Teva Pharmaceutical Industries Ltd., which has been without a permanent CEO for six months, plunged $11.74, or 36% last week, to $20.60–the most in almost two decades. The Israel-based drugmaker revealed the full extent of the challenges facing its next leader by announcing more job cuts, a retreat from 45 markets and a steep cut to its dividend after slashing its earnings goals for the second time this year.
Teva also cautioned that it may breach some debt covenants this year if sales don’t rise. The company said its profit may fall to as low as $4.30 a share for the year. The onslaught of bad news points to the difficulties in attracting a new chief after Teva ousted Erez Vigodman in early February.
Once the sweetheart of the generic-drug industry and a poster-child of Israel’s vibrant corporate scene, Teva has fallen on hard times after cycling through three CEOs in the last five years. Shares closed down another 10% Monday, Aug. 7, to $18.59.
Now how could a bombshell like this one take everyone by such surprise? Well, not everyone.
Bloomberg points out that back in July 2016, analyst Carol Levenson at Gimme Credit wrote disparagingly of Teva’s proposal to pay $40.5 billion for a generic-drugs division of Allergan Plc (Dublin IRL). She doubted management’s ability to cut the massive debt load they’d be taking on to finance the deal, and even took a punch at Moody’s and S&P Global Ratings for having “gone easy on the company,” though both had downgraded Teva’s credit rating.
Last week, Levenson and other Teva critics could gloat. The world’s biggest maker of generic medicines on Aug. 3 triggered a selloff in its debt and equity by shaving a profit forecast and warning investors that it may have to renegotiate some debt covenants if cash flow worsens.
The Israel-based company slashed its dividend by 75%, and said it plans to cut jobs and sell off non-core assets to cast off some of its $35 billion debt load. Moody’s dropped its credit rating toBaa3–one step above junk. (S&P reaffirmed the drugmaker’s rating a single level higher at BBB.)
Compounding the abject mess, Teva is facing this crisis without a leadership team–it has been without chief executive and chief financial officers for months.
Bloomberg points out that Teva is just the latest example of a company taking on massive debt in an effort to prod growth in a low interest-rate environment. Yet while debt may be historically cheap, nearly free money, it still has to be repaid. And if revenue doesn’t keep up with payments, the downfall can be swift, even for a former go-getter like Teva.
The deal for Allergan’s Actavis drug unit was just one of Teva’s multibillion-dollar takeovers as it piled on the debt while building itself into an industry powerhouse.
The Actavis generics unit was supposed to help Teva “generate multiyear top-line and bottom-line growth as well as significant cash flow,” former CEO Erez Vigodman said a year ago when the sale closed.
The gamble failed to pay off, however, as generic drugmakers’ profit margins were squeezed. The drivers included the US Food and Drug Administration speeding up drug approvals, flooding the market with products from smaller companies that compete on price, while pharmacy chains and retailers began consolidating their orders to the point where four groups account for 80% of the purchases, Teva said on its recent earnings call.
Going full-on into generics “was completely the wrong move for them,” said Elizabeth Krutoholow, an analyst who covers biotechnology and pharmaceuticals for Bloomberg Intelligence. She said the acquisition of another blockbuster drug like its multiple-sclerosis drug Copaxone “would’ve been more in their wheelhouse. That could’ve been a great way to go,” she said.
Investors are looking for progress as the company has almost $5.5 billion of bonds maturing before the end of 2019, according to data compiled by Bloomberg. The company’s debt posted its biggest selloff on record on Friday, with $2 billion of bonds maturing in October 2046 sliding 4.6 cents on the dollar to about 86 cents.
“The pressure on the company to deliver bondholder-friendly measures has increased further given the significant debt maturities,” said Bastian Gries, head of investment-grade credit at ODDO BHF Asset Management GmbH, which oversees about 100 billion euros ($118 billion) of assets and doesn’t expect a downgrade to high yield in the near term without an additional deterioration in 2018.
While the situation looks dire, Bloomberg Intelligence’s Krutoholow suggests there may be a way out for Teva:
“I don’t expect the creditors to be too hard on them–they should be able to refinance,” she said, because debtholders “want their money back.” One solution might be to split off the generics business. “If they could pull that off, it’d be a good way to go,” she said. Specialty pharmaceuticals “is completely overshadowed because generics is such a drag at this point.”
