TEVA - Long

What is it?

Teva is a global multinational pharmaceutical company based out of Israel. It is one of the world’s largest manufacturers of generic drugs, as well as several branded specialty pharmaceuticals like Austedo and Ajovi.

Currently $9 bn market cap, $21 bn net debt, another $1 bn of minority interest/other, $5 bn EBITDA, for an EV/EBITDA of 6x.

The setup

1.       The generic pharmaceutics industry had a powerful run from 2000 to 2015. Various blockbuster drugs came off patent, dovetailing into a slate of new and profitable generic drugs.

2.       Investors – expecting this rate of growth to continue – rewarded the sector with high earnings multiples. Management teams used their lofty share prices, as well as incremental debt, for M&A takeouts that drove share prices higher.

3.       The music stopped in 2015. Payers – the buyers of drugs – achieved better negotiation power through a wave of consolidation of their own. Lower prices for generic drugs ensued, which the industry was not able to offset with new product launches. Industry-wide annual revenue declines have persisted every year since then.

4.       Across the sector, share prices dropped 85%+ from the 2015 peak.

5.       Teva and others had used debt to pay for some of the acquisitions. Shrinking revenue and cash flow led to increased leveraged (5x+ Net Debt/EBITDA for Teva). Investors began fretting about solvency risk, further punishing share prices.

The value trap

1.       Original value thesis (circa 2017) was that Teva would be able to stave off bankruptcy, extend some near-term maturities, and gradually pay down debt with operating free cash flow. The stock had dropped 80% from the peak already. Eventually, investors would stop worrying about default and the stock would rerate.

2.       Long-term value investors (you know who you are) would just need to hold for 2-3 years and be rewarded for their diamond hands.

3.       That hasn’t happened. Why? Two reasons.

a.       First, industry trends have remained weak for longer than expected. A return to sector-wide revenue growth remains elusive.

b.       Second, litigation stemming from the nationwide opioid crisis has expanded beyond the original culprits i.e., Purdue Pharma and the Sackler family. A broad universe of players, ranging from medical distributors to generic pharma companies, is now expected to pay billions of dollars to settle claims from thousands of local, municipal, and state governments as well as miscellaneous other plaintiffs.

4.       Ultimate cost of this litigation is currently undetermined, although various court rulings and partial settlements in the last three years have narrowed the range of expected outcomes.

5.       Consequently, Teva has remained a value trap during this period. The stock dropped another 45% from 2017 until now.

Now what?

1.       Teva did survive and deleverage during a difficult period for the industry. Net debt dropped by a third during the tenure of current CEO Kare Schultz, from $34 bn in 3Q17 to $21 bn in 4Q21.

2.       Since debt is 1/3 less and the stock has only gone lower, the margin of safety for the stock is substantially better now than it was back in 2017.

3.       An investor can make relatively adverse assumptions as to industry revenue trends and the ultimate cost of opioid litigation and still find Teva inexpensive at the current price.

a.       We believe Teva may be worth 2-3x the current share price after $5bn+ in opioid costs and assuming no stabilization in the US generics market for at least another three years.

4.       Crucially, key catalysts are expected within 12-24 months. Teva’s debt is expected to reach the management target of <3x EBITDA by sometime in 2023. At that point, the company can use its $2 bn+ in annual free cash flow for other uses. Like buying 20% of the market cap every year at current share prices.

What mental models apply

1.       Value with a catalyst. Teva’s CEO has said he believes an opioid settlement in 2022 is possible.

a.       The three big medical distributors – AmerisourceBergen, Cardinal Health, and McKesson, collectively a much bigger defendant than Teva – announced on February 26, 2022 a revised settlement proposal ($19.5 bn over 18 years) with major opioid plaintiffs.

b.       Double that timeframe and you might reasonably expect a resolution to the opioid overhang in 18-24 months.

c.       A $5 bn (present value) opioid liability for Teva, on the upper end of what public participants have estimated, adds a turn to Net Debt / EBITDA and does not materially change the currently high ratio of cash flow to market capitalization.

2.       LBO in the public markets. Teva is generating >20% of its current market cap in free cash flow every year and using the vast majority of it to pay down debt. This is value accreting to the equity.

3.       Public markets overdiscount uncertainty. An announced settlement, even at the upper end of analyst estimates, will almost certainly be a big upside catalyst for stock. Further, the headline settlement number is likely to include (a) the provision of free drugs and (b) cash payments over 15+ years. Both will have a present value of (ballpark) half the headline number.

4.       Inflection point in use of cash flow. Once Teva hits the desired <3x net debt/EBITDA, management can redirect $2 bn+ a year to other uses. Yes, they can go on an M&A shopping spree or engage in unproductive R&D. With the stock trading for less than 5x earnings, however, buying back 20% of the stock every year might be a tad more accretive.

5.       Investors extrapolate recent trends. It is likely just as wrong to assume presently that generic pharma industry revenues will contract in perpetuity as it was to assume back in 2015 that they will continue to grow at a torrid pace indefinitely. New generics will be introduced (including so-called biosimilars which Teva is developing), and this too shall pass.

Notes

For brevity, we have omitted a few elements of the Teva story like the declining revenue from a multiple sclerosis drug called Copaxone and the additional potential legal costs from an ongoing investigation of price-fixing in the generics industry. While $0.5-1 bn line items are not nothing, we do not believe they materially change the Teva narrative.