What’s the Hidden Value in TEVA’s Stock?

Last week I added Teva Pharmaceutical Industries (Symbol: TEVA) to my stock portfolio, at a price of $44.40. It’s not medtech, but it’s still within my chosen niche area of healthcare, and offers many of the traits I look for in medtech stocks. So, why did I buy?

Any hidden value?

TEVA is the world’s largest generics pharmaceutical business, incorporated in 1944, HQ’d in Israel and valued at around $40 billion at the time of writing. It also sells proprietary branded drugs and active pharmaceutical ingredients. On a normalised basis, TEVA has had year on year positive earnings per share (EPS) growth since 2000, along with positive year on year sales and sales per share growth. That’s quite a feat.TEVA also pays a healthy 2.4% dividend (though this is subject to Israeli with-holding tax of 25%), and has paid a regular dividend since 1986.

TEVA has several other characteristics I look for. Return on equity (ROE) was 20% in 2011 and it has a history of ROE consistently over 15% (other than two years where it dipped slightly below before recovering – 14.2% in 2007 and 14.6% in 2008). A high, maintained ROE means the business can reinvest earnings and keep growing profits over time. Net profit margin is historically over 20%, and 24% in 2011. Debt to Equity is around 65% – I like to see levels below 100% (i.e. debt makes up no more than half of the capital structure).

Current valuation is attractive against both historical norms and industry peers, based on price earnings ratio (PE). Trailing twelve months PE=9x (normalised), and Forward PE=7.5x. Historically, TEVA has spent many years with aPE >15x, and quite a few with a PE>20x as a growth stock. I don’t see it as a growth stock anymore, but the current valuation may be overly pessimistic. Forward projections also look healthy – I like to see them positive, but honestly, I don’t put too much weight on the exact numbers anything more than one year out. (What would concern me is a projected FALL in earnings and EPS – things must be bad for usually rosy analysts to project a drop).

So, on the face of it, TEVA looks good – growth, history, good valuation, low debt. Let’s look into it in a bit more detail to see if there’s a reason the valuation may be low. Here are some excerpts from notes I made while reading through the annual report, year ended 31st Dec 2011 (Form 20-F in SEC filings):

