Israeli firm Teva is the world’s largest manufacturer of generic drugs. There’s no doubt it will gain from both Obama’s reforms and future patent expiries. What matters more is that there are deep-rooted structural problems in this space that Wall Street hasn’t yet appreciated.
Firstly, generics have fallen victim to their own success. A decade ago, lack of competition meant producers were able selectively to ‘price scalp’ prescription drugs once they came off patent, winning market share while simultaneously delivering excellent profit margins.
Not anymore. As the number of players has ballooned, particularly from India, the extra capacity has triggered a wave of discounting, almost like supermarket price wars. Worse still this deflation is set to intensify as the recession bites, and big pharma groups (such as GSK, Sanofi-Aventis and Pfizer) also ramp up their in-house generic production.
Teva Pharmaceutical (Nasdaq: TEVA), rated a strong BUY by Buckingham Research
To its credit, the board has been ahead of the curve and responded by snapping up rival Barr Laboratories for $7.4bn last year, as well as developing its own patented drugs (such as Copaxone for multiple sclerosis), which now account for around 30% of revenues. All the same, this strategy is like running in quick-sand. Copaxone itself is facing stiff competition from the likes of Merck KGaA and Novartis, thus jeopardising the group’s lucrative 26% Ebita margins.
The board expects 2009 revenues and underlying EPS of $14.3bn and $3.3 respectively. Adjusting for the $6bn debt pile, that puts the stock on a heady EV/sales multiple of 3.3. I’d value the stock at 13 times EV/Ebita (assuming an ongoing 20% profit margin), giving an intrinsic worth of around $34 a share, 25% less than today. To make things worse, there’s mounting speculation that Teva could untie its purse strings again by gobbling up another expensive rival – potentially disastrous while it’s still digesting Barr.
So while the generics outlook is upbeat, the industry’s supply-demand dynamics have deteriorated markedly over the past couple of years. With Teva being forced to invest more in research and development, as well as defend its market share from rivals, I reckon it’s time to sell. Generics are not the panacea to cure all-known investor ills.
Recommendation: SELL at $47
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments