Why I Think Teva Pharmaceuticals is Cheap

Stock Price: $53.75
Shares: 921mm
Market Cap: 50BB
Net Debt: $6.2BB
TEV: 56.4BB
EPS 2011 est: $5.30


Today I am buying a half position in Teva Pharmaceuticals, ticker TEVA. I paid around $53.75 per share, and believe that I would make it a full position at around $50 per share.



I finished work on this awhile ago, and have merely watched it, waiting for a pullback. Technically its a terrible stock, it hasn't done much in the past year, down 15% off its highs. And since September its only up 10% against the market up 20%. I think this is unwarranted, and recommend buying some.



As you can guess, Teva is a drug company. Specifically, their primary business is manufacturing and marketing generic drugs. Key is that 70% of their revenue is from selling generic drugs, and 30% is from selling branded drugs that they have developed. I think what is interesting about this stock is 1) its a little beaten up, with quite a bit of concern over its primary branded drug, Copaxone, and 2) the generic industry is growing rapidly over the next five years, as branded drug patents expire. First a look at the macro environment.



The so-called patent cliff is horrible for the branded companies. But their loss is the generic company's gains. Teva should benefit tremendously. The top 20 drug companies in the world sell about $500BB of drugs per year, and I saw one estimate that the total industry is $800BB in annual sales. The patent cliff, or amount of branded drugs losing their patents in the next 4 years, is estimated to be $150BB. That is a huge percentage of the industry, almost 20% of total revenue. Given this, its hard to like the branded guys, they are desperately trying to grow revenue via acquisitions, and also cutting back on R&D costs. Pfizer announced decent earnings guidance this week, but only because they are taking an axe to their R&D costs, cutting them from $9BB last year to $7BB in 2011. Pfizer's Lipitor and Plavix are just two blockbuster drugs losing their patents THIS YEAR.



That means there is a huge market for the generic companies to pick up off-patent drugs and grow revenue. Generally speaking, generic drugs sell at a 50% discount to the price of the branded drugs. The formulations are the same, and key to getting into the generics market is by being the first to file an ANDA application (the "Abbreviated New Drug Application") with the FDA. Basically, if you are first, then you get a 180 day exclusivity window on selling your generic to the US market. This first mover advantage is clearly important, and the best generic companies win this race.



So, industry wise, if $150BB of branded drugs are coming off patent between now and 2015, then how much can Teva get? Well, this was my first big picture analysis as it relates to TEVA. First of all, branded drug companies like Pfizer actually have about 50% market share in the generics. They have the know-how and the manufacturing capacity to produce generics, so it makes sense. Second, if prices are 50% lower on average (they start at a 20-30% discount, then migrate down over time to a 60-70% discount), then that means the generic industry has $38BB of revenue up for grabs. Given that Teva has about 25% market share worldwide in generics, then I think they should be able to pick up $9.4BB of revenue in that time period. With annual sales at Teva today running around $15.4BB, that is a huge number.



Looking at it from the micro perspective, Teva reports that they have 216 ANDA or new generic drug applications pending right now. They were first to market on 83 of these drugs. Further these 216 drugs amount to $113BB in branded sales. At a 50% price discount, times 25% market share, that gets me $14BB in revenue potential. That would double their revenue over the next few years.



So, net net I wouldn't be surprised to see Teva add between $9 and $14BB of generic revenue per year between now and 2014. And in fact, if you look at the company's "Targets for 2015" management believes they can get to $31BB in sales by then. That is an additional $15BB in revenue, much of which will be from new generics, with the rest from acquisitions. It seems actually quite doable. (Now, to be fair, there is a decline in price in generic drugs over time, as more generics hit the market, prices tend to fall.)



Next I looked at the micro-environment, the financials, and TEVA's valuation. The big risk to the stock, and the subject of many questions seems to be their primary branded drug, Copaxone. Copaxone is an MS drug, Multiple Sclerosis, and became Teva's blockbuster drug starting in 2007. From a revenue perspective, its done so well, that its grown to be 20% of the TOTAL COMPANY'S REVENUE. In 2009, they did $2.8BB in sales of Copaxone, and Teva did about $14BB in total sales. And, furthermore, it has higher margins, so that I estimate that Copaxone ALONE generates about $1BB of Operating Income for the company, out of about $5BB total.



On that front, the bad news started rolling in last year. First of all, Copaxone's revenue growth, which had been tremendous, died. Q3 revenue outside the US was down a little year over year. Then Novartis got FDA approval for its drug, Gilenia, an oral MS tablet. Copaxone is injected. A tougher sell. So, there will be pressure here no doubt. I could talk at length on Copaxone, but generally I think you have to file it under the "unknowable" bucket. There are legal challenges to the patent, requests for early generics from competitors, and its patent runs out in May 2014. All the big guys are after a piece of this business. Generally though, its supposedly a very complex formulation, and a trial won't start until 2012, and probably will last for years. I would hazard a guess that Gilenia is the biggest risk, and Copaxone slides 1-5% in revenue in 2011 vs 2010. I do note that they are working on a tablet version of Copaxone. Management also recently said that they expect revenue growth from Copaxone in 2011.



