Disclosure of APMs, purpose, uses, reconciliations, limitations

Novartis AG – Annual report – 31 December 2018

Industry: pharmaceuticals

Operating and Financial Review and Prospects (extract 1)
Non-IFRS measures as defined by Novartis (extract)
Novartis uses certain non-IFRS metrics when measuring performance, especially when measuring current-year results against prior periods, including core results, constant currencies, free cash flow and net debt.

Despite the use of these measures by management in setting goals and measuring the Group’s performance, these are non-IFRS measures that have no standardized meaning prescribed by IFRS. As a result, such measures have limits in their usefulness to investors.

Because of their non-standardized definitions, the non-IFRS measures (unlike IFRS measures) may not be comparable to the calculation of similar measures of other companies. These non-IFRS measures are presented solely to permit investors to more fully understand how the Group’s management assesses underlying performance. These non-IFRS measures are not, and should not be viewed as, a substitute for IFRS measures.

As an internal measure of Group performance, these non-IFRS measures have limitations, and the Group’s performance management process is not solely restricted to these metrics.

Core results
The Group’s core results – including core operating income, core net income and core earnings per share – exclude fully the amortization and impairment charges of intangible assets, except software, net gains and losses on fund investments and equity securities valued at fair value through profit and loss, and certain acquisition-related items. The following items that exceed a threshold of USD 25 million are also excluded: integration- and divestment-related income and expenses; divestment gains and losses; restructuring charges/releases and related items; legal-related items; impairments of property, plant and equipment, and financial assets; as well as income and expense items that management deems exceptional and that are or are expected to accumulate within the year to be over a USD 25 million threshold.

Novartis believes that investor understanding of the Group’s performance is enhanced by disclosing core measures of performance because, since they exclude items that can vary significantly from year to year, the core measures enable better comparison of business performance across years. For this same reason, Novartis uses these core measures in addition to IFRS and other measures as important factors in assessing the Group’s performance.

The following are examples of how these core measures are utilized:
• In addition to monthly reports containing financial information prepared under IFRS, senior management receives a monthly analysis incorporating these core measures.
• Annual budgets are prepared for both IFRS and core measures.

A limitation of the core measures is that they provide a view of the Group’s operations without including all events during a period, such as the effects of an acquisition, divestments, or amortization/impairments of purchased intangible assets and restructurings.

Constant currencies
Changes in the relative values of non-US currencies to the US dollar can affect the Group’s financial results and financial position. To provide additional information that may be useful to investors, including changes in sales volume, we present information about our net sales and various values relating to operating and net income that are adjusted for such foreign currency effects.

Constant currency calculations have the goal of eliminating two exchange rate effects so that an estimate can be made of underlying changes in the consolidated income statement excluding the impact of fluctuations in exchange rates:
• The impact of translating the income statements of consolidated entities from their non-US dollar functional currencies to US dollars
• The impact of exchange rate movements on the major transactions of consolidated entities performed in currencies other than their functional currency

We calculate constant currency measures by translating the current year’s foreign currency values for sales and other income statement items into US dollars, using the average exchange rates from the prior year and comparing them to the prior-year values in US dollars.

We use these constant currency measures in evaluating the Group’s performance, since they may assist us in evaluating our ongoing performance from year to year. However, in performing our evaluation, we also consider equivalent measures of performance that are not affected by changes in the relative value of currencies.

Free cash flow
Free cash flow is presented as additional information because management believes it is a useful supplemental indicator of the Group’s ability to operate without reliance on additional borrowing or use of existing cash. Free cash flow is a measure of the net cash generated that is available for debt repayment and investment in strategic opportunities, and for returning to shareholders. Free cash flow is a non-IFRS measure, which means it should not be interpreted as a measure determined under IFRS. Free cash flow is not intended to be a substitute measure for net cash flows from operating activities
as determined under IFRS.

Novartis defines free cash flow as net cash flows from operating activities and cash flows associated with the purchase or sale of property, plant and equipment, as well as intangible, other non-current and financial assets, excluding marketable securities. Cash flows in connection with the acquisition or divestment of subsidiaries, associated companies and non-controlling interests in subsidiaries are not taken into account to determine free cash flow.

