After reviewing Teva's (TEVA) latest results, we are left to conclude that significant downward risks remain. EBITDA continues to worsen and management yet again shows their inability to manage investor expectations. Additionally, the decreasing EBITDA has set the company on a course to breach its covenant leverage ratio, which was just recently amended to 5 from 4. Currently, the forward leverage ratio sits at 6.0. While rumors of a $3 billion investment are indeed positive and could provide much-needed relief, we caution that these remain rumors.
A quick recap
On October 24th, we published our Teva earnings forecast in which we alleged that analysts were not correcting for accelerated price compression in Copaxone. Most of the discourse centered on the introduction of a new competitor, Mylan (NASDAQ:MYL), which was, in fact, related to the fourth quarter and not the recently released results of the 3rd quarter.
On that same day, we also published a more comprehensive forecast on Teva for our marketplace subscribers called “High Confidence Trade Alert” in which we concluded that it was highly likely to us that Teva’s stock would sink post-earnings, as the company would be forced to lower its guidance. Something most viewed as “priced in” given the available facts.
We stated that we had a 9/10 confidence in the stock declining the following day. For more information on our high confidence alert system, see this instablog.
Most important takeaway from 3Q17 results
Today we attempt to answer the following question:
So, looking forward, what can investors infer from the latest quarterly results and how does this affect a position in Teva shares?
The most important takeaway is that Teva is losing a significant amount of pricing power. We believe that there are two main reasons for this.
First, the current sentiment surrounding “drug price gouging” is inhibiting not only a drug company’s ability to raise prices but also their willingness as executives are terrified of their company being singled out by the media as the face of the drug price problem.
Second, and more relevant specifically to Teva, is an increase in competition. While it was already known that Teva’s 20mg Copaxone has lost its exclusivity, many were underestimating the impact this was having and will have on the company’s results. Instead, the narrative was that Copaxone would not face any competition until 2018. This was a statement from management but what it does not relay is that this refers to the 40mg version.
So how does this factor into the numbers? The company’s gross margin came in at 53% compared to 61% in the same quarter last year. This 8% lower gross margin means that the company’s gross margin is now 14% less than it was just a year ago. Investors have still to be confronted with a reduced pricing power as a result of Mylan’s generic competition.
Management continues to over-promise and under-deliver
Second, in our earnings forecast, we stated that “Management is consistently either underestimating risks or overestimating their ability to deal with risks as evidenced by the dividend cut, leverage ratio, pricing pressure and competition misjudgment.”
This, again, appears to be the case regarding Mylan’s competitive prowess:
“Mylan came in with a lower price and net price – or higher discount than any analog or any previous experience would suggest. So this was higher than expected.”
In the comments of our previous analysis on Teva, it was suggested that it is habitual of executives to underestimate risks or overestimate one’s ability to effectively deal with risks. We reject this assessment and provide that most executives of successful companies on Wall Street follow the mantra of under-promise and over-deliver. Clear examples are Apple (AAPL) and Nvidia (NVDA). The reason for this is simple, it creates reliable expectations and minimizes negative surprise risks. This article states that:
“Far and away, reliability is the most sought-after of all the skills uncovered through the CEO Genome Project. Of all the highly-qualified CEO candidates that the researchers looked at, 94% received high marks for consistency.“
The CEO Genome Project is a 10-year study, which attempted to identify key traits of the world’s most successful CEOs. The study used data on more than 2,000 CEO (candidates). We would suggest skepticism when it is ever proposed that failing to meet expectations is par for the course as, clearly, this is ludicrous, particularly when discussing executives of publicly-listed companies.
It might seem trivial to nitpick on management’s failures but it speaks to how investors should interpret statements from management. It creates a boy who cried wolf attitude, which negatively impacts sentiment.
Copaxone pressure – worst is yet to come
However, Mr. Schultz is no superhuman and there will be situations that he must simply accept and work around. For example, he must accept that there is little he can do about Copaxone competition. Instead, the lost revenue, and more importantly EBITDA, must be generated elsewhere.
We would suggest caution for those that feel that the Mylan competition is priced in. To those investors, we offer the following statement of Robert Koremans, President and CEO of Teva’s Global Specialty Medicines when asked if he could share how much lower net pricing was:
“No, I don't think that would be wise.”
We acknowledge that bulls will state that “this is for competitive reasons.” We believe this to be an optimistic perspective. When it comes to equities and executives in general, especially those that have consistently disappointed, it does not pay to be optimistic.
This reminds of a chess analogy in which there is a distinction between “real” chess and “hope” chess. In hope chess, one plays a move hoping that one’s opponent will not find the best move with which to reply. In “real” chess, one always assumes the reply to be the best move, no matter the level of your opponent. With regards to Teva, we feel that the best move for investors would be to assume the worst. Besides being a healthy skeptic, there are multiple arguments to be made that the worst is yet to come.
For example, we now know that Mylan is already competing at a price beyond what management is expecting. Second, management has consistently disappointed so it makes less sense to assume that this “unwise” statement can be interpreted as positive. Third, for those who believe this is “priced in” we offer that this same argument was presented in retort to our previous earnings forecast. Clearly, it was not.
