Toward the end of 1990, when generic drugs still accounted for less than 30% of the total US prescription market, Teva was just trading at just $0.47. Today, generics account for 72% of the market and Teva is $47. You can tell by Teva’s strategy of acquiring innovative drug makers, that even the management of Teva thinks the game is just about over, but what if you could go back in time and buy Teva before anyone knew what was going to happen to the generic market?
Japan, of all places, offers just such an opportunity. Generic penetration, at 22%, is the lowest of any OECD country and arguably, Japan has a greater incentive to promote generics than any other country. It has the most rapidly aging population in the world, has universal health care insurance that is administered by the government, and already expenditures on healthcare account for 9% of GDP. The recent earthquake will only accentuate the urgency of Japan’s need to cut its healthcare bill.
The Japanese government first enacted legislation to promote generic drugs in 2002 but until last year, the progress was disappointing. Japanese doctors had total control of the prescription process and no incentive to even learn about generic alternatives. But early in 2010, control shifted to the pharmacists, and incentives were altered to make certain that the more generics they substituted, the higher their profits would be. Wouldn't you know it, the total generic market grew 25% in 2010, while total growth in prescription drug costs was held to 1% - after having averaged more than 6% annually for the past 5 years despite the country’s persistent problems with deflation in almost all other categories of goods and services.
It is not too late for investors to capitalize on this change. Most local analysts are viewing this success as a one off, but more than $17bn worth of prescriptions drugs will go off patent in Japan during the next 5 years and the largest company local company in the space generated only about $770mn in revenues last year. Sawai Pharmaceuticals (Ticker symbol 4555) generated a return on equity that is twice that of any of its nearest rivals with less than half the debt/equity ratio. Moreover, I believe Sawai has further distanced itself from competitors in terms of both product development and distribution capabilities during the past year, and these strengths should continue to drive share gains. I expect the company’s average growth in net profits to exceed 25% annually during the next 5 years. On my projections, the stock trades 13x fully diluted EPS, 9x cash flow, and 1.9x book. Even if the P/E drops to 10x, which would be lower than Teva’s 12.6, long-term investors should still be handsomely rewarded.
Japan’s Generic Market
Generic drugs account for only about 22% of the prescription drug market in Japan, compared to over 60% in most other OECD economies. Japanese government incentives designed to promote generic drugs have consistently fallen short of expectations and most observers still express doubts that the government will achieve its goal of 30% penetration by March 2013.
The economic incentives for achieving these goals are obvious. Total nationwide growth in expenditures on prescription drugs increased an average of 6.44% during the past 5 years. For a country in which the majority of all prescription costs are born by a government insurance program which is funded by a declining number of workers in a country where there has been no meaningful wage inflation, this is clearly an unsustainable path. In 2010, however, the growth rate was held to 1%, and for the first time since the government began setting targets, the share of generics rose by more than one percentage point.
Despite the significant change in effectiveness of these policies, the consensus view appears to be that the effect of stimulus has largely worn off and that while Sawai will continue to take market share, its growth rates will return to sub 15% rates in the year to 3/12, from in excess of 26% in 3/11.
In 2001, the government insurance program instigated a series of fees paid to pharmacies for various services related to the preparation of generic fees, and when this had little effect, the fee system was greatly simplified in 2003. The problem was that while the incentives were in place to influence pharmacists, it was doctors who were writing prescriptions, and Japanese doctors were unfamiliar with generics and continued to prescribe specific branded drugs. In 2006, prescription forms were revised to include a check box for doctors to make clear that substitution was acceptable, but doctors who were still unfamiliar with the generics and untrusting of them, took little advantage of this form. In 2008, power was finally placed in the hands of pharmacists by changing the form to require a doctors’ separate signature to prevent substitution. Still, as it turned out, the overly complex set of incentives to pharmacists encouraged an increase in the number of prescriptions, but not the number of drugs. When these incentives were revised in 2010 to emphasize quantity, the generic drug market finally took off.
It would be reasonable to assume that the 24%% growth in the generic market last year would taper off if it had been a result of one-off incentives that merely brought forward demand from future periods and there had been no supply constraints. But the incentives are permanent, natural demand is still probably more than double the actual supply, and supplies of quality products are still very constrained. We simply do not know what will happen with these incentives in place when the more than 1.4trn worth of prescriptions drugs go off patent during the next 5 years, but it seems likely that penetration of new generics will increase at a much faster rate now than in the past. The key drivers of growth will depend on a company’s ability to develop and distribute new compounds at competitive prices.
