Teva’s acquisition of Taiyo, officially announced yesterday, did not come as any surprise given that it had been reported in the Japanese press some days previously. However, we now have the terms of the deal, which are that Teva will pay $460m to acquire the founding family’s 57% of Taiyo and will make an offer to the remaining shareholders (Taiyo has more than 800 shareholders despite being a private company), with the hope of buying as close to 100% as possible and closing the deal by the end of Q3 this year. The purchase is also being made directly by Teva and not through its existing 50:50 jv in Japan, Teva Kowa.
Taiyo’s turnover in 2010 was $530m of which about 30% (we estimate) came from contract manufacturing and the rest from the sale of finished dosage forms. Within the contract manufacturing part, the vast majority is injectable drugs used in hospitals, so that overall, about half of Taiyo’s revenues come from this type of product. Within the finished dosage forms, the ratio is more like a third, but this is still higher than most generic companies, certainly the larger ones. Teva has not disclosed how profitable Taiyo is (although it may do so after the deal reaches financial close), but we believe that Taiyo has low margins compared to its peers, mostly due to the contract manufacturing element in the mix. We estimate that Taiyo’s operating margin is not more than 10%, which suggests that Teva is probably paying an EV/EBITDA multiple of around 20x for the company.
According to Teva, the total EV of the deal (assuming that it eventually buys all of Taiyo) is $1.3bn, which implies that Taiyo has around $500m of debt. If we are correct that Taiyo’s EBITDA is in the region of $60m, this means a debt/EBITDA ratio of close to eight times, which may help to explain why the owners were willing to sell out to Teva. Another reason could be that Taiyo is having difficulty getting over some serious quality problems that were exposed last year, when the local regulators briefly halted production after they discovered that the company had released sub- and super-potent batches of product that its quality department had passed. Subsequent investigation suggested that the quality team had known that the batches were defective but had been put under pressure by senior management. Since then, the CEO of Taiyo has been changed and the company has embarked on a massive quality offensive, but its reputation in the marketplace has been severely dented. Perhaps as a result, its sales growth has been much slower than that of the other leading Japanese generic companies, although the product mix probably also plays a part.
Given Taiyo’s difficulties and the poor public perception of its brand, Teva will have a major job of work on its hands, notwithstanding that it can bring its recent experience at its Irvine plant to bear. Additionally, it needs to deal with the conflict of interest that it now has between Teva Kowa and Taiyo. On the analysts’ call yesterday, Teva’s CEO said that Teva was now in talks with Kowa about how to extract synergies between the two operations and that these talks were proceeding positively, but as we see it, it will be impossible to bring the two operations together unless Kowa is willing to sell its 50% to Teva and allow a full merger. Kowa’s other options (depending on exactly how the agreement that set up the jv was worded) would be to buy out Teva or to insist on keeping things as they are, but neither of these can be very attractive. The former would cost a lot of money and require Kowa to find a new pipeline source (since this is what Teva was bringing to the party) while the latter would risk Teva Kowa being sidelined in favour of Taiyo, which Teva controls. If Kowa is sensible, therefore, it will focus its efforts on getting as high a price as possible for its 50% holding, with the multiple that Teva has just paid for Taiyo being a useful starting point.
Teva’s increased scale in Japan brings it within sight of its target of $1bn turnover in the market by 2015. Assuming that it manages to combine Taiyo with Teva Kowa, it will have total sales of close to $800m and finished form sales of $600-650m, which would put it in third place in the Japanese generic market after Saiwai and Nichi-Iko, both of which had turnover slightly above $700m in 2010. Growth from here will be boosted by the large number of drugs that are expected to come off patent in the period to 2014, which include Aricept (Alzheimer’s, Esai), Actos (diabetes, Takeda), Paxil (depression, GSK), Blopress (hypertension, Takeda), Nulosan (hypertension, Banyu) and Diovan (hypertension, Novartis). In total, more than a quarter of the total value of the Japanese pharma market will lose patent protection by the end of 2014 (worth $17bn, according to Teva), which creates a huge opportunity for the generic industry.
It’s not all good news, though. For one thing, although the Japanese government has recently put in place measures to force the adoption of generics, leading to a rise in generic penetration (by volume) from 12% ten years ago to 23% now, we currently see growth flattening. The reason for this is that the government’s efforts have so far mostly affected hospitals (which have been set targets) and pharmacy chains (which have taken advantage of additional payments) and have had relatively little impact on independent pharmacies or dispensing doctors. Moreover, even in hospitals, there is a reluctance to use generics any more than the mandated amount, so the government is going to have to do more if it wants to reach its own target of 30% generic penetration by volume (supposed to be achieved by 2012, but more realistically by 2013/14). On top of this, there are price revisions every two years in Japan, with the reimbursement price of generic products being cut to their actual in-market price. When a drug goes off patent, the first generic has to be at a 30% price discount to the originator, but discounts are always offered on this and these get reflected in the reimbursement price at the next revision, which means that the profit margins on older generics are very slim. It also means that generic companies try not to compete on price, because the revisions are done by brand not by molecule and having the cheapest reimbursement price is actually a negative because it means less money for the participants in the distribution chain. In many markets, Teva has been extremely aggressive on price, but it will have to be careful using this tactic in Japan or it may find itself at a competitive disadvantage in the longer run, albeit gaining market share in the short term, as wholesalers, pharmacists and doctors benefit from its discounts.
The Japanese generic companies are also experiencing increasing competition from mid-sized originator firms that are trying to boost their own growth prospects by adding generics to their product range. The advantage for these companies is that they also have innovative products to promote to doctors, which go down better than a pure generic portfolio. Nichi-Iko recently did a deal with sanofi whereby it took over promotion of some of sanofi’s off-patent brands and we presume that the rationale for this was to try to give Nichi-Iko an improved position with doctors, particularly those that do their own dispensing (and hence make money directly from the pharmaceuticals that they prescribe). Of course, Teva also has a brand business in Japan and if it can bring together Taiyo and Kowa, it may also be able to fold in its brand operation and use Copaxone as a means to drive generic sales.
Overall, we believe that the Taiyo deal is a good one for Teva, notwithstanding the big management challenges that it will undoubtedly create. Teva believes that Taiyo will be earnings accretive in 2012 and even if not, Teva is certainly big enough to sacrifice a little cash now in exchange for achieving a key strategic goal in the emerging markets.
Posted on 17th May 2011