We had no quota," Dr. Rummelt says. "We looked at the track record of each candidate, along with strategy and vision for managing the integration and competing under the specific conditions of the market. Then we made quick decisions, allowing the new country head to build a team from the combined pool of Hexal, Eon Labs and Sandoz associates."
Dr. Rummelt also took the opportunity to eliminate regional and sub-regional management layers in the former Sandoz organization. "We want to increase speed of decision-making. The only way to do that was to avoid having too many levels between top global management and the general manager of a country," he says.
The integration with Novartis has involved significant adjustments for managers and associates steeped in the freewheeling, entrepreneurial culture of a family-owned group like Hexal. The rigorous reporting systems required of a company quoted on the New York Stock Exchange and subject to stringent provisions of the Sarbanes-Oxley Act can seem daunting initially. So can the discipline and transparency required by the Novartis commitment to the United Nations Global Compactand obligations to more than 170 000 shareholders, including many pension funds and institutional investors who depend on investments in Novartis to fulfill their own responsibility to hundreds of thousands of investors.
"It's a challenging communications job," Dr. Rummelt says. At the same time, there are benefits from being part of a bigger company, ranging from broader opportunities for career development and sharing of best practices, to financial resources required to maintain a position of global leadership amid consolidation and intensifying competitive pressures.
Still, the real promise of the new Sandoz lies in the combination of two highly complementary businesses. Sandoz offers a solid foundation through its presence in more than 100 countries, and globalized development and technical operations functions. The combined portfolio includes more than 600 active ingredients in more than 5 000 dosage forms. And crucial for a generics company, a significant part of the production of commodity products, such as tablets and capsules, is based in low-cost countries, providing Sandoz a competitive position against its biggest rivals.
"Today, key accounts want to buy the full spectrum from a supplier, not just one or two products. But to survive in the commodity end of the business, where you have to be able to offer the broad portfolio key accounts want, you need to manufacture in low-cost countries," Dr. Rummelt says. Sandoz has a strong presence in India, with more than 1 000 employees and four production plants, including a new plant under construction. In addition, Sandoz buys significant volumes of chemical intermediates and other active ingredients from Indian suppliers.
"Another crucial part of our strategy is to increase the proportion of our portfolio in difficult-to-make generics, which not everybody can do," Dr. Rummelt says. "That's where Hexal and Eon Labs will make a huge difference."
Dr. Rummelt is emphasizing key values essential for success of the new organization: speed and flexibility, customer and quality focus, as well as trust and mutual respect. All are critical success factors in generics, reflecting shorter product cycles and more volatile product development timelines than innovative pharmaceuticals.
Competitive conditions in the generic industry can change from one day to the nextwhen an originator product loses patent protection, or as the result of a court decision. "We can't afford to debate our strategy for six weeks and go through three approval bodies, You basically have to decide on the spot what a new development means, and what to do," Dr. Rummelt says.
"Your plan has to be in place ahead of time and if something unexpected happens, Plan B ready in reserve."
The timing of such developments normally varies from market to market. "There is no global generic market yet. You need dedicated, focused teams in the countries, with deep understanding of their market," Dr. Rummelt adds. "It is essential that the countries are entrepreneurial nuclei with sufficient autonomy and a defined frame."
National conditionsfrom legislation and distribution to acceptance of genericsdiffer significantly from country to country but Sandoz has uniformly strong market positions today. Besides its No. 1 position in Germany, where penetration of generic medicines is the highest in Europe, Sandoz ranks No. 2 in the US measured by annual net sales. Sandoz also ranks among the top three in most European markets, including France and Spain, where acceptance and penetration of generics are climbing rapidly.
The US generics market is better developed than Europe: 52% of all prescriptions by volume are dispensed as generic drugs. Nevertheless, competition is intenseas is pricing pressure for standard generic products. In a recent example, prices of generic glimepiride, for treatment of type 2 diabetes, dropped 95% within a few weeks of patent expiry on the innovator product Amaryl®. The lean Sandoz sales force in the US targets key national distribution accounts, reflecting the freedom pharmacy chains have to dispense the generic version of a drug, when available.
In Germany, however, Hexal maintains an effective and well-trained sales force that calls on physicians and pharmacists, promoting mostly Hexal's umbrella-branded products. Success factors for Hexal include constant renewal of the development pipelineplus a large proportion of unique products that generate high profitability. Besides the Hexal brand, both the Sandoz and 1 A Pharma brands help to support the strong position the Sandoz division has established in Germany.
Hexal and Eon Labs have a stellar track record in product development. Sandoz expects to launch more than 80 new products in 2006 and 2007, and the pipeline has more than 250 generic medicines in various stages of testing. Even more important, a large proportion of those launches will be specialty generics such as injectable, inhaled or sustained-release formulations that are difficult to make and earn higher profit margins than commodity products.
CENTERS OF EXCELLENCE
One recent example is fentanyl, an analgesic compound delivered through a transdermal patch. It was the biggest-selling prescription medicine in Germany before the recent expiration of its patent. Hexal has been preparing the launch of its generic version for years, investing in patch technology and other specialized know-how. The preparations paid off as Hexal launched the first generic version of transdermal fentanyl, earning several months of exclusivity by being first to market.
Hexal's German plants will be included among the centers of excellence in the Sandoz production network. The Hexal plant in Holzkirchen specializes in transdermal patch technology while the Rudolstadt plant focuses on inhalation devices for respiratory medicines. The Dresden facility has a containment section for production of cytotoxic anticancer drugs. "In this difficult-to-make part of our business, cost isn't the decisive consideration and there's no need to move everything to India. We can afford to have the best specialists available to run development and production in higher-cost, highly productive countries," Dr. Rummelt says.
Eon Labs, in turn, has been first to market for more than half of its new drug applications in the US in recent yearsa key reason that profit margins have exceeded 30% of net sales. "The Eon Labs portfolio is packed with sustained-release formulations that are extremely difficult to manufacture and have been successful in quickly gaining market share," Dr. Rummelt says.
Moreover, Eon Labs has looked beyond the handful of blockbuster drugs losing patent protection and developed cost-effective generic versions of mid-size products where it has met limited competition from generic rivals and grabbed a significant share of the market.
Sandoz, for its part, remains one of the world's biggest producers of generic antibiotics at its longtime site in Kundl, Austria. Another Sandoz unitSandoz Canada Inc.is a leading producer of injectable formulations.
The combined prowess in difficult-to-produce generics, plus the pharmaceutical heritage from Novartis, leaves Sandoz in a strong position to pioneer the next frontier in genericsso-called follow-on proteins or generic versions of genetically engineered medicines. Omnitrope, a human growth hormone developed by Sandoz and produced by recombinant DNA technology, was approved by Australia two years ago and launched in 2005.
"With 60 years of experience in fermentation and downstream processing, as well as familiarity with clinical trials and registering new drugs, we're in a very strong position for future growth," Dr. Rummelt says.
"There are two things you need to achieve in this business: being first to market and last out of a market. Being first in requires an excellent development organization driven globally, with the brightest people in more than one place focusing on different technologies," he adds.
"But you can only be last out if you have a very cost-effective supply chain. It sounds simple but it's very difficult. We have a chance to succeed by bringing together the best elements of Sandoz, Hexal and Eon Labs."
When the first thin film breath fresheners reached the US market in 2001, researchers at Novartis Consumer Health were convinced the new technology could be adapted to deliver medicines as readily as mouthwash.
Convenience and compliance go hand in hand in self-medication. And it would be hard to beat the convenience of handy strips of starch-based film the size of postage stamps that melt on the tongue to deliver accurate doses of medication without mess or waste. For all the promise of the technology, however, the innovators had to surmount formidable technical hurdles.
They succeededand made Triaminic Thin Strips a model for the nimble product development driving growth at the Consumer Health Division. "This is a story about vision, speed, commitment and refusing to take no for an answer," says Larry Allgaier, Head of the Consumer Health Division's OTC Business Unit.
"Successful innovation builds momentum," he adds. "Our team was driven to make Novartis the first company to improve well-being of consumers by putting real medicines in Thin Strips."
One challenge in delivering a medicine with the Thin Strips formulation is that the film format has a relatively restricted dosage capacity. It's not possible to deliver an adequate dose of all classes of over-the-counter medicines. At the same time, active ingredients in many medicines have bitter, unpleasant flavorsso effective taste-masking is essential for success.
And though speed was critical to the Thin Strips project, the OTC Business Unit could not turn to one single supplier with the combined expertise required. A potential supplier needed to be familiar with standards of good manufacturing practice in the pharmaceutical industry.
Yet sufficient infrastructure to support an aggressive launch, acceptable costs and the sense of urgency necessary to win a fiercely competitive commercial race also were indispensable. "We literally went around the world but couldn't find anybody with everything it would take to get this done," Mr. Allgaier recalls.
Instead, the project team hand-picked its future supply chainone link at a time. At a decisive meeting in the autumn of 2003, key suppliers were assembled around a table for the first time. "We knew it wouldn't happen unless we could get all the suppliers to act as a seamless unit," Mr. Allgaier says. "We needed their commitmentto communicate proactively and resolve issues quickly to stay on track for launch."
The ad-hoc group adhered to ambitious timelines, culminating with the market debut of Triaminic Thin Strips, a pediatric cough and cold product, in July 2004. The launch rejuvenated the Triaminic brand. Net sales during 2005 surged 35% from the previous year. The market share of Triaminic exceeded 20% last year for the first time since 1999, regaining share leadership from Tylenol®.
Theraflu Thin Strips, an adult cough product, was also launched during 2004. Last year, a new cherry-flavored Triaminic Thin Strips was introduced, complementing the original grape flavor. Continued product development is expected to result in launches of additional Thin Strips products from the OTC Business Unit in the future.
Thin Strips isn't the only example at Novartis Consumer Health of successful innovation focusing on novel delivery technologies. The Medical Nutrition Business Unit translated key insights from market research about consumer preferences in Japan to successfully launch Isocal Arginaid, a drink containing specific nutrients to promote wound healing, in a major new market.
And the Animal Health Business Unit transformed shape, texture and flavor of traditional pills to develop a potentially life-prolonging medicine more to the taste of finicky catsand to the relief of their owners, desperate for a better way to make the medicine go down.
COMMON AND COSTLY HAZARD
Pressure ulcers are a common and costly health hazard for the growing number of elderly people living in nursing homes or other long-term care facilities. The main cause of pressure ulcersor "bedsores"is immobility. When a person isn't able to change position without help, the constant pressure on skin and muscle can close tiny blood vessels that nourish the skin and supply oxygen.
Nutrition is a recognized and important component of pressure ulcer prevention and treatment. According to guidelines from governmental and professional groups such as the (US) Agency for Health Care Policy and Research, and the European Pressure Ulcer Advisory Panel, poor nutrition is a major risk factor for development and progression of wounds, including pressure ulcers and diabetic foot ulcers.
Inadequate nutrition can make body tissue more susceptible to the effects of pressure, resulting in greater risk for wound development, and slow healing. Moreover, the aging process itself is associated with reduced appetite and overall intake, putting elderly long-term care residents at greater risk for malnutrition. Adequate medical nutrition therapy or dietary intake of calories, protein and fluidsalong with key nutrientsis a cost-effective strategy to prevent and treat pressure ulcers, with the potential to significantly accelerate healing.
For years, Novartis Medical Nutrition has provided patients and physicians with RESOURCE Arginaid EXTRA drinksan easy and convenient way to provide the specific nutrients that help wound healing. These nutrients range from zinc and vitamins C and E, to arginine, an amino acid that works at the cellular level to help promote wound healing.
Last year Novartis Medical Nutrition launched the product in Japan, under the Isocal Arginaid brand, as the first oral supplement specifically targeting wound care. The success of the launch reflected the consumer insights used by the Medical Nutrition Business Unit to adapt Isocal Arginaid to the Japanese diet and taste.
Compared to Western countries, the Japanese diet traditionally is lower in fat content, but higher in levels of protein, zinc and other micronutrients. "So we adapted the core components of Isocal Arginaid to the nutritional profile and habits of the Japanese consumer," says Michel Gardet, Head of the Medical Nutrition Business Unit.
Isocal Arginaid was launched in raspberry and orange flavors already available in Western marketsbut the taste is milder, in line with local preferences. Novartis Medical Nutrition also is preparing the launch of two additional flavorsgreen apple and grapethat are popular with seniors in Japan.
The flavors are designed to go with foods usually eaten for breakfast and the main meal of the day. And while Isocal Arginaid comes in a ready-to-serve brik package, the volume is reduced to 125 milliliters, or about half the size of the standard US brik pack.
Catering to local consumers seems to be paying off, especially in terms of compliance. In pilot studies in Japanese hospitals and geriatric institutions, almost 90% of participating patients finished the Isocal Arginaid drinks served with their meals.
THE CATNIP PILL
Fortekor, the daily treatment for chronic renal insufficiency in cats from Novartis Animal Health, is one of the first veterinary medicines to address the needs of both cats and their owners. Fortekor pills are oval in shapean unconventional design that reflects two fundamental consumer insights.
Animals don't understand that a medicine is good for them. Cats compound the difficulty of drug treatment because as notoriously finicky eaters they may bite pills, rather than swallow them, and consequently lose part of the intended dose.
To ensure correct dosing, an owner often has to force the medicine down the animal's throat. Yet many pet owners simply won't force-feed medication for fear of damaging the trusting relationship they have established with their pet. In the case of Fortekorindicated for a chronic disease and requiring daily administrationthat challenge is magnified.
Novartis scientists hit upon a solution by using innovationnot force. Extensive tests of diverse tablet shapes showed that a soft, oval tablet is easier for cats to swallowby being slimmer at its widest point than the diameter of a comparable round pill. In addition, Fortekor was transformed to sheer catnip by varying texture of the tablet and adding a flavor.
In home tests involving hundreds of owners and their pets, almost 90% of cats voluntarily took the oval, flavored Fortekor tabletcompared to only about 50% of cats given a conventional round pill.
The shape, texture and taste of animal medication is a relief for owners, ensuring correct and regular dosing to achieve the desired therapeutic effect, while strengthening the relationship with their pets. Buoyed by the success of the new Fortekor, Novartis Animal Health has developed and launched formulations of other medications applying the same principle.
Corporate Citizenship at Novartis begins with the success of our core business.
The more successful we are in discovering, developing, manufacturing and marketing new medicines, the greater the benefits we can offer to patients and health-care professionals, associates and shareholders, our neighbors around the world, and other key stakeholders.
Our uniquely broad portfolio of medicines provides patients, physicians and payers the right treatment at the right time and the right price. We offer innovative patentprotected medicines that address unmet medical need; cost-effective generics as an alternative once patent protection on an originator compound has expired; and non-prescription, self-medication, products that are convenient to buy. Such a diverse portfolio becomes increasingly important as aging populations and rising affluence increase demand for drugs and medical services.
Thanks to our good financial results, we also try to help where there is immediate needwith products, funds and other supportive measures, on a case-by-case basis. In 2005, Novartis was able to contribute USD 696 million and reach almost 6.5 million patients in need through access-to-medicine programs.
Novartis has a longstanding tradition of active engagement in society, reflected in our Policy on Corporate Citizenship.
We pledge to recognize the interests of stakeholders, and the public at large, in our social behavior, and the health, safety and environmental impacts of our business.
We seek to maintain an active dialogue with diverse stakeholder groups through community panels, focus groups and collaborations with patient advocacy organizations.
At the same time, we are building a reputation as an exciting place to work, where people can realize their professional ambitions. We strive for a motivating environment where creativity and effectiveness are encouraged, and where cutting-edge technologies are applied.
The clearest example of the interrelation between business strategy and Corporate Citizenship is our commitment to the United Nations Global Compact. The Global Compact asks companies to embrace, support and enact a set of core values in the areas of human rights, labor standards, the environment and efforts to combat corruption.
Last year, in an acknowledgement of the pioneering role of Novartis in the evolution of the Global Compact, UN Secretary-General Kofi Annan named Professor Klaus Leisinger, President of the Novartis Foundation for Sustainable Development, as a Special Advisor to the Global Compact. Professor Leisinger will act as a global ambassador for the Global Compact and advance issues critical to the initiative.
Another important acknowledgement of our commitment to the Global Compact came from DNWE, the German Business Ethics Network which awarded Novartis its Preis fuer Unternehmensethik, the Business Ethics Award, for 2006.
MEASURE PROGRESS AND IMPACT
To be recognized as an innovative and trustworthy company, Novartis fosters a culture where associates are expected to behave ethically and lawfully. Besides complying with laws and regulations that govern our operations in more than 140 countries around the world, Novartis associates uphold the ideals and values defined in our Code of Conduct and Corporate Citizenship Policy, and as related policies and guidelines.
Corporate Citizenship at Novartis is firmly anchored at the Board level. The Audit and Compliance Committee is responsible for auditing Corporate Citizenship implementation and compliance. The Group Executive Committee (ECN) is responsible for implementation and has established a Corporate Citizenship Steering Committee, which has overall responsibility for Corporate Citizenship Policy and guidelines.
The operating units within each of our Divisions establish appropriate structures and allocate sufficient resources to reasonably meet the expectations of our Corporate Citizenship Policy. Through management reviews, plus internal and external audits, we measure progress and verify compliance with the Policy, related guidelines and regulatory requirements.
Each year, we report our progress in addressing key challenges of Corporate Citizenship, as well as establishing targets for the coming year. Reporting on Corporate Citizenship activities includes regular surveys of employees and contacts with suppliers.
(For a summary of Corporate Citizenship-related results for 2005 and targets for 2006, see table pages 48-50.)
The commitment by Novartis to the UN Global Compact in 2000 led to a number of initiatives aimed at integrating the vision and core values of the Global Compact into day-to-day company operations. The Corporate Citizenship Steering Committee drove extensive internal consultations with senior Group executivesas well as outreach to influential external stakeholdersand identified key challenges likely to have a material impact on Corporate Citizenship Policy.
Many of those issuesranging from Fair Working Conditions and Human Rights, to Bribery, Gifts and Entertainment and relations with Third-Party Suppliers have been addressed through guidelines to the Corporate Citizenship Policy. Implementation of the Third-Party guideline as well as so-called Living Wage standards accelerated during 2005.
