How much shareholder value can a failed acquisition destroy? Look no further than Teva Pharmaceutical Industries (TEVA). Once the symbol of Israeli success, an ill-conceived buying spree coupled with a collapse in the global generic drug market has left the company in a financial crisis. Today, the company is down nearly 80% from its 2016 highs. However, the worst may be over for this beleaguered pharma giant. The company has been making the hard but necessary changes to simplify the company and new management is in place to lead it towards a different future. This article will detail the past struggles of Teva and explain why the company is undervalued and positioned to return to prominence in the future.
Teva’s Well-Documented Struggles
Teva’s fall began with its massive $40.5 billion purchase of Actavis Generics from Allergan (AGN) in 2015. The deal was initially well received by investors. After the acquisition was announced, the company’s stock skyrocketed by an incredible 16% to a record high market cap of $61 billion. Management boasted at the time that this purchase would help the company “win in global healthcare” and set lofty financial targets that in hindsight we can see were way off. For example, Teva expected the combined company by 2018 to deliver $11.6 billion in EBITDA and $8.5 billion in free cash flow. In reality, last year the company recorded just $5.3 billion in EBITDA and $3.7 billion in free cash flow, both less than half the projected amounts.
Overpaying for Actavis put a tremendous financial burden on Teva and saddled it with $35 billion in debt. The acquisition also proved to be done with the worst possible timing. In 2016 with the election of Donald Trump, the FDA started speeding up the approval of generic drugs which flooded the market with a record number of new products. This, combined with the rise of group-purchasing organizations (GPOs), has put severe downward pressure on generic drug prices. In 2018, Evercore ISI found that generic price deflation was around 11%. When Teva acquired Actavis, it was at a time when the generic market was at the height of its business cycle. Past management gambled that those strong pricing conditions would continue - they were clearly wrong.
Teva has also struggled due to the patent expiry of its blockbuster multiple sclerosis drug Copaxone. In its heyday, the drug was a major revenue driver for the company delivering annual sales in excess of $4 billion. While it remains a major MS therapy in the US, the drug has since gone generic and faces harsh competition from a multitude of companies including Mylan (MYL) and Novartis (NVS). As a result, quarterly prescription volume in the US has fallen over 21.7% YOY from 143,000 prescriptions last year to 112,000 in the most recent quarter. Pricing for the drug has also been negative, falling 25% as Teva is forced to lower the costs of Copaxone in order to remain competitive.
Even with these declines though, Copaxone has actually stood stronger than what most analysts expected. It still currently has 75% of the glatiramer acetate market, the active ingredient of Copaxone, though this advantage is likely to be whittled away moving forward as generic competition intensifies. Overall, Copaxone is a major drag on Teva’s revenues as well as profits, as margins for this specialty drug are significantly higher than its generics business. Globally, it recorded $2.4 billion in sales last year but this figure is expected to fall to $1.5 billion in 2019.
Tides Are Turning
Teva’s struggles are clear and in no way is the company free of the challenges that have plagued it in the past. However, there has been evidence that the worst may be over. The wave of approvals that contributed to the depressed generic drug market in the first place seem to finally be peaking, and while 2018 set another record for the number of approvals, the rate of growth has slowed over the past two years. This has led new Teva CEO Kåre Schultz to call 2019 a “trough” year, or the bottom of the business cycle.
Teva is also turning a corner in creating a more efficient company. Since Schultz took over the company in November 2017, he has actively been cutting costs and undergoing steps to streamline the company with its new organizational structure “One Teva.” In 2018, he has already cut $2.2 billion (-13%) in costs and is on track to cut $3 billion in total by 2019. One major source of savings has been closing unprofitable manufacturing plants. Last year, 7 locations were closed and management expects 11 more to be closed or sold in 2019. As a result of these and other changes, Teva has reduced its employee headcount by 10,300 workers.
These new changes have not come without backlash. In its home country of Israel, Teva’s closures of plants have sparked outrage from the public, politicians, and the powerful Histadrut labor union. This anger culminated in numerous protests around the country, including a half-day-long strike that The New York Times reports closed “banks, government institutions, the stock exchange and Ben-Gurion International Airport near Tel Aviv.”
Despite this, Teva has continued with these painful but necessary steps for the company to recover. Some of its manufacturing plants in Israel have gotten simply too expensive and keeping them open just to help lawmakers save face is a reason the company is in its troubled state today. Schultz knows this, which is why he has been so direct and unwilling to deviate from his plans despite immense outside pressure. He was even quoted as saying the “company would have gone bankrupt without layoffs.” Though this is likely a hyperbole to justify his company’s actions, it shows that Teva is truly on a different road towards a better future.
Growth In 2020
While 2019 is supposed to be the bottom, or the “trough” as management calls it, 2020 is when the company plans to return to growth. Those are very reasonable expectations. Even as revenues and profits have fallen for the company, Teva remains the largest generic drug manufacturer in the US and in the world. In the US, it led the market in both total and new prescriptions with 504 million total prescriptions in 2018. This represents 13% of all U.S. generic prescriptions.
Teva’s massive scale means it will be well-positioned when pricing for generics turn positive, which inevitably will happen. Generics also remain a major part of the global drug market. In the US for example, the FDA reports “9 out of 10 prescriptions filled are for generic drugs.” The demand for generics are also increasing at a rapid pace, with some projecting the market to grow at a 10.8% CAGR and reach $380.6 billion by 2021. With its leading portfolio of generic drugs, Teva will be able to tap into this growing demand and use it to fuel its future growth.
