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Posted on 19th February 2018

Hero or zero? Kåre Schultz proposes rational solutions in an irrational market

Teva’s new CEO, Kåre Schultz, has now been in place for just over three months, and at the end of last year, he laid out his plans to deal with Teva’s immediate problems of excessive debt and sliding profitability. The main highlight was massive cost cuts, to be achieved by shedding 14,000 staff; combining (or, rather, re-combining) the branded and generic divisions of the business; culling R&D programmes that are unlikely to deliver adequate returns; and shutting a large number of factories. In addition, Teva intends to stop selling drugs at prices that are too low to deliver an adequate return, something that is to be achieved either by putting prices up or, where this is not possible, by dropping products from the portfolio. Further asset disposals may also form part of the plan, but are not a priority and will only be of activities that are clearly not part of the core business.

From our perspective, the new operating structure makes sense, as we were never convinced that making a rather arbitrary division between ‘brands’ and ‘generics’ was a good idea, given that in many markets the two are sold on the same basis. And it has been obvious for years that Teva’s supply chain was creaking, to a considerable degree due to its complexity. One thing that Mr Schulz failed to mention was the cost to the company of being out of stock. In our opinion, Teva is losing millions in revenue every year as a result of not being able to supply the market, so an improvement here could make a big difference. Unfortunately, the disruption caused by the loss of staff and the plant closures will almost certainly make the situation worse before it gets better.

The really interesting piece of the plan, though, is the approach to product pricing. While not selling goods below cost – or even below the price needed to deliver a positive ROI – might sound blindingly obvious, the generics industry does it all the time. The need to keep factory volumes high, a desire to get rid of stock before it goes out of date, demand from customers that companies offer a full range of products and the impact of competitive tenders all mean that generic companies tend to operate on a portfolio basis, accepting poor returns in some areas as the price of maintaining market share, but trying to compensate elsewhere in order to deliver an acceptable return overall. In addition, companies’ COGS and internal return requirements vary, so what appears to be an impossibly low price for one manufacturer might be acceptable to another. This helps to explain what has been going on in the US, where the consolidation among buyers has led to the rapid rise of Indian suppliers at the same time as prices have nosedived.

Kåre Schultz believes that current US pricing is irrational and that rationality will eventually prevail. In this, most other generic CEOs would agree with him. The big difference is that his peers expect to be among the last men standing while their competitors eventually drop away, and hence are perpetuating excessively low pricing in the near term, whereas Mr Schultz plans to enforce rational pricing on his own organisation irrespective of what anyone else is doing.

In our view he is both wrong and right. Right to make a stand despite the likely drastic impact on Teva’s revenues, but wrong about the chances of rationality being achieved in the industry as a whole any time soon. A quick glance at Europe, where pricing has been much lower for much longer, demonstrates this point. In the UK, for instance, which has free pricing and low barriers to entry, prices of high-volume molecules are very volatile. As the price goes down, suppliers drop out of the market and then as supply tightens – and particularly is there is a sudden shock such as one of the remaining producers suffering a stock-out – prices will start to rise again, sometimes going up by hundreds of percent in a very short period. This will then bring competitors back into the market, driving the price back down again and re-starting the cycle.

To that extent, the situation is rational. However, the timing of a single cycle is not fixed. The price of a particular molecule may remain very low for years, or may be elevated for a long period and there is no way of predicting which drugs will deliver the best returns in a given year. If Teva follows through on Mr Schultz’s new policy here, it is likely to end up dumping a high proportion of its product range, which in turn will adversely affect its relationship with its pharmacy customers. Meanwhile in Germany, which is perhaps a better proxy for the US as the retail market is mostly supplied via two-year tenders run by the health insurers, there has been a gradual decline in the number of firms willing to participate. This has definitely led to a rise in tender prices after a period in which companies were typically bidding at little more than their variable cost of production, so again, rationality is prevailing – up to a point. But prices still remain ultra-low for many products and we are sceptical that Teva can continue to operate in the tenders if it sets its return thresholds in double digits.