During 2005 Novartis reviewed health, safety and environmental activitiesand labor practicesof more than 30 000 Third-Party Suppliers with annual sales to Novartis exceeding USD 10 000. We will ask these suppliers to maintain comparable social and environmental values to our own. As a result of the initial review, pilot on-site audits were conducted with 55 Third-Party Suppliers last year. Similar on-site audits are planned for more than 400 other suppliers by 2010 to track compliance with Group guidelines on Third-Party Management.
The issue of fair marketing practices has been addressed by establishment of a set of principles governing promotional practices worldwideand creation and enforcement of Marketing Codes by all Novartis Divisions.
In recent years, Novartis has intensified training programs for associates and further progess was achieved during 2005. Compliance e-learning at Novartis is available in 14 languagessetting a high standard among global companies.
Courses on the Code of Conduct, Corporate Citizenship and Conflict of Interest Policies are mandatory for associates worldwide. In addition associates in certain functions are required to complete additional courses in areas such as Competition Law and Insider Trading. Mandatory courses in the fields of Human Rights and Sales/Marketing will be introduced for certain functions this year.
During 2005, Novartis also moved to global implementation of a "Living Wage". The principle of paying fair wages that meet or exceed the amount needed to cover basic living needs was outlined in our Corporate Citizenship Guideline on Fair Working Conditions adopted by the ECN in 2002. Novartis is one of the first major international industrial companies to implement such a commitment. (For additional details, see page 61)
Last year, the ECN approved a global Animal Welfare Policy and named Professor Paul Herrling, Head of Corporate Research, as the company's Animal Welfare Officer (AWO).
The appointment of Professor Herrling consolidated efforts of several internal organizations that previously monitored animal welfare within the Group. Animal Welfare Officers have been appointed by each division to oversee implementation of Novartis guidelines within company laboratoriesas well as by third-party partners to which Novartis outsources animal experiments.
Implementation of the animal welfare guidelines remains the responsibility of line managers worldwide, who will report on compliance to the AWO on an annual basis.
Novartis complies with all legislation on animal welfare and experimentation applicable to it. The Group's updated animal welfare policyto be rolled out worldwide this yearestablishes minimum standards for studies conducted by Novartis, or third-party partners, in countries where insufficient legislation is in place.
Discovery and development of new drugs involve animal testing for scientific and ethical reasons. Animal testing is also required by law to determine the safety and efficacy of new medicines before they can be tested in humans.
In line with our commitment to comply with currently applicable scientific, regulatory and ethical requirements, studies at Novartis are carried out by individuals who are trained and qualified in science, and the proper care, handling and use of animals. Generally, these persons also have experience with the specific species being studied. Novartis is committed to ordering and using only animals specifically bred for research purposesby the company itself, or by certified breeders.
In 2005, Novartis was widely recognized for its Corporate Citizenship program:
Novartis also is recognized as a leader by the rapidly expanding Socially Responsible Investment (SRI) community. In 2005, Novartis was again selected as a component of the Dow Jones Sustainability Indexes (DJSI), which track the performance of companies in terms of corporate sustainability.
Pharmaceutical innovation in coming decades must address emerging diseases and other unmet medical needs to deliver sustained improvements in life expectancy and quality of life comparable to those achieved in the 20th Century. Yet a flow of new medicines can't be taken for granted.
Daniel Vasella, M.D., Chairman and Chief Executive Officer of Novartis, emphasizes the dominant role played by pharmaceutical companies in conducting and funding research and development. "Often the public forgets or ignores the immense progress achieved by medical practice thanks to modern pharmacotherapy," Dr. Vasella says.
"Remember that overall, the pharmaceutical industry invests more than USD 50 billion a year in research and development, the single most important source of investment in health research."
During 2005, the Novartis Pharmaceuticals Division increased R&D investments by 18% to almost USD 4 billion, one of the highest figures in the global pharmaceutical industry relative to sales (19.6%)(1).
Still, there is considerable public hostility to the pharmaceutical industry today. Critical stakeholders and the media attack the industry on issues ranging from pricing and promotional practices, to limited access to medicine in developing countries and scant research devoted to "neglected" diseases such as tuberculosis and malaria. In addition, drug safety has moved into the spotlight following withdrawals of major medicines in recent years.
Pharmaceutical companies are subject to more stringent scrutiny by the public and regulators than many other industries.
Regulatory agencies may at any time reassess the safety and efficacy of our products based on new scientific knowledge or other factors. In addition to normal price competition in the marketplace, the prices of our Pharmaceuticals Division's products are subject to direct controls and other pressures imposed by governments and health care providers in most countries.
There are significant differences, however, between strategies of individual companies within that regulatory framework. Novartis, for example, is the only major pharmaceutical company holding positions of global leadership in both innovative, patent-protected medicines and generics.
CLINICAL TRIAL REGISTRY
During 2005, Novartis and other pharmaceutical companies unveiled major initiatives to improve disclosure of results of clinical trials. The move came amid legal challenges in the USand calls from editors of 11 major medical journals for creation of a public registry for clinical studies involving human patients.
That registry became reality last year under the leadership of Dr. Vasella in his capacity as President of the International Federation of Pharmaceutical Manufacturers Associations (IFPMA). Fulfilling a pledge to provide an industry blueprint to improve clinical trial transparency, IFPMA launched a clinical trials portal offering access to online information concerning more than 250 000 clinical trials worldwide.
In 2003, Novartis established its own web-based registry, providing retrospective data on results of global and local clinical studies. At the end of 2005, the Novartis Clinical Trial Results Database (CTRD) included more than 250 trials. Novartis also provides information on trials of medicines to treat serious and life-threatening diseases, through an electronic registry sponsored by the US National Institutes of Health.
"We believe that all trial results must be publishedwhether they are favorable or not," says James Shannon, M.D., Head of Development for the Novartis Pharmaceuticals Division. "We recognize that there are important public health benefits associated with making clinical trial information more widely available to healthcare practitioners and patients."
The withdrawal of the painkiller Vioxx® by the US company that discovered and marketed the drugalong with withdrawals of other medicines in recent yearshas ignited a heated debate about drug safety. "There is no doubt that the news around Vioxx® has led to more conservative attitudes toward new therapies as well as existing medicines," Dr. Vasella says.
"In the first quarter of 2005 we saw an all-time peak in the number of 'black box warnings' from regulators," he adds. "We hope in the interests of physicians and patients that we can get back to normaland focus on science and facts that have historically led to the discovery and development of important pharmaceutical products which have vastly improved the quality of life for each of us."
Novartis and other pharmaceutical companies are obliged to establish and maintain comprehensive, worldwide networks to monitor safety of their products. At Novartis the Clinical Safety and Epidemiology functionin collaboration with our local operating companiesis responsible for worldwide safety surveillance; the collection and reporting of safety data according to regulatory requirements of all Novartis investigational and marketed drugs; and for providing medical safety evaluations and epidemiological support for drug development activities.
Surveillance begins during initial stages of development of a new compound (or new formulation of an existing medicine) and is maintained throughout the lifetime of a product. The company's drug-safety policy applies to all active pharmaceuticals undergoing evaluation or development in any clinical trial in any countryincluding products sold by third-party licensees, or co-marketed by Novartis and third parties.
Each local country organization in the Novartis group is responsible for overseeing the safety of pharmaceuticals it sells locally, for complying with local regulatory and legal obligations, and for communicating appropriate safety information to the Clinical Safety and Epidemiology staff at our central sites for onward processing. More than 400 associates are part of the drug-safety organization worldwide.
In yet another initiative, the Novartis Pharmaceuticals Division created a Product Stewardship Board responsible for proactively identifying, assessing and managing any possible product-related risk. Generally, each marketed product is subject to a standard annual review by the Stewardship Board for the first five years following market authorization. Subsequent reviews take place every five yearsin addition to any further unscheduled assessments deemed necessary. The process aims to ensure appropriate product information and communications to doctors, patients and authorities.
The Product Stewardship Board reports every quarter to the Pharmaceuticals Division Executive Committee. Both Sandoz and the Consumer Health Division have established similar product stewardship processes.
The voluntary withdrawal of Vioxx®a medicine in the category of painkillers called COX-2 inhibitorsposed a strategic dilemma for Novartis which has a COX-2 inhibitor of its own, Prexige, in registration in a number of markets.
Vioxx® was withdrawn after studies allegedly demonstrated an increased risk for cardiovascular-related adverse events that some would argue outweighed benefits of use.
Prexige, however, has been approved by regulatory agencies in Brazil and the United Kingdom among other countries. Novartis has launched the medicine in Brazil and also plans to commence the mutual recognition procedure (MRP) for Prexige that could lead to approval in other European Union member countries.
Evidence-based medicine and unmet medical need were the pivotal factors in the decision by Novartis to launch Prexige despite the troubles facing competing products such as Vioxx®. "We have always believed that Prexige is a well-characterized product with a very positive risk-benefit profile," Dr. Shannon says.
"Novartis showed in the 18 000-patient TARGET study that Prexige has a better gastrointestinal safety profileand no significant difference in cardiovascular safetycompared to nonsteroidal anti-inflammatory drugs (NSAID), the standard treatment before introduction of COX-2 inhibitors", Dr. Shannon adds. "We believe Prexige is an excellent alternative for the right patientswho are at risk for GI bleeds and who are free of any cardiovascular risks."
For additional information and to see key documents such as the Corporate Citizenship Policy, Code of Conduct and the Novartis Global Reporting Initiative Report, please visit:
Novartis endorses the right to health. We believe that each sphere of societypatients, medical professionals, government and businesshas a role to play in support of the right to health.
Our primary and most important contribution to society is to discover, develop, produce and distribute high quality health-care products, targeting unmet medical need. Our commitment to patients leads us to maintain one of the highest levels of research investment among top-tier pharmaceutical companies. Our drug development program has been one of the most productive in the global pharmaceutical industry in recent years.
Thanks to our good financial results, we also try to help where there is immediate need, with products, funds and other supportive measures, on a case-by-case basis. Last year, we were able to contribute USD 696 million and reach 6.5 million patients in need through access-to-medicine projects around the world.
The Novartis Institute for Tropical Diseasesbased in Singaporeis bringing the ongoing revolution in biomedical science and technology to bear on diseases of the developing world, initially tuberculosis and dengue fever.
We provide medicines at cost, or sometimes free, to patients in the developing world afflicted by diseases such as leprosy, malaria and tuberculosis. We also offer discounts and support programs to patients in industrialized countries who lack medical insurance or other financial resources.
For more than 25 years, the Novartis Foundation for Sustainable Development (NFSD) has made significant contributions to the health of people in the developing world. The NFSD is developing patientcentered daily-observed-treatment systems (DOTS) for tuberculosis and also supports patient education programs against malaria.
MILESTONES 2005: LEPROSY
Late last year, NFSD reaffirmed its longstanding commitment to eliminate leprosy by extending an ongoing public-private partnership with the World Health Organization for an additional five years, through 2010.
Since 2000, Novartis has provided free treatment for all leprosy patients worldwide in a pioneering collaboration with the WHO. More than 4 million people with leprosy have been cured through the use of effective multi-drug therapy (MDT) supplied by Novartis.
By 2000, the prevalence of leprosy had been reduced to less than one case per 10 000 population worldwide. Efforts today focus on eliminating leprosy in nine countries where the disease remains a public health problem: Brazil, India and Nepal, as well as several African nations including Angola, Mozambique and Tanzania. During 2005, the number of new cases detected fell 21% from the previous year, indicating that the backlog of undetected cases is being reached and effectively treated.
"The leprosy drug donation program is an expression of our belief at Novartis that a special effort needs to be made against diseases of poverty," says Urs Baerlocher, Head of Legal and General Affairs of the Novartis Group and Member of the Group Executive Committee.
Novartis continues to enhance access to its cancer therapy Glivec(1) through a global patient-access initiative. Over the last three years, the Glivec International Patient Assistance Program (GIPAP) has been expanded to 79 countries and in 2005 provided Glivec free of charge to more than 15 000 patients with chronic myeloid leukemia (CML) and gastrointestinal stromal tumor (GIST).
Novartis continues to find innovative solutions for access despite administrative and infrastructure barriers within many countries. By partnering with experienced physicians and local organizations, Novartis has been able to reach patients who would otherwise not have access to treatment for their life-threatening diseases.
The GIPAP program is based on a "patient-direct" modelensuring delivery of Glivec to patients through a network of more than 780 registered physicians and more than 280 qualified treatment centers worldwide. The Max Foundation (TMF) and Axios International are the global partners that administer GIPAP.
In China, Novartis has partnered with the Chinese Charity Foundation (CCF) to establish a national GIPAP. More than 120 physicians, representing 78 qualified medical institutions in 27 provinces, have registered with the Chinese GIPAP, helping more than 1 000 patients in need receive treatment with Glivec at no cost.
In a separate development involving Glivec, Novartis submitted unconventional applications to regulatory authorities around the world during 2005 and early this year, seeking to expand access to Glivec beyond CML and GIST to include a cluster of rare conditions. In studies, Glivec had shown efficacy in treating these rare disorders but the limited number of patients with each disease precluded the large, randomized clinical trials usually required for regulatory approval.
To provide access to treatment for these patients, Novartis assembled data from published studies into regulatory applications. Regulatory agencies, including the US Food and Drug Administration, have agreed to consider the unusual applicationbut there's no guarantee of success.
"Our commitment has been to ensure that any patient who could benefit from Glivec also could get the medicine," says David Epstein, Head, Oncology Business Unit, at the Novartis Pharmaceuticals Division. "We did this first through patientassistance programs for patients with CML and GIST. Once we saw that the drug was effective in these other rare indications, we felt an obligation to explore and to push approval for them as well," he adds.
"We have a bond with these patients and we have to keep doing whatever we can for them, to the extent of our scientific capability."
CHANGING THE FACE OF MALARIA
During 2005, Novartis also stepped up its commitment to change the face of malaria. We expanded production capacity dramatically and doubled shipments of the pioneering antimalarial medicine Coartem which the company provides on a non-profit basis for public-sector use in developing countries where the disease is endemic.
More than 33 million Coartem treatment courses were produced last year and deliveries reached 9 million treatments, from 4.4 million in 2004. Since 2001, when Novartis created the partnership with the WHO to distribute Coartem at cost, more than 20 million treatments have been provided to patients in the developing world.
In addition to Zambia, the initial country in Africa to adopt Coartem as first-line therapy against malaria, major deliveries were made last year to Angola, Ethiopia, Nigeria, Mozambique and Sudan.
To meet rising demand, Novartis and partners on three continents continued a scale-up of manufacturing capacity virtually unprecedented in commercial drug production for a new chemical entity. The scale-up will make it possible to keep pace with further increases in demand expected this yearto more than 100 million treatment courses of Coartem, according to the latest forecasts from the WHO.
This represents a 25-fold increase from 2004. Late last year, Novartis received an order from Uganda for more than 15 million Coartem treatment courses, the biggest order yet for the drug, or any artemisinin based combination therapy (ACT).
"This scale-up is the most rapid increase in capacity for any drug I knowand it is especially remarkable for a product provided on a not-for-profit basis," says Daniel Vasella, M.D., Chairman and Chief Executive Officer of Novartis. "Effective drugs are available now, but solving the problem of malaria is much more than just a question of drug availability. These countries are facing a lack of physicians and nurses, the lack of an efficient distribution system and of other preventive steps against unnecessary infection," Dr. Vasella adds.
"Governments, health ministries, international organizations and industry all have roles to play in addressing and resolving this challenge."
MOST EFFECTIVE TREATMENT
A publication last year in Britain's leading medical journal, The Lancet, suggested that Coartem is the most effective available treatment for malaria in children in areas of Africa where resistance to conventional antimalarial drugs is high. Coartem achieved a parasitological cure rate of 99%, significantly higher than the three comparator drugs, which achieved parasitological cure rates between 58% and 89%, respectively.
Developed and produced by Novartis and its Chinese partners, Coartem currently is the only fixed-dose ACT prequalified by the WHO for procurement by United Nations agencies.
Yet for much of last year, tight supplies of key raw materials prompted questions about the ability of Novartis and its partners to satisfy demand, as African countries turned to Coartem to replace their existing antimalarial medicines rendered increasingly ineffective by the emergence of drug-resistant strains of the malaria parasite.
As recently as 2002, annual production of Coartem was only 100 000 treatments and the original 2001 agreement between Novartis and the WHO had projected worldwide demand of slightly more than two million treatments by 2005.
The supply chain for Coartem and other ACTs is complex and time consuming. Artemisinin, the intermediate from which the active ingredient in all ACTs is derived, is a plant-extraction product, and crops of Artemisia annua must be planted one growing season ahead of harvesting and extraction for use in production.
Cultivation requires a minimum of seven months. Extraction, drug-substance production, tableting, packaging and shipping extend the production cycle to 14 months.
During 2005, Novartis broadened and diversified its supplier base for artemisinin and other key raw materialstransitioning from China's largely wild crop of Artemisia annua to more reliable commercial cultivation on plantations. A key step was an agreement between Novartis and East African Botanicals (EAB) that led to new planting of more than 1 000 hectares in Kenya, Tanzania and Uganda. The additional commercial cultivation boosted global agricultural production of Artemisia annua to roughly 10 000 hectares, a sufficient level to support projected future demand for ACTs.
Financing from Novartis enabled EAB to offer firm purchasing agreements to numerous local farmers, including many on small lots. At the same time, construction or expansion of extraction and purification facilities in Kenya and Uganda is creating hundreds of jobs, improving the local economy and upgrading safety standards.
Artemisinin has been used for centuries in traditional Chinese medicine to treat malaria. The Chinese researched and discovered the medicinal value of artemisinin and Chinese scientists played pivotal roles in research and development of both of the active ingredients in Coartem. The drug was co-developed by Novartis and Chinese partners who continue to supply active ingredients, though the final Coartem tablets are produced by Novartis in China and the US.
