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Novartis: Leading a Global Enterprise 413-096

a British CFO, and a Swiss general counsel and a German human resource head. Its six businesses were led by four Americans, one Swiss and one Brit. The Novartis board, once comprised of 12 Swiss members, one American and one German, had also globalized, and now included five Swiss, two Germans, two Americans, a Chinese woman, and one member each born in India and Lebanon. (See Exhibit 8 for 2012 board composition.)

Leadership Challenges

In terms of developing global leaders, Vasella noted, “Hard skills are easier to transmit, while soft skills are much more difficult to teach. You can teach concepts, but you can’t teach experiences. To be a good leader, you need to be intelligent, a conceptual thinker, ambitious, and take pleasure in building organizations.” He continued:

Those qualities need to be balanced by skepticism—recognition that not everyone wants you to succeed and that bad things will happen. If I look at the reasons leaders fail, it’s usually the soft factors, such as failing to resist seduction. I talk to my team about the temptations that come with leadership—sexual enticement, money, or praise. You need to be aware of your vulnerabilities in order to resist seduction and keep your integrity.24

“Today’s leaders must understand what society needs, values and will pay for,” Vasella continued, “and have the courage to stand up for it even if unpopular. They need courage to make mistakes and not think their heads will be cut off. Leaders need to avoid taking shortsighted actions. I worry most about pressures people feel from the stock market to take short-term actions like portfolio management and restructuring to pull the white rabbit out of the hat.”

Breu added, “New leaders should not imitate the past. They have to think very differently about the next ten years. How do you anticipate what will happen and place your bets? There will be changes to the way business units operate, to the portfolio and the company’s global footprint. In my time the challenge was getting larger in the U.S. Now the opportunities are in Asia, Brazil and potentially in Africa. Novartis’ culture has become very international. From two Swiss companies we became a global healthcare leader. In 1996 people would have said: ‘As an American, I have no chance of being CEO of Novartis.’ That has changed.”

When Vasella concluded his 14 years as CEO, he said he left the company with strong leadership, excellent financial results, a diversified set of healthy businesses, and a full pipeline of new products. That year 910 million people benefited from Novartis products. He noted:

We came out of a diversified business, and divested everything except healthcare. By expanding there, we became stronger and more diversified. Now there is a different evolution. Companies which were once on the top of the industry have fallen, so the analysts are saying companies should diversify. Competitors who once said generics were incompatible with pharmaceuticals, are suddenly entering generics.

After 25 years with Novartis, including three additional years as board chair, Vasella announced he would step down at the 2013 AGM. With the board’s support, he persuaded Reinhardt to return to Novartis as non-executive chair of the board. Vasella agreed to refrain from competing with Novartis for six years in exchange for CHF 12 million per annum, which he committed to donate entirely for philanthropy. Nevertheless, the disclosure set off a political firestorm in Switzerland, which was in the midst of a referendum on the Minder Initiative supported by activist shareholders aimed at limiting CEO pay. One week before the AGM, Vasella announced that he decided to forgo any

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413-096 Novartis: Leading a Global Enterprise

payments related to his non-compete agreement while the Board cancelled the non-compete clause of his contract. Five days later the Minder Initiative passed.

Joe Jimenez’s New Era

On February 1, 2010 Jimenez became the first American to lead a Swiss pharmaceutical company. He was not a physician by training and had spent most of his career in consumer goods. At age 37, he headed up H. J. Heinz’s North American operations, and was head of its European operations from before joining Novartis. He recalled, “When Dan asked me to run pharmaceuticals, I said, ‘You’re kidding, somebody with no pharmaceutical background, not a scientist, a researcher, or a medic?’ He replied, ‘We have lots of good medics and good scientists, but don’t have someone who can look outside and see what is happening in the world and position the division for future growth.’”

Just as Moret had bet on him, Vasella bet on Jimenez. “Not being a physician or a scientist and running a science-based organization is an interesting challenge,” Jimenez conceded.

You have to know enough about the science to know whom to listen to. My advice is, play to your strengths. I could look outside this industry, understand how the world was changing, and position the company to take advantage of it. Coming from outside has its advantages, as you don’t get caught up in the internal way of thinking.25

As Jimenez looked ahead to his challenges, he saw several imperatives: 1) addressing the rapid changes in global health systems; 2) sustaining research excellence; 3) building a balanced, vibrant health care portfolio; 4) expanding in emerging markets; and, 5) developing global leaders.

