Teva: Value Trap

Summary

• Teva's debt downgrade looks likely to be on the cards.
• Management has little control over its financials.
• The stock might actually be overvalued.

Investment Thesis

I was previously bullish Teva (NYSE:TEVA) while not being a shareholder. Now, I'm totally bearish but ended up being a shareholder. Which is ironic. Teva's Q3 2017 results were so much worse than I had been expecting. Well, not so much their results, but its guidance and management's total inability to understand and forecast their business.

In my previous article, a few weeks back, I wrote,

Teva could generate recurring cash flow in 2017 of $4 billion, down from the original $4.4-4.6 billion in its August forecast. Then, for 2018, its cash flow could have a run rate of $3 billion - a realistic estimate once competition for Copaxone has had time to properly ramp up their own sales.

Yesterday's results show that this forecast of mine was just too optimistic. No matter how conservative I tried to be at $4 billion in cash for the full year 2017, in hindsight, it was nothing short of fallacious. The company's outcome is, now just too speculative.

Its Debt Position

Let's face this squarely on. In spite of Teva shedding several assets which the company claims are non-core, these will only bring in $2.3 billion by the end of Q4 2017. While these asset sales are significantly higher than they were originally earmarked to bring in, nevertheless, this cash is just a drop in ocean.

Further compounding issues, is the fact that management no longer believes that Teva will be able to substantially bring down their debt in 2017. Originally, $5 billion was estimated to be brought down. In the earnings call yesterday this figure has now been revised downwards to $3.5 billion to $4 billion. Having a bit better understanding of Teva's inability to forecast its own cash flows, let me assume that in the best case they pay off $3.5 billion - which should not be too hard, since they are already bringing in $2.3 billion from asset divestments. Therefore, with the understanding that Teva needs some liquidity in its balance sheet, together with these debt repayments assuming to occur by the end of 2017, the company will have a net debt position of approximately $31 billion by the end of Q4 2017.

Debt Downgrade

While I do not agree with the circular reasoning with which others on SA have argued their valuations; when all is said and done, it makes little difference. Since a downgrade on its debt appears highly likely, as well as imminent.

Source: TEVA4384552

Seen as how Teva's bonds were trading on the last notch of investment grade already - Moody's Rating Baa3 - combined with the response from the debt markets, which is depicted above, I can reasonably assume that its debt will now become non-investment grade. Which immediately translates to higher costs of borrowing (25 basis point increase upon a notch downgrade), therefore, less free cash flow available to pay back the principle. Even if Teva does bring down its debt by $3.5 billion in Q4 2017, it still has another $2 billion maturing in 2018 - assuming that Teva uses the $3.5 billion to pay down the most immediately maturing debt. Without getting too caught up in technicalities, Teva is in a very tough spot, with its outcome just too speculative.

To surmise this section, the company pays back some debt, however, the debt downgrade makes it extremely more difficult to refinance at a favorable rate, thus becoming a vicious circle.

Pipeline

While I was cognizant that Teva had its problems, I still assumed that its pipeline of new drugs could help the business finding stability. I was excited about the prospects emerging from the sales of generic versions of Viagra, Viread and Reyataz in Q4 2017. And although these drugs will still come to the market, I do not feel Teva's narrow pipeline will be enough to help steer the company to safety.

Further evidence of not only my delusion, but management's delusions, has been Teva's persistent downward revisions on the amount of revenue that their new products launches this year, might fetch - down from $500 million to $400 million. In fact, originally, these were estimated to be closer to $750 million at the beginning of 2017.

Equity Raise

At this point in the game, I would not be too concerned with an equity raise. Teva stated in the earnings call,

We do not have a plan to raise equity. But these are some of the things that we'll be considering together with new management and the board as we move into the future.

Plan or no plan, I think that Teva will have little choice in the matter. As it is, the company is already trading as an equity stub - essentially worthless. While diluting its shareholders might buy Teva some time, with no significant pipeline, declining revenues and very tough secular headwinds in its generics business, could well leave the company with few other options.

Takeaway

I was previously very bullish of Teva's prospects as well as its market cap valuation. And while its market cap valuation remains particularly attractive, the company's prospects of a successful turnaround remain highly speculative. This stock is a value trap.

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Disclaimer: Please do your own due diligence to reach your own conclusions.

Analyst’s Disclosure: I am/we are 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.