As part of last year's scale-up, both the Chinese firms that manufacture active ingredientsKunming Pharmaceutical Corp. (KPC) which provides artemether and Zhejiang Medicine Co. (ZMC) which provides lumefantrinecompleted major capacity-expansion programs and passed inspections by Australia's main medicines regulator certifying compliance with international good manufacturing practice (GMP).
Meanwhile, Novartis raced to install new production and packaging lines at a pharmaceutical plant in Suffern, New York. Production of Coartem at Suffern began in September and annual capacity exceeds 100 million treatments. In all, Novartis and partners invested almost USD 50 million during 2005 to expand production capacity for Coartem.
"This has really been a joint project and I can't give enough credit to the Chinese government and Chinese scientists," Dr. Vasella adds. "The partnership has been outstanding."
Along with the exceptional efforts on the supply side, parallel efforts by the WHO and the Global Fund to Fight AIDS, Tuberculosis and Malaria have been critical in expanding access to Coartem. The WHO provides technical guidance on malaria-control policy and helps countries make proper use of the new drugs when they arrive in the field.
Meanwhile, the Global Fund has become the world's largest financier of anti-malarial programs and has committed more than USD 200 million for the 2005-06 period, sufficient funding to cover projected Coartem demand through the end of 2006. Additional funds for malaria-control programs could become available this year through other international initiatives, such as the USD 1.2 billion US Presidential Malaria Initiative.
"While we provide Coartem at cost, our efforts would be in vain without the Global Fund's financial aid allowing governments of malaria-endemic countries to purchase the drug," Dr. Vasella says.
Professor Moise Azria has spent more than 30 years as a research and development scientist at Novartis
Among dozens of projects he's worked on over the years, three medicines ultimately reached the market, including Miacalcic nasal spray, used to treat bone disorders such as osteoporosis. After devoting several years to each successful project, Professor Azria moved on to new opportunities inside the company.
Today, however, that kind of lifelong loyalty is increasingly rare. Globalization has intensified competition for world-class researchers as well as executives in marketing and sales, technical operations and other functions.
Novartis remains an attractive destination for top global talentreflecting the company's rapid growth and one of the pharmaceutical industry's richest new-drug pipelines. Yet retaining world-class talents once they are on board remains a major challenge.
"The best way to foster loyalty and commitment is to generate opportunities for professional advancement that match personal aspirations of employees," says Juergen Brokatzky-Geiger, Head of Human Resources of the Novartis Group and Member of the Group Executive Committee (ECN).
At Novartis, the primary instrument to manage professional and career advancement is the Organization and Talent Review (OTR), an annual, worldwide talent assessment that tracks performance and updates development plans for promising executives and associates. For top Group management, the reviews help gauge the depth of the talent pipelinea critical dimension of succession planning.
The OTR program employs uniform global processes and methodology to identify talent in a vast cascade. It begins with discussions between managers and their direct reports at Novartis sites worldwide, and culminates in a final, Group-wide OTR review with Chairman and Chief Executive Officer Daniel Vasella. To identify the right talent to grow the business, the scope of OTR has expanded dramatically in recent yearsfrom only a few dozen senior managers five years ago, to more than 15 000 Novartis associates who participate today.
In development discussions, managers and their direct reports assess strengths, weaknesses and development needs; pinpoint career aspirations; and propose concrete actions. At the next level, managers as a group review this informationincreasing the visibility of talented candidates to senior executives and Human Resources staff. "We aim to build an exciting workplace where our people can realize their full potential," Dr. Brokatzky-Geiger says.
BLUEPRINT FOR CAREER ADVANCEMENT
In the blueprint for career advancement at Novartis, learning from experience goes hand in hand with systematic accumulation of skills to prepare managers for challenging future assignments.
Expansion of the OTR program has refined planning for upward career moves. Rotations between assignments in country organizations, regional organizations and Group headquarters in Switzerland have become more frequent across our broad and diverse worldwide talent pool. Mercedes Echauri began her career with Novartis in her native Spain as a regulatory-affairs specialistbut moved to Munich, Germany, in 2002 as Head of Business Development and Licensing for the Pharmaceutical Division's European Office. Last year, Ms. Echauri returned to Spain as Head of Partnering and Market Access for the new Emerging Growth Markets organization.
In recent years, Novartis has taken steps to insure that there is room at the top to reward loyalty and commitment. In 2005, Novartis achieved a Group objective of filling 70% of leadership positions with internal candidates for the first time. As recently as 2003, the proportion of internal promotions was 51% and in the year 2000 the figure was only 21%.
STAFF FLUCTUATIONS 2005
(Figures represent headcount)
As cross-functional teams become more common throughout the company, diverse backgrounds and experience are increasingly important for senior executives. Ann Bailey had worked in Consumer Health, Technical Operations and launched the Pharmaceutical Division's IQP (Innovation, Quality, Productivity) initiative before being named Head of Corporate Communications last year.
Maeve Devlin joined a predecessor company of Novartis in conjunction with construction of a new manufacturing plant in Ringaskiddy, Ireland. A decade later, she transferred to Switzerlandinitially as head of multipurpose production, but since 2004 as Head of Chemical Operations Switzerlanda post carrying responsibility for four key production sites.
Despite the emphasis on internal succession, however, there is still ample opportunity at Novartis for external hires as well. Ludwig Hantson joined Novartis in 2001, as Head of Commercial Development at the Pharmaceuticals Division. Then, in a succession of positions outlined in OTR discussions, Mr. Hantson became head of the Neuroscience Business Franchise, then Head of Pharma at Novartis Canada, before assuming his current position, Head of Region Europe for the Pharmaceuticals Division, at the beginning of last year.
Amid the rapid increase in the number of participants in the OTR process, Group Human Resources has worked hard to improve execution of the annual reviews. During 2005, more than 600 Basel-based line managers participated in a special OTR training program led by Dr. Brokatzky-Geiger. The aim was to fine-tune collection and analysis of data, as well as to strengthen managers' sense of ownership of the talent development processes.
"We want people to understand this better," Dr. Brokatzky-Geiger says. "OTR isn't just a form you fill in and send to HR. The ability to build a talent pipeline is a key indicator in every manager's performance."
Mentoring is an increasingly important instrument for professional and career development at Novartis, complementing a broad array of corporate learning programs run in collaboration with renowned institutions such as Harvard Business School, Stanford Business School and INSEAD.
For several years, mentoring programs led by ECN members and other top executives have been an essential part of grooming high-potential executives for new roles.
Mentoring also is an established feature of leadership development at key functions and Business Units at both the Pharmaceuticals and Consumer Health Divisions. At the Pharmaceutical Division's Development function, more than 100 high-potential associates took part in mentoring programs during 2005.
And the Technical Operations (TechOps) function broadened a four-year-old program by both expanding the number of participants, and introducing cross-functional mentoring. The TechOps program paired almost 200 high-potential associates with experienced mentors, including leadership teams at both Chemical Operations and Pharmaceutical Operations. Tech Ops also shifted several of its mentors to new cross-functional programs at the Pharmaceuticals Division's Development and Pharma Affairs functions.
At the Consumer Health Division mentoring has been a career springboard for female executives who head US operations for three of the Division's five Business Units. Karen Gough, US Head of CIBA Vision, Jan Coneely, US Head of Medical Nutrition, and Diane Jacobs, US Head of the Gerber Business Unit, participate actively as mentors today in programs targeting the next generation of leaders in their respective Business Units. Andrea Saia, a native of the US and alumna of the Consumer Health mentoring program, crossed the Atlantic last year as new Head of CIBA Vision's operations in Europe.
EMPLOYEES BY REGION AND DIVISION PER DECEMBER 31, 2005
(Figures represent headcount)
A LIVING WAGE
Novartis established the standard of paying a Living Wage at operations worldwide as part of the Corporate Citizenship Guideline on Fair Working Conditions adopted by the ECN in 2002.
A Living Wage is not the same as a legal minimum wage, or per capita income in a country. As defined by Novartis, a Living Wage should be the minimum pay sufficient to enable employees and their families to meet their basic material needs.
This year Novartis will begin extending the Living Wage concept to third parties as well.
However, as one of the first major international industrial companies to implement such a commitment, Novartis was confronted with methodological challenges. Importantly, a Living Wage remains poorly defined and no international consensus about methods of calculation has been established so far.
As the first step in implementing the Living Wage standard, Novartis and Business for Social Responsibility (BSR), an international consulting firm, defined the components of a basket of goods and services representing the subsistence level for the family of an average worker. The basket includes reasonable housing, health care, clothing, nutrition and education for dependent children. A Living Wage also includes target bonus, social security contributions and health insurance fees and benefits, such as housing subsidies or contributions to onsite meals.
Based on that basket, Living Wages were calculated for 60 countries. Novartis affiliates in each of those countries were asked to review the calculations.
In 38 countriesa clear majoritythe initial calculation was accepted as the Living Wage standard. In another 15 countries, Novartis affiliates proposed a Living Wage higher than the initial calculation. Implementation of the new Living Wage standard began in 2005 and will continue with additional adjustments this year.
Some affiliates commissioned independent local studies to validate the initial proposals. A study on behalf of Novartis India documented significant variations in Living Wage between citieswith the Living Wage in Mumbai 70% above that in Bangalore and 61% higher than Kolkatta. The gap primarily reflected higher housing costs in Mumbai than other Indian cities included in the study.
Regional adjustments to the initial Living Wage calculation were also proposed by Novartis affiliates in Canada and the US. Implementation of the Living Wage standard promises to attract more skilled, productive and loyal employees, as well as contributing to stability and prosperity in communities in which Novartis operates.
Besides the direct impact on Novartis associatesas well as employees of major suppliers or service providers to Novartisthe principle of a Living Wage is expected to expand locally and regionally through the commitment of international companies to the UN Global Compact.
AWARDS AND RECOGNITION
Novartis continually implements measures which improve the health and safety of our associates and neighbors.
Novartis cares about the impact of its activities on the environment. Special initiatives are under way to improve energy efficiency, reduce CO2 emissions and resolve issues involving historical landfills.
During 2005, we defined mid-term targets for key performance indicators and strengthened Business Continuity Management (BCM) to protect the uninterrupted supply of key products and services for the benefit of our patients, customers and the business.
Our success in Health, Safety and Environment (HSE) depends on the full involvement of all Novartis associates. Balancing business interests, safety considerations and environmental concerns in a global context is a complex process that requires many different decisions every day. Our associates are key to this endeavorparticularly as we focus increasingly on behavioral aspects of Health, Safety and Environment (HSE).
HSE departments strive to promote awareness among associates on all levels, defining policies, setting standards, supporting implementation and verifying compliance. Knowledge of risks and emerging technologies is maintained and shared through active communication and engagement with stakeholders.
Protecting health, safety and the environment is an integral part of business strategy in all Divisions and Business Units.
In 2005, targets were set for occupational accidents as well as energy efficiency, demonstrating our focus on these areas. Both targets were successfully met. Novartis improved its energy efficiency by 5%. The lost time accident rate decreased to 0.44 last year, from 0.48 in 2004.
However we deeply regret the deaths of two Novartis associates in traffic-related accidents during 2005. We extend our condolences to their families.
Novartis HSE risk portfolios are developed on a bottom-up, science-based approach. Since 1997, Novartis sites have developed local risk portfolios that are consolidated at a Group level, into a global HSE risk portfolio. During 2005, more than one-third of the priority risks identified in the 2004 risk portfolio were reduced as a result of measures taken. Action plans for all remaining prioritized risks have been developed and are currently being implemented.
Locally, Novartis faces a variety of risks that could also have an impact on business processes, and thus affect patients, customers or shareholders. To ensure management control and strengthen resilience to disruptions, Novartis has implemented a framework for risk management based on international standards. This framework allows us to anticipate incidents that could affect mission-critical functions and processes for the organizationand to apply necessary remedial measures. For remaining business risks, continuity plans are developed locally, ensuring that the response to any incident occurs in a planned manner.
In the second year after the formal launch of a Group-wide business continuity management program, positive results have been achieved in preventive activities such as establishing a framework for building resilience to business disruption and interruption. Risk reduction and operating strategies have been defined widely throughout the Group. Further business-continuity activities are planned.
Novartis Emergency Management (NEM) is an established, worldwide system developed to protect Novartis associates, the public and the environment in case of accidents or other emergency situations. Training programs and drills are conducted to keep preparedness of NEM teams, and the organization as a whole, at a high level. A new set of targets measuring NEM readiness and training was introduced in 2005. Reports from Divisions and Business Units also confirm the readiness of the global NEM system.
Novartis paid a total of USD 5 200 in fines for HSE violations during 2005.
Hexal AG and Eon Labs Inc.acquired by Novartis in 2005have been integrated into the Sandoz Division. Though the acquisitions of Hexal and Eon Labs were only completed in June and July, respectively, a detailed account of their full-year HSE performance is presented in the table on page 69.
Both companies are now integrated with the Group-wide HSE performance-management and data-collection system. HSE targets have been established for 2006.
As a legacy from chemical operations of predecessor companies, Novartis shares a number of confirmed or potential environmental liabilities from contaminated sites and landfills that were created in various countries. Novartis has set aside the financial reserves and established the appropriate structures to manage these liabilities proactively and keep related environmental impacts to a minimum.
In cooperation with third parties who may also have responsibility at certain sites, and the responsible authorities, surveillance programs have been installed and technical solutions are being prepared and implemented, as needed.
For example, Novartis jointly with other Swiss companies reached an agreement with local authorities in November 2005 regarding the Bonfol hazardous-waste landfill in Switzerland, which operated from 1961 through 1976. Under the agreement, the landfill will be excavated and the contents incinerated.
ENERGY AND CLIMATE
The consumption of energyand in particular the use of fossil fuelsis directly related to greenhouse gas (GHG) emissions and to potential adverse effects on the global climate. Moreover, it is clear that fossil energy sources are limited and their availability increasingly less secure. With energy also being an increasing cost factor, energy efficiency has become an important driver for cost reduction. Even though the pharmaceutical industry is not an energy-intensive sector, management of energy usage and related greenhouse gas emissions is important for the long-term success of Novartis. With the Kyoto Protocol, a large number of industrialized countries havefor the first timeaddressed the global issue of ever-increasing GHG emissions. These countries are currently implementing policies and instruments to reach their Kyoto targets.
Governments, however, can only reach these targets with the engagement of major companies. To this end, Novartis made a voluntary commitment to reduce global direct GHG emissions of CO2 to the same level prescribed in the Kyoto Protocol: i.e. 5% below the 1990 level for the period 2008-12.
So far, Novartis has been successful in holding direct GHG emissions in check. Extensive work at many sites has resulted in significant emission reductions and energy efficiency improvements. Still, increased efforts and investments in more efficient energy technology and renewable resources will be needed to continue on this path in the coming years.
To support the energy efficiency strategy, Novartis has approved a revised investment policy for capital investments associated with energy savings. In addition, an energy efficiency/renewable energy challenge has become a mandatory part of all major projects.
Many such projects have already been identified and rewarded through the Novartis Energy Excellence Awards. The annual award program recognizes the projects with the best energy performance proposed by Novartis teams worldwide.
To reach the Corporate CO2 target, behavior that fosters energy efficiency will become an important complement to further progress toward technical solutions.
Moreover, along with in-house energy efficiency programs, Novartis is exploring possible direct investments to fulfill the company's CO2 commitment. Options under consideration include emission reduction and development projects under the Kyoto Clean Development Mechanism schemeas well as long-term reforestation projects removing CO2 from the atmosphere.
ENERGY USE AND CO2 EMISSIONS
Novartis had set a Group-wide target of improving energy efficiency by 6% between 2003 and 2006. By 2005, however, Energy use had improved by a Group-wide average of 10%, reaching the target a year ahead of schedule.
The table below shows trends in energy use and global direct CO2 emissions (Scope 1) relative to sales growthhighlighting reductions achieved in both energy and carbon dioxide intensities.
HEALTH OF ASSOCIATES
We strive to provide our associates with the safest possible workplace and to offer programs that promote and improve their health and well-being. Through state-of-the-art health protection initiatives, we identify and aim to reduce injuries and occupational illnesses that could arise out of the workplace as a result of exposure to physical, chemical, biological or ergonomic factors. In addition, Novartis has implemented prevention-oriented health promotion activities that expand the view of occupational health to include environmental, behavioral, and lifestyle factors outside the workplace. A variety of initiatives and programs are offered to maintain the health of our associates, while respecting personal views and privacy. Either a full-time or a part-time occupational medical service is available to associates, depending on the size and type of site operations of their employer.
During 2006, Group functions Occupational Safety, Occupational Medicine and Human Resources will integrate their existing health promotion programs to implement health and safety policies more effectively at local companies and sites worldwide.
LOST TIME ACCIDENT RATE
Reducing accidents is a top priority for Novartis. We have instituted training programs for associates and each Business Unit continues to set targets for further reductions of the Lost Time Accident Rate (LTAR). Novartis reports work-related injuries or illnesses that have occurred during the year of reporting according to local legal requirements. LTAR is considered a benchmark indicator, enabling direct comparison of performance between companies and countries.
LTAR IN 2005 AND TRENDS
The Group-wide LTAR declined to 0.44 last year from 0.48 in 2004. A mid-term target of 0.2 by 2010 has been established for the existing business.
As the LTAR has declined, leading to steadily lower targets, it has become necessary to identify new measures to further decrease the risk of occupational accidents. Studies have shown that the behavior of people at the workplaceand the way technical and administrative controls are appliedare as important as engineering controls.
Achieving an accident rate which is as close to zero as possible requires that associates at all times not only care for their own safety, but also for the safety of their colleagues. Safe behavior is not a one-off program but the ongoing result of a cultural change that affects every person in the company. We are committed to a behavior-based safety approach across all our sites to ensure the health and well-being of all our associates.
Smoking is one of the most important risk factors to the health of individuals and society. From January 1, 2006, the Novartis Headquarters site in Basel, Switzerland became the latest Novartis location worldwide to adopt a nonsmoking initiative inside all buildings as well as within site boundaries. Visitors to the Basel site and staff of partner companies operating at Novartis are also expected to observe the nonsmoking initiative. Novartis is committed to promoting healthy societies and providing leadership through a positive example in health-related issues. Associates who wish to stop smoking are being offered voluntary, free counseling and medication as part of the new nonsmoking initiative at the Basel site.
