Why Teva Pharmaceutical is down 80%

Teva's common stock is only for the contrary-minded investor

Published on:
February 8, 2020
Reading time: 9 Minutes.
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

Buying Teva is the classic contrarian position. There are fears because of management turnover. There is an anxiety over declining sales. Mr. Market is now selling Teva at $10 a share because of the pending, opioid lawsuits while I am buying the stock. Paradoxically, both of us feel we got a bargain!  

Buying Actavis was wrong

When Erez Vigodman, Teva's former CEO, pitched to shareholders that he wanted to buy Actavis, the generic arm of Allergan plc, he said the combined entity would benefit from a diversified revenue stream, cost synergies, tax savings, and economies of scale. The typical m&a nomenclature.  

In a pitch deck titled the 2016-2019 Preliminary Financial Outlook, he estimated revenue to be between $26.7 billion and $27.8 billion by 2019, an Ebitda compounded growth of 14%, and to report on earnings per share of $7.5 to $8.1 per share.

Teva's board of directors bought the story. And no later than three weeks after the initial discussions, Teva announced a whopping, $40.5 billion purchase price. To fund the Actavis purchase, Teva's board gave away 100 million of the common stock [1] and $33 billion in cash. The right side of the balance sheet mushroomed to $34 billion as a result.

Teva not only leveraged the balance sheet, but Teva had no trouble paying up. The press release noted that "Actavis Generics had net revenues and total direct expenses of $6,184.4 million and $5,367.4 million of expenses."

Actavis reported total assets of $12 billion - of which half of intangibles and goodwill – and total liabilities of $3 billion. Teva, in short, bought Actavis at eight times the sales and four times the book value.

Did Vigodman ever read Benjamin Graham?



How companies grow

"I firmly believe that acquisitions are an addiction, that once companies start to grow through acquisitions, they cannot stop," lamented Professor Aswath Damodaran at the CFA Institute Equity Research and Valuation Conference. "Everything about the m&a process has all the hallmarks of an addiction."

In that presentation, Damodaran brought data from a McKinsey study, showing that "the very best approach of creating growth historically has been to come up with a new product," he noted. "Look at Apple. Between 2001 and 2010, Apple went from being a $5 billion company to a $600 billion company, and they built it on the iPhone, the iPad."

In addition to inventing new products, companies grow by expanding into new markets. For example, with hardly anywhere to grow in the United States, Costco is building stores globally and recently launched a store in China.

The only other option is to grow or maintain market share in an expanding market. "Think of Apple and Samsung between 2011 and 2015 in the smartphone market," Damodaran said. "Apple's market share decreased between 2011 and 2015, but its value increased. Why? Simply because the smartphone market itself was growing."

What is worrying about Teva

Teva now faces three challenges: pricing-fixing and opiod-related lawsuits, loss in revenue because the patent behind Copaxone had expired, and a leveraged balance sheet. More on Teva's worrisome future below: 


The lawsuits

You can't avoid shaking your head when reading about Teva's current troubles. Not only did the pro forma numbers never materialize, but also Teva's lawyers are  busy defending the company on price-fixing and opioid-related charges.

(To get a sense of how serious is the U.S opioid crises, read aboutThe Family That Built an Empire of Pain.)

Analysts estimate that Teva will be liable to pay anywhere between $2 billion and $10 billion in the future. According to CNN, an Oklahoma judge approved $85 million settlement with the opioid drugmaker.

"In the first nine months of 2019, Teva recorded an expense of $1,171 million in legal settlement and loss contingencies," writes management in the 2019 third-quarter filing. "The expense in the first nine months of 2019 was mainly related to an estimated settlement provision recorded in connection with the remaining opioid cases."

I wrote about the difference between risk and uncertainty in a prior essay. Wall Street analysts, often with a background in math, attempt to understand risk with probability theory and statistics. But they hate uncertainty because it is difficult to quantify in numbers. So, capital markets are frustrated by Teva's unknown future.

Copaxone

"Our leading specialty medicine, Copaxone, faces increasing competition, including from two generic versions of our product," writes management in the risk section of the annual report. Indeed, the FDA approved in October 2017 and February 2018 two generic versions of the medicine, and Teva's revenue from Copaxone was immediately hit. In 2016, Copaxone's revenue was $4,223 million. It dropped to $2,365 million in 2018.

