New Challenges to Teva’s Business Model

Includes: MNTA, NVS, SNY, TEVA
by: Israel's Financial Expert
Teva’s shares fell sharply on Friday after a generic version of Sanofi-Aventis's (NYSE:SNY) blood clot treatment drug (Lovenox) was approved. The news boosted the shares of Momenta (NASDAQ:MNTA), which is making the drug with Novartis (NYSE:NVS). Teva is also in the process of developing a generic version of its own. However, that was not the reason for the sharp fall in the share price of over 8% which is very uncommon among drug manufacturers. What spooked the market was the fact that the decision was seen as a sign the FDA is going to approve a generic version of Teva’s multiple sclerosis drug, Copaxone.

What drove Teva’s growth in the last 10 years?

Teva’s growth in the last 10 years was due to two main elements. The sale of one ethical drug, Copaxone, and the sale of a variety of generic drugs of which Teva enjoyed exclusivity after the patent of the ethical on which the generic drug is based has expired.

Both of these areas are currently going through a period of profound change. It is possible that these changes have already affected the share price of Teva, which fell from about $63 a share to the current price of $49. The main question is this: Will these changes affect Teva’s ability to maintain its profitability and growth rate that characterized it in last few years?

The contribution of Copaxone to the growth in Teva’s profit over the years

An important fact in the market for the treatment of multiple sclerosis is that none of the five main drugs that are sold in it actually cure the disease. Their main contribution to the patients is their ability to reduce the amount of strokes. Almost all of the patients that are treated with these drugs continue to suffer for a long period of time from a gradual deterioration in their condition.

As a consequence of this condition patients that are treated for a certain period of time with a specific drug arrive at a stage where the doctors that treat them try a different kind of drug. Besides that, a large number of the patients suffer from side effects that cause them to stop using the drug. The result is that there is a large potential of patients that in the future will approach a stage where they are not satisfied with the drug. That is the simple nature of chronic diseases. For a large portion of the patients it is just a matter of time before they will want to try a different kind of treatment.

These market characteristics haven’t harmed the growth in sales and earnings of the leading distributors of the drugs as long as there was a growth in the total number of patients that were using the different kinds of medicines. In other words, the growth in the number of patients outstripped the growth in the number of unsatisfied patients. Another important point is that these drugs are already being sold in Europe, the United States, and Japan where incomes enable the sale of the drugs at high prices. As a result, the growth in the market for these drugs may slow or even halt in the coming years. Moreover, certain companies may even experience a decline in earnings and sales.

These facts have more significance when a new drug enters the market. The ramifications of a possible entrance of a new drug on a market that has seen a dramatic slowing of the rate of growth is that a large number of unsatisfied patients may decide to try and use the new drug. In a market that is not growing rapidly it means a zero sum game, a game in which one company's gain is the others' loss.

If these threats materialize then the pricing of Teva as a growth stock may be harmed. Since the market will perceive that it would not be able to duplicate its growth in recent years.

The generic market

When the United States Congress made the law that enables the approval of the production of generic drugs without clinical experiments it did so to reduce the cost of developing the drug. Besides that, an economic incentive was created. Since generic drugs are not defended by a patent, they are basically a commodity that a large number of market participants can produce.

As a result, the profit in this kind of market may be so low, that there will be no economic incentive to produce and market these drugs. (Of course the same can be said about socks, but people continue to produce them, albeit at a very low profit margin. But never try to use logic when analyzing political decisions.)

So Congress made a law that gives generic manufacturers a six month period of exclusivity in the production and distribution of drugs. It is like a patent that prevents competitors from producing the same kind of product as the patent owner produces. The exclusivity is given to the first drug company that receives an approval for the distribution of a specific generic drug.

As a result of this piece of legislation there are two different drug manufacturers in the market: The producer of the ethical drug, which enjoys the protection of the patent and the generic manufacturer. The generic manufacturer can sell his product at a price which is a bit lower than the price of the ethical drug, since he does not have any other competition in the marketplace. The generic manufacturer can enjoy sharing the profits of a product which he did not develop in full, while enjoying monopolistic profit margins. It enjoys these margins without the need to bear the very high costs of R&D which are associated with the development of drugs.