The health promotion program "One HealthLink" of Novartis Pharmaceuticals Corporation in East Hanover, New Jersey (US) has been awarded a silver medal by the US National Business Group on Health. Based on the two pillars of physical activity and healthy nutrition, a wide range of activities are offered to associates such as nutrition education, low-cost healthy meals, nutrition counseling, fitness centers and on-campus walking trails. In essence, the role of the health and medical center has evolved from primarily one of treating injury and illness on the job, to becoming a partner with the business in providing people with information and resources to live healthier, more productive lives.
Novartis sets HSE targets covering periods of at least three years to allow better analysis, planning and implementation of programs. The current targets apply for the period through 2008. However HSE targets are reviewed annually with each Division and Business Unit. Divisions and Business Units are also involved in target setting based on recommendations by functional experts.
HSE performance data, as needed for management purposes as well as external reporting in line with international guidelines such as Global Reporting Initiative (GRI), are collected, validated and consolidated with the Novartis HSE Data Management System. Systems and processes are reviewed by third partiesin addition to Corporate and Divisional HSE auditsto ensure compliance with legal and Novartis HSE standards. Such processes support local sites in increasing the completeness and accuracy of their performance data.
For 2006, new global targets have been defined in the areas of CO2 emissions, water efficiency, waste management and volatile-organic-compound (VOC) emissions. The targets exclude effects of the ongoing integration of Hexal and Eon Labs which were acquired in 2005. These businesses will be fully integrated into Group targets over the next two years.
These new HSE targets include our Kyoto commitment to reduce global direct CO2 emissions by the period 2008 to 2012, and a 6% water efficiency improvement (excluding non-contact water for cooling) over the next three years. Furthermore, hazardous waste to landfills will be reduced from currently 890 tons to less than 100 tons by 2008. VOC emissions will be reduced by 90%, from 285 tons to 30 tons (halogenated) and by 35%, from 1 061 tons to 700 tons (nonhalogenated), by 2008.
HSE REPORTING PRINCIPLES
Global Reporting Initiative
Since 2004, Novartis has reported its HSE performance following the 2002 Guidelines for Sustainability Reporting of the Global Reporting Initiative (GRI). The GRI is a multi-stakeholder initiative, launched in 1997, with the aim of establishing globally applicable guidelines for reporting sustainability performance. The Novartis GRI Report Indexalong with a more detailed overview of our HSE performanceis available at: www.novartis.com/gri
HSE performance data for 2005 was collected from 179 sites around the world, owned and managed by Novartis. That coverage includes all sites with relevant HSE impacts, including all production, formulation, research and development sites, as well as major headquarter offices.
The number of locations reporting increased last year. The 24 locations reporting for the first time were from Hexal and Eon Labs, plus five locations from the Novartis Consumer Health Division.
Performance indicators were adapted to the GRI requirements for core environmental and social indicators. We believe the performance data reported in this Annual Report and on the adjacent Novartis website represent a fair and balanced picture of the Novartis HSE performance.
The Reporting Process
The HSE performance management system and data-collection process are key elements of Corporate Citizenship Management at Novartis. In gathering this data, we take into account impacts originating from our own operations (Scope 1)as well as major material flows across boundaries and CO2 emissions from purchased energy (Scope 2). We currently do not monitor impacts for the manufacture and delivery of purchased goods, nor use of energy and related CO2 emissions for activities outside company boundaries (Scope 3), such as transportation by third parties.
HSE data is collected and reviewed on a quarterly basis. The 2005 environmental and resource data published in the Annual Report and on our website are actual data for the period from January through September and best estimates for the period October through December, which will be updated with actual data in the first quarter of 2006. Significant deviations will be reported on our website and restated in next year's Annual Report. The Employees and Health/Safety data are actual data from January through December 2005.
Restatement of 2004 data
The emission and resource data published in the 2004 Annual Report included estimates for the October through December period that in several areas required subsequent adjustments. Inaccuracies identified in data from previous years were also corrected. The Data Table in the 2005 Annual Report includes full year actual values for 2004.
Along with economically, socially and environmentally responsible behavior, high ethical standards are essential to the business of Novartis.
We strive to maintain and to strengthen a culture where associates recognize that acting honestly, lawfully and with integrity is a key to successas well as the right thing to do.
The ideals and values which Novartis expects associates to uphold are defined in the Code of Conduct, and the Policy on Corporate Citizenship with its related policies and guidelines. "By ensuring compliance with the Code of Conduct and our Corporate Citizenship Policy, we are better able to earn the trust of the company's stakeholders and of the public at large," says Urs Baerlocher, Head of Legal and General Affairs of the Novartis Group and Member of the Group Executive Committee (ECN).
Amendments of the US Sentencing Guidelines in 2004 gave added impetus to compliance programs at major international companies around the world. Although Novartis companies were already meeting most, if not all, of these requirements, Novartis leveraged the Amendments in further driving its Compliance program.
For example, the Compliance Steering Committee established a new framework for the company's Ethics Compliance program last year, meeting requirements of the Sentencing guidelines. This new framework is being implemented by local Novartis entities worldwide and will be used to set Ethics Compliance objectives for 2006.
At Novartis, line management bears ultimate responsibility to maintain and improve Ethics Compliance, which is viewed as an embedded management process, included among managers' annual performance objectives.
Line managers are supported by the Group Ethics Compliance Officeras well as counterparts at each Division. In addition, roughly 180 part-time compliance officers provide support to local management in 72 countries and more than 270 Novartis operating units around the world. This structure ensures a global perspective while still taking advantage of local expertise on Ethics Compliance issues.
CODES, POLICIES AND STANDARDS
The Novartis Code of Conduct sets out our standards of ethical behavior. On the basis of the Code of Conduct, detailed policies and standards have been established for specific activities, such as marketing.
Marketing Codes have been put in place by the Pharmaceuticals and Sandoz Divisions, as well as for each Business Unit of the Novartis Consumer Health Division.
The Novartis Purchasing Department has been working on the implementation of our "Third-Party Management" guideline, requiring that our main business partners also apply a minimum set of ethical business standards in their organizations.
Demonstrating high ethical standards is particularly important at the management level. Managers and insiders are expected to support and to encourage their staff to comply with our high ethical standards. As part of a formal certification process, more than 20 000 Novartis managers and insiders confirmed, in writing, their adherence to company policies and standards during 2005.
TRAINING AND COMMUNICATION
In recent years, Novartis has intensified training programs for associates and compliance e-learning. In 2005, Novartis associates worldwide completed more than 197 000 e-learning coursesinvesting more than 148 000 hours in Ethics Compliance e-training. In parallel, several thousand associates without access to e-mail completed other forms of Ethics Compliance training.
Ethics Compliance e-learning at Novartis is available in 14 languagessetting a high standard among global companies. A survey conducted last year showed that 96% of Novartis associates in the US participated in Ethics Compliance training during 2005. Of those participants, 97% said the courses were "effective" or "very effective".
Courses on the Code of Conduct, Corporate Citizenship or Conflict of Interest Policies are mandatory for all employees around the world. If employees do not have e-mail access, Novartis provides other training methods to offer the possibility to complete these courses.
In addition, training courses in areas such as Competition Law and Insider Trading are mandatory for associates working within certain functions. In 2006 Novartis will launch additional training courses on topics such as Human Rights and Sales/Marketing.
Last year, a new Corporate Ethics intranet site was launched to assist associates in understanding the Group's commitment to high ethical standards and to provide them with practical help, such as publishing examples of inappropriate behavior, updated on a regular basis. The intranet site also is a valuable training tool for Ethics Compliance Officers throughout the Novartis organization.
The emphasis on training underscores a key objective of the Ethics Compliance program. All companies in the Group must exercise due diligence to prevent and detect criminal conductbut self-regulation by associates, facilitated through appropriate management procedures, is the most effective deterrent.
Through our Ethics Compliance program we attempt to ensure that associates not only read about their obligations, but also understand what is expected of them, depending on the role each individual associate performs. We encourage associates to think before acting and in cases of uncertainty, to seek clarification, addressing any concerns.
INQUIRIES & COMPLAINTS
A new Business Practices Office (BPO) was established during 2005 to facilitate reporting by employees of actual or suspected cases of internal misconduct. All employees are requested to report suspected misconduct to the BPO, which in turn ensures that all complaints are properly investigated, enabling management to take appropriate actions.
The Business Practices Officer reports monthly to senior management on allegations of misconduct received, sanctions applied and lessons learned. All cases of financial fraud, however, are reported to a committee led by the Chairman and Chief Executive Officer on a monthly basis.
The identities of Novartis employees are fully protected both when they make a report and during any subsequent investigation. Novartis has a strict policy guaranteeing non-retaliation against associates who make reports under the "whistleblower" policyand violations of this right are not tolerated.
During 2006, a global network of telephone help lines will be rolled out to allow all associates to report incidents of misconduct locally, in their native language, on a confidential basis.
VIOLATIONS AND REMEDIAL ACTION
From April to December 2005, Novartis received reports of 442 alleged violations of our internal rules, such as the Code of Conduct and Marketing Codes. Of these cases, 228 have been fully investigated and closed, resulting in 142 cases being fully or partly substantiated. Employment contracts of 78 associates were discontinued and other relevant sanctions were taken against 64 employees.
Novartis intends to publish annual data on misconduct and sanctions in the future. Last year, two Novartis Consumer Health (NCH) affiliates in the US settled potential claims against them arising from an investigation of the enteral pump industry by the US Department of Justice.
Data privacy involves the protection of personally identifiable information about individuals, such as their health information, employment and financial information, and the companies with which they choose to do business. New, complex privacy laws now exist in many areas of the world, and the landscape continues to evolve rapidly in response to factors such as advances in technology, electronic communications, Internet use and security.
Novartis appointed a Data Privacy Officer in the US in 2003. The following year, the Global Privacy Office was established as a new department to address internal compliance and the external landscape. The Global Privacy Office is also charged with creating a corporate culture that respects privacy and fosters trust both within the company and with regard to its external customers and vendors.
Many country organizations in the Group have appointed a privacy officer and numerous employees assist with privacy matters in countries such as Japan and those of the EU, where data privacy laws are particularly stringent. The US organization has cross-functional privacy teams as well as department-level privacy nominees who coordinate with the Privacy Office. Significant progress has been made in achieving our data privacy goals.
INDEPENDENT ASSURANCE REPORT ON THE NOVARTIS GROUP CORPORATE CITIZENSHIP REPORTING
TO THE AUDIT AND COMPLIANCE COMMITTEE OF NOVARTIS AG, BASEL
We have performed evidence-gathering procedures on the following aspects of Corporate Citizenship (CC) and Health, Safety and Environment (HSE) reporting of Novartis AG, Basel and its consolidated subsidiaries (the Group), all for the year ended December 31, 2005 (hereafter jointly referred to as the subject matter):
We have evaluated the subject matter against the following criteria: the CC Policy including the CC Guidelines and the Code of Conduct prepared by the Group, the CC and the compliance reporting guidance and the principles summarized in the section "HSE Reporting Principles" on page 67 which define the scope of the reporting, the inherent limitations of accuracy and completeness for the HSE information, and the fact that the CC management process is in its fourth year of operation.
The Board of Directors of Novartis AG, Basel is responsible for both the subject matter and the evaluation criteria.
Our responsibility is to report on the internal reporting processes, data and key figures for CC and HSE based on our evidence-gathering procedures in accordance with the International Framework for Assurance Engagements, approved December 2003 by the International Auditing and Assurance Standards Board (IAASB).
We planned and performed our evidence gathering procedures to obtain a basis for our conclusions in accordance to the International Standard on Assurance Engagements (ISAE) 3000 "Assurance Engagements other than Audits or Reviews of Historical Information", approved December 2003 by the IAASB. However, we have not performed an audit according to International Standards on Auditing. Accordingly, we do not express such an opinion.
The scope of our evidence-gathering procedures was to:
Our evidence-gathering procedures included the following work:
In our opinion and based both on our work described in this Report and the principles detailed in paragraph 2 of this Assurance Report, nothing has come to our attention that causes us not to believe that:
From our work, we have provided the following recommendations to the management, which have been agreed:
Dr. Thomas Scheiwiller
Basel, January 18, 2006
The following standards apply to us:
We fully comply with each of these standards except that, as permitted under US law and the rules of the NYSE, Novartis continues to apply Swiss (home country) practices in these areas:
We have incorporated the above standardsand the principles of corporate governance under the Swiss Code of Obligationsinto our Articles of Incorporation, the Regulations of the Board and the Charters of the Board Committees. The Board's Corporate Governance and Nomination Committees review these standards and principles regularly in the light of prevailing best practices and forwards suggestions for improvement to the full Board for approval.
of the aforementioned regulations and references to further information relating to Corporate Governance can be ordered in print from Novartis AG, attn. Corporate Secretary, Bruno Heynen,
CH-4056 Basel, Switzerland. Further information on Corporate Governance can be found on page 112 of this Annual Report or by visiting:
Novartis AG, a holding company organized under Swiss law, owns directly or indirectly all companies worldwide belonging to the Novartis Group.
Novartis AG shares are listed on the SWX Swiss Stock Exchange and traded on Virt-X (Valor No. 001200526, ISIN CH0012005267, symbol: NOVN.VX) and on the New York Stock Exchange (NYSE) in the form of American Depositary Shares (ADS) (Valor No. 567514, ISIN US66987V1098, symbol: NVS).
The Novartis Group is divided operationally into three Divisions: Pharmaceuticals, Sandoz (generic pharmaceuticals) and Consumer Health.
The Pharmaceuticals Division is comprised of Business Units responsible for the marketing and sales of pharmaceutical products. These Business Units have common long-term economic perspectives, common customers, common research and development activities, production and distribution practices, and a common regulatory environment. As a result, their financial data is not required to be separately disclosed.
Sandoz is organized as a Retail Generics business which also operates an Anti-Infectives business.
The five Business Units of the Consumer Health Division are: Over-the-Counter self-medication (OTC), Animal Health, Medical Nutrition, Gerber and CIBA Vision.
The business operations are conducted through local Novartis Group companies. The most important Novartis subsidiaries and associated companies are listed in Note 33 to the Group's consolidated financial statements.
There are two Novartis affiliated companies whose shares are traded on public stock exchanges. These are:
Idenix Pharmaceuticals, Inc. and Novartis India Limited are directly or indirectly majority owned by Novartis AG.
Additionally, Novartis holds significant investments in two large publicly listed companies:
Further information on these participations and the method of consolidation is given in Note 10 to the Novartis Group's consolidated financial statements. Both Roche and Chiron are independently governed, managed and operated and not under the control of Novartis.
The other significant Group subsidiaries and associated companies, shown in Note 33 to the Novartis Group's financial statements, are not publicly traded.
The largest registered shareholders of Novartis AG are:
No other shareholder is registered as owner of more than 2% of the issued share capital and there are no cross-holdings equal to or higher than this amount.
Novartis AG has not concluded any shareholders' agreement or other agreement regarding the voting or holding of its shares.
CAPITAL STRUCTURE, SHARES
The share capital of Novartis AG is CHF 1 369 585 500, fully paid-in and divided into 2 739 171 000 registered shares of CHF 0.50 nominal value each. Novartis AG has neither authorized nor conditional capital. There are no preferential voting shares. All shares have equal voting rights. Novartis has not issued participation certificates, nonvoting equity securities (Genussscheine) or profit-sharing certificates.
CHANGES IN CAPITAL, SHARE REPURCHASE PROGRAMS
Since the merger creating Novartis in December 1996, we have implemented four share repurchase programs with a total commitment as of December 31, 2005 of CHF 15 billion. Three pro grams have been completed, with the shares repurchased in the 2nd and 3rd programs being cancelled and the capital of Novartis AG correspondingly reduced by shareholder resolution at the Annual General Meetings held in 2002, 2003, 2004 and 2005 (see chart below). In August 2004, we announced the start of a 4th program to repurchase shares via a second trading line in the SWX Swiss Exchange. Since the start of the 4th program, a total of 25.4 million shares have been repurchased for USD 1.2 billion, of which 10.2 million were purchased in 2005. It is anticipated that shareholders will be requested at the next General Meeting to approve the retirement of the shares bought through the 4th repurchase program. A 5th repurchase program with a maximum value of CHF 3 billion was approved by the shareholders at the Annual General Meeting held in 2005, but will only be started after termination of the 4th repurchase program.
Further information on the development of the share capital structure of Novartis AG during the last three years is presented in tabular form in Note 5 to the financial statements of Novartis AG.
CONVERTIBLE BONDS AND OPTIONS
Novartis had no convertible bonds outstanding in 2005.
Information about Novartis share options granted as a component of executive and employee compensation is set forth below in this section under the heading "Compensation" and further information can be found in Note 27 to the Group's consolidated financial statements.
Each registered share entitles the holder to one vote at the Annual General Meeting. Shareholders also have the right to receive dividends, appoint a proxy, convene a General Meeting of the shareholders, place items on the agenda of an Annual General Meeting and hold such other rights as defined in the Swiss Code of Obligations. One or more shareholders, whose combined shareholdings represent an aggregate nominal value of at least CHF 1 000 000, may demand that an item be included in the agenda of an Annual General Meeting. Demands must be made in writing at the latest 45 days before the date of the Meeting; specify the item to be included in the agenda; and contain the proposal for which the shareholder requests a vote.
REGISTRATION AS SHAREHOLDER
There are no restrictions regarding the transferability of Novartis shares. However, only those persons having their shares registered in the Novartis share register may exercise their voting rights. Pursuant to Swiss law, a person who wishes to register shares must make a declaration to the Shareholder Registry that the shares have been acquired in his/her own name and for his/her own account.
Each share carries one vote. However, the Articles of Incorporation provide that no shareholder shall be registered to vote for shares comprising more than 2% of the registered share capital unless the Board of Directors has granted, upon request, an exemption. Exemptions are in force for the two largest shareholders reported above (Novartis Foundation for Employee Participation and Emasan AG). In 2005 no other exemptions were requested.
