When Teva Pharmaceutical (NYSE:TEVA) acquired the Actavis generic drug business from Allergan (NYSE:AGN) in August 2016, the Company not only paid a big financial price ($40.5 billion using $33.75 billion cash and $6.75 billion in TEVA's stock), but it also paid a big operational price. The US Federal Trade Commission would only clear the transaction after TEVA agreed to divest one or more strengths of 79 different drugs. Most of these 79 drugs were products already in direct competition with each other, but 19 of them were drugs in development as alternatives to an existing branded product and another nine were in markets with at least one other generic competitor.
TEVA needs revenue from that generics portfolio to offset an expected decline in sales of multiple sclerosis drug Copaxone, the Company's lead product. Leading up to the Actavis generics deal, Copaxone were 20.8% of TEVA's LTM top line. In Q3'16, one year after the Actavis deal closed, Copaxone sales still accounted for 19.1% of total revenue. But the drug's FDA exclusivity period ends Thursday (January 28th) and generic copies of the now standard 40mg dose will hit the market next month. Management's strategy was to acquire significant new sources of revenue even as it sued in court to invalidate the FDA applications for generic versions of Copaxone. Management successfully executed on its acquisition strategy, but has had more mixed results with its legal maneuvers. Competitors successfully invalidated three of TEVA's patents through inter partes review. TEVA is appealing the decision.
See graph below of projected TEVA specialty drug product sales. Consensus estimates for TEVA's Copaxone sales this year are around $3.6 billion. But management still forecasts $3.8 to $3.9 billion even as it concedes two new competing generic alternatives of the 40mg dose could cut into that higher estimate. Generics could garner $1 billion (or more) of sales revenue this year and, within three years' time, reduce Copaxone sales by 50%. For FY'20 the consensus estimate for Copaxone is down to $2.1 billion. TEVA would not be under so much pressure if sales of the Company's other top specialty drugs were headed higher. But as you can see from the graph below, projected trendlines for its other key products - Treanda, ProAir, QVAR, and Azilect - are also downward sloping:
See Segment Information table below. TEVA's generics segment develops, manufactures, sells and distributes generic or branded generic medicines plus active pharmaceutical ingredients. This segment includes the Actavis generics and over-the-counter medicines business. The specialty segment develops, manufactures, sells and distributes branded specialty medicines, including medicines for the central nervous system (e.g. Copaxone) and respiratory indications (e.g., QVAR), women's health, oncology and other specialty businesses. Per the table below, generics revenue has been increasing while specialty revenue has been sliding:
Generics revenue has been offsetting the decline in specialty revenue, but, for that trend to continue, Copaxone sales cannot suddenly fall off a cliff. They very well might this year and, as noted above, the Company is not getting much help from its other key specialty drugs.
A second point is that profit margins are significantly higher from selling specialty pharma products than from selling generics. Hence, the best way for TEVA to improve profitability is by significantly increasing the number of generics it brings to market. See Segment Profit Information table below. As can be gleaned from comparing revenues in the table above and profits in the table below, in the most recent quarter, generic gross margin was 50.5% while specialty gross margin was up at 87.1% and generic operating margin was 29.9% while specialty operating margin was up at 53.6%. Both price and volume matter. TEVA management's intention is to protect the price of Copaxone through the courts, on the one hand, while hiking up generic volumes on the other. The combined impact would be to increase generics revenue faster than specialty revenues decline:
Ah, but the road to good intentions is paved with hell. TEVA's purchase of Actavis generics didn't instantly marginalize the Copaxone exclusivity expiration problem or the falling sales trends for other specialty pharma products. Here's the rub. TEVA's best chance of generating higher revenue depends on how successful management is at launching new generics and its best shot at accomplishing that task depends, in turn, on whether the Company has "first-to-file" status in settled cases.
A quick explanation. Under the Drug Price Competition and Patent Term Restoration Act (a/k/a, the Hatch-Waxman Act), a company can seek approval from the FDA to market a generic drug before the expiration of a patent relating to the brand name drug for which the generic is based. The first company to submit an Abbreviated New Drug Application (or ANDA) with the FDA has the exclusive right to market the generic drug for 180 days.
Back to TEVA. First-to-file status is a major factor in determining the future success of TEVA's generics business. For example, its biggest potential sales gain would come from launching a generic version of cholesterol drug Zetia. That would set the Company up for an estimated $828 million in sales under a first-to-file scenario. But it's questionable whether TEVA will have first-to-file status with which to launch a Zetia generic. Without first-to-file status, the associated revenue potential may not crack $100 million in the first year of the launch. In other cases, first-to-file status is more likely but the timing of legal activity may delay launching the generic version. For example, first-to-file status for a generic version of Viagra could be worth $555 million of first year annual revenue and a first-to-file generic version of Viread (for Hepatitis B) could generate another $360 million. Unfortunately, the Viagra and Viread generics may not be launched until very late in Q4'17.
