Teva Pharmaceuticals (TEVA) is the latest addition in my long / short portfolio, a portfolio that has served me well with a year to date return of 49%. While I don't particularly like investing in slow growers, I do occasionally pick some that pay me good dividends and trade at a significant discount to their intrinsic value.
Stocks of this kind that have contributed to the significant appreciation of my portfolio for the year, include the likes of European banks ING (NYSE:ING) and BNP Paribas (OTC:BNPZY) Thanks to Mr. Market, I bought them two days after the Brexit vote at half their book value. Barclays (NYSE:BCS) also did well for me but the returns were constrained by the sterling depreciation.
Now that I needed to put a bit of new money to work in this overheated market, I really struggled to find compelling investment ideas. I therefore decided to put the return of my capital, ahead of fascinating returns on capital and opted for Teva Pharmaceuticals. While the company faces a number of well documented challenges, I believe that these have largely been baked in and at the current price levels the stock has investment merit for patient investors like myself that invest on a 5- to 10-year horizon.
Teva's Generic Business
The pharmaceutical industry includes innovators focusing on branded drugs and manufacturers that focus on affordable versions of these innovative drugs once they go off patent. Naturally the profit margins for the latter are significantly lower, as they should be. I bet that most of you consider Teva as a generics player, and there is a good reason for this.
Source: Moody's Investors Service
Teva is indeed the largest global generic drug company and the recent Allergan Generics Acquisition, confirmed their role as the primary consolidator in the industry. In 2015, revenues from the generic segment amounted to approximately $9.5 billion, or 49% of the total revenues. Gross profit from that segment amounted to approximately $4.5 billion, or 39.6% of the total gross profit. In terms of profitability, Teva's profit margins from their generic business come at a respectable 50% gross margin and 30% operating profit margin which many manufacturing companies in other sectors would envy. After the acquisition, Teva's generic segment is expected to post revenues of around $15.0 billion that will be significantly greater than its competitors, representing a market share of approximately 7.5%. Going forward, the company will therefore be more dependent than ever on the generics business.
Generic drug makers had been the darlings of Wall Street for quite some time but this is no longer the case. I attribute this to two main reasons: i) the furore over drug prices and ii) pricing pressures due to the due to the consolidation of generic drug purchasing power among major buyers (Governments, Insurance Companies, PBMs etc). These headwinds have indiscriminately pulled down the valuations of pharmaceutical companies across the board. I'm however of the opinion that not all pharmaceutical companies are created equal and therefore deserve to be treated the same. Teva is the market leader for a reason, and as such it has some unique advantages. Their size and global geographical coverage (their combined generic business after the Allergan acquisition will have a commercial presence across 100 markets, including a top three leadership position in over 40 markets), will offer them stability and good negotiating leverage with pharmacies and drug distributors. Their pipeline is also very strong and will help offset price erosion. As such, the management are 'very confident' that the recent price erosion they experienced in the US (around 7% in a market that represents more than 50% of their sales) will remain in the mid-single digits as per the guidance.
When it comes to the crackdown on drug prices, Teva side with the good guys and are part of the solution rather than part of the problem by offering affordable drugs. Despite being opportunistic when they can, they have predominantly grown not by hiking prices, but by constantly bringing new drugs into the market. This is in their DNA and I expect this trend to continue due to their good track record in operational execution. Ultimately I do therefore believe that while faster approval times for drugs will spell bad news for some pharmaceutical companies, they will benefit Teva with their strong product pipeline (they now have more than 2,000 product registrations pending approval around the world). In the next 12-24 months Teva will launch alternative products to NuvaRing, Viagra, Axiron, Byetta, and many others that will help offset price erosion. Generic Epipen is also still on track for 2018.
Another major factor that attracted me to the stock are the good long term fundamentals of the sector as a whole. Overall demand for generic drugs will grow globally as more people have access to healthcare (particularly in emerging markets, the rest of the world segment that Teva wants to grow). It will also grow as insurers, governments and individuals will look for ways to reduce the ever increasing healthcare costs. It was good to see that during the last conference call, the management reiterated their belief on the long term fundamentals of the generic business pointing to the fact that short-term volatility will always show in the generics business, but over the long-term they see profitability and growth. They see this business growing mid-single digits going forward and I have no reason to doubt them as the long term fundamentals of the generics business look good.