  1. Sales 2011 comprise: 56% from generics (including APIs sold to 3rd parties); 35% from branded products including Copaxone (for Multiple Sclerosis, MS), Azilect (Parkinson’s Disease), respiratory and women’s health prods from Cephalon acquisition, Provigil (for excessive sleepiness associated with narcolepsy, obstructive sleep apnea and shift work disorder) and Treanda (for chronic lymphocytic leukemia and indolent B-cell non-Hodgkin’s lymphoma).
  2. Business areas – Generics (largest in world), Branded (specialty, with marketed and late stage pipeline following Cephalon acquisition), OTC (JV with P&G). Revenues 48% US, 31% EU. Incorporated 1944.
  3. Strategy: Increasing Generic Market Share – brand products from other cos. with 2011 sales of approximately $135 billion will lose patent protection by 2015. It also plans to increase generic share in emerging markets (Latin America, Central and Eastern Europe, Asia) where currently low generic penetration – TEVA is a world beater at patent challenges for branded products coming off patent; Investing in Generic Portfolio; Expanding Branded Pharmaceuticals; Increasing Global OTC Opportunities; Investing in Biopharmaceuticals; Expanding Vertical Integration; Enhancing Customer Service; Pursuing Potential Acquisitions. So, maintaining and driving core generics business, while expanding other high value allied niches.
  4. Corporate Development in last 12 months – Cephalon acquisition Oct 2011 for $6.5bn; Taiyo acqn for $1.1bn in July 2011 (Japanese generic); Teva-Kowa Sept 2011 (acquired remaining Japanese JV); PGT Consumer Healthcare Nov 2011 (combines both OTC business in JV outside N America – P&G own 51%, TEVA own 49%); Laboratoire Théramex Jan 2011 (women’s health products in 50 countries); Infarmasa Jan 2011 (Peru branded and unbranded generics).
  5. Product Offerings: Generics – worlds largest generics business, largest generic R&D team, builds revenue by challenging patents and launching products, or challenge patents and enter into agreements to settle patent litigation (=payment to TEVA), API producer for 3rd parties; Branded Products – CNS, respiratory, women’s health, oncology. Copaxone (MS, IV) biggest MS seller but tough market and  subject to new competitive threats from orally administered MS drugs (Gilenya, Novartis). TEVA has own oral MS product in development, Laquinimod, but so far appears limited threat to Gilenya. Also, Copaxone under generic challenge so may come off patent before 2014.
  6. Leading Generics co in US, EU overall (and top in 11 countries), no.3 in Japan, one of top 2 in Canada, no.2 in Russia, no.1 in Israel, Latin America v fragmented with no single leader.
  7. Revenue growth in 2011 to $18.3bn (increase of $2.2bn over 2010), largely driven by acquisitions. Will have to work hard to maintain this growth, but markets identified, and has good track record of buying and integrating cos that build EPS over time. Been acquisitive since early days of company’s history.
  8. Revenue split: Generics = $10.2bn (3% increase over 2010); branded prods $6.5bn (up 34% due to acquisitions), with Copaxone sales of $3.9bn.
  9. Strong generic pipeline – as of Feb 9 2012, 175 prod registrations awaiting approval. Although generics revenues fluctuate widely, this is a core expertise of TEVA’s business and they have a track record of keeping the pipeline of new generic products primed.
  10. Repurchased $1bn in shares to Dec 2011, authorised further $3bn worth repurchases from Dec 2011 for next 3 yrs. Good for shareholders – boosts ESP, management feel stock undervalued.
  11. New CEO designate from 2012 is Dr Jeremy Levin – experienced in big pharma BD&L and M&A. Previous CEO was Shlomo Yanai – ex-Israeli army general. New CEO’s industry specific experience was well received by market (share price went from $36 to $45 after announcement).
  12. Debt increased to $14bn from $8bn (short and long-term) – increased for acquisitions. Still manageable on cashflow basis, and acceptable within debt to equity ratio ceiling.
  13. Risk with Copaxone generic competition – TEVA net margin = 24%; good biotech net margin =30% (e.g. Amgen, Gilead). Copaxone sales of $3.9bn. So, back of envelope net earnings from Copaxone alone = 0.3×3.9 = $1.17bn. If lost all Copaxone sales within 3 yrs, profit based on 2011 (assuming no other forward growth) = $3.245bn (non-GAAP). With valuation of $40bn, this would give PE of 12.3x so still not expensive. AND, likely not be as bad as this as other revenue lines grow and new prods approved.
  14. Assuming there WAS some further growth, projected at $4.9 billion profit in 2012 (analyst figs), subtracting all of Copaxone’s profit contribution gives a net profit of $3.73 billion. This leaves a PE=10.7x for end 2012.
  15. So, worst case scenario assuming loose all Copaxone profits, with no further growth at all from any new product lines is PE=10.7-12.25x. However, market doesn’t seem to punish all companies with imminent genericization if believes pipeline opportunities (real or potential), or acquisition potential which can prevent profit falls. E.g. Forest Labs, and Lilly – both maintained valuations around current sales and profits despite forward projected falls in EPS due to genericization.

So, particularly focusing in on points 5, 13, 14 and 15, the main reason for TEVA’s share price being so beaten up seems to be around the imminent genericization of Copaxone, and also from orally available competition  likely for MS from Novartis’ Gilenya.

But as described in point 15, even assuming a worse case scenario, TEVA still would maintain a forward PE of 10.7x-12.25x. It’s unlikely that sales from Copaxone would be completely wiped out, and indeed, many of the analyst projections already discount lost sales from Copaxone in coming years.

It seems the worst case scenario, and more, is already priced into the stock.

What do you think?

Full Disclosure: I am long TEVA

This post is by Raman Minhas. He is a medtech enthusiast, CEO of ATPBio, and works with entrepreneurial companies, providing partnering, licensing and financing support. He is also an investor in medtech stocks, using a value based approach.

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