Meeting the Challenges of Global Health Systems In the U.S., the Affordable Care Act was expected to put cost pressure on healthcare providers,

including drug manufacturers. In Europe, highly stressed governments sought ways to reduce health care and drug payments.26 “Patients need innovative pharmaceuticals, but also low-cost options,” Jimenez said, observing that this played to Novartis’ strengths:

With financially troubled healthcare systems around the world, just offering innovative pharmaceuticals at $60,000 to $80,000 per year is a risk profile we don’t want to be in. Due to the breadth of our healthcare portfolio, less than 55% of our sales are reimbursed by public agencies. We see significant opportunities in healthcare starting with the patient to offer more than just pharmaceuticals. We can also use our R&D expertise to excel in generics and take advantage of the volume growth. There are hundreds of millions of patients around the world who need Sandoz generics with very high-quality but low-cost.

Jimenez said the future for pharmaceuticals was in moving from the science of medicine to the art of healing. “Everything must start with the patient,” he said. “Our traditional business model was a transaction—selling pills to physicians. Today payers and physicians are insisting on positive outcomes for patients. We need leaders with skills who focus on holistically helping patients with programs, technology, and services to help physicians deliver positive patient outcomes.”

As global head of Novartis Pharmaceuticals, Epstein anticipated major shifts in the pharmaceutical industry. “In the past we were just selling pills. Today you have to understand the patient’s journey from diagnosis through treatment of their disease,” he said. “Without that understanding, you don’t have the insights to develop a sophisticated strategy. In the oncology

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Novartis: Leading a Global Enterprise 413-096

business, we worked together on the same team with the same metrics in commercial and development. Together we talked to customers, developed strategy, and made smarter decisions enabling us to leapfrog the competition with the next clinical trial, drug combination, or new patient segment. Now we’re using that approach for the entire pharmaceutical business.”

Jimenez added, “The global financial crisis has put tremendous pressure on national governments to constrain healthcare spending. These days we have to partner with governments to demonstrate the value of patient outcomes. In oncology, this means developing companion diagnostics to provide 100% certainty that patients will respond to a drug, thereby avoiding the waste of ineffective drugs.”

Sustaining Research Excellence

While spending $9 billion per year on Group R&D (including an amount for pharma research which totaled 20% of pharma sales), Novartis considered research productivity critical to its future. Jimenez’s attitude was to invest where the talent was. “We build our research centers where the scientists are—in Cambridge, Basel, and Shanghai,” he explained. He and Fishman planned to expand on the pathways approach to drug discovery by understanding the molecular pathway of diseases, often rare diseases with small but homogeneous patient populations. “We develop a drug that interrupts that pathway, and then expand into other disease areas impacted by the same pathway,” he noted. See Exhibit 9 for Novartis’ pipeline.

Jimenez was bullish about two therapeutic areas, oncology and regenerative medicine. “The sequencing of the human genome has created a wealth of data that will allow discovery of new drugs never before possible,” he said. He was also betting on regenerative medicine, using technology to tackle problems of muscle, sight and hearing loss.27 “Mining bioinformatics data is essential in understanding specific mutations leading to cancer,” Jimenez noted.28 “This requires melding medical, scientific, and information technologies to create medical advancements.”29 Through all the shifts Novartis expected to maintain its high R&D investment (see Exhibit 10).

Building a Balanced, Vibrant Health Care Company

One of Jimenez’s concerns was getting Novartis’ other health care businesses up to critical mass so they would be full contributors to the company’s revenues and profits, giving counterbalance to its pharmaceutical business. In examining them, he noted that Alcon’s industry leadership gave it that mass in eye care, and Sandoz’s recent expansion brought it just to critical mass in generics. However, OTC, vaccines and diagnostics, and animal health were too small to sustain required investments while contributing significant bottom-line profits. He said:

There is a scale benefit that comes from multiple divisions that permits longer-term investment decisions. We let businesses invest through the cycle, and use good years in one division to permit another division to invest. There are also costs to being part of Novartis. Quality standards that make sense for pharmaceuticals are being imposed on smaller divisions in ways that wouldn’t happen if they were independent. Last year’s quality problems were a painful reminder that Novartis must set its standards at the most demanding level, which is expensive. In Sandoz and OTC, this accounts for a disproportionate amount of their profitability. The challenge is turning superior quality in these businesses into a competitive advantage over smaller competitors.

