The Importance Of A Maintenance-Free Moat

| About: Teva Pharmaceutical (TEVA)

In a previous article, I laid out my thesis that while many people have pronounced value investing dead, the only truly intelligent investing strategy is still buying shares in a company you understand for less than they're worth. You might ask why shares would ever trade for less than they're worth, but I assure you they often do. Value investing luminaries like Warren Buffett would tend to agree with me or they would have quit their day jobs and invested in index funds instead of attempting the supposed impossible of beating the market.

If you consider the flip side of this, you can certainly find many times in history when stocks have traded for much more than they were worth, notably the dot com boom. If overvalued stocks exist, then we can be fairly certain that undervalued ones persist in any market, even one like today that is beginning to see valuations a bit stretched.

Endless quantitative easing has caused a liquidity tidal wave that has raised all boats, especially the ones that aren't anchored down by pesky things like earnings. Stodgy value investors have looked foolish by missing out on story stocks like Tesla (NASDAQ:TSLA) and Netflix (NASDAQ:NFLX), not to mention a raft of cloud computing stocks led by (NYSE:CRM) and joined by Amazon (NASDAQ:AMZN), which has thrown its hat into another low-margin ring with Amazon Web Services.

While critics would say traditional value investors are myopic when it comes to the long term vision necessary to see the value contained in business models that need to lose ever increasing amounts of money to maintain dominance of their domain, the truth is we simply don't understand the businesses well enough to calculate their lifetime earnings power.

Will Tesla really overtake traditional automakers like its stock price foreshadows? Can Netflix and Amazon both benefit from the streaming video era they've ushered in without engaging in the mutually assured destruction of lowering prices in the face of rising content costs? Maybe, but for us these fall into the category of "too hard". Better to miss out on some potential gains than buy a business we don't understand, especially for more than it's likely worth.

So what type of businesses do we look for? Generally companies that are easy to understand and have durable competitive advantages, preferably ones that don't require much capital spending to maintain. Buffett's concept of a "moat" is a good analogy, and I would add that it's best to have one that's not leaking and doesn't have to be constantly refilled with capital spending. A strong brand name can create this type of impermeable barrier and will help a company generate steady, predictable earnings.

One cautionary tale that helps illustrate this is Teva Pharmaceuticals (NYSE:TEVA), a mostly generic drug maker. For a while, it didn't enjoy the name brand recognition enjoyed by some of the blockbuster drugs of their competitors, but they were able to generate tremendous earnings and cash flow by using their manufacturing know-how and scale to churn out lower priced alternatives once those drugs lost patent protection. This basically gave them all the benefits of a trusted name brand product but at lower research and marketing costs.

However, recently they have been moving into developing more proprietary offerings, such as their multiple sclerosis drug Copaxone. While this strategy can increase revenue by offering pricier products, it comes at the expense of increased research and development costs, not to mention additional testing and marketing costs to gain the trust of doctors and patients. At Teva, revenue had been growing at double digits for the past several years, but R&D and general selling costs have been growing even faster, which has led to declining GAAP earnings, from $3.67/share in 2010 to $3.09 in 2011 and $2.25 in 2012.

Perhaps because of this worrying trend, which has continued into the first half of 2013, with midyear earnings a mere 21 cents because of losses in the latest quarter, management and analysts have focused instead on non-GAAP earnings, which are tabulated by excluding certain items they deem "non-recurring", such as legal settlements, R&D write-offs, restructuring costs, and impairment charges, although some might argue that these are merely the cost of doing business as a pharmaceutical giant.

As top line growth has leveled off, it's tough for the company to slow the inertia of these other cost increases, even if they really are non-recurring, trapping the company in the Catch-22 of having to spend more to goose growth but falling victim to the diminishing returns these costs have seemed to have lately. Thankfully, management seems to have grasped this death spiral before the company completely stalls, accelerating layoffs and other spending cuts to try to achieve $2 billion in annual cost savings by 2018.

While these real cost savings are certainly preferable to the theoretical non-GAAP ones we've seen lately, they'll likely initially lead to additional restructuring costs that will again manifest themselves first in non-GAAP earnings, so investors should keep a skeptical eye on the actual GAAP earnings to make sure they really are showing improvement as well. If the spending cuts reach $1 billion a year by the end of 2014 and $2 billion by the end of 2017 as expected, we'd like to see GAAP earnings back over $3/share in 2015 and over $4/share in 2017 just on the strength of cost savings alone, even if revenue growth merely keeps pace with the remaining spending increases needed to maintain it.

At these earnings growth rates, if the company traded at a conservative PEG ratio of 1, the stock could command a share price of around $50 in 2015 and $60 in 2017, good enough for an approximate 10 percent annual return from today's price. Coupled with a decent 3 percent (and growing) yield, this still looks like an enticing value proposition, plus there's the additional upside if the company can maintain patent protection on some of their major drugs for longer than expected or even develop some new ones.

For if the company really is to return to its former glory, it will likely have to continue spending significantly to bolster its drug pipeline. Ironically, the company is now struggling against the same issue that bogged down competitors while their generic lines stole market share. I believe the market has overreacted to the specter of Teva losing patent protection on some of its major drugs, but it should serve as a warning to companies that leave their cozy castles to try to wade across competitors moats.

I still have faith in the long term viability of Teva as a hybrid branded/generic drug company that can flourish in an environment of continuing medical innovation but also rising health care costs. Therefore, I have bought shares in the company because I believe it is a good company at a wonderful price, but like Buffett says there's a higher state to aspire to on our way to investing nirvana, and in my next article I will try to find a wonderful business at a fair price.

Disclosure: I am 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: I am also short CRM through puts.

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