By Mark Bern
Does the dividend really matter? Most investors have heard of Teva Pharmaceuticals (NYSE:TEVA), the largest producer and of generic drugs worldwide. But how many have heard of Watson Pharmaceuticals (WPI) which is in the same space? Both companies make and distribute primarily generic drugs, but both also offer branded drugs. Teva is about 4.5 times the size of Watson in terms of sales. Teva pays a small dividend while Watson does not. Can the smaller company take advantage of its smaller size by being more nimble? Can Watson grow faster because it has not yet turned into a bureaucratic mammoth? Has Teva lost its advantage by being too big or can it still wield its size efficiently and take advantage of more opportunities than its smaller peer? Let’s look at the two, compare the trends and find out.
Most of my analysis is based upon history and trends, but I also look into the qualitative aspect as well as I can to determine if there are advantages that could translate into higher growth rates for one company over another. I think it is worth pointing out that these two companies, while having similarities, also have some stark differences.
Near term concerns for both companies include integration of acquisitions into each company. Both companies have made significant acquisitions recently and how smoothly the transition goes as well as how much savings can be achieved from synergies will be very important to each. Teva’s acquisition of Cephalon increased 2010 sales of branded drugs from $4.6 billion to $7.0 billion and increased its proportion of sales coming from branded drugs relative to generics out a total of $16.1 billion in total sales. This move also reduced the share of sales from Teva’s largest sales-producing branded drug, Copaxone, from 70 percent to 47 percent. This helps diversify Teva’s branded drug revenues over a broader array of products. The company expects to achieve $500 million in annual savings from synergies and elimination of overlapping operations. Earnings from the acquisition should become accretive by the end of this year. Watson’s acquisition of Arrow in 2009 was strategic in another way as it provided the company with an expanded global footprint giving it access to new overseas markets. Both are on course to realizing expectations at this time.
One significant difference between the two companies is their structure. While very similar in many ways there is one major difference. Watson provides distribution services of over 3,500 products for more than 200 suppliers which accounts for approximately 23 percent of revenue. Generics sales account for about 66 percent of sales while 11 percent of sales are derived from branded drugs. Teva sales are split approximately 57 percent from generics and 43 percent from branded.
Watson produces and distributes about 160 generic drugs and 30 branded, while Teva has over 1,300 generics and about 22 branded drugs on the market. Obviously, Teva will face greater risk when Copaxone faces generic competition. Fortunately, both companies have strong pipelines, especially Teva (with the Cephalon acquisition) and both companies have significant expansion opportunities in their international operations. Teva alone has several new products ending phase III trials in 2012 and 17 more ending phase III trials 2013-2015.
Now let’s look at the numbers. Watson’s Return on Equity is slightly higher at 16.5 percent compared to 15 percent. Teva’s debt to equity level is significantly lower at about 15.9% percent compared to Watson’s 28.8 percent. The industry average is 27 percent, so Watson’s debt level isn’t really out of line. The higher ROE figure tends to make me believe that they are managing their debt fairly efficiently. Teva has the higher profit margin at about 24.5 percent compared to only about 13.4 percent for Watson while the industry average is 19 percent. Again the discrepancy is to be expected because of Watson’s greater concentration of sales in the lower margin arenas of generics and distribution services. The estimated book value per share is almost identical at 27.55 and 26.95 for Teva and Watson, respectively. Earnings per share have grown consistently for both companies over the last ten years, but at a higher rate for Teva (29 percent) compared to Watson (7 percent). Current year expectations are for a much higher increase for Watson (31.6%) compared to Teva (11.2%). Cash flows continue to grow nicely for each company over the past ten years, but Teva again has outpaced Watson by a significant degree in this area, growing an average 25 percent per year compared to 9.5 percent annual average. So far I have to give the advantage to Teva, especially for its long-term consistent track record in earnings and cash flows. But results over a more recent three-to-five year period begin to favor Watson.
Now we are about to delve into the meat of the analysis for me, looking at sales and dividend growth. I like dividends and increasing sales combined with stable or improving profit margins generally lead to rising dividends, the cornerstone of long-term investing. Teva currently offers the better yield of 1.7 percent compared to no dividend from Watson. Teva has a very low payout ratio at 18 percent compared to 40 percent average for the industry. That would tend to indicate that Teva still has plenty of flexibility to increase dividends going forward and is likely to be able to maintain the higher dividend yield. Sales for Watson have increased dramatically in 2011 and 2010, rising an estimated 26 and 27 percent, respectively, well above the company’s ten year average of 13.5 percent. Meanwhile Teva’s sales have grown 15 percent and 16 percent in 2011 and 2010, respectively, much more in line with its 10-year average growth rate of 16.5 percent. Going forward, I believe that both companies will slow their growth pace somewhat growing revenues near ten percent per year but I think Watson will increase the bottom line about two percent faster.
So, which one would I chose to own and why? Well, there is one more critical metric that I haven’t brought up thus far: Price to earnings ratio (P/E). While Teva sports a P/E of about 12 times trailing twelve months earnings, Watson’s P/E rate is 16.3. Watson’s long-term, historical average P/E is about 14, while Teva’s is 17. However, I don’t believe that Teva deserves a premium anymore and based upon Watson’s most recent sales growth record I might even consider giving it a slight premium to about 18 five years out. But I don’t think that the current P/E is sustainable over the next five years or longer. Thus, at their current respective price levels I believe that Watson offers the better value. And let's not forget the dividend!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.