Teva is already making progress towards improving its important generics business. Some of its most significant products are generics of Cubicin, Concerta, and Cialis, which brought in $1.8 billion for Lilly (LLY) in 2018. Teva also has several promising products nearing a market launch. One of these is its generic of Restasis, Allergan’s popular eye drop product that raked in $1.26 billion in sales last year. The generic has already launched in Canada and management is hopeful that a US launch will take place later this year. Generic Epipen is also a promising product for Teva. It has already launched in the US on a limited-volume basis and the company plans to quickly ramp up production this year to fill a market shortage caused by a manufacturing issue for Epipen. Management has high expectations for this important product and expects that by the end of 2019, it will capture 25% market share.
Specialty drugs are another aspect that the Company hopes will fuel future growth. Unlike generics, these have considerably higher margins and allow the manufacturer to have more pricing power over the drug. The two major drugs in this area for Teva are Ajovy and Austedo. Ajovy, recently approved in late 2018, is part of a new class of drugs known as CGRP inhibitors that treat chronic migraines. In this area it has two direct competitors, Amgen (AMGN) and Novartis’s Aimovig and Lilly’s Emgality.
By many metrics, Ajovy has performed well in the limited time it has been available on the market. It has seen a strong uptake, with total prescriptions increasing dramatically to just over 6,000 per week in the four months following its launch. With that, it has also captured 29% of new-to-brand prescriptions as well as 19% of total prescriptions. Right now, revenues for Ajovy are small, sitting at around $3 million, due to the limited time it has been on the market. But as its launch continues, Teva projects it to grow to $150 million in sales in 2019. The revenue stream from Ajovy will be an important part of Teva moving forward and if all goes well, it could cash in on potentially $500 million in peak sales.
Austedo is the other major drug in Teva’s specialty portfolio and it treats movement disorders related to Huntington’s Disease as well as tardive dyskinesia (TD). The potential in Huntington’s Disease is small, but in the TD market Austedo is a major player and competes with Neurocrine Biosciences’ (NBIX) Ingrezza. Ingrezza was the first product to be approved in this area and was once seen as superior to Austedo, though this edge has been waning.
According to Leerink Partners analyst Ami Fadia, doctors now see Austedo and Ingrezza as “more similar than different.” As a result, they believe Austedo will capture 45% market share with Ingrezza picking up the other 55%. One of the reasons for Ingrezza’s advantage is the black box warning Austedo has for increasing depression and suicide. Even with this, Austedo remains an area of growth. In the US, there are estimated to be 500,000 patients with TD and Austedo was given to just 10,000 unique patients in the previous quarter. In 2018, it brought in $204 million for Teva but these are expected to rise to $350 million next year and from there, potentially to as much as $1.33 billion in 2022.
Teva Has An Appealing Valuation
At a price of around $14, Teva trades at just a $15.6 billion market cap. This is not without reason, as the company as gone through seemingly endless bad news for the past couple of years. But this has also given the company an attracting valuation for investors. Today it trades at just 6 times next year’s EPS, which the company forecasts to be between a range of $2.20 to $2.50 per share.
The primary reason behind such a low multiple is because of Teva’s tremendous debt load. Last year, it was downgraded by Moody’s to junk bond status and was forced to issue high yield bonds in order to refinance its debt. In this issuance, it offered rates of 6% on its 6-year bond and 6.75% on its 10-year bond. But now, following these restructuring initiatives, the company is in a strong liquidity position. It has just $2.2 billion in short-term debt and only an addition $3 billion in debt becoming due in 2020.
The company will be able to adequately cover these with both its cash on hand, around $1.78 billion, and free cash flows projected to be around $1.6 to $2 billion next year. Moving beyond these short-term liabilities, Teva does have $28.9 billion in gross debt on its balance sheet. Since taking over, management has been set on taking this down to a much more manageable amount. By the end of 2020, they expect to reduce debt to around 4x EBITDA (though Schultz did acknowledge it may take a little longer) and eventually bring it down to less than 3x in 3–5 years.
Overall, Teva is ripe for investment right now. But just as all investments carry risk, there are many factors that can hinder its turnaround and prevent it from returning to growth in 2020. The first and most blatant risk is that the generic market has not bottomed out. With the ever-changing regulatory environment and the continuous record-number of generic drug approvals, it is no guarantee that we are nearing a bottom. Teva with its Actavis acquisition has made itself highly dependent on this market and if things do not get better, the situation at Teva will not either.
Another risk is that its specialty medicines portfolio will not perform up to the level that management expects. Copaxone has proven to be more resilient than many have expected, but its fall will continue as more generics batter its competitive position. If its sales decline faster than expected, free cash flow will suffer and the company’s liquidity may not be as strong as this article assumes. Austedo and Ajovy continue to grow strong, but the respective revenue streams that they provide are still insignificant when compared to Teva as a whole. Some may worry that they may be diverting attention and resources away from other areas that could potentially benefit the company more.
Finally, debt remains a problem for the company. The failed acquisitions by past management regimes have put a tremendous burden on Teva and as a result, the company has no financial flexibility. In these next couple of years, management has little room for error.
Teva right now is at a watershed moment. Just a year in, CEO Kåre Schultz has revamped the entire business and taken the difficult but necessary measures to streamline it into a more efficient company. Now with the generic drug market seemingly about to bottom out, Teva is well-positioned to rebound and use its scale as the world’s largest generic drug manufacturer to succeed in the upcoming business cycle. To complement its core business, Teva also has two new specialty drugs - Austedo and Ajovy - that are just beginning their growth trajectory and one day will be capable of delivering strong revenues streams to the company.
Teva, however, is not a stock without risks. Its load of nearly $29 billion in debt is concerning and if the generic drug market does not recover soon, the company will be in serious trouble. However, those risks are why Teva is trading just 6 times next year’s earnings and at one of the lowest valuations in the history of the company. Teva is a great investment right now.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TEVA over 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.