By Paul Tait and Kris Rosemann
Since Teva Pharmaceuticals’ (TEVA) addition to the Best Ideas Newsletter portfolio in mid-2013 in the low-$40s, the company has been a strong performer, even though the past several months have been rather rough. Following difficult fourth-quarter results, we’re ready to take profits on the equity, and we plan to release an alert in the coming days, hopefully on market strength.
Last year was a transformational year for Teva, or in the words of management, a year of “exceptional strategic, operational and financial performance.” The company has pursued a number of growth-driving acquisitions to offset headwinds mounting for its leading drug Copaxone, a top treatment for multiple sclerosis. The spotlight has shifted to the development of other drugs in its specialty medicines pipeline, which will become increasingly more important for Teva moving forward, but we still like its generics opportunity and think its combination with Actavis’ Generics will bear significant fruit in coming years. The risk-reward, however, has deteriorated for investors, in our view.
In the fourth quarter of 2015, Teva’s revenue fell to $4.9 billion, a 6% decrease from the year-ago period; excluding the impact of currency headwinds, revenue fell 1% in the quarter. The firm’s generic segment revenue, ~46% of revenue in the quarter, amounted to $2.3 billion, a 9% drop on a year-over-year basis (down 3% on a currency-neutral basis). We were very disappointed in the company’s generics revenue performance during the quarter as Teva blamed medicines Lovaza, Pulmicort and Xeloda for a 15% decline in US revenues compared to last year’s period. Even generics revenue in Europe was considerably weaker than expected, though it did advance modestly on a currency-neutral basis.
Teva’s specialty medicines segment also experienced a shrinking top line in the quarter, as revenue decreased 6% from the year-ago period (also down 3% on a currency-neutral basis). Capaxone, the world’s leading treatment for multiple sclerosis, was the biggest loser in terms of aggregate dollar weakness due to the launch of generic competitor, Novartis’ (NVS) Glatopa. Copaxone’s global revenue fell by 14% from the year-ago period. The drug’s revenue as a percentage of Teva’s overall revenue fell as well in the quarter, a trend investors will need to get used to. Sales of Copaxone made up 20% of Teva’s total revenue in the fourth quarter of 2015, down from 22% in the prior year’s quarter, but more significantly, Copaxone accounted for 40% of Teva’s operating profit in the quarter, down from 47% in the fourth quarter of 2014. Its oncology portfolio also experienced considerable weakness – down 5% in the quarter, mostly due to declining sales from chemotherapy drug Treanda.
If the broad-based weakness wasn’t enough, Teva’s GAAP net income suffered in the fourth quarter as well, falling more than 27% on a year-over-year basis to $500 million. In turn, the firm’s cash flow from operations and free cash flow both fell 8% compared to the prior year’s period, but free cash flow conversion remained strong in the quarter. Though the fourth quarter was rather disappointing, full year free cash flow generation was solid, but we’re concerned about the trajectory. Cash flow from operations advanced 8% in 2015, to $5.5 billion, while free cash flow excluding net capital expenditures, came in at $4.9 billion, up 15%. Cash and cash equivalents stood at $6.9 billion at the end of the year, while short-term debt and senior notes/loans stood at $10 billion. The debt on Teva’s balance sheet has ballooned in part due to pending acquisitions.
In July 2015, Teva agreed to buy Allergan’s (AGN) generic drug business, operated under the name Actavis Generics, for $40.5 billion in cash and stock. The acquisition will significantly advance Teva’s R&D capabilities, as the combined company will have ~320 pending Abbreviated New Drug Applications (ANDAs) in the US alone, 110 of which are First-to-File (FTF) ANDAs. Annual cost synergies and tax savings of approximately $1.4 billion are expected to be mostly achieved by the third anniversary of the closing of the deal, and double digit non-GAAP earnings per share accretion in 2016 is expected with the potential for over 20% accretion coming in years two and three following the close. The acquisition will give Teva a top three position in over 40 markets worldwide, and it will now have its hand in 100 markets overall. The deal is expected to close in the first quarter of 2016.
The company also boasts a diverse specialty pipeline from early stage development through the registration phase that is expected to continue to drive growth for years to come. One of the highlights of Teva’s specialty pipeline is a drug for the treatment of Huntington’s disease, SD-809, which was the leading product of Auspex Pharmaceuticals when Teva acquired it in May 2015. The drug has received an Orphan Drug Designation and has been designated as a breakthrough therapy for the treatment of patients with moderate to severe tardive dyskinesia, a hyperkinetic movement disorder affecting about 500,000 people in the United States. Teva is in full preparation mode to launch SD-809 in 2016. The company looks to learn from its success with the Copaxone launch in the multiple sclerosis market, as there is a large amount of opportunity in the market for SD-809 as there was for pre-launch Copaxone; approximately 90% of Huntington’s disease patients have no treatment. The firm also has promising respiratory drugs in the late stages of its pipeline, an already well-performing area that experienced 23% year-over-year growth in the fourth quarter of 2015.
Teva has released its guidance for the first quarter of 2016: Revenue of $4.7-$4.9 billion, compared to $5 billion in the first quarter of 2015; non-GAAP earnings per share of $1.16-$1.20, down from $1.36 in the year-ago period; and cash flow from operations of $1.2-$1.3 billion, a decrease when compared to $1.4 billion in the same period of 2015. The firm is waiting to release its full year guidance for 2016 until after the Actavis Generics acquisition closes but it did release estimates for compound annual growth rates for the period from 2015-2018, including the synergies from various acquisitions announced in 2015. Sales are expected to grow at a CAGR of 12.5% in the period, while EBITDA, cash flow from operations, and free cash flow are all expected to grow at a CAGR of 20%. The company is setting a high bar, and most of the growth will be significantly inorganic in nature due to lost Capaxone sales.
The fourth quarter of 2015 and first quarter of 2016 may be viewed as the-calm-before-the storm at Teva, as the firm experiences a few quarters of suppressed results but has multiple potential growth drivers on deck, which may or may not pan out as expected. As you may have gathered, we didn’t like the fourth-quarter results at all, and the pace of Capaxone losses are growing more and more concerning; pricing resiliency of the drug may not hold much longer. The addition of Actavis Generics will offer Teva a jolt once it is integrated and we are excited to see what the launch of SD-809 brings for the company, though integration proficiency and FDA approval can never be guaranteed, respectively. We’ll be monitoring performance going forward, but given all the moving parts with Teva in coming years, the story no longer holds the allure it once did. We’re going to take a nice profit, hopefully on market strength.