The Perfect Storm – Teva – Part 2

Recent development

This is the continuation of my post (Teva – Part 1) more than a month ago on Teva Pharmaceutical Industries. At the time the ADR was trading at about 18.5 USD per share. The share price would continue to deteriorate over the coming month down towards a low of 15 USD per share. But a week ago the stock made a huge jump upwards after the new CEO was announced. So before we dive into the valuation, let’s look at recent development.

The 3 billion CEO

As was mentioned Teva has been in a long (and desperate) search for a new CEO. When it finally was announced that Kåre Schultz, the danish drugmaker Lundbeck’s CEO has taken up the position, the Teva share rallied about 20% and increased Teva’s marked cap with about 3bn USD. At the same time Lundbeck saw it’s share drop with -13%, so the value of a CEO can apparently be very big. I suspected a pop the day the CEO was announced, but this was way out of proportion in my oppinion. Showing Teva’s desperate state is the size of Schultz sign on bonus, which all-in amounts to about 44 million USD, with 20m in cash. Nicely done for some who earned the equivalent of $6.1 million in salary and bonus last year!

Looking at what Schultz has accomplished. Schultz comes with a strong track record at Novo Nordisk and lately as Lundbeck CEO where he navigated the company through a difficult period that saw patents expiring for its biggest drugs. He cut about 17 percent of the workforce and oversaw a $480 million restructuring and brought a number of new medicines to the market. Lundbeck is now on track to report record sales and earnings this year and its stock price has almost tripled since Schultz’s appointment.

So this is obviously a big positive for Teva and it increases the probability for a successful execution of their very crucial strategy going forward.

Asset sell-offs

Teva needs to sell assets to meet debt covenants. I have been trying to build an model of future cash-flows over the last few weeks. One of my starting assumptions was around the anticipated asset sell-offs. I spent some time trying to estimate how much Teva would be able to get for it’s “non-core” units. This exercise became less meaningful now, since half of the asset sales already been announced.

Women’s health unit

What has been announced so far, in 2 tranches, is Paragard and the rest of the Global Women’s health portfolio, for a total sales value of 2.48bn USD. Here I have to say that Teva surprised on the upside. In my estimates I had a range for potential sales value of about 3-6x Sales, with me leaning closer to the 3x Sales valuation. But here they got paid close to the 6x range for the whole unit. It seems the Paragard unit which sold for 1.1bn USD with sales of only 168m USD, was worth a lot more than I anticipated. Well done Teva!

Future asset sales

I previously assumed that Teva would want to sell it’s Respiratory business to bring in enough cash, but it seems they got paid enough for the Women’s health unit, to be able to keep it. Which brightens my analysis of the future somewhat. The other unit up for sale is the European Oncology and Pain unit. Again it’s hard to guess on multiples, but sales 2016 was 285m USD and high estimates of valuations has been in the 1bn USD range. So I will assume 1bn and with that sell, in total shaving off a total of 3.5bn on a 35bn USD debt burden.

Valuation discussion

It has not been an easy task to come up with detailed estimate of Teva’s future cash flows. The Generics business is at an infliction point, where margins have been expanding for a number of years for all companies. As with most businesses, when margins gets more attractive, competition moves in. As we will see from my analysis, the million dollar question for Teva’s future is how will margins for Generics products develop over the coming years.

Teva has two main business units

The two main business units are: Generics and Specialty Pharma (meaning mostly pharma under patents). The two units are further split into the following and also a “other” unit:

  • Generics (Sales 11,990m)
    • US (4,556m)
    • Europe (3,563)
    • Rest of the World (3,871)
  • Specialty Pharma (Sales 8,674m)
    • Copaxone (4,223m)
    • Other CNS (1,060m)
    • Respiratory (1,274m)
    • Oncology and Pain (1,139m)
    • Women’s Health (458m, now sold)
    • Other Specialty (520m)
  • Other Revenues (1,239m)

Although Generics Sales is higher, the total Operating Income is slightly higher for Specialty Pharma, given its a higher margin business. In my analysis I try to forecast at least partly on this sub-level.

Assumptions – Future Generics market is the key

I quite quickly realized that valuing Teva is about understanding how the Generics market will look like in the future. Up until now Teva has managed to substantially increase its margins on Generics, so has also other companies, like Actavis that Teva bought. With margins now decreasing, both due to pricing power of major buyers (See link) in the US, as well as increased competition from Indian and Chinese players, the investment case might look very different. One the other hand, the sales volumes of generics seems to have a continuously bright future. Generics sales have exploded over the last decade, but with more big drugs falling out of the patent cliff as well as countries pushing for usage of generic alternatives to lower costs, it seems plausible that growth continue at an above market rate.

