Teva is an attractive long investment with considerable upside and limited downside over a 3 year horizon.

We believe Teva will generate roughly $15bn in free cash flow over the next 3.5 years over a market cap of roughly $33bn. At that point, the patent of Teva’s most important product, Copaxone, will have expired. Nevertheless, we believe the company could still earn in excess of $4.5bn in annual net income post 2015. Given that the patent cliff will be over, the company could easily trade at a market multiple of those earnings so assuming half the cash is returned to shareholders (and the rest is used to pay down all the company’s debt) the value of the investment would be roughly $70bn or double the current market cap.

Why the shares are depressed:

• Copaxone patent & upcoming competition: Copaxone is the leading MS therapy and Teva’s largest product, accounting for a quarter of revenue. In June Teva won a favourable court ruling validating its patents on Copaxone until September 2015, removing the risk of an immediate hit to earnings. In addition, Teva has completed clinical studies of a lower dosage/higher injection frequency version of the drug, which if approved by the FDA, may extend the product life by a couple of year to the extent that patients can be switched by September 2015. Investors are also concerned about competition from oral MS drugs coming to market, the most significant of which (BG-12 from Biogen) is expected to launch at some point in 2013. While this will likely pressure Copaxone’s market share over time, it is unlikely to have an immediate massive negative effect as such drugs take time to gain confidence among doctors and existing Copaxone patients will not massively switch to a new therapy from one day to the next. Hence, we believe the effect is manageable, particularly in the context of a well anticipated patent expiry a year and half later.
• European Exposure: Teva generates roughly a quarter of its revenues from Europe. About 2/3 of that is generics. The macro environment in Europe has impacted this business as there is ongoing destocking in the various distribution channels as well as through imposed pricing pressures from local agencies. Combined with the falling Euro, these issues have caused Teva’s European top-line results to come in below expectations for several consecutive quarters until the most recent one. (new CEO cealry did a better job at guiding for this segment). However, looking through these short-term issues, the European generics market is growing organically as penetration is far below U.S. levels (e.g. <10% in Italy, Spain, France and <50% in Germany and the U.K. compared to ~80% in the U.S.) and national health systems across the continent are looking for ways to significantly reduce their spending. In addition, the aging population is driving sustained growth in drug usage. Teva has a strong footprint across the continent with leading positions in key markets.
• Management: Teva has built the world’s leading generic drugs company over decades via M&A. In recent years, the cash flows derived from Copaxone have helped make some large accretive and strategically sound acquisitions such as Sicor, IVAX, Ratiopharm and Taiyo. With Copaxone coming off patent investors have increasingly focussed on Teva’s ability to replenish those cash flows and there was a growing perception that the existing management team did not have the experience to build a solid branded drugs pipeline. Last year’s acquisition of Cephalon was perceived as a desperate move, exacerbating the concerns. Teva’s board has reacted to this by appointing Dr Jeremy Levin as CEO. This was well received in the market place. Dr Levin has extensive experience and a respectable track record from his work at BMY. He is currently going through a thorough review of Teva’s pipeline opportunities and will report to the market on the long-term plans later this year. Successful pipeline products play little to no role in our long term investment thesis for Teva.
• Quality Problems: Last year Teva’s U.S. generics growth was weak for a number of reasons. One major one was that 2 manufacturing plants for injectables (Irvine and Jerusalem) were shut down by the FDA due to quality issues. These issues are now resolved and the production lines are gradually coming back on stream. The market however has taken this negatively as it probably harmed Teva’s perception as a quality producer relative to Indian importers that are trying to gain share in the U.S. We generally agree witht his notion though we should point out that injectables are difficult to make (see Hospira’s issues) and competition in that space is therefore far less intense than in other areas of generics. Teva’s know how in that area remains a key competitive advantage.
• U.S. generics pricing & product launch opportunities: 2012 is generally perceived as the biggest year in terms of new launches for the generic drug industry and investors believe opportunities will become scarce after that. In addition, pricing continues to decline 3-4% per year in the base business. Our view is that new opportunities are presenting themselves in more specialized areas were competition is less severe and Teva has the ability to develop a competitive advantage such as Biosimilars. Over time these will more than offset the saturated opportunity in simple molecule exclusivity periods. In addition, our post 2015 earnings outlook assumes new launches halve from the current run-rate.

The positives

In addition to the above being well understood and priced in by investors, we see several interesting upside opportunities:

• OTC JV with P&G: this has just launched and is growing at double digit rates with the potential of being an attractive sustainable profit driver deserving a staples like multiple. ( see J&J’s Pfizer OTC transaction of 2007 as example)
• ROW generics: Teva has built a strong presence in Japan which is a very attractive market as generics penetration is still around 20%. Given the budgetary constraints and aging population this is rising rapidly. Latam is another attractive region where Teva is increasing its presence. In all, Teva’s ROW generics business is growing at a double digit pace and will likely continue to do so for the foreseeable future.
• Pipeline: as mentioned before, we attribute little value in our base case scenario to the pipeline though there are some promising Phase 2 and 3 products in there that could significantly improve the post 2015 earnings outlook.
• Cost cutting: In recent investors meetings Dr Levin has mentioned Teva enormous global manufacturing footprint numerous times. Teva has 74 manufacturing plants. Dr Levin has just hired Carlo De Notaristefani (as CEO global operations) who worked with him at BMY where they reduced the company’s manufacturing footprint from 28 to 12 without reducing quality and at the same time increasing overall capacity.
• Value creative capital allocation: Teva currently spends just under $1bn a year on its dividend and has a 3 year buyback program totalling $3bn. Given annual free cash flow of somewhere between $4bn-$5bn it leaves $7bn-$10bn in cash flow that could be used in a value enhancing way (rather than pay down cheap debt). If this is invested at ~10% (any pharma M&A should yield at least that post synergies given current valuations) it could enhance post 2015 net earnings by ~15%.

In conclusion, this appears as a safe , non-cyclical investment where the negatives are very well understood and the positives ignored so that there is limited downside with considerable upside over a long term horizon.

• Pipeline progress
• Analyst day announcements (buybacks, cost cuts, etc)
• New Copaxone approval
• Delivering on earnings expectations