The statutory voting restrictions can be cancelled with a two-thirds majority of the shares represented at the Annual General Meeting.
The voting restrictions were imposed and have been retained to achieve a certain spread of share ownership allowing for diversity among the shareholders and avoiding that a large minority shareholder unduly dominates the Annual General Meeting due to traditional low shareholder representation.
Nominees may not vote shares absent registration with the Share Registry and, with registration, may only vote shares constituting an amount less than or equal to 0.5% of the registered share capital. The Board of Directors may register nominees with the right to vote in excess of that limit if the nominees disclose such particulars of the beneficial owners of the shares as the Board shall require. Such agreements are in force with Nortrust Nominee and JPMorgan Chase Bank. Groupings formed to circumvent this limitation are treated as one single person or nominee.
Holders of American Depositary Shares (ADS) may vote by instructing JPMorgan Chase Bank to exercise the voting rights attached to the registered shares underlying the ADSs. JPMorgan Chase Bank as depositary may exercise the voting rights for deposited shares represented by ADS at its discretion to the extent the holders of the ADS have not given instructions as to how such underlying shares should be voted.
RESOLUTIONS AND ELECTIONS AT ANNUAL GENERAL MEETING
Shareholders registered at least 10 days prior to the Annual General Meeting may vote their shares at the Annual General Meeting. Resolutions of the shareholders at an Annual General Meeting are approved with a simple majority of the shares represented at the meeting, except in the following matters which by law (Swiss Code of Obligations, Art. 704) and our Articles of Incorporation require the approval of two-thirds of the shares represented:
THE BOARD OF DIRECTORS
Members of the Board of Directors
Further biographical information can be found on pages 101 to 106.
The Board of Directors has promulgated independence criteria for its members. These criteria are appended to the Regulations of the Board and can be found on the Internet at: www.novartis.com/investors/en/corporate_governance.
Pursuant to these criteria, the Board has determined that all of its members, save for Dr. Vasella and Mr. Jetzer, are independent and have no material dealings with Novartis AG or other companies of the Novartis Group outside their role as a Director.
Dr. Vasella is the only Executive Director. Mr. Jetzer was a member of the Executive Committee until 1999 and continues to support the Government Relations activities of the Group under a consultancy agreement. With effect from March 1, 2006 Professor Datar will be considered to be an independent director given the expiration of the three-year look-back period on compensation other than Board fees paid by an issuer to its directors, as per the NYSE Rules.
In 2002, Novartis made a gift to Harvard Business School of USD 5 million. This amount established and endowed a professorship in the name of Novartis at Harvard Business School. The Board of Directors concluded that this endowment, which under the rules of the New York Stock Exchange must be reported, does not have any influence on the independence of either Professor Datar or Mr. William W. George, who became a member of the faculty of Harvard Business School in 2004. Professor Zinkernagel has been delegated to the Scientific Advisory Board of the Novartis Institute for Tropical Diseases (NITD). He is also a delegate to the Board of Directors of the Genomics Institute of the Novartis Research Foundation (GNF).
Novartis on a regular basis and in the ordinary course conducts business with Barclays Capital, of which Hans-Joerg Rudloff is presently Chairman of the Executive Committee. The Board of Directors concluded that pursuant to its independence criteria this does not have any influence on the independence of Hans-Joerg Rudloff.
No Director is a member of a board of directors of a listed company with which any Novartis Group company conducts a material amount of business.
TERM OF OFFICE
The specific term of office for a Director is determined by the shareholders at an Annual General Meeting on the occasion of his or her election. The term of office shall not exceed three years. In order to provide for continuity on the Board the terms of office have been coordinated such that in each year approximately one third of all members of the Board shall be subject to individual reelection or election. This is subject to the right of the Annual General Meeting to remove Directors at any time. The average tenure of our Directors is eight years and their average age is 62 years. In principle, a Director is to retire after 12 years of service or the reaching of 70 years of age. The shareholders may grant an exemption from this rule and reelect a member of the Board of Directors for further terms of office of no more than three years at a time.
CHAIRMAN AND CEO, VICE CHAIRMEN, LEAD DIRECTOR
Dr. Vasella has been elected by the Board as its Chairman and also to serve as Chief Executive Officer of the Group. It is the view of the Board that this dual role ensures effective leadership and excellent communication between the shareholders, the Board and Management.
To ensure that the interests of the shareholders are well represented at the highest possible level, the Board has appointed an independent Lead Director, whose responsibilities include the supervision of an orderly process in evaluating the performance of the Chairman and CEO, and to chair the Board's private sessions (i.e., the meetings of the Non-Executive Directors). The Lead Director, as any other Board member, may request from the persons entrusted with the management information about all matters concerning Novartis AG. In case of a crisis, the Lead Director would assume leadership of the Independent Directors. The Lead Director also is a member of all of the Committees of the Board.
ROLE AND FUNCTIONING OF THE BOARD
The Board holds the ultimate decision-making authority of Novartis AG for all matters except those reserved by law to the shareholders.
The agenda for Board meetings is set by the Chairman. Any Board Member may request a Board meeting or that an item be included on the agenda. Board Members are provided, in advance of Board meetings, with adequate materials to prepare for the items on the agenda. Decisions are taken by the Board as a whole, with the support of its four Committees described below (Chairman's Committee, Compensation Committee, Audit and Compliance Committee, and Corporate Governance and Nomination Committee).
The primary functions of the Board are:
The Board has not concluded any contracts with third parties for the management of the Company but has delegated to the Executive Committee the coordination of day-to-day business operations of Group companies. The Executive Committee is headed by the Chief Executive Officer. The internal organizational structure and the definition of the areas of responsibility of the Board and the Executive Committee are set forth in the Board Regulations.
The Board recognizes the importance of being fully informed on material matters involving the Group and ensures that it has sufficient information to make appropriate decisions through several means:
Once yearly, the Board reviews the performance of the Chairman and CEO and approves his business objectives for the following year. The Board of Directors also performs a self-evaluation once a year.
During 2005, the Board met 10 times. Detailed information on each Director's attendance at full Board and Board Committee meetings is provided in the following table.
Detailed information on attendance at full Board and Board Committee meetings is as follows:
ROLE AND FUNCTIONING OF THE BOARD COMMITTEES
Each Board Committee has a written Charter outlining its duties and responsibilities and a chair elected by the Board. The Board Committees meet regularly and consider meeting agendas determined by the Chair. Board Committee members are provided, in advance of meetings, with adequate materials to prepare for the items on the agenda.
THE CHAIRMAN'S COMMITTEE: The Chairman's Committee consists of the Chairman and Chief Executive Officer, the two Vice Chairmen, one of whom is the Lead Director and such other members as are elected by the Board from time to time. The Chairman's Committee reviews selected matters falling within the authority of the Board before the latter takes decisions on such matters and, in urgent cases, can take preliminary and necessary actions on behalf of the Board. The Chairman's Committee also interfaces with the Executive Committee, specifically deciding on financial investments and other matters delegated to the Committee by the Board of Directors.
THE COMPENSATION COMMITTEE: The Compensation Committee is composed of three independent Directors. The Compensation Committee reviews the compensation policies and programs of the Group, including share option programs and other incentivebased compensation, before the full Board makes final decisions. It is responsible for reviewing and approving the compensation paid to members of the Executive Committee and other selected key executives, and for reviewing the performance of the Chairman and Chief Executive Officer. The Compensation Committee seeks outside expert advice from time to time to support its decisions and recommendations.
THE AUDIT AND COMPLIANCE COMMITTEE: The Audit and Compliance Committee is composed of four members. The Board has determined that all the members of the Committee are independent, as defined by the rules of the New York Stock Exchange as well as by the independence criteria of Novartis, and that its Chair, Professor Sihler, is adequately qualified in financial management matters. The Audit and Compliance Committee has determined that Professor Lehner and Hans-Joerg Rudloff, possess the required accounting and financial management expertise required under the rules of the NYSE. Therefore, the Board of Directors has appointed them as the Audit and Compliance Committee's Financial Experts. The Board has also reassured itself that other members of the Committee have sufficient experience and ability in finance and matters of compliance to enable them to adequately discharge their responsibilities.
The Committee's main duties are:
THE CORPORATE GOVERNANCE AND NOMINATION COMMITTEE: The Corporate Governance and Nomination Committee is composed of four independent Directors. The Corporate Governance and Nomination Committee develops corporate governance principles and recommends these to the Board for approval. Its duties include the regular review of the Articles of Incorporation with a view to reinforcing shareholder rights, and of the composition and size of the Board and its committees. The Corporate Governance and Nomination Committee conducts an annual evaluation of the Board as a whole and gives guidance to the Directors on how to avoid potential conflicts of interest.
The Corporate Governance and Nomination Committee also proposes to the Board of Directors individuals who are qualified to become (or be re-elected as) Board members.
MEETINGS OF THE NON-EXECUTIVE DIRECTORS: The non-executive independent directors held 2 private sessions chaired by the Lead Director, Professor Sihler.
CHANGE OF CONTROL AND DEFENSE MEASURES The Swiss Stock Exchange Act provides that whoever acquires more than 331/3% of the equity securities of a company shall be required to make a bid for all listed equity securities of that company. In its Articles of Incorporation a company may increase this threshold to 49% (opting up) or, under certain circumstances, waive the threshold (opting out). Novartis has not adopted any such measures in deviation from the rules applicable to it under the Swiss Stock Exchange Act.
The employment agreements with four members of senior Management contain change-of-control provisions whereby their normal contractual notice period of 36 months is extended by 24 months during the 12 months following a change of control as defined in those agreements. One executive has a provision where- by the normal contractual notice period of 12 months is extended by 12 months during the 12 months following a change of control. One executive has a provision whereby the normal contractual notice period of 12 months is extended such that the employment agreement may not be terminated with effect prior to 24 months
The following documents describe the Corporate Governance standards applied by Novartis:
These documents can be ordered from the Corporate Secretary Bruno Heynen, CH-4056 Basel. They also are available on the Novartis website:
NON-EXECUTIVE DIRECTORS' COMPENSATION
The Compensation Committee advises the Board of Directors on the compensation of Non-Executive Directors. Non-Executive Directors receive an annual retainer in an amount that varies with the Board and Committee responsibilities of the Director. Directors receive no additional fees for attending meetings or acting as committee chairs.
Directors can choose to receive the annual retainer in cash, shares, or a combination thereof. As of January 1, 2003, we no longer offer share options to Directors, or grant shares to Directors in acknowledgement of business performance. Directors are reimbursed for travel and other necessary business expenses incurred in the performance of their services.
2005 DIRECTORS' COMPENSATION
Members of the Board of Directors
In December 2003 the Board of Directors adopted a share ownership guideline, under which Non-Executive Directors are required to own at least 5 000 Novartis shares within three years after joining the Board. The total number of Novartis shares owned as of December 31, 2005, by the Non-Executive Directors and persons closely linked to them was 401 288. "Persons closely linked to them" are (i) their spouse, (ii) their children below age 18, (iii) any legal entities that they own or otherwise control, or (iv) any legal or natural person who is acting as their fiduciary.
No Non-Executive Director owned 1% or more of our outstanding shares. As of December 31, 2005, the individual ownership of Novartis shares by the Non-Executive Directors (including persons closely linked to them) was as follows:
As of the same date, the Non-Executive Directors held a total of 256 483 Novartis share options. The number of share options granted and exercise prices have been adjusted to reflect the share split of 1:40 in 2001. Broken down by grant year, the number of options held for the last 5 years are:
COMPENSATION FOR FORMER DIRECTORS AND EXECUTIVES
In 2005, a total amount of USD 101 465 was paid to two former members of the Board and USD 991 857 to three former Executives.
EXECUTIVE COMPENSATION POLICY
Novartis' compensation programs are designed to attract, retain and motivate the high-caliber executives, managers and associates who are critical to the success of the Group. Globalization of labor markets for specialists and executives has led to a rapid convergence between US and European principles of compensation and a strong focus on long-term, equity-based forms of programs. Overall, the intention of these programs is to provide compensation opportunities that:
Total actual compensation delivered may reach levels comparable to the upper quartile of our peer companies if superior performance is achieved. Annual cash and equity incentive awards are based on both, overall Group or affiliate company and individual performance. Long-term incentive awards include share options and other forms of equity participation. Executive compensation programs strongly encourage significant levels of share ownership and put a high portion of total compensation at risk, subject to individual and company performance and the appreciation of Novartis shareholder value. In addition, to further strengthen the Company's ownership philosophy, the Board of Directors established in 2003 share ownership guidelines under which designated executives are required to own a multiple of their base salary in Novartis shares. Compensation programs and levels are reviewed regularly, based on publicly available data and the analysis of external compensation advisors. The Compensation Committee believes that this position is consistent with the performance of the Group and its evaluation of the external market.
COMPENSATION PROGRAM DESCRIPTIONS
The total compensation package for each executive consists of the three basic components discussed in more detail below.
SALARIES: The 2005 salaries of the Executive Committee members are shown in the "Salary" column of the 2005 Summary Compensation Table on page 91.
ANNUAL INCENTIVE AWARDS: Under the annual incentive plan, awards are made each year based on the achievement of predetermined Group, or affiliated company and individual performance objectives. Below a certain performance threshold, no awards may be granted under the plan.
LONG-TERM INCENTIVE COMPENSATION: Long-term incentive compensation, in the form of share options, shares contingent on performance, and restricted shares, comprises a major portion of the total compensation package for executives. In any given year, an executive may be offered share options, performance-contingent shares, and/or restricted shares. Below a threshold level of performance, no awards may be granted under the plan.
A) NOVARTIS EQUITY PLAN "SELECT"
In 2004, the Board of Directors adopted a modification to the Share Option Plans described below. Under the plan called "Select," participants have the choice to receive their equity award in the form of share options, or restricted shares. An exchange ratio of share options to shares is set by the Board. For 2005, four share options could be exchanged for one share. Shares granted have a restriction period identical to the vesting period of the share options.
SELECT REST OF WORLD PLAN: Under the Plan, Non-Executive Directors (through 2002), executives and other selected employees of Group companies (collectively, the "Participants") may receive equity awards. These equity awards are made both in recognition of past performance and as an incentive for future contributions by the Participants. They allow the Participants to benefit as the price of the shares increases over time, and so provide a long-term incentive for improvements in our profitability and success. The share options are tradable; therefore they can be used to purchase the underlying Novartis share or they can be transferred to a market maker. If a Participant voluntarily leaves Novartis, equity not yet vested generally forfeit. In 2004, the vesting period for the Plan was changed from a two-year vesting period to a three-year vesting period for most countries. Due to pending tax legislation in Switzerland, it was decided not to implement the three-year vesting period in Switzerland. The current view is that the new law will come into force in 2007, at which point the vesting period might be reviewed. The share options under the Select Rest of World Plan are granted at a strike price corresponding to the market price of the underlying share at the time of grant, have a term of ten years and an exchange ratio of 1:1.
SELECT US PLAN: Introduced in 2001, the Plan provides for equity awards for US-based Non-Executive Directors (through 2002), officers and other selected employees, thus replacing a Share Appreciation Rights Plan. The terms and conditions of the US plan are substantially equivalent to the Select Rest of World Plan. As of 2004, share options granted under the plan are tradable share options on ADS.
B) OTHER LONG-TERM INCENTIVE PLANS
We offer to nominated executives a Long-Term Performance Plan, a Leveraged Share Savings Plan and a Restricted Share Plan. These plans are designed to foster long-term commitment of eligible employees by aligning their incentives with our performance.
LONG-TERM PERFORMANCE PLAN: Under the Long-Term Performance Plan, participants are awarded the right to earn Novartis shares. Actual payouts, if any, are determined with the help of a formula which measures, among other things, our performance using economic value added relative to predetermined plan targets. Additional functional objectives may be considered in the evaluation of performance. If performance is below the threshold level of the predetermined targets, then no shares will be earned. To the extent the performance exceeds the threshold performance level, participants are eligible to receive an increasing amount of Novartis shares, up to the maximum cap. Payout of shares is amongst others conditioned on the participant remaining in the employ of a Novartis affiliate at the time of payout.
LEVERAGED SHARE SAVINGS PLAN: There are two separate Leveraged Share Savings Plans. Under both plans participants receive their Annual Incentive Award in shares at the fair market price of the share on the grant date. Under the first plan, participating executives are free to sell part or all of these shares immediately. Shares not immediately sold are blocked for five years after the grant date. After expiration of the blocking period, the respective shares are matched with an equal number of shares. Under the second plan, associates with a Swiss employment contract are free to sell 50% or 100% of these shares immediately. Shares held under the plan have a three-year blocking period and are matched at the end of the blocking period with one share for every two shares that were blocked. A participating employee may only take part in one plan per year. Generally, no matching shares will be granted if an associate voluntarily leaves Novartis prior to expiration of the blocking period.
RESTRICTED SHARE PLAN: Under the Restricted Share Plan, associates may be granted restricted share awards either as a result of a general grant or as a result of an award based on having met certain performance criteria. Shares granted under this Plan generally have a five-year vesting period. If a participant voluntarily leaves Novartis, unvested shares generally forfeit.
Employee benefits offered to executives are designed to be competitive and to provide a safety net against the financial catastrophes that can result from disability or death, and to provide a reasonable level of retirement income based on years of service with Novartis.
EVALUATION OF THE EXECUTIVE COMMITTEE MEMBERS' PERFORMANCE
The Compensation Committee and the Board of Directors meet without the Chairman and CEO to evaluate his performance, and with the Chairman and CEO to evaluate the performance of other Executive Committee members. The bonuses and long-term incentives for 2004 and the base salaries for 2005 were discussed and approved at the meetings of the Compensation Committee held in January 2005. The decisions on compensation of Executive Committee members were mainly based on individual performance evaluations whereby market conditions were taken into consideration. The Compensation Committee considered management's achievement of short- and long-term goals, including revenue growth, economic value creation (operating and net income, earnings per share and economic value added) and ongoing efforts to optimize organizational effectiveness and productivity. The Compensation Committee also takes into consideration management's responses to the changes in the global marketplace and the strategic position of the Group. The performance measures were weighted subjectively by each member of the Compensation Committee.
