Teva Pharmaceuticals (“Teva” or nature in Hebrew) is an Israel-founded global pharmaceuticals company that develops, produces, manufactures and markets generic drugs in all major therapeutic categories. Teva has a leading position in the U.S. (in terms of both value and volume) and in Europe (in terms of value). While the core of Teva’s business is generic drugs, around 30% of Teva’s sales are generated from branded drugs like the MS drug Copaxone and the Parkinson’s drug Azilect.

Teva has around 36 manufacturing facilities around the globe, making it nearly 4 to 6 times the size of any of its competitors: Mylan (MYL) and Watson Pharmaceuticals (WPI). This allows it to produce drugs more cheaply and consequently makes its drugs cheaper, one of the most important things in the generic market.

Generic Drugs

As generic drugs are a big part of Teva’s sales, we need to pause a bit and understand the market of generics. Generic drugs are an equivalent alternative to the patented drugs they copy. They are sold at a significantly lower prices because their development process is relatively short and less costly. Generic drugs contain same active ingredients and they also meet similar regulatory requirements. The generic drug market continues to grow as many blockbuster drugs are set to expire in the near term and the need to control the healthcare costs, particularly given the increase of elderly population and the worse financial conditions of the governments around the world.

II Business

Teva is not entirely a generics play. It has some significant innovative medicines of its own. In the pie chart below, we see that only 67.7% of the sales came from the generics business in 2010. Nearly 20% of the sales come from two of its patented drugs: the MS drug Copaxone and the Parkinson’s drug Azilect. Combined they have sales of more than $3.2 billion in 2010. Furthermore, as these are patented drugs, Teva likely has higher margin from them than its generic division drugs.



The generic division grew by 21% in 2009 and 17% in 2010. But the innovative division clocked in a growth of 39% in 2009 and 20% in 2010. The smallest division of biosimilar compounds had the best growth rate. It grew at 17% and 51% respectively in 2009 and 2010.

Pipeline

Teva has one of the most impressive pipelines in the world. Here is a brief overview:

• Approximately 206 product applications awaiting final FDA approval
• Approximately 80 first to file applications pending in the U.S.
• 1846 generic approvals in Europe, as of December 2010
• Over 3,000 marketing authorization applications pending approval in 30 European countries
• Over 1250 drugs in the pipeline

With so many compounds, it is hard to look into the details of the pipeline. But in the generics play the pipelines are inherently less risky. You already know that the drug has been approved and you only need to make a copy as cheap as possible.

III Moat

Opportunity

Teva is a pharmaceutical drug vulture — ready to snatch a drug on the patent cliff. Teva probably brings more revenue than its competitors — Novartis’ Sandoz (NVS), Ranbaxy International and Watson Pharmaceuticals put together!

To put the future market in perspective let us look at the some of the companies facing a patent cliff pretty soon and how Teva is going to gain from this loss.

• Eli Lily (LLY): Lily has one of the worst patent cliffs to face among the big drug names. It is set to lose Zyprexa (in 2011, $5 billion and 24% of Lily’s sales), Evista, Cymbalta and Humalog, all before end of 2014. These drugs rake in nearly $6.2 billion in sales combined, which is nearly 27% of Lily’s revenue.
• GlaxoSmithKline (GSK): Glaxo is slated to lose both Advair ($5.1 billion in sales) and Avandia to patent expiration before the end of 2012. These two drugs put together account for 24% of Glaxo's revenue.
• AstraZeneca (AZN): AstraZeneca, by the end of 2014 is going to lose Seroquel, Symbicort, Iressa and Nexium. Nearly 60% of the current sales are set to expire by the end of 2016.
• Pfizer (PFE): By the end of 2014 Pfizer will lose Viagra, Celebrex, Xalatan, Geodon, Detrol, and the best-selling drug in the world, Lipitor, with $5 billion in sales. These drugs contributed $8.8 billion in sales in the first of 2011 which is nearly 30% of the revenue.
• Bristol Myers Squibb (BMY): BMY's largest drug, Plavix, will lose its exclusivity in 2012, and all of its current blockbuster drugs will also lose patent protection by 2017. Plavix rakes in $6.67 billion in sales and Ablifiy $2.57 bilion.
• Sanofi (SNY): All of Sanofi’s blockbuster drugs except Lantus are losing patent by the end of 2011.

And who is going to profit from all these losses in sales? Why, our dear Teva! For example, sales of Eli Lilly's blockbuster antidepressant, Prozac, fell from peak sales of $2.8 billion in 2001 to a negligible amount (out of the company's annual reports) after its patent expiration in 2001.

Economy of scale

Let us look at the sales of Teva by the outlet.


