There is no better time to reflect on portfolio holdings than today . This week's essay is about the three questions you should ask as you spring clean.
The first question is whether the business will survive for the next few years. The second question is whether the company generates free cash flow. And how essential is the business is the third question. To illustrate the concepts, I will use examples from my portfolio.
It is going to be challenging to refinance debt and to raise equity. And any business that relies on capital markets to fund its on-going business operations is going to face a large number of rejections.
A friend of mine, a founder of a start-up company, told me she is now spending the bulk of her time in understanding (1) how long can her business run until cash reserves are depleted, and (2) what can she do today to better prepare for that day.
The same mindset is applicable to portfolio holdings. If you own a company that has a sizeable maturing debt over the next year or two, you should reflect on how likely will it be able to refinance the mortgage, at what terms, and how it will affect operations.
Here is a summary of what I learned about some of the stocks I bought in 2019:
Graftech reports $1,812 million in long term debt. And on page 80 of the 2019 annual report, you can read that the debt facility will mature on February 12, 2025. In other words, Graftech has five years of breathing room.
Teva Pharmaceutical reports on $24,562 million of long term debt. The company will have to pay down $5,263 million, an average of $1,023 million each year until 2025. But I don't foresee that an issue as the company has $1,975 million in cash on hand and $5,676 million in receivables.
Micron reports on long term debt of $4,541 million and holds $7,152 million in cash and $3,195 in receivables. And on page 58 of the 2019 annual report, we read that most of Micron's debt is due after 2025.
Two companies that will face challenging times ahead are Seritage Growth and Gulfport Energy. Seritage Growth Properties reports on $1,598 million in fixed debt with Berkshire Hathaway Life Insurance as the lender. The loan matures July 31, 2023. Gulfport energy reports on $1,978 million in long term debt. Where $329 million in due 2023 and $603 million is due in 2024, and $529 million is due in 2025.
In the case of Gulport, current cash and receivables will not cover the pending debt obligations. So either Gulfport will sell assets (it reports on $10,595 million of oil and natural gas properties), or somehow it will manage to refinance the debt miraculously.
Investors usually accept negative free cash flow when the business promises growth. But future growth always comes with a present cost: either the right side of the balance sheet increases or current shareholders will be diluted.
Consider Ormat Tech (Ora on Nyse) as an example. The Israeli-based, geothermal company reported negative cash flows between 2015 and 2019 . So, the company issued more debt and diluted shareholders. (Long term debt in 2015 was $856 million and increased to $1,035 in 2019. Common shares were 49 million in 2015 and went up to 51 million in 2019.)
Yet positive, free cash flow is one of the most useful antidotes to keep a healthy balance sheet. Positive cash flow allows management to remain independent of capital market woes and fury and to grow the business without niceties to lenders.
There are two ways to find free cash flow. The CFA Institute defines free cash flow  as net income plus non-cash charges plus interest minus capital expenditures minus working capital expenditures
Another approach is to use cash flows from operations. To find the free cash flow, you take the cash flow from operations, add back interest less capital expenditures.
Consider Whirpool as an example. On page 37 of its 2019 annual report to shareholders, management reports on $1,230 in cash provided by operating activities less $532 in capital expenditures. It reports on $912 million in free cash flow
If you can't reasonably estimate today where the business will be in ten years, you shouldn't invest in it. The 10-year outlook is important because of two reasons, a pragmatic one and a psychological one.
The pragmatic reason is that if you can't estimate the business outlook, you can't estimate the earnings. And if you can't estimate the earnings, how could you determine the value of the business?
The second reason is psychological. When capital markets freeze, when investors are selling, and the quoted price of your stocks drops, understanding the future of the business will allow you to better weather the storm. A few examples will explain this statement.
I bought Carriage Services in January 2019 for about $20. The stock went up to $28 by year-end 2019 and now trades at $15, a 46% drop from the peak, and a 25% discount from my cost basis. But instead of selling the position, I remind myself that the business outlook for Carriage, who is a funeral home company, is invariably the same. Just because markets are discounting the business does not mean the business fundamentals deteriorated.
Another example is Teva Pharmaceutical. Two months ago, I explained Teva's tailwinds:
"Other trends in global healthcare include an aging population, chronic diseases, and growing pressures from governments to provide affordable healthcare solutions."
I don't believe the tailwinds changed.
But I have made mistakes by overlooking the 10-year outlook criteria. For example, I bought Weight Watchers in March of last year. I didn't have the slightest idea then, and I don't know how the business will look like in a decade from today. This business falls in the "too complicated" bucket.
Another mistake I made was buying L Brands in late 2018. In hindsight, there is no way to predict our clothing preferences in a decade (let alone next season.) Not only is it difficult to correctly predict what color will be fashionable next season.
Management will find reasons to keep the lights on. You just never hear of management declaring "we quit, let's just liquidate the company and return capital to shareholders".
One popular technique to keep capital is turnarounds. In turnarounds, management explains to shareholders that the changing business landscape requires a total, 180-degree change in the business mindset, which, in turn, requires a change in the company's strategy and long-term business plan.
Turnarounds follow three basic promises: (1) cost reductions, (2) a change to the business’s fundamentals, and (3) long term growth. In cost reductions, management promises investors of improvement in operations. Usually this means reducing labor costs, selling unprofitable assets, and focusing on high return-on-invested capital projects.
In the second item, the promise to change, management tells investors that the company needs to evolve in order to grow in the future; old products are replaced with newer ones, and new products get a newer look.