The Compensation Committee believes that the compensation practices and compensation philosophy of Novartis align executive and shareholder interests. Ongoing adaptation of the programs and practices further allowed the Company to attract, retain and motivate the key talent Novartis needs to continue to compete and provide a strong return to shareholders.
In 2005, there were 20 Executive Committee members, Permanent Attendees to the Executive Committee and Business Unit Heads ("Executives"), including those who retired or terminated their employment in 2005. In total, the Executives received USD 10 649 000 in salaries and USD 3 638 000 in cash bonuses. The number of share options granted was 3 242 269 and the number of shares granted was 653 787. Other compensation in the amount of USD 3 384 000 was set aside for their pension, retirement and other benefits. Compensation represents all payments made in 2005; however, cash bonuses and long-term compensation are based on 2004 business performance. For the compensation of key management, consisting of the Executives and non-executive Directors based on International Financial Reporting Standards, see Note 28 of the consolidated financial statements. The following summary compensation table provides details on the 2005 compensation of the Executive Committee members in their respective currencies.
2005 SUMMARY COMPENSATION TABLE
DISTRIBUTION OF SHARE OPTIONS GRANTED TO EMPLOYEES
Under the Novartis Equity Plan "Select" described above, a total number of 17 million share options and 3 565 213 shares were granted to 8 208 participants in 2005. Under the plan, 17% of the equity valued at the time of grant were granted to the Executives.
As of December 31, 2005, a total number of 59.3 million share options was outstanding, providing the right to an equal number of shares, which corresponds to 2.2% of the total number of Novartis AG issued shares.
OWNERSHIP OF NOVARTIS SHARES AND SHARE OPTIONS BY THE EXECUTIVES
The total number of Novartis shares owned by the 16 Executives in office as of December 31, 2005, and persons closely linked to them was 2 278 812. "Persons closely linked to them" are (i) their spouse, (ii) their children below the age of 18, (iii) any legal entities that they own or otherwise control, and (iv) any legal or natural person who is acting as their fiduciary. No Executive owned 1% or more of our outstanding shares. As of December 31, 2005, the individual ownership of Novartis shares of the Executive Committee members (including persons closely linked to them) was as follows:
The 16 Executives in office as of December 31, 2005, held a total of 5 982 362 Novartis share options. The number of share options and exercise price were adjusted to reflect the share split of 1:40 in 2001. Broken down by grant year since 2001, the numbers of share options held are:
SWISS EMPLOYEE BENEFIT PLANS
(A) SWISS PENSION FUND
The Swiss Pension Fund is a defined-benefit fund that provides retirement benefits and risk insurance for death or disability. The Swiss Pension Fund is funded by contributions from Group companies and the insured employees. The Swiss Pension Fund insures remuneration up to a maximum of CHF 220 000 per year, reduced with a coordinating offset of 30% of salary up to a maximum of CHF 24 120. The maximum retirement pension is 60% of the insured remuneration after 40 years of contribution. The table shows the annual pension benefit by base salary and years of service. In 2005, Novartis contributed on average CHF 18 650 to the Pension Fund for each of the six Swiss-based Executive Committee members.
(B) SWISS MANAGEMENT PENSION FUND
The Swiss Management Pension Fund is basically a definedcontribution plan and provides retirement benefits and risk insurance for death and disability for components of remuneration not covered by the Swiss Pension Fund. Swiss law provides certain minimum requirements, e.g. return on employee contributions; however, these requirements do not substantially affect the "defined-contribution-character" of the pension plan. Employees exceeding the maximum insurable remuneration of the Swiss Pension Fund are eligible for the Swiss Management Pension Fund. The benefits under the Swiss Management Pension Fund are granted in addition to those of the Swiss Pension Fund. The Swiss Management Pension Fund is funded through contributions by Novartis and the employee.
SWISS PENSION FUND
US-BASED EMPLOYEE PENSION PLAN
The Pension Plan for certain US-based employees of Novartis Corporation (Pension Plan) is a funded, tax-qualified, non contributory defined-benefit pension plan that covers certain employees of Novartis Corporation and its US affiliates, including Dr. Fishman. The Pension Plan provides for different pension formulas, depending on which Novartis company is the employer of a particular employee. The pension formula in which Dr. Fishman participates under the Pension Plan is a pension equity (PEP) formula. Benefits under the PEP formula are based upon an employee's highest average earnings for a five-calendar-year period during the last ten calendar years of service with Novartis and the employee's accumulated PEP credits (expressed as a percentage of final average earnings, and ranging from 2% to 13% for each year of service based on the employee's attained age in a particular year), and are payable after retirement in the form of an annuity or a lump sum. The amount of annual earnings covered by the Pension Plan is generally equal to the employee's base salary and annual bonus. The amount of annual earnings that may be considered in calculating benefits under the Pension Plan is limited by law. For 2005, the annual limitation was USD 210 000. Novartis Corporation and its US affiliates also maintain various unfunded supplemental pension plans, each of which provides its respective employees with an amount substantially equal to the difference between the amount that would have been payable under the Pension Plan in the absence of legislation limiting pension benefits and the annual earnings that may be considered in calculating pension benefits under tax-qualified pension plans, and the amount actually payable under the Pension Plan.
US-BASED DEFINED-CONTRIBUTION PROGRAM
Employees of Business Units located in the US, including Dr. Fishman, generally are eligible to participate in tax-qualified definedcontribution plans through which they may contribute a portion of their annual compensation (subject to the annual limitation described above) and receive a Company match that is generally USD 1 for each USD 1 contributed by the employee, up to 6% of the employee's annual compensation. In addition, employees of certain Business Units are eligible to receive a retirement contribution equal to 3% of their annual compensation (subject to the annual limitation described above) in lieu of the pension benefits they may otherwise have been eligible to receive under the Pension Plan. Dr. Fishman is not eligible to receive this 3% retirement contribution. Novartis Corporation and its US affiliates also maintain various unfunded supplemental defined-contribution plans, each of which provides its respective employees with an amount substantially equal to the difference between the amount that would have been payable under the applicable defined-contribution plan in the absence of legislation limiting retirement benefits and the annual earnings that may be considered in calculating matching contributions and retirement contributions under taxqualified defined-contribution plans, and the amount actually payable under such plans.
PERSONAL LOANS AND SEVERANCE AGREEMENTS
No loans were granted to the Executives during 2005 or were outstanding as of December 31, 2005. During 2005, one Executive received USD 327 942 as severance.
AUDIT AND COMPLIANCE COMMITTEE
Management is responsible for creating the financial statements and managing the reporting process. Further, Management is responsible for designing internal controls over financial reporting and assessing and reporting on the effectiveness of those internal controls. The Audit and Compliance Committee (the "ACC") reviews the Group's financial reporting process on behalf of the Board of Directors.
For each quarterly and annual financial release, Management's Disclosure Review Committee reviews the release for accuracy and completeness of the release's disclosures. The decisions taken by the Disclosure Review Committee are reviewed with the ACC before publication of the financial release.
The internal audit function, which reports to the Chairman and works closely with the ACC, reviews the effectiveness, efficiency and appropriateness of the internal control systems, particularly regarding the protection of assets, the completeness and accuracy of operational and financial information (with emphasis on internal reporting) and the adherence to Novartis Group guidelines.
The independent auditor, PricewaterhouseCoopers AG (PwC), is responsible for expressing an opinion on the conformity of the audited financial statements with International Financial Reporting Standards ("IFRS") and compliance with Swiss law. Additionally, PwC is responsible for expressing an opinion on Management's assessment of the effectiveness of internal control over financial reporting and for providing an opinion on the effectiveness of internal control over financial reporting.
The ACC is responsible for overseeing the conduct of these activities by the Group's Management and PwC. During 2005, the ACC held 9 meetings. PwC attended all meetings of the ACC and all matters of importance were discussed. PwC also attended one meeting of the Board of Directors of the Group. PwC provided to the ACC the written disclosures required by US Independence Standards Board Standard No. 1 (Communications with Audit Committees), and the ACC and PwC have discussed the auditors' independence from the Group and its Management.
Based upon the reviews and discussions with Management and the independent auditors referred to above, the ACC recommended to the Board of Directors, and the Board approved, inclusion of the audited financial statements in the Group's Annual Report for the year ended December 31, 2005.
DURATION OF THE MANDATE AND TERMS OF OFFICE OF THE INDEPENDENT AUDITORS
The ACC proposed to the Board of Directors the independent auditor for election at the Annual General Meeting. PwC assumed the existing auditing mandate for Novartis in 1996. The head auditors responsible for the mandate, Mr. Robert Muir and Mr. Daniel Suter, began serving in their roles in 2005 and 2003, respectively.
POLICY ON PRE-APPROVAL OF AUDIT AND NON-AUDIT SERVICES OF INDEPENDENT AUDITORS
The ACC's policy is to pre-approve all audit and non-audit services provided by PwC. These services may include audit services, audit-related services, tax services and other services, as described below. Pre-approval is detailed as to the particular service or categories of services, and is subject to a specific budget.
PwC and Management report to the ACC regarding the extent of services provided in accordance with this pre-approval and the fees for the services performed to date on a quarterly basis. The ACC may also pre-approve additional services on a case-by-case basis.
The following fees were charged for professional services rendered by PwC for the 12-month period ended December 31:
The total of Audit-Related, Tax and other Services was USD 2 594 000 for 2005 and USD 5 455 000 for 2004.
AUDIT SERVICES are defined as the standard audit work that needs to be performed each year in order to issue opinions on the consolidated financial statements of the Group, to issue opinions relating to Management's assessment of internal controls over financial reporting and the effectiveness of the Group's internal controls over financial reporting, and to issue reports on local statutory financial statements. Also included are services that can only be provided by the Group auditor, such as auditing of nonrecurring transactions and application of new accounting policies, audits of significant and newly implemented system controls, pre-issuance reviews of quarterly financial results, consents and comfort letters and any other audit services required for US Securities and Exchange Commission or other regulatory filings.
AUDIT-RELATED SERVICES include those other assurance services provided by the independent auditor but not restricted to those that can only be provided by the auditor signing the audit report. They comprise amounts for services such as acquisition due diligence, audits of pension and benefit plans, contractual audits of third-party arrangements, assurance services on corporate citizenship reporting, and consultation regarding new accounting pronouncements.
TAX SERVICES represent tax compliance and other services and expatriate and executive tax return services.
Novartis is committed to open and transparent communication with its shareholders, potential investors, financial analysts, customers, suppliers and other interested parties. Novartis ensures that material information pertaining to its businesses is timely and broadly disseminated in a manner that complies with its obligations under the rules of both the Swiss Stock Exchange and the New York Stock Exchange. Novartis voluntarily complies with Regulation FD of the United States Securities & Exchange Commission (SEC). In an effort to help stakeholders better understand the progress of our business, Novartis makes forward-looking statements which reflect its Management's understanding of the Group's situation and performance as of the date of such statements.
Novartis publishes each year a detailed Annual Report to its shareholders, which provides information on the results of its various businesses. The Annual Report also provides information on developments in the Group's efforts regarding Corporate Citizenship, Health, Safety and Environment and Human Resources. Central to the Annual Report is one section entirely devoted to Corporate Governance and another to the audited financial statements of the reported year. Novartis' financial statements are produced following the International Financial Reporting Standards (IFRS) and a bridging statement to US GAAP is offered. Apart from the Annual Report, Novartis also produces an annual report on Form 20-F, which is filed with the SEC.
Since 2003 Novartis has published its results, on a quarterly basis, in a Form 6-K to the SEC. Financial results releases are disseminated in the same manner as press releases. The quarterly results press releases contain unaudited financial statements in accordance with IFRS and US GAAP.
Novartis issues press releases from time to time regarding developments in its various businesses and other activities in which the Group and its Affiliates involve themselves. All releases are disseminated broadly and simultaneously pursuant to the rules and regulations of the Swiss and New York Stock Exchanges. Press releases relating to financial results and material events are also filed with the SEC under Form 6-K. An archive containing Annual Reports to Shareholders, annual reports to the SEC on Form 20-F, and quarterly results releases as well as related materials, such as slide presentations and conference call webcasts, can be found on the Novartis Investor Relations website (www.novartis.com/investors) and is accessible to anyone, irrespective of whether or not that person is a shareholder. A press release archive is maintained on the Novartis website at: www.novartis.com/news/en/media.shtml
Information contained in all reports and releases is deemed correct and accurate at the time of release. Novartis does not update past releases to take into account changes in the marketplace or our businesses.
INVESTOR RELATIONS PROGRAM
Novartis runs an Investor Relations program, which includes the following:
These activities focus on recently announced activities or financial results and are conducted in line with stock exchange disclosure rules and Regulation FD.
Presentations to the financial community are regularly posted in an archive on the Investor Relations website, as audio webcasts and/or pdf documents for slide presentations. These presentations are not regularly updated, but reflect the developments within the company over time.
Novartis Investor Relations is managed out of headquarters in Basel, Switzerland. A team of professionals is located in New York to assist in coordinating responses to inquiries from the US. Their contact details as well as an Investor Relations mailbox are made available on the Novartis Investor Relations website (www.novartis.com/investors).
Through the Internet there is also an opportunity to sign up for the Investor Relations e-mail distribution system.
This graph compares our total shareholder returns, the Morgan Stanley World Pharmaceuticals Index (MSWPI), and the Swiss Market Index (SMI). The graph assumes CHF 100 invested in Novartis at the closing price on December 31, 1995and an equal amount invested in each of the indices.
DANIEL VASELLA, M.D.
HELMUT SIHLER, J.D., PH.D.
DR. H.C. BIRGIT BREUEL
PETER BURCKHARDT, M.D.
SRIKANT DATAR, PH.D.
WILLIAM W. GEORGE
ALEXANDRE F. JETZER
ULRICH LEHNER, PH.D.
DR. ING. WENDELIN WIEDEKING
ROLF M. ZINKERNAGEL, M.D.
ALEX KRAUER, PH.D.
INGRID DUPLAIN, J.D.
DANIEL VASELLA, M.D.
URS BAERLOCHER, J.D.
RAYMUND BREU, PH.D.
JUERGEN BROKATZKY-GEIGER, PH.D.
PAUL CHOFFAT, J.D.
MARK C. FISHMAN, M.D.
ANDREAS RUMMELT, PH.D.
SECRETARY TO THE EXECUTIVE COMMITTEE
MAX KAUFMANN, PH.D.
FREE CASH FLOW
This operating and financial review should be read in conjunction with the consolidated financial statements. The consolidated financial statements and the financial information discussed below have been prepared in accordance with International Financial Reporting Standards (IFRS). Please see note 34 of the consolidated financial statements for a discussion of the significant differences between IFRS and US Generally Accepted Accounting Principles (US GAAP).
FACTORS AFFECTING RESULTS
The global health care market is growing rapidly due to a number of reasons, particularly the aging population in developed countries, unmet needs in many therapeutic areas (such as cancer and cardiovascular disease), the adoption of more industrialized lifestyles in emerging economies, and increased consumer demand fueled by broad and rapid access to information. At the same time, the health care industry is under increasing pressure to reduce costs as payors in the public and private sectors seek to curb rising health care expenses.
Novartis Group revenues are directly related to the Group's ability to identify and develop high-potential products and to bring them to market quickly and effectively. Efficient and productive research and development is crucial in this environment since Novartis, like its competitors, searches for efficacious and cost-efficient pharmaceutical solutions to health problems. The resource requirements to access the full range of new technologies has been one reason for industry consolidation as well as for the increase in collaborations between leading companies and niche players at the forefront of their particular technology areas. The growth in new technology, particularly genomics, is expected to have a fundamental impact on the pharmaceutical industry and upon the Group's future development.
In addition, competitive conditions have intensified as a result of regulation, price reductions, reference prices, parallel imports, higher patient co-payments and increased pressure on physicians to reduce their prescribing of prescription medicines. Pressure on the Novartis Pharmaceuticals Division and other pharmaceutical companies to lower prices is expected to increase primarily due to government initiatives to reduce patient reimbursement, restrict prescribing levels, increase the use of generics and impose overall price cuts. The introduction of technologically innovative products and devices by competitors and growing product distribution and importation anomalies, mainly in the EU, pose additional challenges.
Competition in the generic pharmaceutical market continues to intensify as the pharmaceutical industry adjusts to increased pressures to contain health care costs. Brand-name pharmaceutical companies have taken aggressive steps to counter the growth of the generics industry. Certain brand-name pharmaceutical companies continue to sell their products to the generic market directly by acquiring or forming strategic alliances with generic pharmaceutical companies. No significant regulatory approvals are required for a brand-name pharmaceutical manufacturer to sell directly or through a third party to the generic market. In addition, certain brand-name pharmaceutical companies continually seek new ways to delay generic introductions and to decrease the impact of generic competition. These efforts by the brand-name pharmaceutical industry have had, and likely will continue to have, a negative effect on the results of operations of the Sandoz Division.
Under US law, the Food and Drug Administration (FDA) must award 180 days of market exclusivity to the first generic manufacturer who challenges the patent of a branded product. However, recent changes in the Hatch-Waxman Act may affect the availability of this market exclusivity in the future. These amendments now require generic applicants to launch their products within certain time frames or risk losing the marketing exclusivity that they had gained through being a first-to-file applicant.
At times Sandoz seeks approval to market generic products before the expiration of patents held by others for those products, based upon its belief that such patents are invalid, unenforceable, or would not be infringed by its products. As a result, Sandoz often faces significant patent litigation. If Sandoz is unsuccessful in such litigation, then its ability to launch new products will be substantially limited. In addition, depending upon a complex analysis of a variety of legal and commercial factors, Sandoz may, in certain circumstances, elect to market a generic product even though litigation is still pending. This could be before any court decision or while an appeal of a lower court decision is pending. Should Sandoz elect to proceed in this manner, it could face substantial patent liability damages if the final court decision is adverse to the expectations of Sandoz and Novartis.