TEVA lowered its FY'17 guidance primarily to reflect delays in generic launches even as it continued to assume Copaxone would not face generic competition in the US this year. The revised guidance forecasts FY'17 revenue of $23.8-24.5 billion, gross margin of 57-58%, R&D expenses of $1.75-1.85 billion, sales and marketing expenses of $3.40-3.55 billion, and general and administrative expense of $1.0-1.1 billion. Those estimates lead to a forecast for operating income of $7.4-7.8 billion, cash from operations of $5.7-6.1 billion, and free cash flow of $6.3-6.7 billion. Consensus estimate for EBITDA this year is $8.2 billion. See Financial Information Summary table below. Free cash flow would effectively rise by 37% from the LTM period through Q3'16, but at the cost of much higher 5.9x net leverage.
The Debt. TEVA now has $36.9 billion of outstanding debt on its balance sheet, including $3.6 billion of short-term debt. Interestingly, neither Moody's nor S&P has reviewed their Baa2 or BBB rating, respectively, on the senior unsecured debt since before the Actavis generics deal was announced last August and both agencies continue to list the outlook as stable. That seems odd given the significant increase in net leverage. In addition, the Company is facing increasing debt repayment obligations over the next three years even as it loses one of the key contributors to its top line. There are $550 million of revolving credit loans, $6.6 billion in term loans (denominated in both US Dollars and Japanese Yen), and $27.9 billion of bond principal (denominated in Euro, US Dollars, and Swiss Francs). The closest maturity is the $567 million equivalent of Yen denominated Term Loan A which matures in June of this year. But the size of debt repayments coming due moves significantly higher over the next two years. In FY'18 there's $2.2 billion equivalent of bond maturities and $303 million equivalent of term loans that come due. Debt repayments peak in FY'19 when $3.1 billion equivalent of bond principal and $2.8 billion of term loans mature.
It's curious that the rating agencies continue to view TEVA as a stable credit even as net leverage sharply increased and the composition of its underlying business changed significantly. Consensus estimates for FY'16 imply $7.4 billion EBITDA in FY'16 and $8.2 billion in FY'17. That implies leverage of about 5.0x and 4.5x, respectively. Assume cash on the balance sheet continues to clock in at about $1.5 billion and net leverage would be about a quarter turn lower.
TEVA's Term Loans aren't cheap. The $2.5 billion Teva Pharmaceutical USA, Inc. Delayed Draw Term Loan B is guaranteed senior unsecured in ranking (and no floor) but pays only LIBOR + 112.5 basis points. The company's two most widely traded bonds are the unsecured TEVA 3.15 Senior Notes '26 and 4.10 Senior Notes due '46. At recent trade prices of 92.71 and 86.11, they yield 4.07% and 5.00%, respectively. Their Z-spreads are +173 basis points and +244 basis points, respectively. Those also look rich. Viz the TEVA '26 notes, that Z-spread is tighter on average than where comparably rated bonds from Allergan, Mylan (NASDAQ:MYL), or Perrigo (NASDAQ:PRGO) trade. AGN 3.80s due '25, MYL 3.95s due '26, and PRGO '26 notes carry Z-spreads of +157, +240 and +207, respectively. Viz the TEVA '46 notes, that also tighter on average than where AGN 4.75s due '45, MYL 5.25s due '46 and PRGO 4.90s due '44 have been trading. The Z-spreads for those instruments at their most recent trade prices are +225, +312 and +287, respectively.
Net leverage is lower at AGN and MYL and higher at PRGO for the LTM period. The net leverage metrics for those three pharma companies is 0.8x, 4.4x and 7.8x, respectively (PRGO's senior notes are the lowest rated at Baa3/BBB- and Moody's placed the credit on Outlook Negative in August 2016). At a minimum, however, the TEVA '26 and '46 paper should be no richer than where the MYL '26 and '46 paper. The implication is that at Z-spreads of +240 and +312, the TEVA '26s and '46s would be trading at 87.63 and 77.40, respectively. That's about 5.0 points and 8.75 points lower, respectively, than where they presently trade.
See graph below showing price histories for TEVA's bank debt, bonds, and common. The two most popular TEVA bond issues are highly correlated with the Company's common stock (r-squared 88% over the past six months), which implies that any significant change in the price direction of the equity will have a real impact on the prices you see for the Company's debt. In other words, even if the bonds look overpriced for their rating and credit metrics, if management can successfully launch the 80 generics it plans for this year, the common stock should then recover and take the bonds back up too.
Preferred Stock. TEVA has more going on in its capital structure than just multiple currency instruments issued by a holding company and three different subsidiaries domiciled in three different countries. The TEVA 7 Mandatory Convertible Preferred Shares are another interesting instrument (and class of security) within the complex. You can read through the associated prospectus for these preferreds by clicking on the following link.
Or, should you favor retaining your eyesight, you can read through this summary. Let's start with their par amount. The preferred shares have a liquidation preference of $1,000 per share. That makes them more of an institutional investment versus retail preferred shares issued with $25 par amounts. The holders list demonstrates what happens when a preferred stock requires paying a high price per share to participate: at least 67% of the outstanding shares are held by institutional accounts. The concentration among this group on institutions is also high - the top 5 of them own 41% of the issue. Don't let that deter you though.