We assess each unit during the annual strategy cycle to ensure it has a viable strategy to become a leader in its field and create net present value. We have the financial ability to invest deeply in innovation and apply that innovation across all the divisions. Each

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division has also benefited from each other’s talent, especially the smaller units that have access to pharmaceutical capabilities.

Novartis’ vaccine business was the most volatile in the portfolio. In 2009 the division was $500 million below target, but the following year it hit high profit margins with the first vaccine for H1N1 for swine flu. Recalled business head Andrin Oswald: “By hiring 1,000 people, we were first to ship the vaccine. This is great example of Novartis doing extraordinary things in a crisis.“ Unfortunately, the pandemic took management’s focus off the core vaccine business. “When the panic was over, orders for the H1N1 vaccine fell close to zero, profits disappeared, and the business went into a loss. During the crisis it was hard to focus on our core strategy, as demand for other vaccines dropped, and quality issues arose. This might not have happened had we not focused on the pandemic,” Oswald said. However, in 2012 three new vaccines were approved, an industry first.

While Jimenez saw the potential for generics to expand Novartis’ reach, especially in emerging markets, he acknowledged the challenges of competing in generics. On average, the cost of a generic drug was 80% to 85% lower than the brand-name product; generic drugs saved American consumers alone $150 billion per year. Although profit margins were lower as limited barriers to entry meant more competitors and lower prices, production costs were rising because the FDA required generic manufacturers to pass the same quality standards as those for brand-name drugs.

When George took over Sandoz in late 2008, it was considered Novartis’ step-child, with revenue growth only 1% and costs up 10%. The culture was considered slow, complacent, and weak commercially. George replaced half of Sandoz’s top 200 people and focused on near-term performance. The first three years produced annual revenue growth of 12% and profit increases averaging 17%. In 2012 new competition for its best-selling product and added quality costs drove down 2012 revenues and profit margins, in spite of $2 billion in cost savings between 2009 and 2012. Meanwhile, George shifted Sandoz’s strategy to specialty generics such as biosimilars, oncology, ophthalmology and dermatology where profit margins were higher. He noted, “Each year we face high single-digit price erosion which must be offset with higher volumes. We need to recreate two- thirds of annual income to stay even while aggressively cutting costs.”

Expanding in Emerging Markets

With slower growth in the U.S. and Europe, Jimenez saw great opportunities in emerging markets. “China grew 24% last year,” he said, “because the Chinese government made a massive commitment to improving health care. The Russian government is dedicated to improving healthcare access to reverse its population decline. Africa is the next emerging market so we are building infrastructure in sub-Saharan Africa. Nigeria and Kenya are growing 6% to 7% per year.”

To accelerate revenues in select high-growth emerging markets, Novartis shifted to a single country organization in 2008 under Global Emerging Markets (GEM). While the new organization worked well for pharmaceuticals, lower margin businesses like generics found it difficult to get the attention of country management. According to George, “We found that the growth rate in GEM markets was well below what the generics business generated with its own country managers.” In 2012 the GEM organization was disbanded with country responsibilities returned to the divisions.

An experiment in China with a single country management was much more successful. The large size of the market enabled the Chinese country organization to staff the divisions at appropriate levels with clear focus on their respective business. “We feel this structure is working well under centralized management in China,” said George. “We are realizing growth exceeding 20%.”

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Novartis: Leading a Global Enterprise 413-096

Nevertheless, Oswald pointed out how challenging it was to reconcile Novartis’ high cost base with local employee expectations and immature markets. In 2011 Novartis purchased a Chinese vaccine company. Within two years of becoming part of Novartis, its costs doubled, as the 600-employee company had no HR or IT systems. “We brought in the Novartis systems and applied our strict business practices,” Oswald noted. “It’s hard to compete against local companies with Novartis rules.”

Patent protection was also a challenge. In early 2013 India’s Supreme Court denied Novartis’ Gleevec patent, concluding a seven-year process that began in 2006. The court’s decision was a major win for local generic makers like Cipla and Natco Pharma, which sold generic versions of Gleevec for 10% of Novartis’s price. India managing director Ranjit Shahani, said the company would now be cautious about investing in R&D activities in India. Industry leaders worried the Gleevec decision could cause the global patent system to unravel.

