Making The Case For Teva

| About: Teva Pharmaceutical (TEVA)


Teva Pharmaceuticals has been in stagnation mode for several years.

Its lead profit center, Copaxone, is under imminent threat from generics.

Yet, it has turnaround characteristics, and Copaxone may turn out better than feared.

Overall, I rate TEVA as a reasonable "buy" here to gain exposure to secular growth trends at a low valuation, with the possibility of a takeover if operations go poorly.

Background: While biotech and biopharma companies are sexy for investors, generics dominate the drug products that people actually put in and on their bodies.

The world's largest generic company, Teva Pharmaceutical Industries (NYSE:TEVA), has grown by acquisition and now has numerous competencies, which run the gamut from basic small molecule tablets and capsules all the way to biotech proteins known as biosimilars. Because of the diversity of its product lines and territories in which it operates, Teva is a pharmaceutical company that many individuals and funds can own to gain representation in the industry.

It looks to me as if TEVA is well-positioned to surge. Having sold the stock in 2010 in the high $50s, due to the company losing more than one major lawsuit but suggesting to investors that those losses were not operating losses, I've recently gotten back in this name for reasons that I discuss below. My core thesis is that the stock is making up for years of stagnation, and while there is clear downside risk, the upside potential is greater - and includes takeover possibilities if operations do not make a clear turn for the better.

Introduction: Teva, which means "nature" in Hebrew, traces its roots to 1901. The modern Teva was formed by merger in 1976. It received FDA manufacturing approval in 1982, which was the year it IPO'ed on Nasdaq. The company has grown internally and by numerous mergers and acquisitions to become both the world's largest generic manufacturer, as well as the largest manufacturer of active pharmaceutical ingredients. Wikipedia features a concise review of Teva's history. It's worth reading to allow an appreciation of the scope of Teva's growth and to think of the challenges involved in integrating that growth while headquartered in little Israel, remote from the major markets the company serves.

One reason is that despite all the costs, debt and stock dilution from its growth strategy, as far back as the Yahoo Finance stock chart goes, TEVA has had a total return of 21%-22% since the early 1990s. This is despite the stock having stagnated for the past five years:

Splits: Apr 14, 1993 [2:1], Feb 23, 2000 [2:1], Dec 6, 2002 [2:1], Jul 1, 2004 [2:1]

I prefer to buy into companies with an overall record of strong success, and TEVA fits that bill. The rest of the story is operational, not thematic, and is presented by segments.

1. Copaxone: This product for multiply sclerosis was discovered in Israel years ago. It represents about 20% of Teva's sales and perhaps half its pre-tax profits. Thus, I am going to discuss it at some length. The legal story is complicated, and I will try to get it right.

Copaxone is also known as Copolymer 1. This alternate term explains the first three letters of the brand name. The 'axon' in the name refers to the part of a nerve cell that is surrounded by a myelin sheath. Thus, "Copaxone" suggests that the active drug works on/protects the myelin that is required for healthy neural function. Myelin gets damaged in MS, causing lesions and disability. Copaxone improves the situation over time in remitting-relapsing multiple sclerosis, RRMS. The discovery process was interesting:

Originally developed to mimic myelin basic protein, a major component of the neuronal myelin sheath, it was intended for use as an inducer of experimental autoimmune encephalitis (EAE). The unexpected inhibition of EAE that was observed with glatiramer acetate led to clinical trials and subsequent approval for RRMS.

Note that the name glatiramer involves an acronym. The "glat" part of the chemical name for Copaxone refers to the four amino acids that form dozens of peptide chains of variable length. These amino acids are glutamic acid, lysine, alanine and tyrosine.

Copaxone was approved by the FDA in the mid-'90s, and has become the most commonly-prescribed treatment worldwide for MS. It is now the subject of complex litigation and regulatory maneuvering regarding going generic in the U.S.

The details of how Copaxone works are not fully known. The precise starting materials and formulation methods are trade secrets. Copaxone is a complex mixture of peptides. For these and other reasons, Teva argues that a generic equivalent to Copaxone cannot be approved solely on the basis of chemical analysis, and that a clinical trial is required for the FDA to approve an ANDA. Teva has adopted an aggressive approach with the FDA, suing it before the FDA has even approved an ANDA. In the same time frame, Teva has sued the ANDA applicants Sandoz and Mylan (NASDAQ:MYL) for violating its Orange Book-listed patents, the last of which expires in September 2015. Sandoz is a division of Novartis (NYSE:NVS). The developer/manufacturer of the Sandoz product is Momenta Pharmaceuticals (NASDAQ:MNTA). Mylan similarly partners with an Indian company, Natco, for its product. I believe that a Synthon ANDA is pending as well, which is discussed below.

As matters stand now, the FDA is free to approve one or both of the Sandoz or Mylan ANDAs for Copaxone, but has not. If it does approve either generic for marketing, the company that markets it will be doing so "at risk" because, to add to the complexity, the Supreme Court has agreed to hear Teva's request that the Appeals Court wrongly invalidated its Copaxone formulation patent (which runs until September 2015).