Most of Teva's sales come from drug stores and the wholesalers. It is important in these cases to have the pricing power on your side. Teva's benefits are twofold here. First, Teva is huge in scales, compared to any of its nearest competitors. This allows it to manufacture drugs cheaper and hence already puts it ahead of its competitors. Secondly, retail chains and large distributors buy drugs in bulk and this allows them to negotiate lower prices. These chains can then offer lower prices for their customers. While such pricing pressure is a major concern for smaller generics manufacturers, Teva is unique because of its size. As it controls a huge share of the generics market, it can more effectively bargain.



IV Risks

Patent cliff

It is ironic that a generic manufacturer that snatches the patented drugs as soon as possible for its profit, is facing a big patent cliff of its own. Teva's two patented drugs that contribute to nearly 20% of the sales are facing patent expiration soon.

Copaxone is the leading multiple sclerosis therapy in the U.S. and globally and is approved in over 50 countries worldwide, including the U.S., Canada, all European countries, Russia, major Latin American markets, Australia and Israel. There are patents relating to Copaxone expiring in May 2014 in the U.S. and in May 2015 in most of the rest of the world. There are also various patents protecting aspects of the process of preparing Copaxone and analyzing the product between 2019 and 2024.

There are also several drugs that compete with MS and with the approval of Novartis' orally administered drug Gilenya, the competitive landscape is going to change in the next few years.

Azilect is protected in the U.S. by several patents that will expire between 2012 and 2027. In addition, Azilect is entitled to new chemical entity exclusivity for a period of five years from its 2006 approval date. The European patents expire between 2011 and 2014. Azilect is also protected by data exclusivity protection in the EU until 2015.

Azilect also competes with Mirapax, Requip, Neupro and Comtan. Still the sales of these two drugs put together have grown at the rate of 20% in 2010.

Competitors

A few years ago, Teva was a single player in the generics market until its competitors started expanding. It had the largest sales by volume, the largest number of products, the most patent challenges and only Sandoz (Novartis' generics drug division) came anywhere close. But with the recent merger and acquisitions in the generics market, Mylan and Barr are becoming major players (Barr was acquired by Teva in 2008). Mylan's acquisition of Merck's generic division its international sales have jumped from $5 billion to $75 billion. These companies are now in a position, for the first time in history, to compete against Teva on the global front.

Patent Challenges

Generics can be made under two conditions. When the patent expires the drug company loses the exclusive right to producing and selling the drug and this allows the generics to quickly make a copy and sell it cheaper. It is also possible for a generics company to challenge a brand name and claim that parts of it should not be protected by a patent. If this occurs and the generic brand wins the challenge then it gains a 180-day exclusive right to produce the drug. Teva has gained several of these rights on Simvastatin, Bupropin, Pravastatin and more. But this makes Teva more vulnerable to patent challenges than other generic manufacturers. Recently, drug manufacturers have started fighting these drug challenges and even when they are not successful, this wastes a lot of money and time for the generic manufacturers.

Medicare

This is the government health subsidy plan. Recently, the government has begun suing the drug companies, including Teva, for price fraud. The government is suing for defrauding the state-owned programs like Medicaid. If the government wins, the companies will be forced to pay million of dollars to the government and also change the pricing scheme of the drugs. The first of these trials will not be finished until the end of 2012 but Teva, being the biggest generic manufacturer, is going to lose the most.

Financial Risk

Teva has always been financed at an average leverage of around 2. In recent years the trend has been to my liking. It has been paying its debts and the equity ratio has improved significantly.




Liquidity and capital resources

If we look at the long-term debt of Teva we arrive at the following table.

Payments Due By period	Less than 1 year	1-3 years	3-5 years	More than 5 years
Obligations	$9,835	$3,729 $2,814	$1,496	$1,796

With a current ratio of 1.24, the debt situation is not something to worry about at the moment. The current ratio is below the average in the last decade — the average stands around 1.9 but with the recent acquisition of Cephalon for $6.8 billion, the balance sheet is in tremendous shape.

Share count

Teva has a history of diluting its shareholders by growing the number of outstanding shares. The share count has increased from 546 in 2001 to 921 in 2010. This is an annual increase of 5.3%. In-spite of this the EPS has grown at a tremendous rate of nearly 20% in the same period. Teva has also been able to increase the dividend per share at an astounding rate of 25% in the last five years. This I like very much. But that said, the share count is something investors should keep their eye on.



V Profitability and Management

Teva has a fabulous management. Their performance and the health of Teva is their best testament. So, let me get back to analyzing the company to prove to you that they have a very good corporate culture.

Revenue

Teva has grown its revenue at the rate of 25% in the last 10 years. Analysts believe that the future growth rate will be muted but they have a consensus of growth around 10% each year in the near future.