The more I read about Generics, it looks like any other maturing market with limited barriers to entry. Volumes go up, margins come down and left are the largest most skillful players who can use its scale to out-compete smaller players. So what is left to find out is if Teva is one of those players, has the market in its panic priced Teva way too low, even if what is left is a lower margin business but with good volume growth over the coming 10 years.

Assumption Details

Given that Teva is such a huge company, it’s very hard to accurately model each units future cash-flows but hitting the right assumptions for revenue and margin. I have focused on the broad picture and spent most of the time trying to get the figures right for Generics and Copaxone. It would be too lengthy to go into all the assumptions on margin deterioration and sales.

  • For both business units when calculating margins, R&D, Selling & Marketing and General & Admin expenses has been added into the cost structure. For a bull case, more synergy effects from the merger have been assumed than in the bear case.
  • Discount rate in Bear Case 10%, Base Case 9% and Bull Case 8%. 1% change in discount rate, changes valuation by about 2-3 USD per share.
  • 31.5bn USD debt assumed

Copaxone and other Specialty Pharma

Copaxone is a case about it’s patent expiring on it’s 40 mg drug. It’s not so much a question if the patent will expire, but just how soon, and how quickly generics will take over the market. Here are my assumptions on Specialty Pharma:

copaxone

otherspecialty_Teva

Generics Markets

Teva does not specify how much of the recent margin deterioration in Generics is affecting the different regions. But since Teva still produces Actavis Sales numbers separately, together with total sales numbers, one can back out, at least an approximate Sales deterioration per region. The Sales deterioration is not due to less sold drugs in volume, but due to margins shrinking so quick that top line decreases. What is not really mentioned by Teva is that “Rest of the World” margins and revenue is suffering even worse than the US market, while Europe is seeing more of a mild margin deterioration. I therefore make different revenue decrease assumptions for the different regions. Unfortunately Teva does not produce Generics margins for the regions, so only Sales numbers are modeled with such detail. I have used what I can find in terms of short term and long term forecasts for the generics market.

generics_revenue_teva

generics_grossmargin_teva

generics_operatingmarg_teva

Total

The Total becomes mainly a combined effect of Copaxone income falling off a cliff and the future for the Generics market:

Teva_totaloperatingInc

Other costs

Teva is very good to hide costs and show PowerPoint presentations with very hyped up figures, showing figures excluding for example Legal settlement costs, which is more or less a re-occurring item every year. So on top of the business units Operating Income above I have afterwards deducted legal and settlement fees of 500m USD per year.

The issue with leverage

Naturally with leverage the company becomes more risky, how much more risky is really shown in a DCF of the above cash-flows. I value the company including it’s assumed remaining debt of 31.5bn USD, meaning NPV of Cashflows has to be larger than the debt, to give a positive value to equity. This is of-course does not become a realistic case close to zero equity value. Since an option value kicks in, the option that the companies future cash flows will improve.

But this leverage also makes it more easy to understand why some analyst has a buy recommendation with a target price 100% above current market price and others come to the conclusion it’s still a sell. The difference in assumptions is actually not that large.

Valuation results

Bear Case

The bear case gives a negative equity value of about -2 USD per share, accounting for option value and dilution, the value per share is set 3 USD.

The meaning of this result would be there is only option value left (as described above). It also gives an indication of how hard it will be for Teva to service it’s debt, especially if funding costs goes up for the company (which it will, when cash flow deteriorates). If funding cost reaches 10% as the WACC in my DCF, then the company really can’t service it’s debt anymore on the cash flow it generates. There is really a non negligible probability for the company defaulting, then one can argue that the Israeli state would never allow that, and that it probably true. The bear case anyhow, indicates a share price with possible future share dilution in the low single digits.

I would give this cash-flow scenario a probability of about 20%

Base Case

The Base case gives a share price of 14 USD per share.

I have done my best to try to estimate a realistic base case scenario for Teva, short-term and long-term. Against the Base case Teva currently is slightly over-valued and before the CEO announcement was fairly valued. The panic pricing I had anticipated before my analysis rather came out as being in-line with my base case.