Net debt
Net debt is presented as additional information because management believes it is a useful supplemental indicator of the Group’s ability to pay dividends, to meet financial commitments, and to invest in new strategic opportunities, including strengthening its balance sheet. Net debt is a non-IFRS measure, which means it should not be interpreted as a measure determined under IFRS. Novartis defines net debt as current and non-current financial debt less cash and cash equivalents, current
investments and derivative financial instruments.

Novartis Cash Value Added
Novartis Cash Value Added (NCVA) is a metric that is based on what the Company assesses to be its cash flow return less a capital charge on gross operating assets. NCVA is used as the primary internal financial measure for determining payouts under the Long-Term Performance Plan introduced in 2014. More information on NCVA is presented as part of the Compensation Report; see “Item 6. Directors, Senior Management and Employees—Item 6.B Compensation.”

Additional information
EBITDA
Novartis defines earnings before interest, tax, depreciation and amortization (EBITDA) as operating income, excluding depreciation of property, plant and equipment (including any related impairment charges) and amortization of intangible assets (including any related impairment charges).

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Enterprise value
Enterprise value represents the total amount that shareholders and debt holders have invested in Novartis, less the Group’s liquidity.

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1 Restated to reflect the product transfers between Innovative Medicines and Alcon that was effective as of January 1, 2018
2 For financial instruments accounted for as fair value through profit and loss, as of January 1, 2018, unrealized gains/losses on financial assets are shown under “Financial assets – fair value adjustments”, due to the change in IFRS 9 (see Note 1).
3 Earnings per share (EPS) is calculated on the amount of net income attributable to shareholders of Novartis AG.

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1 Restated to reflect the product transfers between Innovative Medicines and Alcon that was effective as of January 1, 2018
2 Adjusted for charges of USD 0.3 billion in 2016 related mainly to devaluation losses in Venezuela
3 Earnings per share (EPS) is calculated on the amount of net income attributable to shareholders of Novartis AG.

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1 Amortization of intangible assets: cost of goods sold includes amortization of acquired rights to in-market products, and other production-related intangible assets; research and development includes the amortization of acquired rights, including technology platforms; income from associated companies includes USD 444 million for the Novartis share of the estimated Roche core items
2 Impairments: cost of goods sold, selling, general and administration and research and development include impairment charges related to intangible assets; research and development also includes impairment reversals of property, plant and equipment; other expense includes impairment charges related to property, plant and equipment; cost of goods sold and other expense include impairment charges related to a disposal group held for sale for goodwill and currently marketed products
3 Acquisition or divestment of businesses and related items, including restructuring and integration charges: cost of goods sold, selling, general and administration, research and development and other expense include charges related to acquisitions; other income and other expense include transitional service fee income and expenses, and other items related to the portfolio transformation; income from associated companies includes the pre-tax gain of USD 5.8 billion on the sale of the 36.5% investment in GSK Consumer Healthcare Holdings Ltd.
4 Other items: cost of goods sold, selling, general and administration and research and development include charges and reversal of charges related to a product’s voluntary market withdrawal; cost of goods sold, other income and other expense include net restructuring and other charges related to the Group-wide rationalization of manufacturing sites; cost of goods sold, selling, general and administration, research and development, other income and other expense include other restructuring income and charges and related items; cost of goods sold and other expense include charges related to changes in a contractual agreement; cost of goods sold also includes inventory write-off and other product recall-related costs; selling, general and administration includes a reversal of a provision; research and development includes fair value adjustments of contingent consideration liabilities, a charge for onerous contracts, and amortization of option rights; other income and other expense include fair value adjustments and divestment gains and losses on financial assets; other income also includes product divestment gains, divestment gains on property, plant and equipment, releases of accruals and a legal settlement gain; other expense includes legal-related items and restructuring charges; income from associated companies includes an adjustment of USD 21 million for the Novartis share of the estimated GSK Consumer Healthcare Holdings Ltd. core items
5 Taxes on the adjustments between IFRS and core results take into account, for each individual item included in the adjustment, the tax rate that will finally be applicable to the item based on the jurisdiction where the adjustment will finally have a tax impact. Generally, this results in amortization and impairment of intangible assets and acquisition-related restructuring and integration items having a full tax impact. There is usually a tax impact on other items, although this is not always the case for items arising from legal settlements in certain jurisdictions. Adjustments related to income from associated companies are recorded net of any related tax effect. Due to these factors and the differing effective tax rates in the various jurisdictions, the tax on the total adjustments of USD 329 million to arrive at the core results before tax amounts to USD -1.0 billion. Excluding the gain on the sale of the 36.5% investment in GSK Cosumer Healthcare Holdings Ltd., the tax on the total adjustments of USD 6.1 billion to arrive at the core results before tax amounts to USD 1.1 billion. The average tax rate on the adjustments excluding this transaction is 17.4%
6 Earnings per share (EPS) is calculated on the amount of net income attributable to shareholders of Novartis AG.