What is going to characterize the generic market in the next few years is that a large number of exclusivity periods of generic drugs that enjoy sales of hundreds of billions of dollars are going to end. As long as those exclusivity periods do not expire a company like Teva, that managed to achieve an approval for a large number of drugs, will enjoy profit margins that are associated usually with monopolies. That is one of the reasons that Teva was able to achieve growth in both sales and profit that caused it to be priced as a “growth stock”. Another important fact to consider is that the pricing of Teva as a growth stock enabled it to increase its M&A activities, thus further increasing the growth in sales.

What enabled such fantastic results for generic manufacturers is the decision on behalf of the ethical manufacturers not to reduce the price of their own drugs meaningfully, in order not to harm their own sales. This decision has enabled generic companies like Teva to share with the ethical producers their monopolistic profits during the exclusivity period.

It seems as if there is no reason for the manufacturers of ethical drugs to change their behavior. However, precisely because the generic market has grown so much and since most of the sales of drugs in the United States are done through insurance companies, there might be an incentive for the ethical companies to make their own generic versions or to reduce the price of the ethical drugs to a level that will take significant market share from producers of the generic ones.

Why such a change in the behavior of the manufacturers of ethical drugs? The more the number of expiration of patents of ethical drugs grows, the more the generic drug market grows. It is true that the profit margins in the generic market (after the exclusivity period) is very low compared to those in the ethical market but the absolute size of the generic market has grown to a size that still has a profit potential of tens of billions of dollars. This potential grows every year as more and more ethical drugs lose their patent protection.

It is important to notice that most of the profits of the large producers of ethical drugs come from a small amount of drugs. If they are not able to produce and market new drugs that will replace the drugs that lose the patent protection, they may see a dramatic fall in earnings. It is very hard to succeed over a long period of time to develop every year new drugs that will replace the sales of existing drugs that lost their patent protection. It is also hard to develop new drugs whose effectiveness will justify their high price.

Thus, the market size of ethical drugs may stop growing at a time when the generic market continues to do so. We are approaching the moment where the absolute profits of the generic market will be as large as that of the ethical one. (Especially when taking into consideration the high cost of R&D which is associated with the development of ethical drugs.)

As a result, a large number of ethical manufacturers may need to reconsider their business model. They may decide to manufacture generic drugs as well, especially generic variations to ethic drugs that they themselves developed.

As mentioned before, most of drugs that are sold in the United States and in other places in the world are distributed through agreements with insurance companies. The insurance companies decide for their clients what kind of drug they are willing to finance through the insurance agreement. They tend to sign agreements with companies that can offer a large variety of drugs, especially the generic ones, which are cheaper.

The more the ethical companies leave the sale and marketing of the generic drugs to the generic companies and the more generic market grows, the more the generic companies develop a competitive advantage in the marketing and sale of drugs to insurance companies.

If the market conditions of the drug industry justify a change in the behavior of ethical producers during the exclusivity period it may decrease substantially the profit from the production of generic drugs. Especially for companies like Teva that succeeded in creating a large sequence of approvals.

As a result, the ability of Teva to achieve growth in both sales and earnings may diminish permanently, which will harm its pricing as a growth stock. Moreover, its profits may suffer due to two changes in the drug market which are beyond its control. If over a long period of time it will become apparent that the concerns from such developments were just, the pricing of the stock will reflect the new reality and the P/E ratio will fall substantially. If the sales of Teva will fall in absolute terms, as opposed to a fall just in the rate of growth, then the companies’ ability to continue to grow through mergers and acquisitions will diminish substantially, thus further putting pressure and the share price. The company may not be able to continue to grow through acquisitions that are financed through the issuance of more shares.

Disclosure: Don't hold Teva's shares