I would give this cash-flow scenario a probability of about 60%

Bull Case

The bull case gives a share price of 43 USD per share.

Here the company manages to execute on all it promises and also very optimistically margins of its Generics business improves again in 2018 and onwards. On a gross margin level, they will still slightly decrease from the best levels seen, but thanks to synergy effects, the operating margins come out very good. Also Copaxone generics versions will be delayed by a couple of years. I have found only one example of a generics company that lately managed to keep its margins fairly stable and that is Perrigo, but they still state they expect weakening going forward (Perrigo surprises). So the expectation of a quick turn-around in margins is very optimistic and rather a blue sky scenario in that sense, rather than a very realistic bull case

I would give this cash-flow scenario a probability of about 20%. I think the CEO hire has taken this probability from 10% to 20%.

Summary

Weighted valuation: 20% * 3 USD + 60% * 14 USD + 20% * 43 USD = 17.6 USD, which is 10 cents from where it is trading at this moment.

To be able to buy the stock, either the stock price needs to go lower, or the probability for the bull case needs to go higher. As soon as the market sees that generic margins are not turning as bad as expected, the stock has as we can see great potential. This explosive share price potential is of course due to Teva’s very heavy leverage. But this kind of leveraged bet on the generics market is not anything I’m willing to do without a serious margin of safety. I would not be comfortable to buy the Teva stock before we see almost a single digit stock price. Therefor my recommendation right now is wait and see. Most likely they will deliver another larger good-will write-down during next year, since the cash-flow the Actavis division is generating is nowhere near what they paid for it (they need to shave off probably another 8-10bn USD). Since Teva is such a large and complex company, this analysis has taken a lot of time from researching other interesting stocks, so somewhat frustrating to come to the this conclusion, which was somewhat surprising to me.

As always, any comments are highly appreciated.

 

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The Perfect Storm – Teva – Part 1

Teva Pharmaceutical Industries

I have had Teva on my watchlist for a while now. In my spare time I scan the market for many companies and recently quite many have been Pharma companies. A few of them has sparked my interest and Teva was one of them, at the time due to the “low” valuation and attractive dividend. So I kept it on my watchlist without taking further action. A few days ago when the stock lost another 30% after news that the company risks a breach of bond covenants, I decided it’s time to take a closer look. Teva is a huge and well researched company, I might need to spend weeks analyzing every detail of the company and it might still be hard to get any edge knowledge wise. But, I think that matters less right now. I think something else is dictating the market value of the company. Right now that is investor panic and fear, which is fairly obvious if you look at the stock performance below. So without having a very deep insight in the company I take a stab at this to see if there is a case for taking a position.

Teva_shareprice

 First some background on Teva

To understand why we today are looking at such a sharp stock decline, we have to look at Teva’s history. First starting with some general company background. Teva Pharmaceutical Industries Ltd. is an Israeli multinational pharmaceutical company headquartered in Petah Tikva, Israel. Teva specializes primarily in generic drugs, but also has patented drugs. The main patented drug, Copaxone, has been the companies largest cash cow for many years. Teva is in fact the largest generic drug manufacturer in the world and if I have understood things correctly a very important part of Israels economy. Many Israeli are proud of their Pharma giant, which has grown to a world leader. Teva shares trade on both the New York Stock Exchange (via ADRs) and the Tel Aviv Stock Exchange, the main volume of the stock trades through the ADR.

Teva has a very long history, the modern day Teva was formed in 1976, so it’s hard to give a comprehensive backdrop. As many Pharma companies it has grown through a number of acquisitions throughout the years. Some larger acquisitions were made already before the 08 crisis, but it was really after 2010 that the shopping spree began.

5 year spending spree

The is just an overview of the largest acquisitions made from 2010 onwards. This is important obviously because of the assets that now form Teva, but also to understand how Teva’s huge amount of debt (which we will come back to later) was built up.

Teva started of in 2010 and acquired German generic Ratiopharm for US$5 billion. The deal was completed in August 2010. In May 2011, Teva bought Cephalon for US$6.8 billion. The same month, Teva announced the ¥40 billion purchase of a majority stake in Japanese generic drug company Taiyo Pharmaceutical Industry, a move to secure a Japan-local production facility. Teva completed the $934 million acquisition on July 2011.  In June 2014, Teva acquired Labrys Biologics for up to $825 million, the aim being to strengthen the company’s migraine pipeline. In March 2015, Teva acquired Auspex Pharmaceuticals for $3.5 billion growing its CNS portfolio.

