Investors have yet to warm to embattled generic drug maker Teva Pharmaceutical Industries Ltd (ADR) (NYSE:TEVA). So far this year, Teva stock is down close to 20%, which is a far cry from the market’s return of nearly 9%.
The majority of investors hate to ante up for a problem stock, and Teva Pharmaceutical is perhaps the poster child for what can go wrong with an investment.
Shares are down nearly 50% over the past three years. It’s so bad that the recent performance (or lack thereof) has torpedoed the shareholder return to a loss of 25% over the past decade. The market is up about 60% over that same period.
As they say, though, the past is not an indicator of future returns. That’s a net positive for prospective TEVA stock investors.
What to Love About TEVA Stock
In fact, there is quite a bit of upside potential in the stock. I draw comfort in the free cash flow generation. It has averaged $4 per share over the past five years, and should come in well above that level this year — according to current management projections.
Copaxone is a key wild card right now. Ironically, Teva Pharmaceutical is known as a generic drug maker, but makes a ton of money on patent-protected Copaxone and a large stable of specialty medicines. Copaxone helps treat relapsing multiple sclerosis and accounted for nearly a 20% of total first-quarter sales of $5.6 billion. Total specialty meds were close to 40% of the total top line.
Copaxone accounts for about 40% of total company operating profits and is losing patent protection, which opens it up to generic drug competition from the likes of Novartis AG (ADR) (NYSE:NVS), Mylan NV and Dr.Reddy’s Laboratories Ltd (ADR) (NYSE:RDY). It means a large hit to both existing sales and profits, though estimates are that new drug releases — including treatments for migraine headaches, Huntington’s disease and movement disorder tardive dyskinesia — could help overcome a large portion of the losses.
The generic drug business posted first-quarter sales that jumped 24% to $3.1 billion and benefited from the acquisition of a rival Allergan plc’s (NYSE:AGN) generics business, Actavis. Teva says to expect $1.5 billion in cost synergies from the purchase, which is important in the generics industry as it is driven by scale and low costs.
My comfort level with Teva as an investment is predicated on the cash flow it expects to generate. This year, it expects revenue to hit as much as $24.5 billion, operating income as high as $7.8 billion (for an operating margin of nearly 32%), net income as high as $5.7 billion ($5.30 per share), and free cash flow of between $6.3 billion and $6.7 billion.
That works out to free cash flow of as high as $6.23 per share, a multiple of 4.7 times the current share price of $29.27. Even if Copaxone sales fall off a cliff this year (which they aren’t expected to), that’s a pretty low multiple and corresponding margin of safety.
Teva’s current dividend yield is 4.7%, meaning investors are also getting paid to wait for a recovery in TEVA stock. The wild card is what it might take for the shares to awaken from their multi-year slumber.
Bottom Line on TEVA Stock
It would be nice to see debt levels lowered from $32.6 billion currently. Management has a stated goal to pay down $5 billion of that debt this year, which will stem from cash flow and selling off assets that include its Women’s Health business and oncology and pain business in Europe. Total debt-to-Ebitda looks manageable at 4.63, and management stated during its earnings conference call it is well in compliance with bank debt covenants.
As for a catalyst to move TEVA stock higher, there doesn’t appear to be anything significant on the horizon. Positive results on the development pipeline could help, so could beating sales or profit guidance.
A savvy acquisition might also move the needle, though the debt levels leave little dry powder and the depressed stock price would dilute existing shareholders. Teva is also looking for a new CEO, so hiring an industry veteran or well-respected leader could help bring stability back to the management team.
Investors might be best served nibbling on the shares and getting paid nearly 5% to wait for a slow recovery in the stock. Over the next few years and assuming the underlying operations stay stable, it is very conceivable the stock could double.
This would amount to an annual return well above 20% annually. Patience will be key with this stock, but investors could end up well rewarded for waiting.
As of this writing, Ryan Fuhrmann did not own any shares of companies mentioned.