That said, the focus of Kåre Schultz’s pricing drive is clearly the US, as this is where Teva makes the biggest part of its sales and where prices have been falling most rapidly. Here, Teva is effectively calling the buyers’ bluff: give us better prices on the products where our returns are too low or find an alternative supplier. For this strategy to have the optimal outcome (Teva retains the contracts at a better price) there have to be few or no other viable suppliers. A more likely outcome for many products is that Teva loses the contract because the buyers have sufficient alternatives and Teva’s competitors are happy to pick up the business. And the most sub-optimal outcome would be Teva losing not only the contracts where it has low-priced competition but also some of its higher priced contracts because its customers decide that it is no longer a trusted partner. Kåre Schultz is effectively banking on this last scenario not materialising because there really are too few suppliers to replace Teva in its harder-to-make drugs and because the way in which buyers have shifted from block deals with large providers (Teva’s old ‘big to big’ strategy) to single-product contracts has changed the rules of the game overall. But even if he is right about that, it is impossible to escape the conclusion that Teva is going to lose a huge part of its US business.

In our view, this is precisely what Mr Schultz expects to happen, which explains the anticipated massive downsizing in Teva’s manufacturing base. On the conference call in which the restructuring plan was laid out, analysts queried the timeline for savings on manufacturing, on the basis that it can take many years to transfer products out of a plant in order to shut it down. But of course, if you are not going to transfer the products (or not most of them, at any rate) but simply stop making them, it all gets a lot quicker. And without the need to keep manufacturing volumes of individual products high, there is less pressure to do deals with customers at unattractive margins.

Because of economies of scale in manufacturing, it is clear that the decision to withdraw a product in a market where it sells high volumes at a low price is likely to affect the unit manufacturing cost of that product, which in turn could render it insufficiently profitable in countries where it currently makes an acceptable return. Because of this, Teva will have to look at products on a holistic basis and not just territory by territory, which may yet mean that its UK business can continue to field products that don’t make the financial grade locally. This would be good, because in the UK, as in Germany, France and a number of other European markets, pharmacists deal with Teva at least in part because of the breadth of its portfolio. There is clear evidence here to support the view that a company that tries to restrict its sales to its more profitable lines will lose sales of those products as well as of the less profitable ones, because some pharmacies, or pharmacy chains, will simply move their entire custom elsewhere. As noted, this is less of a risk in the US today, so the question is how much weight Mr Schulz will give to the needs of the European business. His predecessors have generally tended to do whatever suited the US and let Europe bear the consequences, but as a Dane he may perhaps be a bit more mindful of the European situation. Or he may simply feel that it is better to have a far smaller, yet higher margin, operation than it is to hold market share for its own sake.

To a certain extent, analysts appear still to be coming to terms with Kåre Schultz’s strategy, given that it flies completely in the face of conventional generic wisdom that high volumes are what counts. However, they have a valid point when they ask what is actually going to grow Teva’s sales longer term, once the restructuring is through (and assuming, of course, that the company can actually get its debt down to sustainable levels, given that even its re-drawn banking covenants appear extremely tight). The answer, clearly, is value-added products, but Teva has quite some work to do here. The decline in sales of its flagship drug, Copaxone, will only accelerate now that a second 40mg generic has been approved in the US and the company’s pipeline of innovative drugs while interesting, is fairly narrow. Meanwhile, Teva lags far behind its peers in biosimilars, which are the most obvious pool of value-added generics, but currently lacks any spare cash with which to make acquisitions. The ideal scenario would be for growing investor conviction to push up the share price, making it possible for the company to raise new equity. The recent disclosure that Berkshire Hathaway has bought a c2% holding in Teva will help in this regard, but even the Sage of Omaha is not going to save Teva single handed.

If only all generics CEOs thought the same way as Kåre Schultz then everyone would be a lot better off. But they don’t and they won’t. Nevertheless, his appointment may come to be seen as some kind of turning point. Sandoz is believed to be preparing to sell its oral solid dosage form business in the US and Mylan is now big enough in brands that it can afford to give up some of its lower-margin generic business if it chooses, so perhaps 2018 will be the year in which all three industry leaders turn their backs on parts of the business that they collectively pioneered. Not that this will be enough to change current industry trends as long as the Indian manufacturers remain wedded to volume over price and the Chinese continue to pile up product registrations in the US. But the writing has been on the wall for US generics ever since Alliance Boots fully combined with Walgreens at the end of 2014: in Kåre Schultz, Teva finally appears to have found a CEO who can read.

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