Whether either Mylan or Sandoz would launch at risk has not been disclosed, to my knowledge.

Teva has not been standing still with Copaxone. Until recently, the product was given subcutaneously, 20 mg in one milliliter. Teva first reformulated to give 20 mg in 0.5 ml, and was forced to do a clinical trial to get that formulation approved by the FDA. It then did another clinical trial and showed that 40 mg in 1 ml given three times weekly was safe and effective for RRMS. That dose and method treatment is protected by a U.S. patent that runs until 2030. Therefore, Teva has been switching patients rapidly to the more convenient 3X/wk regimen. It may have converted 35% or more of its Copaxone patients to this regimen. How far the conversion rate will go by the time a generic comes to market is unknowable, but it could be quite meaningful and could preserve the franchise.

Over time, Copaxone will tend to lose market share to newer, oral therapies, such as Biogen Idec's Tecfidera, but it could remain a mainstay of Teva's financial returns to shareholders for years to come. Over the years, Teva has jacked the price up substantially faster than inflation as it has provided increasing proof of clinical benefits. A year's supply of Copaxone is said to cost in the range of $60,000 or more at retail (critics of Sovaldi's cost, take note).

The uncertainties with Copaxone just in the U.S. are quite numerous. The FDA might ultimately refuse to approve a generic to Copaxone, based on chemical data. It might approve only Synthon's, which is running a large clinical trial and which states that results to-date are positive for its product's clinical equivalence to Copaxone. Competitors may or may not launch at risk. Teva's patent protection on the 40 mg thrice-weekly formulation may well be tested in court, with an uncertain outcome. Then, there are rest of world sales to consider, along with changes in MS treatment.

It is likely that much of the improved prospect for the Copaxone franchise is reflected in TEVA's move from the $40 range to the current $55, and overall, I think we need to look at the rest of the company to decide whether this stock is a buy. Overall, the evolving Copaxone story is a positive, in my view.

2. Other Teva brands: Teva has other brands focusing on CNS and pulmonary, as well as women's health and others. More important, in my opinion, it has announced that it is going to make a big push to become a specialty pharmaceutical company. In the U.S., that means using the 505(b)(2) regulatory process. Adjusted for risk, Teva anticipates that its new therapeutic entities will provide $3 B in revenue by 2020, with the potential for $5 B without adjusting for development or commercial failure. Amongst these are a family of abuse-resistant opioids. Another is an improved injectable version of the antipsychotic, risperidone.

Putting this ambition together with the possibility that the Copaxone franchise could have further durability, we should begin thinking of Teva as a specialty pharma company as much as it is a generic company. I am positive on TEVA, in part because of this initiative. I think it is an ideal use of the company's strengths, and also that it scales not just in the U.S., but worldwide.

3. Biosimilars: While the FDA has made biosimilars very expensive and Teva has moved away from the field, it does have certain competitors to biotech products such as Neupogen and Neulasta on the market in the U.S. (Granix) and in the E.U. For the most part, this is not going to be a growth area for Teva, at least in the U.S.

4. Generics and active pharmaceutical ingredients: This segment bids fair to increase its profit share. With all the acquisitions and intense competition coming out of Asia, principally India, Teva's margins have declined. It intends to cut costs significantly. It certainly has a very broad product line that provides it commercial advantages. If it indeed can take a billion dollars a year out of its cost structure, it will not only automatically gain in profit margin, but it will be able to bid more aggressively for new business, so its sales may be enhanced as well.

Remaining dominant and increasing profitability in the API and generic fields is a critical part of the Teva story. Some of the formulation and manufacturing expertise it develops for the generic products gets used in its brands, and vice versa. The effort to improve operating margins is essential to Teva remaining an independent and growing company. Given its economies of scale and recognition of the scope of the problem, Teva will, in my best guess, succeed well enough to meet the expectations of investors, which, as a renewed investor, I hope are not very high at this point.

5. Organizational: Teva has had challenges at the top that have gone along with a flat profit trend the past several years. Those changes involved both the CEO and a sudden change in board chairmanship, when former CEO Eli Hurvitz died in 2011 and vice chairman and former IVAX CEO Dr. Phillip Frost acceded to the chairmanship of Teva. This January, a new president and CEO, Erez Vigodman, was appointed to replace acting president and CEO, Eyal Desheh. Mr. Vigodman has been a director of Teva since 2009. Acting CEO Desheh, in turn, had replaced as CEO, a man who had been recruited into Teva from Big Pharma, Jeremy Levin, and whose tenure at Teva was brief. That saga was reported on by Bloomberg News in 2012, and includes the following:

Teva Pharmaceutical Industries Ltd. Chief Executive Officer Jeremy Levin stepped down after less than 18 months on the job in a dispute with Chairman Phillip Frost over how to restructure the world's biggest generic-drug maker.

Teva's American depositary receipts fell the most in more than two years after the company said Levin and the board agreed he would leave. The departure of Levin raises concern Teva, which this month said it would fire 10 percent of its workers, is "a very dysfunctional organization," David Maris of BMO Capital Markets told Frost on a conference call.

