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Posted on 17th August 2017

Oy Vey, Teva!

Things appear to be going from bad to worse at Teva, which is giving the strong impression of being in meltdown. One can only hope that the recent Q2 results, which featured an eye-watering $6.1bn write-down of the company’s recently-acquired Actavis generics assets, mark the low point for bad news. Teva is facing a perfect storm of rapidly-falling falling generic prices, delayed approvals, the loss of exclusivity on its blockbuster drug Copaxone and – overhanging all of this – a mountain of debt due to be repaid by the end of 2019. The debt, of course, is mainly due to Actavis, a deal done in haste and now most certainly being repented at leisure.

As part of its restructuring, Teva plans to shed 7,000 staff and close or sell 15 manufacturing facilities by the end of next year. It has also started to put assets on the block in an effort to pay down enough debt to get through the next 12 months without breaking its debt covenants. Earlier this year it announced that it would sell its global women’s health business and also some pain and oncology assets in Europe. More recently, it has added its Medis dossier development unit to the mix and there is even talk of respiratory products being sold. We very much hope that this last item is only a rumour. Women’s health – all right: it is a declining business with no pipeline to speak of, although it remains extremely cash-generative and cash is currently rather important at Teva. Onco/pain – OK. Not such an obvious candidate, but definitely mature. Medis – absolutely. Most people were surprised that it wasn’t divested when it was still part of Actavis. But respiratory? No way. Respiratory is one of Teva’s crown jewels and a perfect example of the sort of value-added business that every generics company would love to have. If Teva sells that, it might was well just throw in the towel altogether.

It is undeniable that Teva is facing some unpalatable choices given its roughly $35bn of debt, and debt covenants that ratchet down sharply at the end of this year and then again at the end of 2018. As of Q2, net debt/EBITDA was 4.56x, against a covenant that currently stands at 5.25x. However, the covenant becomes 4.25x at year end and 3.5x 12 months later, hence the desire to raise some money. Teva’s expectation for EBITDA this year is $6.6-6,8bn. Taking the lower end of this implies maximum net debt of $28bn. On the face of it, this means that unless the company can get its EBITDA up, it needs to find more than $7bn (more, because selling assets also cuts the EBITDA) to get through the covenant test. According to Teva management, a couple of billion of receipts from asset sales would enable the company to make scheduled repayments of $5bn this year, scrape through its covenants and gain some breathing space, but it will clearly be a close call.

In our view, Teva’s acting CEO and his team need to step back and look at the bigger picture. Yitzhak Peterburg is behaving like a frustrated back-seat driver who has finally seized control of the wheel. Since he is not the actual CEO, he presumably does not see his role as one that involves coming up with a long-term vision for Teva, but more an issue of day-to-day caretaking. Hence the apparent willingness to sell off the family silver in an effort to keep the banks at bay. He should remember the old adage that if you owe the bank £100, you have a problem, if you owe them $1bn, the problem is theirs. The debt holders have no interest in Teva’s future as a company; they just want their money back. Hubris may be what has got Teva into its current mess, but this is hardly the moment to crumple. Teva remains an extremely cash-generative business that is perfectly capable of repaying its debt, just not by the end of 2019. Mr Peterburg should therefore focus his efforts on getting the debt rescheduled so that the new CEO, if one can ever be persuaded to take the job, has got a chance to articulate a proper strategy. Of course, Teva needs to cut its costs – a big rationalisation programme was inevitable given the significant overlap between its operations and those of Actavis – and disposing of assets that are clearly non-core also makes sense, but Mr Peterburg needs to focus on the company, not on its debt holders. Or even on the short-term demands of its shareholders, for that matter. If the company gets its fundamental strategy right, its shares will reflect that: trying to micromanage the stock price in the short term is pointless.

There is, of course, a chicken-and-egg problem around hiring a new CEO insofar as the CEO should come up with a strategy but the choice of the CEO tends to pre-determine what that strategy is going to be. As we see it, Teva’s fundamental problem is (and has been for many years) how to balance its generic and specialty (branded) businesses. On top of this, it has two more proximate issues to deal with: how to replace earnings from the blockbuster MS therapy Copaxone as generic competition starts to bite; and how to cope with the deteriorating pricing environment in the US.