The growth in revenue and the EPS is quite impressive also. The last 10 year growth in revenue has averaged around 25% and the EPS growth around 20%.
The profitability and the margin meanwhile has not suffered too much. The graph below looks a bit zig-zaggy, but let me point out that the net margins have been quite a bit above 6% in the last decade. The average is around 14%. The nature of the graph is best explained by the business itself. If Teva gets a significant drug and can mooch of the sales then it will have a good year. It may also have a down year if none of its newly launched generic drugs perform well.



Teva, on the other hand, has been a cash flow generating machine. It has clocked in a FCF growth rate of 37% in the last decade. This is fabulous and a statement of its cash generating power.



V Valuation

Graham's Intrinsic Value Computation

The EPS in 2010 was $3.67. With a growth rate of a conservative 5% we get the intrinsic value of 3.67*(8.5+2*5) = $67.89

Discounted cash flow calculation

The FCF is currently at $3.4 billion and with a 5% growth (it has averaged a growth of 37% in the last decade) for five years and a 20% discount, the DCF model gives a free cash flow of:

3.67+3.67*(1.05/1.2)+3.67*(1.05/1.2)^2+3.67*(1.05/1.2)^3+3.67*(1.05/1.2)^4+3.67*(1.05/1.2)^5 =
=16billion

With $15 billion in goodwill and $22 billion in equity, the book value is $22 billion, which puts the company to be worth $38 billion. Note that the scenario taken is quite a bit under what the market expects Teva to achieve and we also took a 20% discount and only calculated its worth in five years of FCF. The current cap of $33 billion (share price $37 a share) is a 13% discount to this dire scenario.

Industry comparison

Company	Teva	Mylan	Watson
P/S	2.3	1.4	2.3
P/E	12	20.3	61.3
PEG	-	0.5	1
P/B	1.6	2.5	2.7
P/CF	8.5	13.9	12.9

The industry comparison puts Teva in the best position. It has the best cash flow, and only the P/S ratio is higher than Mylan. But then again, Teva has better margins and hence manages a better P/E. If we look at the RoIC (favored by Warren Buffet) as a benchmark for profitability of a business and the judge of its management, our choice among the three generic manufacturers becomes clear. It seems that Mylan has not been able to handle the increase in business quite well, but Teva had a stellar performance still. The RoIC has recovered from the crisis and sits at 12%, which is slightly above the decade average.



VI Bottom-line

To summarize:

• Teva has a great management with significant growth opportunities due to many patent expirations of major drugs in the near future.
• It is in a unique position to benefit from the cost cutting which is taking place in the government-operated medicare business and also shrinking purchasing power of the global population. Because of the size of Teva, the pricing power favors it by keeping it immune from the pricing pressures from big retailers and wholesalers.
• It has also grown through a series of acquisitions — acquiring Barr for $7.5 billion, Ratiopharm for $5 billion, Cephalon for $6.8 billion and a $934 million majority stake in Japanese company Taiyo Industry in a move to secure a Japanese local production facility.
• Teva is very undervalued on the Graham's intrinsic value calculation which yields a value of $68 a share. It is also a FCF generating machine and will earn more than the (current market cap-book value) in five years with 20% discount and 5% growth in FCF (easy as the historical growth rate has been around 37% in the last 10 years).
• Teva has clocked in a fantastic growth rate of 25% in revenue and 20% in EPS in the last 10 years.
• Teva has a fantastic management and balance sheet. They are paying debt and the dividend is increasing at an average rate of 36% in the last five years and the payout ratio is still around 19%. It also performs very well on several other metrics. The RoIC is 12%, debt/equity is 0.17, the current ratio is 1.25 and it has also bought back $1 billion worth of shares in 2010.
• Still there are some risks: its major innovative drugs, Capoxane and Azilect ($3.6 billion in sales), are set to come off patent soon, but the recent acquisitions and the innovative pipeline of Cephalon will probably cover the gap in the sales.
• It also faces some legal challenges from the U.S. government and states and from big branded drug companies. The litigation cost could run in hundreds of millions, but none of them are due before the end of next year.

Additional disclosure: I am long on Teva. I may buy more if the share price drops below $40. I own no shares of Mylan or Watson.

What Worked in the Stock Market for Long-Term Investors?

Extensive research has found that the companies with predictable revenues and earnings outperform the market average; they also suffer lower probability of loss. As a matter of fact, this kind of companies are exactly what Warren Buffett wants to buy and hold forever. Please read the research about what worked in the stock market:

Part I: What worked in the market from 1998-2008? Part I: Predictability Rank
Part II: Role of Valuations
Part III: Intrinsic Value, Discounted Cash Flow and Margin of Safety

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