It has now been announced that Dr. Frost will be stepping down before his term as chairman ends, around year-end.

All this can be viewed positively. I would assume that Mr. Vigodman will either become chairman or will have an ally as chairman, and will have the full support of the board. As we know, in business, there may be different strategies that can work, but a house (business) divided against itself does not do wonders for the stock price. I own TEVA on the anticipation that the evolving cup formation is not a fake-out, but is the real thing.

Financials: TEVA has a market cap about $47 B, at a stock price of $55/share, on about $20 B in sales. There is long-term debt of about $10 B and about $3 B in net working capital. The stock would be around $70 if it sold at its average price:sales ratio that it enjoyed in 2006, and around $90 if it reached its peak 2006 P:S ratio. Of course, Copaxone was much younger then, and the stagnation in profits that was to come, and associated management disarray, could not have been predicted.

When looking at EPS, everyone can decide how much they want to look at GAAP versus non-GAAP earnings. Non-GAAP EPS for Q1 were $1.22. Of that, the major discrepancy between it and GAAP earnings was non-cash depreciation for intangibles and goodwill. Given that important companies such as CVS Caremark (NYSE:CVS) routinely add those charges back to GAAP earnings, I'm OK with something close to $1.22 as a good estimate of "real" earnings.

For a mature company such as Teva, free cash flow resonates with me as a key metric. Value Line predictions for 2014 and 2015 suggest that FCF will reach or exceed $5 per share, using the definition of FCF that subtracts capital spending from "cash flow" but not subtracting dividends. Thus, if TEVA is at $55 and FCF were $5 (all data per share), TEVA is trading at only 11X FCF, or about a 9% yield. The dividend yield, currently 2.5%, is subtracted from that. This generous FCF yield is likely making allowance for declining cash flows due to Copaxone problems. In contrast, TEVA traded on average around 20X FCF, or only a 5% FCF yield.

Teva has paid dividends at least since 2000. The most recent quarterly dividend was 34.7 cents. This appears secure and suggests around a 2.6% current yield.

The main message I take from Teva's financials is that it is a relatively cheap asset with substantial upside potential in its trading price if the Street's perceptions of its future were to change for the better. In contrast, even if things stayed as they are, or deteriorated, the FCF yield is quite forgiving. Remember, a 30-year Treasury bond has a FCF yield of 3.6% or so. TEVA's FCF yield, as I calculate it, is around 9%, and no one is going to make a takeover bid for a T-bond at a big premium, but that might happen for TEVA.

Industry trends: One of the Big Pharma companies to look to for where the rest of the industry is, or should be, going is Pfizer. Pfizer has developed its Greenstone generic division to where it has a respectable 5.4% of the U.S. market, and is expanding its generic business internationally.

As the richer countries in the world see aging populations, generic drugs is a growth industry in terms of units, as are lower-cost specialty drug products that Teva increasingly intends to specialize in. So the underlying trends are in Teva's favor. Even if they are slow, they appear to be inexorable.

The implication I take from this is that Teva is a marketable company, and that Big Pharma will have broad interest in acquiring it if it were to be shopped around. Whether the Israeli government would put oppressive conditions on the sale of this important company is not known to me, however.

I suspect that either Teva succeeds in its growth strategy, or it will be seriously in play, which ultimately would tend to support its stock price.

Technicals: TEVA is up about 8% and 6% in the past 1 and 3 months, respectively, which together, I take as a negative in the short run. It has surged over the past year, and given its long-term chart, that strikes me as a strong positive - though there are no guarantees that looking at charts tells us anything of value regarding future price action. Overall, I like the long-term technicals of the chart, as shown above, as far as the chances of this name working its way to all-time highs one way or another, within a reasonable time frame.

Risks: There are many risks and uncertainties regarding TEVA, starting with Copaxone. Beyond that, the entire brand strategy is uncertain, and thus the proper P/E to give that part of Teva is up in the air. The generic and API businesses are commodity businesses, and any advantage that Teva may gain even by rapidly gaining operating efficiencies could be transient.

The management disarray may be ending, or perhaps it is not and more turmoil could follow. Buying TEVA after it has run from the high $30s to the mid-$50s may be trend-following at the wrong time, including for general market reasons, should we finally be at or near a peak for stock prices overall.

While Teva receives a top-ranked '1' for Safety by Value Line, I think that the current valuation leaves the shares riskier than that ranking usually implies.

Conclusion: TEVA shares have been immensely successful since the early 1990s, with several concave upward moves that carried the stock impressively to new highs. After a period of stagnation which saw TEVA go nowhere from 2005 until 2014, it is reasonable to entertain hope for improved operations on multiple fronts, and for a resumption of stability in the executive suite and on the board. At the same time, TEVA is a relatively cheap asset with a very satisfactory free cash flow yield. So, there appear to be several ways to win with this equity, and should things go badly with the company, I would look forward to a bidding war, should it look for a suitor.

Disclosure: The author is long TEVA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Not investment advice. I am not an investment adviser.