The real risk for Teva: Profit concentration on Copaxone
Teva has now become a battleground stock and $20bn of their market cap have been wiped out. Conduct Issues (well documented in other SA articles) and the challenges they face in the generics segment have surely contributed to Teva's share price getting halved. The single largest culprit however is Teva's profit concentration on Copaxone, their injectable multiple sclerosis (NYSE:MS) branded drug that faces increased competition from orally administered therapies and a competing generic version. Even after the acquisition of the Allergan Generics business, Copaxone is expected to generate approximately 15% of revenues and one-third of operating profit. That is a huge contribution from a single drug which puts the current profitability level at risk. To put things into perspective their MS franchise profitability was $3.1 billion, $3.2 billion, and $3.3 billion in 2015, 2014 and 2013, respectively. Profitability of their multiple sclerosis franchise as a percentage of Copaxone revenues was 77%, 75% and 76% in 2015, 2014 and 2013, respectively. Copaxone on its own generates sales of $1bn every quarter. New oral treatments, such as Tecfidera by Biogen, Gilenya by Novartis, and Aubagio by Genzyme, provide intense competition in light of their substantial convenience in comparison to an injectable such as Copaxone. As Teva's patents on Copaxone 20mg/mL have expired, a competing generic version of the product was also launched in the United States. Copaxone also continues to face competition from existing injectable products as well as from the two monoclonal antibodies Tysabri and Lemtrada.
Teva's business strategy for Copaxone relied heavily on the continued migration of a substantial percentage of current daily Copaxone patients to a new 40mg/mL, three-times-a-week version and the maintenance of patients on this new version. The strategy has been successful and more than 80% of Copaxone patients in the US are now on the new 40 mg/mL version. In Europe, Teva are experiencing similar conversion rates as they have seen for the U.S and now over 60% of the prescriptions have moved to the 40 mg/mL version. The 40mg version is protected by five patents, three of which were found invalid by the Patent Trial and Appeal Board after a petition by Mylan (NASDAQ:MYL) (a bigger holding in my portfolio with better growth prospects than Teva but does not however pay a dividend). If all of Teva's patents are invalidated and generics receive FDA approval, then Teva may also face generic competition on the 40 mg/mL version sometime in 2018. That is much sooner than 2030 where the product is supposed to go off patent. While the product has so far proven resilient, when a generic new 40 mg/mL version comes out patients may be automatically switched into that, to save cost.
In addition to Copaxone, Treanda, Nugivil , Azilect and Pro Air (drugs representing close to 10% of Teva's revenue) could face loss of exclusivity over the next several years. Their whole branded business is therefore under heavy fire, although there are promising new products tackling migraine, Huntington disease, and chronic pain. These have been covered in sufficient detail in previous SA articles.
For 2016, Teva's management expect net sales of $21.6 million to $21.9 million and diluted non-GAAP earnings per share of $5.10 to $5.20. Next year's EPS Consensus Estimate is $5.91. For 2018, management had guided for EBITDA of $10bn to $10.8bn assuming no generic competition for Copaxone 40 mg. I do believe that these estimates may be revised downward, but even in a stressed scenario where 2018 EBITDA falls to $8bn, the stock still looks good value for me. There may also be some upside as Teva expect significant synergies from the Allergan Acquisition targeting $1.4 billion by the end of 2019. The company is also targeting a generic Epipen launch by early 2018.
While leverage has shot up as a result of the Allergan Generics acquisition and is expected to peak at around 4.7x Adjusted Debt / Ebitda, the company will generate at least $3.5 billion of free cash flow after capital expenditures. As a result, adjusted debt/EBITDA is expected to decline to around 3.5x by the end of 2017 (before any generic competition on Copaxone 40mg).
This low multiple and depressed valuation implies that the Street no longer considers Teva as a company that can grow revenues and profits. While their branded business (contributing more than half of their profits) is clearly under pressure, I do have faith in the long term prospects of the company and I believe that most of the bad news have already been discounted. The good dividend yield should also support the stock from further significant declines. After all, Teva have paid dividends on a regular quarterly basis since 1986.
At current price levels (south of $40), I do therefore think that the stock has investment merit for the patient investor, and I would be willing to add to the position opportunistically if the stock declines further. In an overheated market where slow growers can earn P/E multiples of 15-20, I can think of worse investments.
Disclosure: I am/we are long TEVA, MYL.
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.