Teva Pharmaceutical Industries (NASDAQ:TEVA) stock finally has rallied. Teva’s shares hit their lowest level in nearly 20 years this summer, but they now have climbed more than 60% above that point.
Most of the rally has come in the last three months and there’s been an obvious catalyst for the jump. Specifically, TEVA is making progress towards settling two significant legal cases. Investors are betting that those settlements will remove an overhang from Teva stock and turn the Street’s attention back to the company’s turnaround effort.
That may well be the case. But its turnaround initiatives are problematic. Its cost-cutting is nearing an end, and its debt, less its cash on hand, is over $25 billion. It’s tempting to assume that good news on the legal front will boost Teva stock. But that viewpoint is also far too simplistic.
Good News on the Legal Front
As another InvestorPlace columnist, David Moadel, noted this month, Teva faces two significant legal challenges. The company is the target of multiple investigations and lawsuits relating to its production of generic oxycodone, an opioid. And the U.S. Department of Justice and state attorneys general are investigating TEVA’s potential role in fixing generic drug prices.
The company has made progress on both fronts of late. On the opioid front, a proposed settlement agreed to by some attorneys general would have the company supply $23 billion worth of treatment drugs and pay $250 million in cash over ten years. Reports swirled last month that the company was close to an agreement with the DOJ over the price-fixing issue as well.
Both pieces of news sent Teva stock higher. The shares of distributors McKesson (NYSE:MCK) and Cardinal Health (NYSE:CAH), who have their own potential liabilities, also gained, showing that investors are more upbeat that companies will not be derailed by the opioid issue.
But TEVA is not out of the woods on either front. Multiple potential plaintiffs dismissed the opioid settlement as not going far enough. State-level probes into price fixing may not be covered by a settlement with the DOJ.
There is some hope, however. that TEVA at least will be able to survive these issues; the proposed opioid settlement, in particular, would allow the company to make payments and supply drugs over the course of ten years, freeing up cash for much-needed debt reduction. With bankruptcy fears dimming, it’s little surprise that TEVA has rallied.
The Balance Sheet Problem Facing TEVA
But the problem is that those bankruptcy fears haven’t really gone anywhere. Indeed, recent moves by TEVA show how precarious its situation is. Last month, the company issued over $2 billion of debt at an average interest rate of over 6.5%. Those bonds were issued to repay near-term debt with interest rates as low as 0.375%.
Bear in mind that the new bonds are secured by the company’s assets and mature in just six years. Given the risk posed by the company’s restructuring, the rate is reasonable. Blue chip companies in this environment can sell debt with rates closer to 2%, and even lower in Europe.
Meanwhile, the refinancing will cost TEVA about $75 million in additional annual interest payments. That’s a meaningful sum for a company that expects to generate roughly $1.7 billion of free cash flow this year, particularly considering that the refinancing covers less than 10% of the company’s outstanding debt.
Even assuming the legal settlements are manageable, TEVA still has to fix its balance sheet issues. And it’s difficult to see how that can happen. The company expects its revenue to decline 8%-9% in 2019. Its margins will drop, as it provided 2019 earnings per share guidance, excluding some items, of $2.30-$2.50 versus $2.92 the year before.
The company’s EPS guidance suggests that Teva stock, trading at roughly four times that EPS guidance, is startlingly cheap. But Teva’s business is declining, and its balance sheet was destroyed by the company’s acquisition of Allergan’s (NYSE:AGN) generic business. And TEVA should be cheap because Teva stock may be decimated by a restructuring.
Teva and Bausch Health
The problem for Teva is that it’s not clear how the company can repay its debt, since its free cash flow this year should be $1.7 billion, and its net debt is over $25 billion.
Even assuming Teva Pharmaceuticals can stabilize its free cash flow, it will likely be a decade before the company will be able to pay dividends. It will take longer if the company’s business stabilizes while higher interest expenses pressure its earnings and cash flow. The still-present risks on the legal front adds to the issues facing TEVA.
The model for Teva stock, however, is Bausch Health (NYSE:BHC). Bausch Health, then known as Valeant Pharmaceuticals, seemed headed for bankruptcy. But under CEO Joe Papa, its business has stabilized, its debt has been reduced, and BHC stock has rallied over 250% from its 2017 lows.
There’s a catch, however. Bausch had more attractive branded drugs. It sold the rights to a number of those drugs and used the proceeds to reduce its debt. And its eye care business is reliable and grows steadily, boosting the turnaround.
Teva’s portfolio doesn’t look nearly as attractive. Its $3 billion cost-cutting effort is boosting its profits this year, but there’s not much more fat to cut. And so the company, somehow, has to find a way to cut its $25 billion-plus debt load even though its portfolio is still weighted toward generics, and it doesn’t have any assets that are obvious candidates to be sold.
But it’s possible the company can recover. Bausch, after all, has defied skeptics and short sellers who bet that it was going to zero. Teva’s path, however, is exceedingly narrow and seemingly better news on the legal front hasn’t changed that core fact. The problem for Teva Pharmaceuticals isn’t regulators or lawyers or short sellers. It’s the nearly $27 billion of debt that must be repaid. There is a chance that Teva won’t ever repay those debts — and as long as that chance persists, any rally by TEVA stock is going to reverse.
As of this writing, Vince Martin has no positions in any securities mentioned.