"Invert, always invert!" says Charlie Munger. And if we invert this data point, that branded drug sales fall when the generic version enters the marketplace, we see Teva's competitive position. The company is world-leading in generics.


The financial statements

There are red flags all over the balance sheet, the income statement, and management's turnover. Consider the balance sheet: before the Actavis purchase, Teva reported $8 billion in liabilities on $30 billion in equity, a debt to equity ratio of 25%. After the acquisition, liabilities mushroomed to $32 billion on reported equity of $35 billion, a debt to equity ratio of 91%.


While risk in investing is difficult to define, let alone calculate precisely, it is not good when the debt to equity ratio increases by three times.

The income statement tells a similar tale. Interest expense went up threefold, from $313 million in 2015 to $1,000 million in 2016. And over the past three years, the annual interest expense remains high, at about $950 million a year. The operating income to interest expense ratio used to be over ten times; it is now in 2 to 3 times range.

And there has been a management shake up: Kare Schultz replaced Erez Vigodman [2] two years ago and immediately announced a restructuring plan that included reducing the labor force and divesting assets. Before joining Teva, Schultz served as president and vice CEO of Novo Nordisk, multinational pharmaceutical products company.    

The ensemble of the three concerns resulted in an over 80% drop in Teva's market price. In 2016, the stock traded hands at $60 a share. It now trades at $10 a share.

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The pharmaceutical industry

You could hardly tell of any fundamental changes to the pharmaceutical industry based on the Dow Jones U.S. Select Pharmaceutical index return. The index shows a total return of about 13% over the past decade and a 10% return over the past year.

Current investors are paying up for this return. If you buy the iShares U.S. Pharmaceutical Index (IHE on Arca) for example, you are buying an equity interest in the 46 pharma companies at a price to sales ratio and price to book value of four times.

But the return is not smooth for individual companies. For example, Akorn, Inc. (AKRX on Nasdaq) lost over 90% in market value over the past five years and halved in price in 2019. It is rumored to go bankrupt because of opioid-related litigation.

Another company caught up in the opioid scandal is Endo International (ENDP on Nasdaq). Its market valuation dropped by over 90% in the past five years, and just in the last year, the stock dropped by 60%. The same market loss can be demonstrated with Mallinckrodt (MNK on Nyse), Amneal (AMRX on Nyse), Myland (MYL on Nasdaq.)

According to statistica.com, there is an increase in the proportion of generic versus branded drugs. In 2005, about 40% of prescriptions dispensed were brand name drugs, and around 50% were unbranded generic drugs. In contrast, in 2018, only 10% of orders were brand-name drugs, while over 85% were unbranded generic drugs.  

Other trends in the global healthcare trends include an aging population, chronic diseases, and growing pressures from the government to provide affordable healthcare solutions. It seems those trends are muted compared to the opioid-related charges.

Trends in prices of generic prescription drugs
Trends in retail price of generic prescription. Source: AARP Public Policy Institute.

A stroll over Teva's past five years (2018 – 2014)

Teva's current challenges, drop in operating margins, and impairment losses, immediately show on the income statement. In 2014, revenue was $20 billion, gross sales were $11 billion, and net earnings were $3 billion. After years after, revenue was $19 billion, gross sales were $8 billion, and loss $2.4 billion [3].

The drop in revenue is because of increased competition and price pressure in generics and a decline in sales in Copaxone, as I noted in the investor concerns section.

Teva's income statement shows that the business requires little capital expenditures. If we remove the accounting charges (asset and impairment loss) and look at the total 2018 to 2014 pre-tax earnings, we find $17 billion in pre-tax earnings. During these five years, the reported capital expenditures [4] was $6 billion, less than a third.

(The last time Teva paid a dividend was November 17, 2017.)

Teva's 2019 quarterly earnings.
Teva's 2019 earnings. Source: public filings.

From a stroll over TEVA's balance sheet, two items jump at you. The first is the change in intangible and goodwill accounts between 2015 and 2016. In 2015, management reports on $26 billion in total for both accounts. A year after, the number is up over twofold to $65 billion. Long term debt went up fourfold to $33 billion in 2016 from $8 billion the prior year.

One year after, between 2016 and 2017, the goodwill account was cut by $16 billion. Management effectively halved the book value of equity.  


