Last years patent cliff saw 40 solid brand name drugs lose exclusivity. These products represented $45 billion worth of annual sales. With the Supreme Court reviewing a "pay for delay" case (where pharmaceutical companies pay generic producers to delay production), the downside has been nasty for investors. Therefore, I recommend considering investing in generic producers and those focused on high reward opportunities. Below, I present two such companies, my take on their risks and opportunities, and my conclusion on their stock fundamentals and value potential.
Teva Pharmaceutical (NYSE:TEVA) Needs A Catalyst
In an effort to cut costs, Teva is planning to reduce the number of employees and save $2 billion on the bottom-line before the end of 2017. Now they are planning to reduce the number of locations and transform others into centers, where each will have a primary industry role. At the same time, Teva is maintaining market share, but Copaxone, their multiple sclerosis treatment, represents 30 - 50% of profit and believed to have peaked last year in sales. While some have expressed fears about the Copaxone exclusivity loss in 2015, I find that the company's pipeline has yet to be fully appreciated. The firm has 15 late stage products under development as of 4Q12. And at 7.1x forward earnings and a free cash flow yield of 7.1%, the stock is cheap. While other biotechs have soared over the past 6 months, Teva is actually closer to its 52-week low (6.4% above) than it is to its 52-week high (14.4% below).
But, as a cautious investor, I often like to focus on the downside. To be sure Israeli company faces several competitive headwinds. Perhaps the biggest is related to a lawsuit with the US FDA over Biogen's multiple sclerosis BG-12 product, which will be a direct competitor to the company's flagship Copaxone product. The lawsuit asks the agency to better evaluate BG-12's safety profile, but it is really, in my view, intended to just delay approval and buy time. But even after the Biogen's product has penetrated the market, Teva's Copaxone is likely to remain the undisputed market leader. After recently missing expectations on both the top- and bottom-lines in the fourth quarter, shareholders are much more likely to jump ship if it becomes clear that Copaxone's profit will dip even faster than anticipated.
In addition, Teva has stopped development of a $300 million distribution center in Philadelphia. All of this falls within the context of the company trying to slash expenses and sell off assets, like the divesture of the domestic animal health business to Bayer HealthCare. With investors focused on the downside, the bar has been set low, in my view, for positive surprises.
It's The Growth, Stupid: Why Teva Should Look Towards Small-Cap Biotech For Ideas
Ultimately, the company is likely to look towards smaller companies for ideas. Teva's management has spoken about buying companies with teams that can run themselves. The CEO, Mr. Levin, implemented a "pearl-of-strings" takeover strategy over at Bristol in order to drive growth into a slowing company. He can be expected to do similarly at Teva. While I don't expect any major buyout announcement, the company is likely to explore high-growth niches all the same. There are several companies it can look towards for ideas on new high-growth R&D technology.
Plandai Biotechnology (OTCQB:PLPL), for example, is a bioavailable plant extract producer that is developing a product to prevent malaria symptoms. The product, a green tea gallate catechin extract, is supported by three separate studies that have demonstrated the antimalarial efficacy of ECG and EGCG, green tea catechins. Plandai's product provides 6 to 8 times greater bioavailability compared to traditional extracts and could potentially serve as an antimalarial agent. 500 million worldwide suffer from malaria infections, so the market potential is significant.
Similarly, Endocyte (NASDAQ:ECYT) offers significant market potential in the cancer and inflammatory disease spaces. It is rated "outperform" by RBC and creates small molecule drug conjugates, "SMDCs", and complementary imaging diagnostics. The company's lead SMDC targets one of the most frequently over-expressed folate receptors in tumors. This kind of proprietary technology may be speculative, but it has carryover value in a variety of indications ranging from kidney and breast cancers to lung and endometrial cancers. This breadth minimizes downside while being potentially a "gamechanger".
The patent cliff has certainly created a silver lining for generic producers. Over the last 12 months, Mylan's stock price appreciated by nearly 30%, which outperformed the NASDAQ by around 2,000 bps. Pipeline successes, such as the FDA approval for Dilantin tablets based on a Pfizer (NYSE:PFE) seizure treatment and the FDA approval of Rizatriptan tablets based on Merck's migraine treatment, have kept investors glued to the upside. With the stock now trading at 18.9x past earnings, the question now turns to whether the company can continue to excite the market after such a bull run.
To keep the momentum going, Mylan is now investing in its Irish division with a plan to add in over 500 jobs. There have also been rumors speculating that the company is eyeing the ~$2 billion acquisition of Agila Specialties, a producer of injectable medicines, antibiotics, and cancer treatments. The company has also increased its share repurchase program to up to $500 million following the credit rating upgrade from Ba1 to Baa3 by Moody's. Meanwhile, the pricing outlook for EpiPen sales has started to improve.
I am also optimistic about the firm's expressed interest in acquisitions and geographical expansion. It is rumored to be considering transactions worth well north of $4 billion. The specific strategy is to takeover specialty drugs that diversify the range of delivery and build upon the core pill business through the takeover of topically applied drugs.
Stock Fundamentals and Conclusion
In terms of risk/reward, I believe Teva is better positioned for upside. Its forward earnings multiple is at a 20% discount to Mylan's, which is largely a result of greater free cash flow erosion over the past 5 years. In fact, Teva's EPS has fallen by a rate of 1% over the past 5 years while Mylan's has risen by 10%. But, just like nothing gold can stay, no biotech company can always deliver transformative growth. It happens at certain moments.
Teva has proven itself adept at making coherent transactions. Billionaire Chairman Phil Frost gave the company new life through the sale of Ivax--a deal that made him arguably the most successful healthcare investor of modern time. With Levin at the helm, the company is looking to transform itself through technology plays. Mylan, meanwhile, faces growing and growing competition from industry-wide consolidation that is cornering the market. It therefore is unreasonably trading at a 25% premium to Teva, which--absent any preferential multiple expansion--offers a 100 bps greater expected return of 11% when dividend yields are factored in. It is true that Teva suffers from investor fatigue, but it can dissipate that bearish sentiment by exploring R&D similar to those pursued by small-cap producers seeking high upside. Fortunately, management is set on that course. Accordingly, I strongly recommend buying shares in Teva over Mylan.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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