We would offer yet another piece of evidence on the importance of skepticism. In 3Q17, Teva expected a full year EPS of $4.30 to $4.50. Currently, it has updated this to $3.77 and $3.87. In other words, the company now expects EPS to come in some $0.53 to $0.63 lower. Yes, in 3Q17, the company did not know that Mylan would get approval. So a revision lower makes perfect sense.
However, consider the company’s press release at the time it became known that Mylan would start to compete this year instead of next:
“Teva’s early assessment of the impact of these launches to its earnings for the fourth quarter ended December 31, 2017, is that it could be affected by at least $0.25 cents per share. “
Less than 30 days later, the estimate has increased to $0.53 to $0.63 EPS. We do not believe conditions to have changed so materially as to warrant a more than doubling of the estimate. We believe that Teva executives were simply too optimistic as our own forecast included a higher number, hence our lowered guidance expectation.
It is at an investor’s own peril to assume that this was a “kitchen sink” quarter. Many investors have been stating that since 2Q17 and it has yet to be proven true.
Fifth and final, some analysts believe that Copaxone pricing pressure is already nearing a 50% discount. This is a serious issue that will considerably dampen the company’s ability to pay down debt.
Teva’s debt load – covenant breach
Teva has already once amended its covenants this year. The reason for this, while not stated as such by executives, was that they would simply not be able to meet the previous requirement of a 4.25 leverage ratio. The covenant was amended to a leverage ratio of five times until the end of 2018.
Currently, Teva’s guidance implies a $1.3 billion EBITDA in 4Q17, which is an EBITDA of $5 billion for the full year of 2017. If we assume a net debt load of $30 billion, implying a $1.3 billion debt payment in 4Q17, we arrive at a forward leverage ratio of 6. Already, Teva is again in danger of a covenant breach. Second, speculations of a debt downgrade are already rampant, and with good reason as rating agencies would like to see the leverage ratio at 4.0.
Teva could take measures that are harmful to equity holders in the short term. For example, the company could, yet again, cut its dividend. Second, it could even issue equity. As of yet, management is selling investors on asset divestitures and cost-cutting efforts being enough. These measures would have to collect an additional $5 billion on top of the already assumed payment of $1.3 billion in 4Q17.
The problem with this estimate is that it assumes that Teva’s EBITDA will not decrease any further. This is unlikely, as Teva’s debt woes have not come from an increasing debt pile, but an ever-decreasing EBITDA. This has both impaired the company’s ability to pay down debt as well as increased the company’s leverage ratio, even though it has actually paid down debt.
Three pieces of good news
The good news is that the new CEO, Kare Schultz, is not one to over-promise and under-deliver. We have been very positive on the new CEO and look forward to the effect he will have on the company. For our thoughts on that, please visit this article. It is our contention that this habit of consistently failing to live up to expectations will be a thing of the past. The first step in doing so is to simply accurately manage expectations. We should see Teva conforming to Wall Street expectations within six months from now. It will take the new CEO some time to understand the company dynamics and its employees. Cultures are not easily changed.
Second, Allergan (NYSE:AGN) has not sold its Teva shares as of yet. This suggests that the company is being cautious in disposing of the shares. Previously, we thought that Allergan would start selling its shares in blocks as soon as the lock-up expired. Clearly, this was an error in judgment on our part. The fact that this has not happened can, of course, be considered as further pricing pressure down the road. Thus, a mixed bag but we view the implied caution to be more positive than the fact that there remain shares to sell.
Another piece of much-needed good news is that billionaire Leonard Blavatnik is considering a $3 billion investment in Teva. If the investment is done through a private stock listing, it would add a much-needed pile of cash to the company. This would be the best-case scenario and could be a significant catalyst as it would provide the company with much-needed cash. The other option would be to purchase the shares from Allergan. Purchasing the shares through the public market is unlikely as that would not help the firm. Yes, it could boost the company’s share price but the rest of the problems would not be erased.
If the billionaire would purchase the shares in such a manner that Teva is the recipient of the sum, the billionaire could kill two birds with one stone. It would alleviate Teva’s debt struggles and simultaneously improve his investment.
Investors need to understand that, as of yet, this remains a rumor and basing an investment on a rumor is rife with risk.
Only an assumption that Teva will manage to cut costs, stem the EBITDA decrease and sell enough assets to pay down debt, would warrant a buy. Currently, most of the evidence, notwithstanding the new CEO, points to the other direction. We appreciate that investors do not like to be told that they own, at the very least a risky investment and at worst a downright bad investment. However, we suggest to carefully consider the arguments brought herein, consisting mainly of:
1) Continuing lower EBITDA as a result of the unstoppable pricing decline in Copaxone, possibly forcing management to take measures that are harmful to equity holders. These measures include an equity raise and another dividend cut.
2) An increase in debt costs as a result of a debt downgrade.
Play the best move.
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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.