Jimenez was also considering whether Novartis had the right organizational structure for its global business: each of its six businesses had complete organizations in every country. This gave businesses greater autonomy and increased focus on their customers; however, the high cost of duplicative country and regional staffs was an impediment to profitability. While the structure seemed fully justified for the giant pharmaceutical business, it raised questions for the other units.

Finally, Jimenez questioned whether the back office structures in each country should be managed centrally, leaving front-line sales and marketing to the six divisions. Although experiments with centralized systems had resulted in higher costs, Jimenez was uncertain whether this was the result of the principle of centralized systems or ineffective execution.

Developing Global Leaders

Jimenez believed Novartis faced a major challenge in building its global leadership team for the future. In spite of its successful evolution from Swiss-dominated management, the shortage of leaders from emerging markets concerned him. “Two years ago we launched a project called “Lead” to take 20 high-potential emerging market leaders, and give them 18-month assignments working with the executive committee and on action projects,” he noted. “They come to Basel to learn our culture, and go back to their host country to function as local and global leaders.”

Reflecting on what was required to develop its cadre of global leaders, Jimenez felt they had to develop themselves along three dimensions: leading self, leading team, and leading the business. “When we assess Novartis leaders on self, teams, and business, self is the weakest,” he said.

We are injecting this leadership framework into our 360s review process from the entry level all the way to me. Leading self requires knowing your strengths and weaknesses, backstopping your weaknesses, and focusing your time on what’s most important. We have leaders who are great in motivating their teams, and great strategists who guide their businesses in very thoughtful ways, but struggle in leading themselves. By assessing people on those elements, we identify how to help them. For today’s leaders in such a complex world, leading self is an important aspect where we cannot afford outages. In the past, leadership was about execution. In the next 10 years leading self will be the most important for success.

Jimenez cited an example of why leading self matters. “We had an American who failed as a global leader because he thought he needed to spend his time and energy in the U.S. Instead, he should have been driving our smaller, emerging markets in other parts of the world. This requires an awareness of and respect for cultural differences and an appreciation of the potential of other

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countries. I’ve seen many people who aren’t global leaders because they can’t think beyond their home country. All decisions are steeped in that dominant culture.

Jimenez believed that physically living in different countries was critically important for the globalization of a leader. “When you take leaders out of their U.S. comfort zone and put them in a country like China or India,” he explained, “where they have to figure out how to buy groceries, go to the doctor, and exist in another country, we see powerful transformations in their self-awareness and respect for other cultures. As a result, they figure out how to grow their business using different business models than the ones they are used to.”

Brokatzky-Geiger noted that Novartis employed a high touch approach to its 360 review process. “We work with external professionals to interview executives, their peers and direct reports and have open discussions with them. The interviewers can ask questions that internal people cannot, giving us a better picture of their capabilities, often with very descriptive examples,” he explained. “Our accelerated development program for developing global leaders identifies top talent and sends them to areas where they haven’t worked before.” He added:

Sometimes we move people into commercial, development, or general manager roles. We use this targeted approach because everyone brings something different to the table. Everyone is missing some element required to be an outstanding global leader. In addition to developing expertise, global leaders need to be self-aware and understand their impact on their organizations, take feedback, and change their behavior when needed.

The Future

Looking to the future, Jimenez was clearly focused on his priorities: innovation, growth, productivity and organizational health. “My goal is to put us on a growth trajectory that is sustainable long after I am gone,” he said. He set up a special meeting with his executive committee to sharpen the focus on these goals and become the world’s leading healthcare company.

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Exhibit 1a Group Income Statement, 1996, 2002, 2006, and 2010 to 2012

1996 2002 2006 2010 2011 2012 Net sales $27,060 $20,887 $34,393 $50,624 $58,566 $56,673 Operating income 4,317 5,092 7,681 11,526 10,998 11,511 Net income 1,721 4,725 7,175 9,969 9,245 9,618

Basic earnings per share $1.84 $2.28 $4.28 $3.83 $3.93

Exhibit 1b Healthcase Portfolio Overview, 2012

Source: Company documents.

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