The third promise rests on the long-term growth of the company. In turnarounds, management argues that consumer preferences had changed and the company must adapt its business model. Consider The Wall Street Journal for example. The print newspaper changed its revenue from collecting revenue from print to digital. According to Statistica, a data company, there are 1.6 million digital-only readers compared to 1.03 million print readers.
Turnarounds usually involve a new chief executive officer who appoints a new executive team. From my business experience, it takes at least a year for individuals to trust and understand one another. And in corporate America, a year can be a very long time.
The second risk is that something is fundamentally wrong with the company. Turnarounds, no matter how profitable may be in the future, are the result of something gone wrong. For example, the industry margins dropped due to an unforeseen competitor (think Amazon and retail stores). Or, perhaps, something is wrong in the profitability of the business or in the product itself.
The third risk revolves around capital markets, for it is harder for a company to raise equity or to issue debt while it is changing its operations. This point, that capital markets affect value, is best understood with a story.
A friend is suing his realtor. She promised him that the house he bought, which was on a land lease, had more than 30 years until the lease expired. But, in fact, there were 27 years left. Because of that 3-year difference, buyers are unable to obtain a 30-year mortgage, reducing the demand for homes in that community, and the value of his home. In short, financing affects value.
Because of the risks associated with turnaround situations, investors must look for Benjamin Graham-like criteria before buying such stocks. So a margin of safety is a must; and investors should not pay more than 10 times the trailing earnings per share. Or more than 70% of the net asset value. And any investor in turnaround situation must also realize that a three to five year investment horizon is a must.
(Given the risks and uncertainty in turnaround situations, I never allow more 20% of my portfolio in turnarounds.)
A few examples from my portfolio: Seritage growth company is replacing tenants. I estimated that Seritage is replacing leases with rent that are about 50% below market rents. Read more about Seritage here.
Another turnaround example is Signet Jewelry. Millennials are looking at the institute of marriage differently than their parents. And Signet is adapting: it is now selling carbon-based diamonds - a better option for the conscientious consumer.
In Teva's Common Stock is Only for The Contrary-Minded Investor, I write about Teva Pharmaceutical, another turnaround stock in my portfolio.
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!
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  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?
"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."
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:
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.
"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.
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%.
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  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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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.
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 .
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  was $6 billion, less than a third.
(The last time Teva paid a dividend was November 17, 2017.)
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.
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 
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.
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.
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.
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 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 
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.
It was in Risk, Uncertainty, and Profit, that economist frank Knight first observed the difference between risk and uncertainty. Knight saw the two words are different. He writes:
The essential fact is that 'risk' means in some cases a quantity of susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is present.
It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.
Risk relates to what we can measure. And we measure risk with probability and relative frequencies. For example, when we hear in the news that 'there is a 50% chance of showers tomorrow', the anchor is expressing a form of risk management.
Another example is in the medical profession when we hear that '9 of 10 patients recover from the common cold within seven days." It is worthwhile to note that measuring risk is neutral. It can refer to positive or negative events.
Uncertainty, however, refers to unknown prospects. That is, to outcomes that cannot be understood from experience. The classic example of why the use of risk analysis in futile in an uncertain world is that of the Turkey illusion .
But Mr. Market  understand risk differently. To Mr. Market, how volatile the price of a stock defines riskiness. All else equal, if stock ABC goes up and down in price while stock XYZ's price is invariably the same, the market deems the latter stock safer than the former.
Mr. Market also understands risk as a crucial reason for return [Akin to 'no pain, no gain]. With a mindset of 'no risk, no return.' Also, the investment management profession, through ideas, such as the 'beta'  you can reduce risk by negative beta stocks.
So often, the stock of these companies, especially when fear of recession looms, becomes expensive . In sum, whether we agree or not, Mr.Market has dealt with the definition of risk.
But Mr. Market refuses to deal with uncertainty. When Wall Street analysts are uncertain about the financial picture of a company, they cannot explain the prospects of the company. And when they cannot identify future outcomes, let alone quantify them, it is impossible to measure the risk the investor will take. And this inability to gauge risk reduces our confidence in their recommendations.
Mr. Market becomes even more worrisome when the uncertainty expands to the macro-level when interest rate guidelines are fuzzy. Or when little is communicated about the foreign policy. Or when there are factors such as geopolitical tensions and trade wars, the prices of publicly-traded businesses drop.
Look for a second opinion, especially when considering big changes to your portfolio or strategy. Unbiased, professional insights can help you reexamine your assumptions and reduce emotional decisions.
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You rarely buy a house, and after a month of ownership, someone offers you 40% more or less than you paid for it. Real estate, for the most part, is an open marketplace, with relative ease in comparing the price you pay to the value you get.
But in auction-driven markets , mispricing happens more often than you think. I believe the confusion in the definition between risk and uncertainty is the main reason why you can buy a dollar for 40 cents in the stock market.
I suggest reading TEVA's annual report for a current example of the difference between risk and uncertainty. Here is a shortlist of the uncertainty TEVA faces:
Price-matching lawsuits, lawsuits for the U.S opioid crises, a considerable debt burden as a result of an M&A-gone-bad. TEVA is also in the midst of restructuring plan and turnover in executive management.
But I bought a few TEVA shares nonetheless. Over the next few weeks, I will write in greater depth about the risk and uncertainty of TEVA. Write to me if you would like to be notified when I upload these essays.