Exchange rate exposure also affects the Group's results since Novartis has both sales and costs in many currencies other than the US dollar, its reporting currency. This gives rise to both transaction exposure in subsidiary financial statements due to foreign currency denominated transactions and translation exposure from converting non-US dollar subsidiary results and balance sheets into the Group's US dollar consolidated financial statements. The Group's results have not been significantly affected by inflation.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Novartis Group's principal accounting policies are set out in note 1 of the Group's consolidated financial statements and conform to International Financial Reporting Standards (IFRS). Significant judgments and estimates are used in the preparation of the consolidated financial statements which, to the extent that actual outcomes and results may differ from these assumptions and estimates, could affect the accounting in the areas described in this section.
Novartis recognizes product sales when title and risk of loss for the products are transferred to the customer. At the time of sale, Novartis also records estimates for a variety of sales deductions, including rebates, discounts and incentives, and product returns. Sales deductions are reported as a reduction of revenue.
DEDUCTIONS FROM REVENUES: As is typical in the pharmaceutical industry, Novartis' gross sales are subject to various deductions, primarily comprised of rebates and discounts to retail customers, government agencies, wholesalers and managed health care organizations. These deductions represent estimates of the related obligations, requiring the use of judgment when estimating the impact of these sales deductions on gross sales for a reporting period. These adjustments are reported as a reduction of Gross Sales to arrive at Net Sales.
The following briefly describes the nature of each deduction and how the deduction is estimated. The US market has the most complex arrangements related to revenue deductions. However, in a number of countries outside the U.S., including major European countries, Novartis provides rebates to government entities. These rebates are often legislatively mandated. Specific references are made to the US market, and where applicable, to the Pharmaceuticals Division's US subsidiary, Novartis Pharmaceuticals Corporation (NPC):
The following table shows, the worldwide extent of rebates made and payment experiences for Novartis:
PROVISIONS FOR REVENUE DEDUCTIONS
OTHER REVENUE: Novartis also generates revenue from out-licensing and co-promotion arrangements. Royalty income and revenues from licensing and co-promotion activity are recorded as other revenues in the consolidated income statement. Royalty and copromotion income estimates are made in advance of amounts collected using historical and forecasted trends. Royalties tend to be linked to levels of sales by a third party. Initial payments and other similar non-refundable payments received under licensing and co-promotion agreements are recorded as deferred revenue and are recognized over the estimated performance periods established in the agreements. Non-refundable milestone payments in such agreements are recognized as revenue upon achievement of specified agreed criteria.
IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived assets, including identifiable intangibles and goodwill are regularly reviewed for impairment, whenever events or changes in circumstance indicate that the balance sheet carrying amount of the asset may not be recoverable. In order to assess if there is any impairment, estimates are made of the future cash flows expected to result from the use of the asset and its eventual disposal. Goodwill and in-process research and development and acquired development projects not yet ready for use are subject to impairment review at least annually. Other long-lived assets are reviewed when there is an indication that an impairment may have occurred. If the balance sheet carrying amount of the asset exceeds the higher of its value in use to Novartis or its anticipated fair value less cost of sale, an impairment loss for the difference is recognized. The impairment analysis is principally based upon estimated discounted future cash flows. Actual outcomes could vary significantly from such estimates of discounted future cash flows. Especially, the development of discounted future cash flows for intangible assets under development involves highly sensitive assumptions specific to the nature of the Group's activities such as:
Factors such as lower-than-anticipated sales for acquired products or for sales associated with patents and trademarks or lower-thananticipated future sales resulting from acquired research and development or the closing of facilities or changes in the planned use of buildings, machinery or equipment could result in shortened useful lives or impairment. Changes in the discount rates used for these calculations also could lead to impairments.
FAIR VALUE OR IMPAIRMENT ADJUSTMENTS ON FINANCIAL INSTRUMENTS
The Novartis Group has extensive investments in marketable securities and has significant derivative financial instrument positions. These are held mainly, but not exclusively, for hedging underlying positions. Depending on the development of equity and derivative markets, it may be necessary to recognize impairments on the marketable securities or losses on the derivative positions in the Group's consolidated income statement.
INVESTMENTS IN ASSOCIATED COMPANIES
Novartis has investments in associated companies (defined as investments in companies where Novartis holds between 20% and 50% of a company's voting shares or over which it otherwise has significant influence) accounted for by using the equity method. Due to the various estimates that have been made in applying the equity method, the amounts recorded in the consolidated financial statements in respect of Roche Holding AG and Chiron Corporation may require adjustments in the following year after more financial and other information becomes publicly available. Novartis announced in October 2005 that the Board of Directors of Chiron Corporation have recommended that shareholders approve an offer by Novartis to acquire the remaining 56% of Chiron that it did not hold at the end of 2005. There can be no guarantee that this acquisition, which requires shareholder and regulatory approvals, can be completed. If successful, Chiron would become a wholly-owned subsidiary of the Novartis Group and would no longer be accounted for as an associated company.
RETIREMENT BENEFIT PLANS
The Novartis Group sponsors pension and other retirement plans in various forms covering employees who meet eligibility requirements. These plans cover the majority of Group employees. Several statistical and other factors that attempt to anticipate future events are used in calculating the expense and liability related to the plans. These factors include assumptions about the discount rate, expected return on plan assets and rate of future compensation increases, as determined by Group management within certain guidelines. In addition, the Group's actuarial consultants use statistical information such as withdrawal and mortality rates for their estimates. The actuarial assumptions used may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates or longer or shorter life spans of participants. The Group records differences between assumed and actual income and expense as gains or losses in the Statement of Recognized Income and Expense. The differences could have a significant impact on the Group's total equity.
LITIGATION AND PRODUCT LIABILITY PROVISIONS
A number of Novartis Group subsidiaries are subject to litigation and product liability claims arising out of the normal conduct of their businesses. As a result, claims could be made against them that might not be covered by existing provisions or by external insurance coverage. Novartis believes that the outcomes of such actions, if any, would not be material to the Group's financial condition but could be material to future results of operations in a given period.
The Group has provisions for environmental remediation costs. The material components of the environmental provisions consist of estimated costs to fully clean and refurbish contaminated sites and to treat and contain contamination at sites where the environmental exposure is less severe. Future remediation expenses are affected by a number of uncertainties that include, but are not limited to, the method and extent of remediation, the percentage of waste material attributable to Novartis at the remediation sites relative to that attributable to other parties, and the financial capabilities of the other potentially responsible parties. Novartis believes that its total provisions for environmental matters are adequate based upon currently available information. Novartis cannot guarantee that additional costs will not be incurred beyond the amounts provided. The effect of resolution of environmental matters on results of operations cannot be predicted due to uncertainty concerning both the amount and the timing of future expenditures, the results of future operations and the inherent difficulties in estimating liabilities in this area. Novartis believes that such additional amounts, if any, would not be material to the Group's financial condition but could be material to future results of operations and cash flows in a given period.
COMPLIANCE WITH SARBANES-OXLEY ACT OF 2002 ON INTERNAL CONTROL OVER FINANCIAL REPORTING
In line with domestic US registrants with the Securities and Exchange Commission (SEC), Novartis successfully completed its assessment of internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act in 2004 and has repeated this approach in 2005 and obtained on this assessment a report from its independent auditors. No material weaknesses were revealed in either 2004 or 2005 from this review of the internal control over financial reporting.
2004 PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
Following the adoption of a number of new International Financial Reporting Standards (IFRS) from January 1, 2005, as required by IFRS, the 2004 consolidated financial statements have been restated. Not all of the new standards required retrospective application of the new accounting and reporting requirements.
In order to assist Novartis investors and analysts in their understanding of the Group's results by having comparable information, a pro forma 2004 consolidated income and cash flow statement is provided that includes the following additional adjustments compared to the audited restated 2004 consolidated income and cash flow statement. The discussions on income statement and cash flow items in the following sections of the Operating and Financial Review compares 2005 with the 2004 pro forma financial information.
The following describes in detail the 2004 pro forma adjustments:
IFRS 2 (SHARE-BASED COMPENSATION)
As permitted by IFRS 2, Novartis has restated its 2004 audited consolidated financial statements to reflect the cost of grants awarded only since November 7, 2002, whereas the pro forma income statement includes prior grants that would have had an impact on the 2004 results had there been further retrospective restatements.
IFRS 3 (BUSINESS COMBINATIONS)
IFRS 3 requires non-amortization of goodwill arising from preMarch 31, 2004 business combinations only from January 1, 2005. The pro forma income statement excludes all goodwill amortization in 2004.
IAS 38 (INTANGIBLES)
IAS 38 (revised) requires that acquired R&D assets, such as those related to initial and milestone payments, need to be capitalized as intangible assets only from January 1, 2005, even if uncertainties exist as to whether the R&D will ultimately be successful in producing a saleable product. The pro forma 2004 income statement adopts this policy for all of 2004.
The following is a summary of the above on the audited 2004 restated consolidated income statement:
2004 PRO FORMA CONSOLIDATED INCOME STATEMENT
2004 PRO FORMA CONSOLIDATED CASH FLOW STATEMENT
NOTES TO THE NOVARTIS GROUP PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
RESULTS OF OPERATIONS
Novartis Group net sales rose 14% (13% in local currencies) to USD 32.2 billion in 2005 based on the dynamic expansion of Pharmaceuticals and Sandoz, which was supported by the acquisitions of Hexal and Eon Labs in 2005, as well as good performances in Consumer Health, particularly OTC. Volume increases were the primary growth driver, contributing nine percentage points to Group net sales growth. Currency benefits added one percentage point and acquisitions five percentage points. Prices across the Group declined one percentage point. Pharmaceuticals accounted for 63% of total Group net sales, Sandoz for 15% and Consumer Health 22%. The US remained the largest market for Novartis, accounting for 39% of total Group net sales, Europe for 37% and the rest of the world for 24%.
Group operating income advanced 10%, at a slower rate than sales as productivity improvements and the strong volume expansion were partially offset by one-time costs, particularly related to acquisitions. Costs of Goods Sold rose 22% and increased as a percentage of net sales by 1.8 percentage points to 27.5%, owing mainly to purchase price accounting impacts and increased amortization of intangible assets in Sandoz related to acquisitions and impairment of marketing rights in Pharmaceuticals. Marketing & Sales fell one percentage point to 30.4% of net sales based primarily on productivity improvements in Pharmaceuticals. Research & Development expenses rose 19%, which included a USD 332 million impairment charge for the development compound NKS104, and represented 15% of net sales. General & Administration expenses as a percentage of net sales declined 0.1 percentage points, accounting for 5.4% of net sales. The Group operating margin decreased to 21.4% of net sales from 22.3% in 2004 based on acquisition-related costs in Sandoz as well as impairment related charges in Pharmaceuticals.
Group net income advanced 10% to USD 6.1 billion, reflecting the strong organic growth. Earnings per share rose 11%, slightly faster than net income due to the impact of the recent share repurchase programs, to USD 2.63 per share from USD 2.37 in 2004.
Pharmaceuticals net sales were up 10% (+9% in local currencies) to USD 20.3 billion, delivering dynamic growth ahead of the market and in all regions. Both the Cardiovascular and Oncology franchises generated more than USD 5 billion in annual net sales while also maintaining double-digit growth rates. Many leading products, particularly Diovan, Lotrel and Gleevec/Glivec were the No. 1 products by sales in their therapeutic categories. New data continued to underpin the strong position of Femara,which delivered sales growth of nearly 40% for the year. Volume and product mix accounted for nine percentage points of net sales growth in USD, while currency benefits added one percentage point. Net price changes had no impact.
General Medicines (excluding Mature Products) delivered a net sales increase of 11% (+10% in local currencies) as strategic cardiovascular brand sales rose 15% (+15% in local currencies). Net sales in Specialty Medicines (Oncology, Transplantation and Ophthalmics) were up 15% (+15% in local currencies) as Oncology net sales surged 21% (+20% in local currencies) thanks to new data supporting the clinical benefits of many of these "best-in-class" medicines.
Net sales advanced 10% to USD 8.1 billion in the US as strong performances by the cardiovascular and oncology franchises as well as Zelnorm/Zelmac more than offset lower sales of the eczema treatment, Elidel, which was impacted by an FDA health advisory statement in March 2005 relating to a theoretical risk of lymphoma for this class of medicines. In Europe, net sales rose 7% (+7% in local currencies), supported particularly by Diovan that was partly offset by launches of generic terbinafine (Lamisil) in key markets, while Japan advanced 6% (+9% in local currencies). Emerging growth markets reported an increase of 19% (+17% in local currencies), thanks to dynamic performances in China, Russia and Turkey.
DIOVAN (USD 3.7 billion, +19% in local currencies), the leading angiotensin-receptor blocker (ARB) worldwide, continued its strong performance. Key drivers have been recently approved indications and the global rollout of higher strengths of Co-Diovan (a combination of Diovan and a diuretic) as well as disease-awareness and education programs ("BP Success Zone") in the US. Diovan is the only agent in its class worldwide indicated to treat high blood pressure, high-risk heart attack survivors (VALIANT trial) and patients with heart failure (Val-HeFT trial). In the US, Diovan is the leader with a 38% share of the ARB market (Source: IMS).
LOTREL (USD 1.1 billion, +17% only in US), the No. 1 fixed combination treatment for hypertension in the US since 2002, kept up strong double-digit growth based on new guidelines recommending more aggressive treatment of elevated blood pressure with multiple medicines and the US disease awareness campaign.
LAMISIL (USD 1.1 billion, -2% in local currencies), the leading treatment worldwide for fungal nail infections, had lower overall sales due to generic competition in most major European markets. In the US, sales were slightly higher, further increasing its leadership despite the launch in 2005 of a generic version of the competitor itraconazole.
ZELNORM/ZELMAC (USD 418 million, +39% in local currencies), a novel therapy for irritable bowel syndrome with constipation (IBS-C) and the first and only prescription medicine for chronic idiopathic constipation, maintained robust double-digit growth rates in the US and other key markets, reflecting the product's therapeutic benefits and increasing disease awareness. In the US, the performance was driven by the continued strong uptake of Zelnorm/Zelmac in its new chronic constipation indication and also benefited from the normalization of inventories compared to below-average levels in the year-ago period. Novartis will appeal an opinion from a European Medicines Agency (EMEA) committee recommending against EU approval of Zelnorm. This product has been approved in 56 countries for treatment of women with irritable bowel syndrome with constipation (IBS-C).
ELIDEL (USD 270 million, -23% in local currencies) had a decline in sales since a FDA health advisory statement in March 2005 relating to a theoretical risk of lymphoma for this class of medicines. Sales in the rest of the world declined at a more moderate rate. Novartis remains confident in the safety and efficacy of Elidel in its approved indications.
GLEEVEC/GLIVEC (USD 2.2 billion, +32% in local currencies), indicated for all stages of Philadelphia-chromosome positive (Ph+) chronic myeloid leukemia (CML) and certain forms of gastrointestinal stromal tumors (GIST), maintained robust growth rates through further penetration of the CML and GIST markets. Also supporting growth have been an increase in average daily dose as well as increasing number of patients thanks to improved survival benefits. Data from the IRIS study showed that more than 90% of patients with newly-diagnosed chronic phase CML who are taking Gleevec/Glivec are still alive after 4.5 years. Moreover, less than 1% of patients progressed to advanced disease in the fourth year, indicating an overall decrease rate of progression. Gleevec/Glivec received EU approval in 2005 for increasing the average daily dose to 800 mg from 400 mg or 600 mg in patients with chronic phase CML and in GIST patients whose cancer is progressing on the lower dose. Gleevec/Glivec has been submitted in the US, EU and Japan for Ph+ acute lymphoblastic leukemia (ALL).
ZOMETA (USD 1.2 billion, +13% in local currencies), the leading intra-venous bisphosphonate for bone metastases, reached a record 75% market segment share in a maturing US market. Greater use in prostate and lung cancer was somewhat offset by slowing growth in breast cancer and myeloma due to high penetration rates. In the EU, Zometa is growing market share despite new competition.
FEMARA (USD 536 million, +38% in local currencies), a leading therapy for early and advanced breast cancer in postmenopausal women, benefited from further penetration of the extended adjuvant setting after five years of tamoxifen usage. New data from the landmark MA-17 trial reported at a major medical meeting found that postmenopausal women with early breast cancer received significant benefit from Femara therapy even after a prolonged period of no anti-cancer treatment. In addition, Femara received US approval in December for use as an initial treatment immediately after surgery in patients with hormone-sensitive early breast cancer (adjuvant setting), becoming the only medicine in its class approved in the US for use as an initial treatment as well as after completion of five years of tamoxifen therapy. This new US indication was based on results of the BIG 1-98 study, which were published for the first time in a December issue of The New England Journal of Medicine (NEJM). Submissions for this new indication have been made in Europe, where it has already been approved in the UK. Femara has also received approval in Japan for use in the treatment of breast cancer.
SANDOSTATIN (USD 896 million, +8% in local currencies), for patients with the hormone condition acromegaly as well as for symptoms of gastro-entero-pancreatic neuroendocrine tumors, reported flat worldwide sales and a decline in the US, where the subcutaneous formulation faces generic competition. However, sales of the long-acting LAR version expanded at a double-digit rate in the US and rest of the world.
Net sales increased 8% (7% in local currencies) as Visudyne (USD 484 million, +7% in local currencies), the leading treatment for "wet" AMD (age-related macular degeneration), were higher despite the entry of off-label competition in the US. Visudyne growth was strong in the rest of the world, including the UK, Germany and France, with sales outside the US up 24% in local currencies.
Net sales for the year declined -1% in local currencies based on lower sales of Neoral/Sandimmun (USD 953 million, -6% in local currencies) from the impact of ongoing generic competition.
Sandoz net sales surged 54% (+54% in local currencies) to USD 4.7 billion, bolstered by USD 1.4 billion in sales contributions from Hexal (starting from June 6) and Eon Labs (starting from July 20). Excluding these acquisitions, Sandoz sales rose 9% (+8% in local currencies) thanks to strong retail generics sales in Europe and Russia as well as new launches in the US.
