Description

• Teva Pharmaceuticals (TEVA, $12.7bn market cap) and Viatris Inc (VTRS, $14.1bn market  cap) are the first and third largest generic pharmaceutical manufacturers globally. Both also have a branded drug portfolio.
• For the last 8+ years, the market has viewed these business as overlevered US generic drug companies that are melting ice cubes with idiosyncratic problems. But now, these companies are reaching inflection points that will drive substantial shareholder return.
• We think both companies are significantly undervalued, trading at 4.7x and 4.4x 2024e consensus EPS and have catalysts that will drive re-ratings in 2024.
• We think the upside in TEVA is 29% to 200% and the upside in VTRS is 52 to 123%.

• The US generic drug industry has been a difficult business for the last 8+ years. The generic drug business is a little bit like running up a down escalator - every year, pricing on your existing products go down, so you have to launch new products to offset the decline.  Prior to 2016, annual base price erosion in the mid-single digits was more than offset by double digit growth in new drugs going off-patent, leading to low to mid-single digits industry revenue and profit growth rates.
• Starting in 2016, these base pricing declines accelerated due to significant consolidation among drug buyers – distributors, pharmacies, and PBMs. What had been a fragmented group of buyers became three entities that now account for approximately 90% of generic drug purchases. These buyers immediately began using their scale to drive down the price of generic drugs. To make matters worse, new low-cost entrants have increased competition on the supply side.
• These dynamics significantly eroded EBITDA for manufacturers, as annual base price declines accelerated from mid-single digits to mid-double digits. Some companies compounded their problems by engaging in debt financed acquisitions at the top of the market. The most notable example is Teva's $40.5bn purchase of Allergan's generic business in 2016 which was 83% debt funded. With shrinking contributions from US generics and limited financial flexibility due to elevated debt, manufacturers were forced to aggressively cut costs and use all available free cash flow to pay down debt.
• Over the last few quarters, it's become clear that there are limits to how low pricing can go, resulting in changing industry behavior and more stable pricing.
• In a stable mid-single digit base decline environment, TEVA and VTRS's US generics businesses can grow overall as the base decline is more than offset by new products going off patent.

 

• Due to significant cumulative price declines we're now seeing a supply response in the industry.
• Large manufacturers are rationalizing their portfolios and abandoning low margin products. As an example, VTRS alone has exited over 350 products.
• We've also seen a number of bankrupties including Akorn, Athenex, Lannett, Endo, and Mallinckrodt. This has further reduced supply, especially in the case of Akorn which completely liquidated in chapter 7 and shut down its manufacturing capacity.
• Compounding the supply side response, the FDA has stepped up its inspection efforts, especially on foreign manufacturers. These efforts have resulted in some facilities being temporarily shut down or having their imports into the US banned.

 

• Buyer behavior is also changing to the benefit of the drug manufacturers. Historically the three large buying groups demanded ongoing pricing concessions from the manufacturers, in some cases requiring monthly price reductions. Now, the buyers have shifted the conversation from lower costs to supply certainty Several companies made comments about changing behavior at the recent JPM conference:
  • Amneal: "We're working to make longer-term contracts, that center into a strategic contracts for certain category of products. We were able to convince them that look at these prices. When companies don't make money, they don't stay in business for a long time. So either we adjust the price and make margins or we get out of this [sic] products. Then you are left with unreliable, unproven companies from low-cost countries. ... So you have to look at these [sic] pricing. I think now, and it's not completely done, but most of the buying groups are now saying mature products do not have anywhere to go. They cannot go any further. They have to go up because the inflation is going up."
  • VTRS: "For 7, 8 quarters now, which is seeing, we have seen relatively stable prices, relatively stable pricing than what we have seen in the previous quarter. That, I think is a little bit of realization and appreciation with our big customers. They appreciate the importance of the sustainable supply chain as well as quality. And all this is rendering that -- and I see this, I see this a little bit sticking around. It's not -- it's always been a cyclical, but I see all the signs of pointing towards this stability being sticking out"
• Going forward, we expect this more benign environment to continue. While the overall base businesses will likely continue to decline, the rate will be a more moderate mid-single-digit decline. This is moderate enough that the overall US generic businesses can be more than offset by new launches. The opportunity for new launches is also larger than in the past as $28bn of branded revenues will go generic every year for the next five years vs. $10bn per year for the last five years.