Financial results (first three quarters of 2019) 

In 2019, management reported $4 billion in quarterly revenue with net earnings of one billion. I expect the fourth-quarter results to be similar. So TEVA's 2019 results are likely to be roughly $16 billion in revenue and $4 billion in net earnings, about $3.50 to $4.0 per share [5]

The Europe segment has the highest operating margin, followed by North America's segment and the International segment. In numbers: the operating margin was 57% in Europe.  The ratio was 51% in North America, and 40% in International markets.

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A NOTE FROM NOAM 

In Pen&Paper, I only write about companies I am personally invested in, and on finance topics, I find it important to share.

Buying a stock is easy. But it requires a lot of effort and discipline to keep track of the company's performance. And no matter how much a stock appreciates, you're not capturing those returns until you sell. Join the waitlist to get real-time updates.

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Teva's owner earnings

In the 1986 letter to shareholders, Warren Buffets explains owner earnings. He writes:

These [owner earnings] represent reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges less the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

We can compare owner earnings to GAAP earnings using Teva as an example. I used Buffett's formula with a slight modification. Because Teva has a legal cost - every year - I removed from the owner earnings an arbitrary one billion in legal expenses. The table below summarizes the results:

We can see that between 2014 and 2016, investors paid a premium over the owner-earnings value per share. But their appetite waned in 2017 and 2018 when you could buy the stock less than half the implied value.

In February 2020, at about $10 per share, Teva trades at a quarter of the implied 2018 value.

Over the next 3- to 5-year period, I estimate that Teva's top line will be $18 billion, with a 25% operating margin, resulting in owner earnings of $3 billion or $3 per share. From that, I estimated the value of the Company to be anywhere from $15 billion (5x the implied value) to $45 billion (15x the implied value). I also estimate the opioid-related lawsuit will cost Teva anywhere from $2 billion to $10 billion, which results in a valuation range of $20 to 28 per share.

Teva's owner earnings 2018 to 2014.
Teva's owner earnings. Source: My calculations.


Teva's generic and specialty medicine

Teva sells generic medicine and specialty medicine. Generics aim to provide the same chemical and therapeutic solution of a branded medicine. There are over 300 generics that Teva sells.

Specialty medicine category includes solutions for the central nervous system such as  Copaxone, Ajovy, and Austedo, and solution for the respiratory system such as Proair and Qvar. Teva also sells medication such as Bendeka and Trisonex in oncology.

Last year, generics were about 40% of the revenue; Copaxone was about 20% of the revenue, and Bendeka, Proair, Quar, and Austedo et al., were the remaining about 40% of the revenue. Teva manufactures products using 55 pharmaceutical plans in 22 countries. Last year, the Company produced 80 billion tablets.

The best profit margins are in Europe, followed by North America and the international markets. Over the past three quarters, the profit margin in Europe was 57%; in North America, it was 51%; and 40% in International markets. The difference in profit margins is the result of competition, pricing power, and regulatory red tape.

You can now buy the generic form of Copaxone (see more in the investor concerns sections) in North America. Teva's revenue was hurt as a result. The Company reported revenue of $12 billion in 2016, which dropped to $9 billion in 2018; profits in 2016 were $5.5 billion compared to $2.8 billion in 2018, and Copaxone revenue was $3.5 billion in 2016 compared to $1.8 billion in 2018.

In North America, Teva introduced 22 generic versions of branded drugs in 2019. And it was meeting regulatory approvals for about the same number of generic medicines. Two new products that I believe will be important for Teva are Ajovy and Truxima.

Ajovy was approved in September 2018 and is protected until 2026 in Europe and 2027 in the United States. TruixmTruxima was approved in November 2018 [6]

Biosimilar is a biologic medical product highly similar to another already approved biological medicine, says Wikipedia. Teva writes: "Biosimilar products are expected to make up an increasing proportion of the high-value generic opportunities in upcoming years."  

There is going to be a lot of competition in the biosimilar medication in the future. And whether Teva will win over its competitors is unknown. But a few trends, working in favor of companies such as Teva, are clear. Our population is aging; there is an increasing amount of chronic diseases that need solutions; governments are pressured to provide affordable healthcare; there are scientific and technical discoveries that require unique manufacturing capabilities.

FOOTNOTES: [1] In 2016, the stock traded at about $60 a share. [2] In contrast to Vigodman, Schultz has pharmaceutical background. [3] Teva recognized $5.6 billion in non-cash, impairment losses. [4] Does not include business acquisitions. [5] I took out non-cash expenses such as asset impairment loss. [6] I couldn't find until what year Truxima will be protected.
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