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We bought Teva Pharmaceutical (TEVA) stock recently close to $ 10-$ 11/share earlier this month. Shares are up >20% since we bought them but could have more upside.
Why shares are in decline since 2015:
Investors who have been following the generics drug industry in general, and this company specifically, must be aware of the various issues summarized below.
- The blockbuster drug for multiple sclerosis Copaxone represents about 45% of Teva’s EBITDA and bears are betting that the approval of its generic version by Mylan (MYL) would result in the loss of this revenue stream. Copaxone had $ 1B sales in Q3 2017 and accounts for 25% of the company’s $ 20B in annual sales.
- The generic drug industry overall has been under regulatory scrutiny like the DOJ investigation of drug pricing. Teva is one of the drug makers under investigation. The investigation is for charges like 8 of the 10 drugs with the biggest price hikes in 2014 were generic drugs (Medicare data).
- Some of the other brand names of Teva like Azilect and ProAir are also facing patent cliffs.
- Teva has $ 35B of debt on its balance sheet after a $ 40B acquisition of Allergan’s (NYSE:AGN) generics business. The acquisition has been widely criticized with respect to the price paid and the timing when the regulatory pressures on the generics industry are tightening.
- On November 7, Fitch downgraded Teva’s credit rating to junk, resulting in a big decline in the stock. Bears are betting that Teva will have troubles paying off its debt obligations if the interest rate on its debt increases due to credit rating downgrade (when combined with a decline in future revenue).
Turnaround efforts: a new CEO with a successful track record
Teva appointed Kare Schultz as the new CEO in September. The new CEO Kare Schultz announced plans for reorganizing the company as part of the restructuring efforts. Rather than having two separate divisions for generics and specialty medicines, there will be a single organization, which will be divided into geographical divisions: North America, Europe and Growth Markets. Each of these geographical regions will manage generics, specialty, and OTC products. The company also announced plans for laying off 25% of its workforce in Israel.
The separate R&D divisions for generic and specialty organizations have been combined into a single global R&D division, which will focus on specialty and generic divisions. A new Marketing and Portfolio Division will work across different geographical regions. We expect cost synergies and reduced operating expenses as a result of these reorganization efforts.
(Teva’s new organizational structure)
A more detailed restructuring plan will be announced in mid-December (something to watch out for since it could be a stock price catalyst).
Notably, Mr. Schultz has a history of a successful turnaround at Lundbeck, which he returned to profitability.
New management changes are bullish
Dr. Hafrun Fridriksdottir was newly appointed as Executive Vice President, Global R&D. She served as Senior VP and President of Global Generics R&D at Allergan. She also served as Senior Vice President, R&D for Actavis (bought by Teva).
Michael McClellan was newly appointed as Executive VP and CFO of Teva and importantly, will oversee Business Development efforts (and future acquisitions). He also served as the U.S. CFO for Sanofi (SNY).
Details of more management changes can be read here.
What are the company’s strengths?
The generics business acquired from Allergan has some of the best products in the space. Through this acquisition, Teva acquired Actavis U.S. and international generic commercial units, third-party supplier Medis, global generic manufacturing operations, the global generic R&D unit, Allergan’s international OTC commercial unit (excluding OTC eye care products), etc.
While the price paid for this acquisition has been criticized, Teva’s former CEO Erez Vigodman’s intentions seem right. While Teva was originally a generics company, the success of Copaxone made it a combined generics+specialty drugs company. With Copaxone’s patent cliff looming, Mr. Vigodman intended to return Teva to its generics roots through this large acquisition whose true worth would only be apparent in few years. As this article rightfully points out, the margins have been shrinking in the generics industry and profitability is only possible through economies of scale (through consolidation and acquisitions).
Teva had either the option of making a large acquisition or getting itself acquired. Moreover, the deal was the only way for Teva to fight the growing dominance of its rival Mylan in the generics business. Teva’s management estimate for cost savings was $ 1.5 billion per year. The deal was also expected to have less antitrust issues compared to a similar deal between Allergan and Mylan.
Newer drugs in the pipeline have the potential to make up for some of the revenue losses due to Copaxone. Fremanezumab, an anti-CGRP antibody, which is planned for migraines, could reach peak $ 1 billion in sales (global anti-CGRP antibody market is estimated to be $ 6-7B in size). Austedo, a new medication to treat involuntary movements called chorea in Huntington’s disease is expected to reach peak $ 1.3 billion in sales.
It is like buying Valeant below $ 9/share
I remember bears betting that Valeant (VRX) will go to zero with a similar story playing out a year ago. We all know what happened after that. Valeant changed its CEO, sold assets to pay down the debt, launched restructuring efforts and shares have almost doubled in less than a year. Investors are getting another similar opportunity to get in Teva’s stock at its current lows.
VRX data by YCharts
A Holiday season discount on Teva’s common stock
The table given below shows Teva’s forward relative valuation metrics (using Wall Street consensus: Thompson Reuters).
The forward P/E ratio for Teva is very low compared to the mean for the pharmaceutical sector (21.2) as per NYU-Stern data. Teva’s 5-year mean P/E ratio is 25.
EV/EBITDA may be a better way to perform relative valuation for Teva (since it accounts for debt) and is lower than the mean for the pharmaceutical sector (13.27). Please note that the EBITDA erosion from Copaxone generics is factored in with the declining EBITDA estimates. Teva’s stock has traded at EV/EBITDA as high as 39.1 in the past 10 years. Our own EBITDA estimates are also in line with consensus.
Teva’s debt is manageable and the concerns over the debt covenant breach are overblown
From the recent quarterly report:
“In September 2017, Teva amended certain terms of these loan agreements, including increasing the maximum permitted net debt to EBITDA ratio. As of September 30, 2017, Teva was in compliance with all applicable financial ratios and expects that it will continue to have sufficient cash resources to support its debt service payments and all other financial obligations for the foreseeable future. However, Teva may experience lower than required cash flows to continue to maintain compliance with its net debt to EBITDA ratio covenant within the next twelve months. Teva believes it will be able to renegotiate and amend the covenants, or refinance the debt with different repayment terms to address such situation as circumstances warrant.“
The management outlined plans to tackle debt in the recent quarterly earnings call.
In brief, the current selloff appears an overreaction to a combination of factors like Copaxone’s patent cliff, concern over Teva’s ability pay off its debt, lowered guidance by the management, etc. On the other hand, it is a perfect setting for a large-cap, dividend-paying, diversified contrarian investment with a few years’ time frame. At the current all-time market highs, there are not many large-cap biotech/pharma investments, which I would have confidence that they could double in the next 3-4 years.
Teva, on the other hand, seems to have limited downside here and hit by investor overreaction. Such investor overreactions can provide some of the best buying opportunities as we have seen with our past experiences with Tobira Therapeutics (NASDAQ:TBRA), Juno Therapeutics (NASDAQ:JUNO), Portola Pharmaceuticals (NASDAQ:PTLA) and Alnylam Pharmaceuticals (NASDAQ:ALNY). With a new CEO in the driver’s seat, we are optimistic about the success of the turnaround efforts and expect the stock to hit $ 20-$ 25 in the next 3-4 years. As the Oracle said: ‘Buy when there is blood on the streets.’
Initiation rating: Buy, price target = $ 25.
Risks: Generic industry remains under pressure due to regulatory investigations. Teva is also facing litigation risks like anticompetitive practices. Our price targets may not be achieved. An equity raise by the company to pay off debt could put downward pressure on the stock in the near term.
Disclosure: I am/we are long TEVA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article represents my own opinion and is not investment advice.
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