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1 Amortization of intangible assets: cost of goods sold includes recurring amortization of acquired rights to in-market products and other production-related intangible assets; research and development includes the recurring amortization of acquired rights for technology platforms; income from associated companies includes USD 376 million for the Novartis share of the estimated Roche core items
2 Impairments: cost of goods sold and research and development include impairment charges related to intangible assets; research and development and other expense include impairment charges related to financial assets; research and development, other income and other expense include reversals and charges related to the impairment of property, plant and equipment
3 Acquisition or divestment of businesses and related items, including restructuring and integration charges: other income and other expense include transitional service fee income and expenses, and other items related to the portfolio transformation
4 Other items: cost of goods sold, other income and other expense include net restructuring and other charges related to the Group-wide rationalization of manufacturing sites; cost of goods sold, research and development, selling, general and administration, other income and other expense include other restructuring income and charges and related items; selling, general and administration includes an income from the release of a provision; research and development includes fair value adjustments to contingent consideration liabilities; other income and other expense include legal-related items; other income also includes a gain from a Swiss pension plan amendment, product and financial asset divestment gains, a partial reversal of a prior period charge, income from a settlement of a contract dispute and a fair value adjustment to contingent consideration sales milestone receivables; other expense also includes a provision for contract termination costs, a charge for onerous contracts, and an amendment to the Swiss pension plan; income from associated companies includes an adjustment of USD 150 million for the Novartis share of the estimated GSK Consumer Healthcare Holdings Ltd. core items
5 Taxes on the adjustments between IFRS and core results take into account, for each individual item included in the adjustment, the tax rate that will finally be applicable to the item based on the jurisdiction where the adjustment will finally have a tax impact. Generally, this results in amortization and impairment of intangible assets and acquisition-related restructuring and integration items having a full tax impact. There is usually a tax impact on other items, although this is not always the case for items arising from legal settlements in certain jurisdictions. Adjustments related to income from associated companies are recorded net of any related tax effect. Due to these factors and the differing effective tax rates in the various jurisdictions, the tax on the total adjustments of USD 4.4 billion to arrive at the core results before tax amounts to USD 760 million. The average tax rate on the adjustments is 17.1%.
6 Earnings per share (EPS) is calculated on the amount of net income attributable to shareholders of Novartis AG.

Operating and Financial Review and Prospects (extract 2)
Free cash flow
Novartis defines free cash flow as net cash flows from operating activities and cash flows associated with the purchase or sale of property, plant and equipment, as well as intangible, other non-current assets and financial assets, excluding marketable securities. Cash flows in connection with the acquisition or divestment of subsidiaries, associated companies and non-controlling interests in subsidiaries are not taken into account to determine free cash flow. For further information about the
free cash flow measure, which is a non-IFRS measure, see “Item 5. Operating and Financial Review and Prospects—Item 5.A Operating results—Non-IFRS measures as defined by Novartis—Free cash flow” above. The following is a summary of the free cash flow:

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Operating and Financial Review and Prospects (extract 3)
Group net debt
Net debt constitutes a non-IFRS financial measure, which means that it should not be interpreted as a measure determined under International Financial Reporting Standards (IFRS). Net debt/liquidity is presented as additional information, as it is a useful indicator of the Group’s ability to meet financial commitments and to invest in new strategic opportunities, including strengthening its balance sheet.

Group net debt consists of:

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