CONSUMER HEALTH DIVISION
Consumer Health net sales climbed 8% (+8% in local currencies) to USD 7.3 billion, helped by a double-digit growth performance in OTC tied to its focus on strategic brands and the contribution of the North American OTC business of Bristol-Myers Squibb. This acquisition, effective September 1, added USD 100 million in sales to the division.
Group operating income advanced 10%, at a slightly lower pace than sales as strong volume expansion and productivity improvements were partially offset by one-time costs related to acquisitions.
Pharmaceuticals operating income expansion outpaced sales growth, rising 12% from productivity gains in all areas that led to an operating margin of 29.7%, an increase of 0.7 percentage points over 2004. Other revenues contributed 0.5 percentage points to the improved operating margin, reflecting profits from the successful launch of the asthma medicine Xolair. Costs of Goods Sold improved 0.3 percentage points as a percent of sales, thanks to productivity gains and product mix improvements. Marketing & Sales costs rose 6.3% versus 2004, slower than the 2005 sales growth, leading to an improvement of 1.0 percentage point as productivity gains, especially in the US, offset investments in oncology, particularly for Femara, as well as expansion in emerging markets such as China and Turkey. General & Administration costs were reduced to 3.2% of sales, adding 0.3 percentage points to the improved operating margin. A slight decline in Other Income & Expenses also contributed to the better performance. Research & Development costs were higher, reflecting investments in late-stage development projectsparticularly Rasilez (hypertension), Galvus (type 2 diabetes) and FTY720 (multiple sclerosis). One-time gains of USD 231 million from the divestment of product rights for Cibadrex/Cibacen in Europe and the sale of license rights for Restasis® recorded in Other Income and Expense partially offset an impairment recorded in Research & Development of USD 332 million after Novartis decided the profile of the development compound NKS104 (pitavastatin) was no longer competitive from Novartis' point of view. Principally as a result of the impairment, R&D costs as a percentage of sales rose 1.4 percentage points to 19.6% in 2005.
Sandoz operating income rose 30% to USD 342 million, benefiting from a good underlying business performance. Also supporting growth was an operating income contribution of USD 344 million from Hexal and Eon Labs, which more than offset the one-time acquisition and related integration costs of USD 237 million and the amortization of intangible assets of USD 100 million. These businesses exceeded expectations and performed well since their acquisition in mid-2005.
CONSUMER HEALTH DIVISION
Consumer Health operating income was up 5% over the year-ago period, rising at a slower pace than sales due to investments in strategic brands and acquisition-related costs. The BMS acquisition provided operating income of USD 17 million, which was more than offset by related one-time charges of USD 40 million.
CORPORATE INCOME & EXPENSE, NET
Net corporate expense totaled USD 506 million in 2005 compared to USD 346 million in 2004, reflecting several factors including increased product liability risk provisions.
OTHER REVENUES AND OPERATING EXPENSES
Other revenues were higher, primarily the result of increased contributions from the sale of the asthma medicine Xolair in the US, where it is co-marketed and co-developed in partnership with Genentech and Tanox and additional royalty income.
COST OF GOODS SOLD
Cost of Goods Sold rose 22% to USD 8.9 billion in 2005, rising to 27.5% in 2005 as a percentage of Group net sales from 25.7% in 2004. Purchase price accounting impacts and increased amortization of intangible assets in Sandoz due to the acquisitions more than offset lower costs in Pharmaceuticals related to productivity gains and product mix improvements.
MARKETING & SALES
Marketing & Sales expenses increased 10% to USD 9.8 billion but declined slightly as a percentage of Group net sales to 30.4% compared to 31.4% in 2004, mainly reflecting the impact of sustained productivity gains in Pharmaceuticals.
RESEARCH & DEVELOPMENT
Research & Development expenses rose 19% in 2005 to USD 4.8 billion, reflecting investments in the Novartis Institutes for BioMedical Research in the US as well as in late-stage compounds, particularly SPP100 (hypertension), LAF237 (type 2 diabetes) and FTY720 (multiple sclerosis). Also affecting the operating margin were, an impairment of USD 332 million for NKS 104, a lipid-lowering agent project that has been stopped, and the consolidation of Hexal and Eon Labs in Sandoz. R&D expenses as a percentage of Group net sales went up to 15.0% compared to 14.4% in 2004.
GENERAL & ADMINISTRATION
General & Administration expenses rose 13% to USD 1.7 billion in 2005, expanding at a slower pace than Group net sales and leading to a modest improvement as a percentage of net sales to 5.4% compared to 5.5% in 2004.
OTHER INCOME & EXPENSE
Other Expense was USD 363 million in 2005 compared to USD 354 million in 2004.
IMPACT OF INTANGIBLE ASSET CHARGES AND SIGNIFICANT EXCEPTIONAL ITEMS
As a result of changes in the IFRS accounting rules and the recent acquisitions, Novartis' operating income is increasingly impacted by intangible asset amortization and impairment charges and exceptional costs relating to integration of the acquisitions. The following shows operating income excluding these factors.
RESULT FROM ASSOCIATED COMPANIES
Associated companies are accounted for using the equity method when Novartis holds between 20% and 50% of the voting shares of these companies, or where otherwise Novartis has significant influence over them. Income from associated companies is mainly derived from the Group's investments in Roche Holding AG and Chiron Corporation. Overall, income from associated companies increased to USD 193 million from USD 177 million in 2004. The Group's 44.1% interest in Chiron contributed an income of USD 19 million compared to an income of USD 13 million in 2004.
The Group's 33.3% interest in Roche voting shares, which represents a 6.3% interest in the total equity of Roche, generated income of USD 166 million compared to USD 156 million in 2004. The income for 2005 reflects an estimate of the Group's share of Roche's 2005 income, which is USD 281 million, including a positive prior year adjustment of USD 2 million. This income was reduced by an intangible amortization charge of USD 115 million arising from the allocation of the purchase price to property, plant & equipment and intangible assets.
A survey of analyst estimates is used to predict the Group's share of the net income of both Roche and Chiron. Any differences between these estimates and actual results will be adjusted in 2006.
FINANCIAL INCOME AND INTEREST EXPENSE
USD 461 million of financial income was offset by USD 294 million of interest expense resulting in financial income, net of USD 167 million in 2005, compared to USD 227 million in 2004, a reduction of USD 60 million, as acquisitions led to a decline in average net liquidity. The overall return on net liquidity for the year was 4.2%, up from 3.7% in 2004 principally due to currency gains.
The amount of taxes expensed rose 3% to USD 1.1 billion in 2005. The Group's effective tax rate (taxes as a percentage of income before tax) was 15.5% in 2005 compared to 16.3% in 2004.
The Group's expected tax rate (weighted average tax rate based on the result before tax of each subsidiary) was 16.2% in 2005 compared to 16.8% in 2004. The Group's effective tax rate is different than the expected tax rate due to various adjustments to expenditures and income for tax purposes. See note 6 to the consolidated financial statements for details of the main elements contributing to the difference.
Net income grew 10% to USD 6.1 billion from USD 5.6 billion in 2004, rising at a slower rate than sales mainly due to acquisition related charges. As a percentage of total net sales, net income decreased to 19.1% in 2005 compared to 19.8% in 2004. Return on average equity was 19.0% in 2005 compared to 18.6% in 2004.
EARNINGS PER SHARE
Earnings per share rose 11% to USD 2.63 in 2005 from USD 2.37 in 2004, partially benefiting from a reduced number of outstanding shares through the share buy-back programs.
CONDENSED CONSOLIDATED BALANCE SHEETS
Total non-current assets increased by USD 7.7 billion principally from the acquisitions in the Sandoz and Consumer Health Divisions. The Group's equity increased by USD 1.8 billion during 2005 to USD 33.2 billion at December 31, 2005, as a result of net income (USD 6.1 billion), negative translation adjustments (USD 2.0 billion), valuation differences on marketable securities and cash-flow hedges, share-based compensation and other items (USD 0.4 billion), offset by the acquisition of treasury shares (USD 0.2 billion), actuarial losses principally due to changes in discount rates (USD 0.4 billion) and the dividend payment (USD 2.1 billion). Total financial debts increased by USD 1.6 billion. The valuation differences on available-for-sale marketable securities and deferred cash-flow hedges decreased from unrealized gains of USD 379 million at December 31, 2004, to unrealized gains of USD 304 million at December 31, 2005. The year-end debt/equity ratio increased to 0.25:1 from 0.22:1 in 2004 due to the extra debt assumed to pay for the large acquisitions.
Novartis has long-term financial debt principally in the form of bonds. A total of USD 2.3 billion of straight bonds were outstanding at December 31, 2005, compared with USD 3.2 billion at December 31, 2004. For details on the maturity profile of debt, currency and interest rate structure, see note 18 to the consolidated financial statements.
Novartis debt continues to be rated by Standard & Poor's and Moody's as AAA and Aaa for long-term maturities and A1+ and P1 for short-term debt, respectively making the Group one of the few non-financial companies worldwide to have attained the highest rating from these two benchmark rating agencies. The Group considers its financing arrangements to be sufficient for its present requirements.
LIQUIDITY AND CAPITAL RESOURCES
The following table sets forth certain information about the Group's cash flow and net liquidity.
Cash flow from operating activities increased by 21% (USD 1.4 billion) to USD 8.1 billion reflecting the strong business expansion and good working capital management of the Divisions.
Cash outflow due to investing activities was USD 7.5 billion. A total of USD 8.8 billion was spent on acquisitions, while investments in property, plant & equipment amounted to USD 1.2 billion and USD 0.2 billion was spent on other investing activities. Net proceeds from marketable securities were USD 2.7 billion.
Cash flow used for financing activities was USD 0.3 billion, down USD 2.7 billion from 2004. USD 0.2 billion was spent on the acquisition of treasury shares and USD 2.1 billion on dividend payments. USD 2.0 billion inflow was due to the increase in short and long-term financial debt.
Overall liquidity (cash, cash equivalents and marketable securities including financial derivatives) amounted to USD 10.9 billion at December 31, 2005. Net liquidity fell by USD 4.6 billion to a total of USD 2.5 billion at December 31, 2005, compared to USD 7.0 billion at the start of the year, reflecting the acquisitions made during the year. Acquisitions amounted to approximately USD 8.8 billion to acquire Hexal and Eon Labs as well as the North American OTC business of BMS and an additional 2% stake in newly issued shares of Chiron through an existing agreement totaling USD 300 million.
GROUP FREE CASH FLOW
The Group defines free cash flow as cash flow from operating activities less purchase/sale of property, plant & equipment, intangible and financial assets and dividends paid. Cash effects on acquisition or divestment of subsidiaries, associated companies and minority interests are excluded from free cash flow. The following is a summary of the Group's free cash flow:
Free cash flow increased 42% to USD 4.7 billion in 2005 from USD 3.3 billion in 2004.
Group capital expenditure on property, plant & equipment for 2005 amounted to USD 1.2 billion (3.7% of net sales compared to 4.5% of net sales in 2004). This level reflects the continuing investment in production sites as well as Research & Development facilities. In 2006 capital expenditures for property, plant and equipment are forecast to be approximately 5.0% of net sales, excluding any impact from the planned Chiron acquisition. These expenditures will be funded from internally generated resources.
Free cash flow is presented as additional information since it is a useful indicator of the Group's ability to operate without relying on additional borrowing or the use of existing cash. Free cash flow is a measure of the net cash generated which is available for debt repayment and investment in strategic opportunities.
The Group uses free cash flow as a performance measure when making internal comparisons of the results of Divisions. Free cash flow of the Divisions uses the same definition as for the Group. However no dividends, tax or financial receipts or payments are included in the Divisional calculation.
The following summarizes the free cash flow by Division:
The following summarizes the Group's contractual obligations and other commercial commitments and the effect such obligations and commitments are expected to have on the Group's liquidity and cash flow in future periods.
The Group expects to fund the operating leases and long-term Research & Development and other purchase commitments with internally generated resources.
SPECIAL PURPOSE ENTITIES
The Novartis Group has no unconsolidated special purpose financing or partnership entities.
EARNINGS BEFORE INTEREST, TAX, DEPRECIATION AND AMORTIZATION (EBITDA)
The Group defines EBITDA as operating income before depreciation of property, plant & equipment and amortization of intangible assets, including goodwill, and any related impairment charges.
The segmentation of the Group EBITDA into the Divisions is as follows:
Enterprise value represents the total amount that shareholders and debt holders have invested in Novartis, less the Group's liquidity.
This is the base used by investors in Novartis to measure their EBITDA return.
VALUE ADDED STATEMENT
A total of 49% of the revenue from net sales was used to purchase goods and services from our suppliers. Of the Net Value Added of USD 15.7 billion, 51% was paid either directly or indirectly to the employees, 26% was retained in the business for future expansion and 10% was paid to public authorities and financial institutions. Dividends paid to shareholders represented 13% of the Net Value Added.
ORIGIN OF VALUE ADDED
EXCHANGE RATE EXPOSURE AND RISK MANAGEMENT
Novartis transacts its business in many currencies other than the US dollar, its reporting currency. As a result of the Group's foreign currency exposure, exchange rate fluctuations have a significant impact in the form of both translation risk and transaction risk on its income statement. Translation risk is the risk that the Group's consolidated financial statements for a particular period or as of a certain date may be affected by changes in the prevailing rates of the various currencies of the reporting subsidiaries against the US dollar. Transaction risk is the risk that the value of transactions executed in currencies other than the subsidiary's measurement currency may vary according to currency fluctuations.
GROWTH AND CURRENCY CONTRIBUTIONS
NET SALES AND OPERATING COSTS BY CURRENCIES
LIQUID FUNDS AND FINANCIAL DEBT BY CURRENCIES
The average exchange rate of the US dollar in 2005 was slightly weaker against the Euro, Canadian dollar and several other currencies in Latin America and Eastern Europe than in 2004. The total positive currency effect on net sales growth was one percentage point.
MARKET RISK: Novartis is exposed to market risk, primarily related to foreign exchange, interest rates and the market value of the investments of liquid funds. The Group actively monitors these exposures. To manage the volatility relating to these exposures, the Group enters into a variety of derivative financial instruments. The Group's objective is to reduce, where it deems appropriate to do so, fluctuations in earnings and cash flows associated with changes in interest rates, foreign currency rates and market rates of investments of liquid funds. It is the Group's policy and practice to use derivative financial instruments to manage exposures and to enhance the yield on the investment of liquid funds. It does not enter any financial transactions containing a risk that cannot be quantified at the time the transaction is concluded. The Group only sells existing assets or enters into transactions and future transactions (in the case of anticipatory hedges) that it confidently expects it will have in the future, based on past experience. In the case of liquid funds, the Group writes call options on assets it has or it writes put options on positions it wants to acquire and has the liquidity to acquire. The Group expects that any loss in value for these instruments generally would be offset by increases in the value of the underlying transactions.
FOREIGN EXCHANGE RATES: The Group uses the US dollar as its reporting currency. As a result, the Group is exposed to foreign exchange movements, primarily in European, Japanese and other Asian and Latin American currencies. Consequently, it enters into various contracts that reflect the changes in the value of foreign exchange rates to preserve the value of assets, commitments and anticipated transactions. Novartis also uses forward contracts and foreign currency option contracts to hedge certain anticipated net revenues in foreign currencies.
Net investments in foreign countries are long-term investments. Their fair value changes through movements of the currency exchange rates. In the very long term, however, the difference in the inflation rate should match the exchange rate movement, so that the market value of the non-monetary assets abroad will compensate for the change due to currency movements. For this reason, the Group only in exceptional cases hedges the net investments in foreign subsidiaries.
COMMODITIES: The Group has only a very limited exposure to price risk related to anticipated purchases of certain commodities used as raw materials. A change in those prices may alter the gross margin of a specific business, but generally by not more than 10% of the margin and thus below the Group's risk management tolerance levels. Accordingly, it does not enter into significant commodity futures, forward and option contracts to manage fluctuations in prices of anticipated purchases.
INTEREST RATES: The Group manages its net exposure to interest rate risk through the proportion of fixed rate debt and variable rate debt in its total debt portfolio. To manage this mix, Novartis may enter into interest rate swap agreements, in which it exchanges periodic payments based on a notional amount and agreed-upon fixed and variable interest rates.
EQUITY RISK: The Group purchases equities as investments of its liquid funds. As a policy, it limits its holdings in an unrelated company to less than 5% of its liquid funds. Potential investments are thoroughly analyzed in respect to their past financial track record (mainly cash flow return on investment), their market potential, their management and their competitors. Call options are written on equities that the Group owns, and put options are written on equities which the Group wants to buy and for which cash has been reserved.
MANAGEMENT SUMMARY: Use of derivative financial instruments did not have a material impact on the Group's financial position at December 31, 2005 and 2004 or its results of operations for the years ended December 31, 2005 and 2004.
VALUE AT RISK: The Group uses a value at risk (VAR) computation to estimate the potential ten-day loss in the fair value of its interest-rate-sensitive financial instruments, the loss in pre-tax earnings of its foreign currency price-sensitive derivative financial instruments as well as the potential ten-day loss of its equity holdings. It uses a ten-day period because of an assumption that not all positions could be undone in a single day given the size of the positions. The VAR computation includes the Group's debt, short-term and long-term investments, foreign currency forwards, swaps and options as well as anticipated transactions. Foreign currency trade payables and receivables as well as net investments in foreign subsidiaries are excluded from the computation.
The VAR estimates are made assuming normal market conditions, using a 95% confidence interval. The Group uses a "Delta Normal" model to determine the observed inter-relationships between movements in interest rates, stock markets and various currencies. These inter-relationships are determined by observing interest rate, stock market movements and forward currency rate movements over a 60-day period for the calculation of VAR amounts.
The estimated potential ten-day loss in pre-tax earnings from the Group's foreign currency instruments, the estimated potential ten-day loss on its equity holdings, and the estimated potential ten-day loss in fair value of its interest rate sensitive instruments, primarily debt and investments of liquid funds under normal market conditions, as calculated in the VAR model, are the following:
The average, high, and low VAR amounts for 2005 are as follows: