With Jeremy Levin now CEO of Teva Pharmaceuticals (TEVA), investors can expect more acquisitions for the biotech giant. In this article, I will run you through a DCF model on Teva and then triangulate the result with a review of the fundamentals against Novartis (NVS) and Merck & Co (MRK). I find Teva substantially undervalued even under low growth assumptions.
First, let's begin with an assumption about the top-line. Teva finished FY2011 with $18.3B in revenue, which represented a 13.6% gain off of the preceding year. I conservatively model 8.5% per annum growth over the next half decade or so. While I believe the company will yield around 200 basis points more, I factor this input into the model for the sake of proving my point.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 46% of revenue versus 23.8% for SG&A, 5.8% for R&D, and 5% for capex. Taxes are estimated at around 10% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around 0.2% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $61.33 for nearly 40% upside. The company trades below 10x my 2014 free cash flow estimate.
All of this falls within the context of excellent performance under a wider business transformation:
"The fourth quarter was our strongest quarter ever. Net sales reached $5.7 billion, growing by 28% over the fourth quarter of 2010. Quarterly operating profit was $1.7 billion with net income of $1.4 billion. This brought up to EPS of $1.59. Cash flow from operations during the quarter was strong, reaching a record $1.4 billion.
2011 was a year of major strategic achievements for Teva. Our strategy is focused on growth and creating a highly diversified business, and on reducing our dependence on any one particular market or product".
From a multiples perspective, Teva is cheap. It trades at 14.4x past earnings, but only 7.4x forward earnings. Corresponding figures are 15.2x and 9.8x for Novartis and 17.2x and 10.5x for Merck.
Consensus estimates for Novartis' EPS forecast that it will decline by 2.9% to $5.41 in 2012 and then grow by 3% and 12.9% in the following two years. Assuming a multiple of 12x and a conservative 2013 EPS of $5.52, the stock would hit $66.24 for 22.4% upside. Novartis offers a nice dividend yield of 4.5% and 42% less volatility than the broader market. With the stock trading at just 9.2x cash flow, the reward meaningfully outweighs the risk.
Consensus estimates for Merck's EPS forecast that it will grow by 1% to $3.81 in 2012, decline by 2.9% in 2013, and then grow by 8.6% in 2014. Assuming a multiple of 12x and a conservative 2013 EPS of $3.67, the stock would hit $44.04 for 13.4% upside. According to NASDAQ, the company is rated around a "buy", and this optimism is supported by a 4.3% dividend yield and 8.8x price-to-cash flow multiple. The firm has had good momentum and now trades near its 52 week high. While this could put many value investors on the sidelines, I don't think it will given the firm's brand and strategic opportunities in M&A.
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