Moody’s now ranks Teva’s debt at Baa3, the lowest investment grade level, while S&P reaffirmed the drugmaker’s rating at BBB, the equivalent of one level higher.
Levenson of Gimme Credit, who previously said the ratings companies hadn’t been tough enough on Teva, said they now “are getting it right, belatedly.” She also said the worst of the Teva news has been revealed at this point. “I still believe management’s top priority is to do something about the elevated leverage,” she said. “Although, because of the generic pricing issues, it may take longer than management had originally anticipated to restore the balance sheet.”
Why were so many investors wrong going long?
Beurs-Advies at Seeking Alpha admits to believing that Teva’s strong generics division (including takeover of Allergan’s generics division) would be able to offset sluggish Copaxone sales, and perhaps even grow Teva’s profits.
Why did he believe this? Well, Erez Vigodman, former President and CEO of Teva convinced a lot of investors to keep the faith, saying:
“Through our acquisition of Actavis Generics, we are creating a new Teva with a strong foundation, significantly enhanced financial profile and more diversified revenue sources and profit streams backed by strong product development engines in both generics and specialty. This is a platform that is expected to generate multi-year top-line and bottom-line growth as well as significant cash flow.”
Not only would the Actavis generics acquisition generate new profit streams due to new revenue sources, but management also promised that the acquisition would reduce costs and hence, raise profits.
Delving into the numbers, the earnings for the second quarter were horrible. Teva reported that it had earned $1.02 per share for the second quarter. That compares to analysts expecting the company to earn at least $1.06 per share. With this in mind, I might say okay the EPS number was only off by a small margin. The problem is that the revenue number fared much worse for the quarter, decreasing by a wider margin.
Teva reported that it had earned $5.686 billion for the quarter, which was way below analysts’ expecting $5.718 billion. Just how much of a miss was that? The revenue for the quarter missed by $300 million. That means that generic pricing pressure really did stick it to Teva’s top line and that pressure won’t just come to a sudden stop, going forward.
Bill Mann of Motley Fool sums it up perfectly.
The big issue with Teva, he says, is that it has a market cap of about $30 billion and about $34 billion in debt, which it has to service. When you read down the list–lower earnings, lower yields, lower cash flows, and then AmerisourceBergen came out Monday and said across the board, generics in the US are pricing about 7% lower than the same point last year. That hits Teva smack on its top cash line. So Teva is now a company that’s pretty much between a rock and a very hard place, financially.
Then there’s the dividend cut, which if it’s not the biggest financial red flag a company can wave, it’s certainly near the top.
Mann says Teva has treated their dividend as being somewhat statutory; translation:
“The dividend is very important to us, and we would like to pay the same amount or increase it.” So when they cut it, that says they have a more important need for the cash. A lot of companies don’t have statutory dividends. They say, “We’ll try to pay out what we can.”
But for companies with statutory issues, the explanation for why they would cut their dividend had better be, “We need that cash because we’re about to do something awesome.” Otherwise, it’s a red flag for potentially major stress.
You look at Teva shares and, trading at a 13-year low, they look awfully cheap; almost begging to be bought. But what needs to be grasped clearly is that Teva’s debt is rated BBB. The next step down from BBB means that Teva no longer will be investment grade, and that’s a major problem for a company with so much leverage.
A review of the generic sector once again convinces me there are much better values in the usual names within biotech/biopharma and some Big Pharma. These stocks offer investors lower P/Es, stronger finances, stronger secular growth, vastly higher and more stable operating margins, and often higher (rising) dividend payments than any generic stock that comes to mind, starting with Teva.Steve's Take: @TevaPharm stock may look cheap, but remember creditors get paid off first Click To Tweet
Years ago, I toiled at Merrill Lynch in its healthcare investment banking unit. We were fundamentally credit analysts, not stock analysts, and I can assure you the two camps require completely different skill sets to be successful.
If Teva’s stock looks cheap and your finger is itching to pull the trigger on some shares, look at Teva first through the eyes of a credit analyst, because if everything goes to hell in a hand basket, remember–Teva’s creditors get paid off first.