And after 5 years of intensive fairly large scale buying. One would think that Teva probably planned to slow down a bit and consolidate, no, not at all. In April 2015, Teva offered to acquire Mylan for $40 billion, only a fortnight after Mylan offered to buy Perrigo for $29 billion. Teva’s offer for Mylan was contingent on Mylan abandoning its pursuit of Perrigo. However, both Mylan’s bid for Perrigo and Teva’s bid for Mylan were rejected by the boards of the intended acquirees. Things became messier almost by the day, as Mylan activated a “poison pill” defence against Teva. The entire process could have degenerated into a nasty, lengthy and very expensive legal battle, had a “white knight” not emerged, totally unexpectedly. This was Brent Saunders, CEO of Allergan — the pharmaceutical giant that had emerged from a rapid-fire series of mergers. The essence of the deal Brent had was simple: Teva will buy Actavis, which is the generic arm of Allergan, so that Allergan exits generic pharma and Teva becomes a bigger and more powerful player in that sector, cementing its position as global leader. And so it became, Teva paid $40.5bn ($33.75 billion in cash and $6.75 billion worth of shares) for Actavis. It followed that up with being Allergan’s generic distribution business Anda for another $500m and  in October, the company acquired Mexico-based Representaciones e Investigaciones Medicas (Rimsa) for around $2.3 billion.

To read the full story of this “mess” where Teva bought Actavis I recommend this article: Why Teva Paid $40.5 Billion for Allergan’s Generic Business.

Copaxone

Capaxone the world’s best selling MS drug for treatment of Parkinson’s disease has generated a substantial part of Teva’s revenue/profit over the years (20% of revenue and 42% of profit last year). The Copaxone 20mg patent expired in 2015 and Novartis subsidiary Santoz is now selling a generic version. Teva has extended it’s patent right by introducing a new long-lasting Capaxone 40mg dosage. Teva obtained new US patents covering pharmaceutical formulations for long-acting delivery. Litigation from industry competitors in 2016-2017 has resulted in four of the five new patents being judged invalid, and the fifth remains under challenge. The case reflects the larger controversy over evergreening of generic drugs. At the same time as they sue Teva, Sandoz is now also developing a long-lasting 40mg generic called Momenta Pharmaceuticals M356.

Cash generating company

We will soon move over to a lot of nasty negatives, before that, we should know that Teva has been a very cash generative company, partly due to Copaxone, but also thanks to other parts of the business. Coupled with strong dividend payments one can understand that as long as the business has shown good profits it has been a fairly attractive investment case (although one have had to turn a blind eye to the debt pile).

dividend_history

Although GAAP numbers are far from perfect, I prefer to use those over the numbers Teva wants to focus on, where a lot of adjustments are made. This is back to basics, not trusting anything but an accepted accounting standard (although there is plenty of room to fiddle around with those figures too).

netincome_gaap_teva

Recent events

Although this is not the first time the company is forced to Goodwill impairments, it was still a massive blow a week ago when Teva needed to announce a large write-down on it’s US generics business, which is related to the Actavis acquisition. The impairment was $6.1 billion, and although it’s not a cash outflow now, it shows how the company overpaid for Actavis from Allergan. From a GAAP earnings perspective it will also affect the Net Income. If it had only been a goodwill impairment things would still have been OKish, but second quarter earnings fell short, the company warned that if proceeds from divestment or cash flow fall short, the company could breach debt covenants with lenders. It therefor slashed dividends with 75%.

Due to this Teva has also announced the intention of divesting non-core companies, to raise cash.

So lets list all the negatives

I would argue that almost everything that could go wrong, has gone wrong. And the worst part seems, most of it is still far from solved. In my opinion Teva really is in a perfect (shit) storm right now. I will list all the negatives I have been able to find over the last few days of due diligence.

