Description

Teva Pharmaceuticals stock has been cut in half since the start of 2016 but looks close to finding a floor as much of the bad news appears priced in.  The stock’s decline can be traced back to several factors including concerns about U.S. healthcare reform and the impact to pharmaceutical pricing practices, rising leverage due to a poorly executed and expensive acquisition of Allergan’s generics business and the continued overhang of generic competition on their largest (and most profitable) drug franchise, Copaxone.  In addition, the CEO left in early 2017 and the company is currently conducting a search for his replacement.  Given the amount of negative news over the past year, the sell-off is not surprising.  AT current levels, however, the high free cash flow yield (and potential to delever) make the stock attractive. 

        The bulk of the Company’s revenues come from two segments: Generics (55% of 2016 revenues, moving up due to the Allergan acquisition) and Specialty (40% of 2016 revenues).  In Generics, Teva is the largest global player with expected worldwide revenues of $13.5bn in 2017 ($300bn+ mkt growing high single digits according to BCC Research).  The company recently closed the acquisition of Allergan’s generics business (closed 8/2/16, announced 7/27/15, for approximately $39.5bn) which at the time of the announcement was cheered for adding scale, although at a steep price (the stock peaked shortly after the announcement at $72/share and hasn’t crossed that mark since).  The generics industry is expected to grow over the next several years but is somewhat in flux.  Slowing patent expirations among branded pharmaceuticals mean a lumpy revenue outlook in the US and Europe while competition remains intense (Indian manufacturers continue to gain share with their overall share in the U.S. rising from 14% to 16% over the past five years).  In general generic manufacturers face mid-single digit price declines on their existing portfolios with rapid erosion of profitable new generic drugs (as more entrants come in to make the drug after a period of exclusivity expires).  Despite this, the overall industry (and its manufacturers) continue to grow as there is a pipeline of drugs coming off patent (although the potential sales up for grabs in any year can vary dramatically). 

        The Specialty segment is closer to a traditional pharmaceutical company where they create and sell proprietary (patented) drugs to satisfy unmet medical need.  The problem with this segment is Copaxone.  This drug (used to treat Multiple Sclerosis) generated approximately $4.2bn in revenue in 2016 and $3.4bn in operating profit (versus the segment’s $8.6bn in revenue and $4.7bn in operating profits).  Copaxone will face generic competition in 2017 and will be a drag on revenue and profits going forward.  Other drugs within the Specialty segment also face competition including Azilect (generics launched January 2017), ProAir HFA (generics likely Q3 2017) and Treanda (generics likely at some point before the beginning of 2019).  Collectively these drugs represent $1.3bn in the Company’s 2017 revenue guidance with generic competition baked into the forecasts for both Azilect and ProAir leaving most of the surprise risk with the anticipated $600MM of Treanda sales. 

        Estimates for Teva have been declining for over a year.  At the time of the AGN acquisition the Company predicted $26bn in pro forma revenues and $9.5bn in pro forma EBITDA.  Today their guidance for 2017 stands at $24bn in revenues and $8.0-$8.4bn in EBITDA.  In fact since April 2016, 2017 EBITDA have fallen from $9.7bn to $7.9bn and 2018 estimates have declined from $9.8bn to $7.7bn.  On top of that , current guidance doesn’t take into account the likely entry of generic competition for Copaxone 40mg; so there are likely more cuts to come (although the company did guide to what the impact might be). 

        The obvious question is why get in front of a mis-managed, over-levered company operating in a sector over run with negative headlines (healthcare reform, pricing), facing stiff competition (in the generics business) and likely to have (at least) on more estimate cut coming.  I think it comes donw to price and the potential that the stock has finally found a level where investors are willing to wait for the turn.  None of the issues mentioned above are unknown to the market.  If they are indeed priced in and the company gets some credit for a potential turnaround, I see 35%+ upside to the stock plus a 3% dividend yield. 

        The company currently has $35.8bn in gross debt outstanding (levered 4.5x off of street consensus EBITDA).  They have access to a $4.5bn revolving credit facility with a $1.2bn drawn as of 12/31/16.  Over the next five years principal repayments will be $5.3bn in 2018, $3.85bn in 2019, $4bn in 2020, and $4.1bn in 2021.  Approximately $7bn of the debt is floating rate so the impact of rising interest rates will be somewhat limited.  Given that the company has guided to $6.3-$6.7bn in free cash flow for 2017 (including some divestiture proceeds) the profile looks adequate as long as operations don’t get materially worse. 

        In fact if you look at the free cash flow profile things start to look a little more attractive.  The company guided to $8.0-$8.4bn in EBITDA for 2017 and expects to pay $850MM in interest expense and has an 18% tax rate.  Using their guided $1bn in capex, gest you to free cash flow of $5-$5.3bn before changes in working capital and divestitures (the Company guided to $5.7-$6.1bn in cash flow from operations in 2017).  If they can come in a $5bn (prior to divestitures) that represents a 15% free cash flow yield on the equity.  Reducing the cash flow for the potential loss of Copaxone 40mg (estimated at $1.2bn in EBITDA) you still get to a 12% free cash flow yield. 

        The company currently trades at an EV/EBITDA of just under 9x vs. a recent history closer to 10x.  cash generation and debt paydown should help the relative position of the equity.  Trading from a  double-digit free cash flow yield to a high single digit one would put the stock a approximately $43 or 35% above current levels.  At that market cap the EV/EBITDA would be 10.5x (assuming they use free cash flow remaining after the dividend to pay down debt), at the high end of its recent history. 

        Next year this time the situation should look better.  With the expected decline in Copaxone this year the controversy should be over $1.875bn in profits (at best), you will have incrementally lower debt and the generics business should benefit from the announced cost cutting (synergies related to the Allergan deal).  In addition, the specialty pipeline should start to generate revenues to begin to offset further erosion of Copaxone.  

Catalyst

Debt paydown/Free Cash Flow generation