Also, the other big news for Teva in 2010 was that they dropped a hefty $5.2BB in cash to buy ratiopharm, a German generic drug maker. The German market is tough. Margins are slim and topline growth has died. Healthcare insurers there have cut drug prices to squeeze savings from them. My math on the deal was that they paid 22x earnings of $240mm, or a 4% FCF yield for ratiopharm. That isn't a bargain price, especially when you can buy back your own shares for 10x earnings.



So, was the ratiopharm deal a good one? Well, given that management believes that there are $400mm of synergies associated with this acquisition, it could actually be a home run. Lots of smaller generic companies outsource manufacturing, and don't have quite the scale and size of a Teva. So, Teva buys them, brings more efficient manufacturing in-house and gains scale and margin. It's worked for them in the past when they acquired Barr Pharmaceuticals. I think it has a good chance of working for this deal.



While ratiopharm generates around $2.4BB in sales, they do less than 5% net margins. As a smallish family business based in Europe, and knowing that Teva does 20% net income margins, then I do believe there is a lot of room for improvement. If only $300mm of the synergies works out of the $400mm that management is estimating, then in essence they will have paid 9.6x earnings, or getting a greater than 10% ROI without any revenue growth at all. (which is unlikely over the next few years as you know).



So finally the valuation. Of course my first check was plowing thru the CF statements, understanding how real earnings have been. Generally, its solid. Cash earnings I calculate at $3.19 in 2008, and $2.96 in 2009. Compared to reported EPS of $2.87 and $3.27, the total 2 year Cash EPS number almost exactly matches the reported EPS numbers. TTM EPS: $3.76, Cash EPS, $3.60. Check.



For Q4, management has guided that Teva will generate around $1.25 in EPS. Annualized this is $5.00 per share. There was $0.03 of dilution to EPS from the ratiopharm deal in Q3, which is expected to turn accretive in 2011 already. So earnings of $5.12 seems in the bag. Makes sense to me that the Street is forecasting $5.25 to $5.50 in EPS for 2011. Organic growth has been running around 10% per year, and in all likelihood continues into 2011.



Given the stock is at $54, its trading at around 10x this years earnings. That is quite cheap. In fact, historically this stock has NEVER traded below a market multiple. Market is at 14x 2011 earnings. Sure, its growth is now slowing given that its doubled in size since 2006, but there is plenty of growth left. Think aging demographics, the trend toward generic drugs as patents expire, and growth in the emerging market world. The upside in the stock I estimate at $80 per share, which probably seems ridiculous given that every analyst on the Street only thinks its worth $65 bucks. But consider this: its growing at one of the fastest rates of any drug company, and, among big-cap pharma, Glaxo and Novartis trade at 13.5 and 16.5x. Sure, Lilly trades at 8x. But 5 out of its 6 biggest drugs are ROLLING OFF PATENT in the next 3-4 years. (typically revenue falls 80% after a drug rolls off patent). I have no clue what management plans to do there.



Furthermore, I note that this stock didn't pop up as cheap on my screen. That is, GAAP reported trailing twelve month EPS is $3.24. That looks like TEVA is trading around 17x TTM earnings. I am betting a lot of holders see this and pass on the stock without doing the work. But the reality is, they charged $379mm from a lawsuit in Q4 2009, clearly it is a one-time item. When this rolls off come Q4 earnings, TTM EPS will look more like $4.70 a share. That is 11.4x. Ah now it looks cheap.



So, the downside case has to also be considered. I think the risk here is that Copaxone dies a quick death, instead of a slow gradual decline after 2014 when it loses patent protection. If EPS from Copaxone alone is $1.15, then losing half of that would mean the company is reporting EPS of $4.50 to $4.95 in 2011. That would be a huge miss, and hurt the stock. You would see a $45 stock in my opinion. Probably a great buying opportunity though.



But to reiterate the upside, this stock has traded between 10x and 45x earnings (!) over the past decade. Yes, at one point everyone was chasing generics as the next hot thing. That was 2006. Given healthcare reform here, which could pressure pricing, I think looking out 3 years, and using a conservative 12.5x multiple on $7 in EPS equates to an $88 stock. That's a 3-4 year return of 60%, or around 15-20% per year.



There could be short term downside of up to 18%, but the long term upside is strong. We'll see what happens with Copaxone. I think the markets uncertainty will clear up a little this year, and we'll see it trade better. Either way, this company generates solid 14% ROEs, and also has a low 20% debt to cap. For a blue chip, non-cyclical growth stock, a 10% FCF yield is too good to pass up.