1. Debt

You all have understood by now that Teva has amassed a huge debt pile and risks to break it’s covenants to it’s debtors. Teva’s MCAP today at 18.5 USD per ADR is about $18.8 billion, whereas it’s debt is a grand total of $34.7 billion. With everyone focusing on this debt and the risk of the company not being able to meet it’s obligations, it’s very important to look at the maturity profile. As with any debt, it’s easier to survive if you just need to pay the interest, rather than paying back principal. Teva is still a cash generating company and if given time, should at least in theory be able to survive this, if the just have time. This is the maturity profile of the debt

debt_dist_teva

As we can see, Teva does actually have a bit of time. Nothing of it’s debt does actually mature before 20th of July 2018, then 1.5 billion USD of bonds mature. That amount the company should be able to scrape together just from the cash the business generates. It’s actually all smooth sailing until Q3 of 2019, when a huge amount of debt matures. So if Teva is not allowed to roll the Term Loan they need to come up with about 4.5 billion USD in cash and they basically have 2 years to do it, most likely by sales of parts of it’s business. Is that a tight deadline? Yes I would say so, but far from impossible to execute. If all debt including Q3 2019 is paid off, the debt load of Teva will have shrunk by almost 10 billion USD and if the business generates cash at same levels as historically, that should be manageable. But that might be a big if, which leads us to the next negative.

2. The Generics industry

By buying Actavis, Teva doubled down on the Generics industry, one would hope that was a good bet. Well short term it does not really seems so. The pricing pressure on generics seems to have increased a lot lately. The U.S. Food and Drug Administration sped up drug approvals, flooding the market with products from smaller companies that compete on price, while pharmacy chains and retailers began consolidating their orders to the point where four groups account for 80 percent of the purchases, Teva said on its recent earnings call. So they doubled down on a business which is in a decline, at the same time as they are in dire need of strong cash flow to meet the debt obligations.

So how bad is this pricing pressure, short term and long term? Well that is very hard to say. But without knowing all the details about the generic drug markets, reasonably the worlds largest player should have a scale advantage and a distribution advantage to smaller players. So the margins might be smaller than in the past, but as a well run company that ought to be positive at least.

3. Company Leaders

Again, we have already understood that some of these acquisitions that were made during the last 7 years, were value destructive for shareholders. So from that point of view the management and board of the company has failed the shareholders. In a time of crisis one would look to a strong CEO to steer the ship through the storm. Well the next problem is that the company hasn’t managed to find one. The previous CEO Erez Vigodman was ousted in February 2017 and currently Yitzhak Peterburg acts as the interim chief executive. A very odd appointment, given that Yitzhak was chairman of the board of directors which supported the Actavis bid. The current chairman, Dr. Sol Barer, said that in the past six months he has devoted all of his energies into appointing a permanent CEO. Barer said repeatedly that the next CEO will be a person of stature with extensive experience in the pharmaceuticals industry. This requirement makes Peterburg’s candidacy irrelevant.

Benny Landa the largest active private investor in Teva, did not go easy in his latest round of comments: “Landa adds that someone on the board of directors is trying to undermine the efforts of Teva chairman Sol Barer to bring a CEO with an international reputation to the company. He explains, “There’s a person on the board of directors on whom we pinned great hopes — Sol Barer. We assumed that he would be able to bring a well-known CEO to the company, but it’s clear that someone on the board of directors doesn’t want him to succeed, and is trying to undermine his efforts.”

So there is plenty of drama to go around in the upper echelons of Teva management now when they have a crisis on their hands.

4. The 100 million shares

Another “small” detail when Actavis was acquired, was that part of the payment was in Teva shares, 100 million of them. Meaning that Allergan is the largest shareholder in Teva, holding 10% of outstanding shares. The lock-up on those shares happened to expire a little bit more than a week ago. Allergan has stated that they have no intention to stay as shareholders in Teva. That is a pretty big overhang on the stock. They might have sold some already, the stock has turned over about 300 million shares in the last 3 full trading days. But it would surprise me if Allergan got it’s 100 million shares out in the middle of that selling panic, I think honestly the share would have traded down much more than that. A lot of volume in these cases is not true sellers or buyers, but traders flocking to a highly volatile stock, buying and selling back and forth, creating huge turnover. Most likely they are still sitting on all the shares, a lot less rich than just 4 days ago.

End of Part 1

This is the end of Part 1, in Part 2 we will make an attempt to see if its worth to try to catch this falling knife. Since we are in the middle (or at the end? Stock trading up right this moment) of the free-fall. I will try to be quick to produce a follow up. Although as we see from all the listed problems above, the will most likely not have gone away, by next week, or perhaps not even by next year. Anyhow this might be the first investment case I present, which I will not invest in, depending on where the stock trades when Part 2 is finalized. Right now I don’t know the answer either, so please fill in with your comments to help me make a wise decision in Part 2.

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