Buying companies that have fallen out of favor with the rest of market has always been a skill of Warren Buffett (Trades, Portfolio) and his team at Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial).
With this being the case, it should have come as no surprise the company acquired a $358 million investment in Israel-based drug company Teva Pharmaceutical Industries (TEVA, Financial) in the fourth quarter of last year. But yet, it is a surprise for many Buffett watchers because the company does not fit Berkshire's traditional value mandate.
Similar to Berkshire's $2 billion investment in Canadian subprime mortgage lender Home Capital (TSX:HCG, Financial), Teva is an interesting pick because it is a struggling company in a struggling industry whose survival is not entirely guaranteed.
A struggling business
Teva's problems have been sometime in the making. Over the past several years, the company has accumulated around $23 billion in debt, and last year it was forced to issue several profit warnings. Revenue has started to decline and the company is facing expiring patents and generic competition for its multiple sclerosis drug Copaxone, which has had sales of $3.8 billion annually but is expected to drop to $1.8 billion this year.
To help it try and survive, management has cut more than a quarter of its research and development programs as well as hundreds of jobs, which sparked protests across Israel. In total, management wants to slash $3 billion from the company's cost base by 2019.
It remains to be seen whether this will be enough to stave off bankruptcy. Some analysts have drawn comparisons between Teva and Valeant (VRX, Financial), the now infamous generic drug producer that, after spending billions of dollars trying to grow through acquisitions, is now in recovery mode after losing more than 80% of its equity value.
Teva's management is guiding for the company to produce between $2.6 billion and $2.8 billion in free cash flow for 2018, which is at least something, although when compared to the group's enormous debt pile, it is insignificant.
Still, it seems Berkshire believes the stock is undervalued at current levels. The company does have some things going for it. For example, the demand for low-price generic pharmaceuticals is only going to grow over the long term. If Teva can maintain its position as one of the largest businesses in this space, it should continue to see rising demand, which gives management room to instigate a turnaround. While $2.8 billion of free cash flow against $28 billion in debt is hardly going to transform the business overnight, it could be enough to convince creditors to give Teva breathing space and not pull the plug immediately.
Is there more to it?
There are some other factors to consider here. This investment may not be entirely value-based. Just like Home Capital, by having Buffett on the shareholder roster, Teva should be able to gain additional recognition from its shareholders and creditors, who are unlikely to want to pull the plug now there is such a well-financed and well-known investor supporting the company.
In addition, it could have something to do with Buffett's recently announced entry into the U.S. health care market. Berkshire's collaboration with Amazon (AMZN, Financial) and JPMorgan (JPM, Financial) is currently only an idea, but by being a substantial shareholder in one of the world's largest generic drug producers, Berkshire's health care business will have a potential benefit available to it that few other competitors also have.
So overall, it might not be a good idea to follow Buffett into Teva. Yes, the stock looks cheap right now and could be a profitable contrarian bet as it trades at a forward price-earnings multiple of only 6.5 and price-free cash flow ratio of 8.1. However, its high level of debt is unnerving, competition in the generic drugs space is only getting tougher and, as of yet, we do not know if management's actions on costs will help or hinder the business in the long term.
Further, there could be much more to Buffett's investment in the business than initially meets the eye and the average investor will never be able to access these intangible benefits.
Disclosure: The author owns no stocks mentioned.