The generic/brand balancing act is the toughest part. At the start of this century, when the revered Israel Makov was CEO, generics were clearly in the ascendant. His successor, Shlomo Yanai, did not have a pharma background and this showed in his agnostic approach, making large acquisitions on both sides of the business. After the Board decided that some of these deals (most notably Cephalon) were bad value for money, he was replaced by Jeremy Levin, an out-and-out big pharma man, who pushed the company strongly towards innovation and made the (in our view, mistaken) decision to give up on biosimilars. After he, too, was sent packing (principally for failing to come up with a quick fix for the Copaxone problem, an impossible task to begin with) Erez Visgodman switched back to a generic focus. He vowed to (re-)build a biosimilars pipeline, attempted to extend Teva’s reach outside the developed markets via the acquisition of the Mexican company Rimsa (a catastrophic deal that has wound up in the courts) and, having failed in a hostile bid for Mylan, agreed to pay $40bn for the generic assets of Actavis. It is important to note that at the time that it was announced, this deal was reasonably well received even though it was obviously at a very high valuation. It was only later, as Teva slowly progressed through the disposals needed to gain anti-trust approval to complete the deal and US generic asset valuations started to fall sharply on the back of a deteriorating pricing environment, that concern really started to grow about the price that Teva was paying vs the benefit that it was likely to receive. In the event, Teva ignored its shareholders and closed the deal. The rest, as they say, is history. Generics VP Siggi Olafsson was the first to pay the price, followed by Erez, leaving Chairman Yitzhak to take the hot seat.

We have written before about Teva’s Board, which apart from being large, elderly and almost entirely Israeli, has shown an alarming tendency to shoot first and ask questions later when it comes to dealing with the executive. This cannot be making the search for a new CEO any easier. That the Board has said that it is considering hires who will not be required to live in Israel says something both about the level of concern over Teva’s current performance and about the rather odd way in which it has been run in the past. However, a trophy CEO is not what Teva needs. In our opinion, Pascal Soriot, the CEO of AstraZeneca who was apparently offered the job, would have been a disaster. He is big pharma through and through and killed off AZ’s nascent generics operation almost as soon as he stepped through the door. Teva remains at heart a generics company (and will become more so as Copaxone reduces in importance), so it needs a CEO who both understands and believes in generics. That rules out almost anyone from a big pharma background, no matter how impressive their CV.

As for dealing with the generics/brands issue, a lack of cash means that big M&A deals will be off the table for some time, to the only options are to live with the current structure or to break the company up. The latter has been suggested by a number of investors and analysts, but we are generally very sceptical about the benefits of this approach to strategic problems. There has to be a very high level of dys-synergies between two parts of a business before separating them out makes any sense, given the enormous operational disruption that would result from actually doing it. In a conglomerate where units are run entirely separately, this is less of a problem, but in a company like Teva the branded and generic products are highly intertwined in many markets. And besides, where do you draw the line between generics and brands? Selective disposals make more sense, but taking the simple rule of thumb that any divestments should maximise the cash received while minimising the resulting loss of EBITDA, the most obvious course would seem to be to bundle together the innovative development programmes that have the highest R&D burn and sell those off, possibly with one or two related on-market products to create a more rounded portfolio. Doing what Teva currently is doing, i.e. selling assets that are strongly cash generative but that have relatively modest growth prospects and will therefore attract fairly low EBITDA multiples is simply stupid. In the world of generics – particularly US generics today – flat sales are an impressive achievement, so why get rid of stable products and keep the declining ones? Particularly in a fire sale run so quickly that many possible bidders will give up before the process even gets going and is consequently almost guaranteed to produce sub-optimal results.

The US pricing problem would also suggest that Teva is going about things the wrong way. The company’s size makes it a valuable partner for buyers, but the commoditised nature of its products means that it can only leverage this advantage to hold volume, not to drive prices. Consequently, its strategy ought to be to hold volume as long as possible but be disciplined enough to let go of business that falls below whatever threshold of profitability it considers acceptable. A the same time, it should try to shift as much of its sales as possible into product areas where competition is lower, by continuing to develop (and acquire, if feasible) value added generics and old mature brands. Which is one reason why it bought Actavis, of course.

As for how to offset the loss of Copaxone, the answer to this is easy: it can’t be done. Teva has already made a good fist of defending Copaxone, by switching patients to a higher-strength formulation given twice weekly and trying to get the FDA to set the bar on new approvals as high as possible. It is also discounting Copaxone sufficiently to make it hard for competitors to get on formulary and hence is hanging on to a reasonable market share. None of this will prevent sales of Copaxone eroding, though, and there will certainly be a step down when the generics to the 40mg form arrive. The mistake is to think that there is any quick fix that can make this not matter to earnings and to run around looking for it rather than just getting on with positioning the remainder of the business to deliver growth over the longer term. Something that we hope the new CEO will finally be able to make clear to the Board.

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