There is still a great deal more that the government can do. Sawai’s web site lists 9 policies that various countries around the world have initiated to support generic drugs. Nine countries have initiated more than 4 of these policies, while Japan has initiated only two, namely the incentives to pharmacies and the substitute right, both of which are very recent. Although we cannot set a specific date for any changes, we believe that incentives can and will be increased if generics do not continue to grow at extremely high rates.
It is easy to forget that in the United States, the largest generic market in the world, it was not so long ago that generics accounted for only 19% of total market share as well. This was in the mid-80s. By 1996, generics had surpassed 43% of total countable units. Today, these drugs account for more than 72% of prescription drugs sold in America.
Sawai Generates its own Growth
A significant portion of Sawai’s growth is driven by innovation and not by market forces. Sawai’s quarter on quarter growth follows two distinct seasonal patterns apparently affected by the enforcement of cuts in drug prices every other year. In odd years, when the cuts are enacted, Sawai’s 1st quarter is routinely more than 25% higher than the previous quarter, and its second quarter is routinely some 5% below that of the first quarter. In even years, when there are no price cuts, the first quarter is routinely 10% to 15% above that of the previous quarter, and the second quarter also grows at a single digit pace. For Sawai, there was mothering different in 2011 than in any other odd year. The 27% growth that we think the company achieved in 3/11 was actually routine for an odd-numbered year. As shown in the chart below, our forecast for 3/12 shows above average growth for an even-numbered year, but the difference is all concentrated in the first quarter and is primarily a result of our view about new product introductions.
On closer examination, Sawai has over 560 different products, and quite obviously, not all of them are growing at the same rate. Sawai discloses revenues based on the year in which the product was introduced and it is clear from this data that newer drugs grow significantly faster than older drugs. For example, in the year just ended, we believe that all products introduced before the year to 3/03 grew well below the market rate and that even some introduced as late as FY2005 grew at sub-market rates. These slow growing products probably accounted for 57% of Sawai’s revenues in the year just ended, so to the extent that Sawai outperformed industry growth, it was dependent on the explosive growth of 43% of its revenue base. While market growth in the year to 3/12 may slow significantly, the percentage of Sawai’s revenue base that is still in the explosive growth phase will rise to 47%.
There are occasional hiccups in this pattern that complicate long-term forecasting. Typically, the most newly introduced group of products have accounted for 3% to 4% of revenues in their first year and 6% to 7% in their second year. Products introduced in the year to 3/10, however, generated 7% of revenues in their first year and probably approached 14% in the year just ended. The increased size of this rapidly growing group should significantly alter the company’s growth trend in 3/12 in a way I think the consensus may be under-estimating. On the other-hand, products introduced in the year to 3/11 have been disappointing and probably accounted for only about 1% of revenues in their first year. To a very large extent, the initial impact of new products depends on the market size of the product being replaced and the difference in price between the original drug and the generic version. Sawai does not like to discuss the details of upcoming product launches, but products that recently came off patent have aggregate market potential nearly as large as that for the drugs introduced in 3/10. We expect these new products alone to contribute about 20% of the new growth in revenues in the coming term.
Sawai has a tremendous ability to control its own destiny. Obviously, I can’t forecast the growth rates for 560 individual product lines. We can see the trends in products grouped by year of introduction, but it is difficult to be sure about what is driving these trends, so no matter how sophisticated and detailed ones forecast is, ultimately, it boils down to whether or not you think the company is being conservative or aggressive, and whether or not you think they can execute. If this company’s management believes they can achieve 62bn, 74bn in the following term, and then 100bn in the 4th year, and the consensus estimates are even slightly below this, at 72bn, followed by 83bn, then, in my view, the consensus is making a risky bet.
I think the consensus case on margins is even weaker than its case on revenues. We believe that Sawai increased its operating margin to nearly 22% in the term just ended, compared to only 10.5% just two years earlier. The consensus assumes that these margins have peaked and will enter a period of decline. I think the achievement was a simple case of revenues growing faster than overhead costs, and that while revenue growth may not always exceed 26%, it should continue to exceed the growth in over-head.
