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Matthew Sipos
Matthew Sipos
Articles (9) 

Value Idea Contest: Is Teva Pharmaceutical Industries Ltd. a Buffett Bargain?

Should you follow the footsteps of Berkshire's protégées in this case?

July 29, 2019 | About:

I have had Teva (NYSE:TEVA), an Israel-based drugmaker, on my stock watchlist for a long time. Many investors and financial analysts regard it as a sinking ship. That makes it a security worth analyzing.

Company history

Teva Pharmaceutical Industries Ltd. is a multinational pharma company -- the largest generic drug manufacturer in the world. Through its history, it grew by intense mergers and acquisitions. The company, as known today, was incorporated in 1944.

Now, Teva is a struggling business due to a miscalculated acquisition of Allergan's generic subsidiary, Actavis Generics, at a high figure of $40.5 billion.

In hindsight, this acquisition was an unforced error. Teva is now significantly indebted and has a struggling primary business due to U.S. regulations, increasing competition, delays in launches of its new products and unfavorable tax laws in the U.S.

More recently, it is facing lawsuits connected to price-fixing and the opioid crisis in the U.S. between 2006 and 2012. These legal challenges were widely covered by the media, causing an apocalyptic economic sentiment around the pharmaceutical companies concerned. According to UBS analysts, Teva could pay as much as $4.3 billion in total fines. This amount could quickly set the drugmaker on a slippery slope.

Business

Teva makes money by selling generic, over-the-counter and specialty medicines. In addition, it sells active pharmaceutical ingredients and offers certain contract manufacturing services to other pharma companies. There are pharma operations under the name of Teva worldwide. Its primary markets consist of North American (the U.S. and Canada), European (mainly the European Union) and international markets. Key international markets are Japan, Russia and Israel.

Ongoing U.S. regulatory efforts to lower drug prices and increasing competition through the easing of the Food and Drug Administration approval process for generic medications are compressing revenues and profitability rates.

In the long term, I believe that the U.S. government has no intention to break this industry. Practically, if you want to keep drug prices affordable, you should pay attention not to wreck big pharma. Supply and demand should be balanced. But the sector faces turbulent times, making Teva more enticing for contrarian or deep-value investors.

Moats

Generally, pharmaceutical companies are considered wide-moat businesses. Patented prescription remedies might ensure monopoly position in days to come. Recently, Teva has successfully patented some of its new products: the migraine medicine Ajovy and the Huntington disease treatment Austedo. In partnership with Regeneron, it has a late-stage experimental pain medication Fasinumab. If things work out well, these products may become cash-cows in the future.

Aside from patents, in the U.S. market, customers are being consolidated into larger buying groups. This new practice eliminates the sale of drugs to a friendly, non-price-sensitive middleman who can effectively turn up sales volume. This allows the company to sell medications directly to doctors as they do in other markets like Europe and Russia. That is one of the main reasons for thinning margins. It is safe to say that at the present time, Teva Pharmaceutical appears to have no durable competitive advantage. This is well reflected in the current market value, although Teva may rebound in the future and become a wide-moat business.

Financials

The drugmaker has a price-book ratio of 0.67 with an $8.58 billion market cap. According to GuruFocus, the forward price-earnings ratio is 3.3. The share price of $7.54 is near 20-year low. Share prices tumbled more than 50% this year on concerns emerging about legal issues.

Revenue, net income and operating income

Revenue and even operating income is in a downward channel. Still, analysts estimate free cash flow of around $2 billion ($1.9 billion for this year and around $2.3 billion for the next 2-3 years).

Operating costs

Management’s restructuring efforts appear to be working well. The plan to reduce high-risk, high-uncertainty clinical research and development projects, and have more emphasis on projects that have high barriers to entry, is a good start to regain lost market share.

Return on equity, return on assets and return on invested capital

Historically, the median return on equity at 7.33% and median return on assets at 3.53% are well below the industry average.

The average return on invested capital is around 7-8%.

Source: Teva’s 2018 annual report

As of the end of 2018, the company had a substantial debt load of $28.9 billion on its balance sheet. Last month, Fitch Ratings downgraded Teva from BB to BB-. This year, many other financial analysts downgraded Teva. The analyst price target average is still $13.57.

Management

Kare Schultz became CEO in 2017. He is a Danish business executive, with extensive experience in the field of pharma. Reading the financial statements of the drugmaker, it looks as though it gives a straightforward message to shareholders. The company is in the midst of a restructuring plan that involves aggressive layoffs and shut downs of operations. There is an emphasis on value-added, wide-moat investments. Within two years, new management successfully reduced debt by $6.9 billion. They predict a $3 billion operating cost cut by the end of 2019. The restructuration model seems to be working.

It appears that Warren Buffett's fund managers have trust in management; Berkshire owns a 4.7% stake in the pharma company presently.

Risks

A more than $4 billion penalty could be disastrous leading to Chapter 7.

Hiking interest rates could also eat into profits, but it could survive this.

Another considerable risk is decreasing revenues and profitability.

There is a sector recession associated with generic drugmakers now, which makes Teva a compelling investment opportunity today.

Valuation

Widely respected value investors of Berkshire Hathaway (BRK.A)(BRK.B), Todd Combs or Ted Weschler (I have no specific information about who made this deal), valued Teva north of $15 per share. They built a position with an average price around $15 per share. I assume that this price is fairly below the calculated intrinsic value at that time. At current valuation of $7.54 per share, you can buy this stock with a 50% margin of safety.

The forward price-earnings ratio at 3.3, price-book ratio at 0.58 and price-sales ratio at 0.45 are also good signs of a bargain.

Further, GuruFocus calculated the earning power value, free cash flow and median price-sales value of Teva. These numbers notably exceed current share-price levels. Therefore, the stock looks deeply undervalued in every respect.

Outlook

Legal issues associated with the price-fixing and opioid claims are nothing new. Current price levels are attributable to herd mentality, high short interest and margin-call selling.

For the first quarter of 2019, Teva Pharmaceuticals had free cash flow of $360 million and operating income of only $134 million. Debt was reduced by $500 million to $26.7 billion while $1.6 billion in cash was scheduled for debt repayment for fiscal year 2019. Intangible asset impairments are continually hurting profits. This is the primary reason for the low operating profit. Despite the poor performance of Copaxone, Ajovy and Austedo have a rapidly growing market share. Those can be a substitute for it.

Lawsuits are old stories with an immense media coverage, leading to overall pessimism.
It does not make any sense to blame only these drugmakers for the opioid crisis. There are regulators, doctors and distributors who may be responsible just as much for the damage caused by the overuse and misuse of those substances. I do not think that these claims can stand their ground.

Finally, I consider Teva as a high-risk, but rather high-uncertainty, high-reward contrarian game. Turbulent times provide buying opportunities for enterprising investors. But, investors should use proper risk management and more thorough analysis before buying into it.

Disclosure: No position.

Read more here:

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Value Idea Contest: Aspen Pharmacare

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