TEVA 7 Preferred are more complex than retail preferred stocks too. They are mandatorily convertible on 12/15/18 into a variable number of TEVA ADRs. The conversion ratio takes the price of the average volume-weighted price per ADR over a specific consecutive 20 trading day period. That period begins on and includes the 22nd trading day immediately before 12/15/18 (the mandatory conversion date). So, using a 2018 calendar and translating that back into English, let's put it this way: the number of TEVA common shares mandatorily converted on 12/15/18 will calculate the conversion ratio using the average-volume weighted price per ADR on each of the trading days beginning November 14th and ending December 14th of 2018.
See graph of the TEVA 7 Preferred and Common Stock below. The conversion settlement rate is 13.3333 shares per preferred unit if the average ADR price during that 20-day period is equal to or greater than $75.00 and 16.0000 shares per unit if the average ADR price is equal to or less than $62.50. For average volume-weighted prices between $62.50 and $75.00 the mandatory conversion rate will be $1,000 divided by that average price. The preferred shares are convertible any time at the holder's option into 13.3333 shares of common stock.
There are some other complications related to M&A activity or other events defined as "fundamental changes" in the prospectus. If a fundamental change occurs, holders can elect to convert any TEVA 7 preferred shares during the fundamental change effective date, in which case Preferred Shares will be converted into the issuer's ADRs at the fundamental change conversion rate and converting holders will also be entitled to receive a fundamental change dividend make-whole amount and accumulated dividend amount, payable in cash or ADRs, at the issuers' discretion.
Let's ignore the potential upside and focus on the worst case. TEVA common is currently trading below $34 per ADR so unless the Company is acquired (a fundamental change), its ADR price will have to increase markedly between now and November 14th of next year to move the mandatory conversion ratio from 16 per unit. A conversion ratio of 16 equates to paying 62.50 per ADR or 13.7% more than where the equity is trading because parity on the preferred instrument is 34 * 16 = 544 per preferred unit.
Holders will receive eight quarterly preferred dividend payments of $17.50 per share or $140 between now and 12/15/18. The TEVA 7 Preferred recently traded at $622 per $1,000 face. So unless TEVA defaults between now and 12/15/18, preferred holders will receive $140 in dividends over the next two years. Their basis in the preferred shares would effectively be reduced to $482 per unit or an 11.4% discount to parity. On the other hand, the TEVA Common Stock is paying a 4.06% dividend yield, so if the plan is to buy the TEVA 7 Preferred and hedge with the very highly correlated Common Stock (six-month r-squared 99%), the investor will be paying out $0.34 per share quarterly dividends over the same eight-quarter period. That will put the basis in the preferred position back up to about $504 per unit, or just a 7.4% discount to parity. Net, net, the TEVA 7 Preferred looks a bit cheap based on the technicals, but could prove quite expensive if the TEVA Common Stock continues to drop between now and its maturity date of 12/15/18.
The Common. You can see where I am headed with this. The fixed income components within the TEVA debt complex appear to be either yielding too little (the bank debt), spreading relatively too thin (the bonds), or will only look like a buy if management succeeds at obtaining first-to-file status for its generics launch program and then launches those generics without further delay (the bonds and preferred). Does TEVA Common Stock valuation reflect the potential vagaries in the timing of the generics launch program…?
The TEVA Common Stock is riskier than average largely because of the re-working of its product portfolio. Prior to the Actavis generics transaction, historical 30-day volatility on the TEVA Common Stock was below 20%. That statistic more than doubled after the deal was announced, and although it's seen periods of relative calm, the volatility peaked at 51% at the end of last year and is still running about 32% as of this writing. By comparison, the S&P 500's 30-day volatility was around 12% when the Actavis deal was struck, peaked at 29% in September 2015 and currently runs around 5%. So, while TEVA equity has generally seen greater volatility than the broader market, it's seeing relatively more volatility of late, a consequence of disappointing results and lowered guidance.
See TEVA Valuation Multiples Comparison table below. TEVA Common Stock trades at a 29% discount to the average P/E for the other generic pharma companies. But looked at with respect to TEVA's estimated revenue and EBITDA for this year, the valuation looks right in line with the average for the comps. The revenue valuation multiple at 11.9x is just a smidge below the mean and the 9.1x EBITDA multiple is a few percentage points premium to the mean.
To buy TEVA equity you need not also buy into management's rosier assessment of potential Copaxone competition if, on the other hand, its generic product launches receive the first-to-file opportunities that would significantly move the Common Stock valuation higher. I can understand making that bet - at worst, you're buying in at a market multiple for a pharma company. I can also understand betting on the mandatory preferred using the same rationale - you might even be getting a bit of a discount. What I can't understand is why investors would want to own TEVA's debt at today's prices given higher leverage and greater uncertainty of cash flows.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.