Slowly but surely, Teva Pharmaceutical Industries (NASDAQ:TEVA) is regaining investor confidence. Since touching a 19-year low in August, TEVA stock has more than doubled. And fundamentally there’s a path to further upside.
After all, it was a heavy debt load that weighed on Teva stock as it fell over 90% from 2015 highs. That debt, however, can magnify returns on the way back up. Increase the total value of Teva’s business by just 10% from current levels, and TEVA stock gains almost 30%.
And there’s a blueprint for those types of gains: Bausch Health (NYSE:BHC). The former Valeant Pharmaceuticals also saw its shares collapse amid slowing growth and rising leverage. Bankruptcy seemed a material risk. Yet as that business has stabilized and debt has come down, BHC stock has more than tripled from 2017 lows.
But that comparison also highlights the danger in TEVA after the recent gains. Bausch, then still known as Valeant, was a high-risk, high-reward gamble that has played out well. TEVA is a similar gamble that hasn’t yet played out. With what looks like a weaker business and more external risks, investors betting on a repeat of the BHC story may well be disappointed.
The Business Stabilizes
To be sure, TEVA at least has a chance for huge upside, one of the reasons why the gains of late make some sense. Another is progress on the legal front
Reports last year of a settlement regarding Teva’s opioid liabilities spiked the stock. The reports boosted distributors Cardinal Health (NYSE:CAH) and McKesson (NYSE:MCK) as well.
Teva hopes to address its exposure by giving away its generic opioid addiction treatment. That means the settlement, reported at $23 billion, will actually cost the company a fraction of that figure in actual cash outlays. For debt-laden Teva, limiting cash outlays and spreading out the costs over several years is a major positive.
Meanwhile, Teva’s finances seem to be improving. Shares jumped after this month’s fourth quarter earnings report. The quarter’s results topped Wall Street estimates for both earnings and profits. But the big news appears to be guidance for 2020.
Simply put, Teva sees its business stabilizing. Across the board, from revenue to operating income to adjusted EPS, the 2020 outlook assumes a basically flat performance relative to 2019.
That doesn’t necessarily seem like cause for celebration. But revenue, even in constant currency, declined 5% year-over-year in 2019. Adjusted operating income fell 12% y/y. Adjusted earnings per share dropped 18%, largely due to a higher tax rate. In that context, flattish performance is a step in the right direction.
The Case for Upside
From there, Teva sees better days ahead. With the fourth quarter release, the company laid out its targets for 2023. It’s aiming for 28% operating margins (on an adjusted basis), against a 24.5% print in 2019. More importantly, the company aims to get its net debt to EBITDA (earnings before interest, taxes, depreciation and amortization) ratio, also known as its leverage ratio, down below 3x.
That would be a massive win for Teva. Based on 2019 figures, the leverage ratio currently sits at 5.3x. That’s a concerning figure. It’s a figure that has caused Teva to refinance debt at much higher rates. As I noted at the beginning of this year, Teva in late 2019 issued debt at a 6.5% interest rate. That’s a big number in this low-rate environment; the funds raised went to repay borrowings with rates as low as 0.375%.
Getting the leverage ratio below 3x would allow Teva to refinance debt at lower rates and reduce interest expense, thus boosting earnings and free cash flow. It would also likely increase the so-called “equity slice” of Teva’s valuation.
Right now, the company’s enterprise value (net debt plus market capitalization) sits at about $39 billion. Cut net debt from almost $25 billion to under $20 billion, as the target implies, and in theory the equity slice should fill the remaining enterprise value. That alone moves Teva’s market capitalization from the current $14.5 billion to something closer to $20 billion.
All else equal, TEVA rises to $18, and presuming some level of EBITDA growth, enterprise value rises as well. In that scenario, the stock could well double, at least, from the current price below $13.
The Risks to TEVA Stock
There’s one core problem with that case, however. It requires that Teva actually hit its targets. The company comfortably met its 2019 guidance, which does increase confidence on that front. But the long-term targets put pressure on 2020 results: Teva has little room for error.
That’s not the only risk, however. The opioid settlement still looms. Teva CEO Kåre Schultz told Barron’s in November that a “realistic timeline” suggested the settlement would be completed by the end of last year. On this month’s fourth quarter conference call, however, Schultz said he was “cautiously optimistic” there would be a settlement at all.
A major trial in New York state is due to begin next month, and hopes long have been for a comprehensive settlement ahead of that date. But state attorneys general already have nixed a settlement with distributors Cardinal, McKesson, and AmerisourceBergen (NYSE:ABC). The literally thousands of parties to Teva’s proposed settlement can throw up additional stumbling blocks. Negative news on the legal front could reverse the recent rally.
There’s also the fact that Teva’s generic business remains under pressure. There are industry-wide headwinds on pricing and demand that have pressured stocks across the sector. Mylan N.V. (NASDAQ:MYL), for instance, has seen its stock drop about 70% since 2015. Its lower debt load is the key reason why the decline in its shares has been less severe than that of Teva.
Bausch Redux?
On paper, Teva’s targets look reachable. The Bausch Health blueprint looks achievable. But in practice, the underlying business here simply isn’t as attractive as that of Bausch. Teva’s Copaxone, a major branded drug, is struggling with generic competition. Teva expects sales to decline roughly 20% in 2020.
Teva doesn’t have an asset like Bausch’s eye health business, which has secular growth tailwinds thanks to an aging population and developing market opportunities. Rather, pressures remain on its core business.
If Teva delivers on its promise, TEVA stock is going to rise. In fact, it’s highly likely that shares more than double. Even a reasonable 8-9x multiple to 2023 EBITDA over $5 billion (against a guided $4.5-$4.9 billion in 2020) and net debt of under $20 billion gets the stock in the range of $25. Increasing confidence towards that scenario, as well as progress on the legal front, both explain the rise in TEVA shares since August.
But investors need to remember that’s a big ‘if.’ There’s still a lot that can go wrong here. And if Teva stumbles at all in 2020, the confidence is undercut, and shares can tumble. A roughly 5x multiple to adjusted EPS guidance for 2020 makes TEVA look like a cheap stock, even a steal. A closer look shows there’s more risk here than a single figure suggests.
Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. He has no positions in any other securities mentioned.