• Company Background
  • Teva is an Israel-based manufacturer of branded and generic pharmaceutical drugs with operations in 60 countries.
  • Beyond the broader industry dynamic we discussed, Teva had significant issues that included high financial leverage, legal risks from opioid lawsuits, and the loss of exclusivity of Copaxone, a branded drug for multiple sclerosis that once represented 20% of revenue and a larger percentage of EBITDA.
  • These problems are now abating:
    • Leverage levels have declined to ~3.6x net debt to EBITDA from a high of 5.3x in 2019 as the company's substantial free cash has been used to pay down debt.
    • Teva has settled all its opioid exposure.
    • Copaxone, which was at one point 20% of revenue at 90%+ gross margins has gone generic and now represents less than 4% of revenue.
  • Over the last 8 years Teva's top line CAGR'd at -3%. Gross profit was even worse and CAGR'd at -5%. The lost revenue was primarily price-driven in the generics business and from Copaxone in the branded business, which resulted in very high negative incrementals.
  • We expect the business to stabilize and grow from here. Over the next five years we think Teva can grow top-line at a 2% CAGR and gross profit at a 3% CAGR. Revenue growth should be primarily driven by branded drugs with very high gross margins.
• Pipeline Optionality
  • Teva also has significant pipeline optionality. In particular, there are two pipeline assets with read-outs in the second half of this year that could result in a substantial value inflection:
  • First, Teva has a TL1A antibody currently in phase 2 for ulcerative colitis and Crohn's disease. A drug in the same class recently sold to Merck for $11bn after its phase 2 read out. Roivant also sold its TL1A antibody for $7bn after its phase 2 read out. In October, Teva sold a 50% interest in this drug to Sanofi for $500mm upfront + $1bn of additional milestones and royalties, of which $600mm is payable upon the start of a phase 3 trial. As a large player in the immunology space, this is a very strong endorsement of a drug with only phase 1 data. Other drugs in these indications do $10bn+ in sales so even with 50% share this is an enormous opportunity for Teva.
  • Second, Teva is running a phase 3 trial in schizophrenia for its long-acting (LAI) olanzapine. The LAI schizophrenia market is a $4bn market. There is one other LAI olanzapine on the market, but it does very little sales due to the risk of causing comas. Teva's drug is dosed subcutaneously, so likely doesn't have the side effects of the currently approved version that is dosed intramuscularly. Teva has fully enrolled the trial and has not seen a single major side effect in over 1800 injections. We already know olanzapine is a very effective drug. If Teva can demonstrate their version is safe, it could take significant market share in the LAI schizophrenia market.
  • Combined these drugs represent over $7bn in peak sales potential or over $6bn of gross profit, which could be a significant driver when considering Teva is expected to generate $4.7bn of EBITDA in 2024.
• Valuation
  • Even without the pipeline we think Teva is substantially undervalued.
  • The major headwinds for the stock over the last 8 years are now behind it. The company has new management, has made substantial cuts to its leverage, and has a stable and growing base business. The previously problematic US generics business has shrunk such that it now accounts for around 20% of revenue and the opioid liability has been quantified and included in our valuation. Ex-US generics are performing well and growing.
  • Looking forward, Teva will drive growth from its branded drug portfolio and its pipeline. 
  • Most generics businesses outside the US trade at 8x EBITDA or higher. With leverage normalizing, there’s no reason Teva should trade at a discount. On consensus 2024, Teva currently trades at 4.7x earnings, 7.5x EBITDA, and a 16% FCF yield.
  • As investors recognize the stabilization in Teva's business we expect a substantial rerating, with further upside if the branded pipeline is successful.  We think the upside in TEVA is 29% to 200%.

• Company Background
  • VTRS was formed in 2020 through the merger of Mylan, a US-based generic drug manufacturer, and Pfizer's Upjohn unit. Pfizer's Upjohn unit manufactured all its branded drugs that have gone off patent.
  • The combined business is globally diversified and operates in 165 countries, with 26% of revenue from North America, 34% from Europe, 14% from China, and 26% from other emerging markets and Asia ex-China.
  • The merger also significantly reduced the company’s US generics exposure, going from 20% at Mylan pre-merger to 8% today.
  • When the merger was announced, the company laid out a two-phase journey. Phase 1, which is about to be completed, consisted of selling non-core assets and significantly deleveraging its balance sheet to reposition the company.
  • Phase 2, which begins once VTRS completes its intended asset sales, will focus on sustainable long-term growth via organic and inorganic investments, as well as a commitment to return 50% of FCF to shareholders
• Divestitures
  • The first round of divestitures was completed in November of 2022. The company sold a portfolio of non-core assets to several buyers for gross proceeds of $3.6bn at a highly accretive multiple of 9.2x EBITDA.
  • At that time, the company announced its intention to make additional divestitures. While the company maintained confidence in the sales process through 2023, the market remained skeptical. In October of 2023, the company announced an additional divestitures of $3.6bn at a blended 9.1x EBITDA. These divestitures will close in the first half of 2024. Once these deals are closed, the company will be below its target 3.0x debt/EBITDA and on a net debt basis will be 2.8x net levered.
• Capital Return & Valuation
  • At that point, the company has committed to returning 50% of its free cash flow to shareholders via dividends and buybacks. The remaining 50% will be used for business development. Management has guided to a $2.3bn FCF floor pro forma for their divestitures. We think the actual floor is likely $2.4bn since the company divested less EBITDA than it originally planned. At the current market cap, that would be an 8.5% return of capital to shareholders on an annual basis through share repurchase and dividends.
  • Pro forma for these divestitures, VTRS is trading at 4.4x EPS, 6.2x EBITDA, and 17% FCF Yield
  • With significant product and geographic diversity, it is difficult for any one country or product to significantly impact the business.
  • We expect  the stock to significantly re-rate as the divestitures close and new management execute its business plan, accelerates its return cash to shareholders and increases its investment in business development.  At very modest valuation levels, we believe there is 52-123%% upside in VTRS

Catalyst

• TEVA: pipeline read outs
• VTRS: closing dispositions, initiation of share buybacks
• Both: hitting and beating consensus numbers, continued signs of generics industry stabilization, generating significant FCF for capital returns and/or delevering