The only conceivable reason for a decline in margins would be an expectation for falling unit prices as competition heats up. Currently, Sawai has only two meaningful domestic rivals for generic drugs in Japan, Nichi-iko Pharmaceuticals (4541), and Nippon Chemiphar (4539). Sawai generated twice the return on equity with half the amount of debt as the nearest of these two. Sawai continues to add unit capacity at a rate exceeding 15% per annum, and claims that new machinery being installed today has an average cost per unit of roughly half that of its average existing facilities.
Foreign competition has begun to take notice of the Japanese opportunity. Teva, the largest generics-specialist manufacturer in the US, which is actually an Israeli-based company, is six times the size of Sawai and has production facilities all over the world. Teva currently generates $250mn in revenue in Japan and grew at 25% in 2010, which means that in Japan, Sawai is 3x the size of Teva and Sawai is growing faster. This could change. Teva has plans to grow this business to $1bn by 2015. By this time, we expect Sawai to reach $1.7bn assuming no change in the exchange rate. Teva clearly gains some advantages from its global scale, particularly in its ability to absorb the cost of basic research. But it’s not clear that this will translate into any manufacturing advantage. In the generics business, there are hundreds of minute variations in compounds for every major drug, and advantage goes to the company with the ability to produce small quantities efficiently. Indeed, Sawai already earns a higher gross margin than TEVA, despite its much smaller size and concentration of production facilities within Japan.
We don’t believe any participants in the market other than TEVA pose a meaningful threat to Sawai, and there is still plenty of room for both to grow. Innovator-drug companies are all interested because they face a flood of patent expirations and profitability is about to fall off a cliff. However, as Teva’s president has put it so eloquently, “You can’t train a Persian cat to be an ally cat.” There are very few examples anywhere in the world of a branded drug maker doing well in the generics business. As Sawai increases in scale, we think there will continue to be a linear relationship with its overhead cost reductions, while gross margins can probably be sustained at the current level as Sawai reduces its production costs in line with any declines in unit prices.
Technical Notes (for Geeks only)
My technical models are unique in that they are based on the price/benchmark relative movement, parameters adjust on the basis of each stock’s volatility relative to the index, and finally, in that they are back-tested one stock at a time. It is not a one-size fits all methodology, but all of the models involve mean-reverting strategies, as this is what works most consistently in Japan. There are also several different models that are uncorrelated to each other, and are weighted by efficacy. Sawai is an exceptional case, which only one of the models actually adds value, and even then, it is not nearly as consistent as with most other stocks in the universe. Still, my models have an advantage in that they are back-tested one stock at a time, so I don’t have to use them for any given stock if they don’t work.
In the case of Sawai, the probable explanation for a lack of efficacy is the company’s unique combination of very predictable earnings and a growth rate that is literally off the charts. For one, this makes the hurdle rate of the buy-and-hold strategy very difficult to outperform, and for another, the high predictability reduces the magnitude of mean reversion, at least at the frequency levels that I try to exploit.
It is still possible to use the charts to avoid entry points that are at extreme levels and to occasionally make astute judgment calls if a rare opportunity develops. I was able to make such a call on January 11, when I issued my first report on Sawai. At that point, the thesis was simple: the MACD had reached its lowest point in three years on fall-out from a failed merger attempt, (which, incidentally, was actually a good thing, from a fundamental viewpoint). The MACD then crossed over, indicating a buying opportunity. The multiples seemed reasonable, and earnings surprises uncommon, so for one of the few, perhaps only Japanese stocks that are demographically blessed, this was enough information in my view. Since then, the stock has outperformed Topix by 18%. Now, however, I needed to either close the trade or come up with a more sophisticated argument, hence this report.
There are analysts who insist on only one or the other: technical or fundamental analysis. There are some who insist on using both. My methodology is much fuzzier. I will emphasize one over the other, depending on the situation. Given my fundamental conclusion that a much longer-term and more substantial opportunity exists, the technical analysis is now useful only to avoid entry at any extreme over-bought condition. In this analysis, I’m pleased to report that the relative price is within 4% of the 90-day moving average of the relative price. The standard deviation is 9%, so the stock is not over-bought. One might argue that the stock is even less over-sold, but this is not necessarily true either. The moving average is currently on a very strong upward slope. Whenever this has been the case, the price actually very rarely dips below the moving average, and in fact, rarely even touches it. So a level of 4% above the moving average might easily prove to be the low point, especially if the market likes what it sees in the upcoming results announcement. In short, I am turning the technical analysis to the off position.
Sawai shown Relative to Topix whith MAV, Parabolic SAR and MACD
I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.