Uri Hershkovitz - Ofer Vaknin - February 2012
Uri Hershkovitz. Photo by Ofer Vaknin
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Teva Pharmaceutical Industries suffered many a blow in recent times. One was the flop of its multiple sclerosis pill, laquinimod, which didn't do as well as hoped in clinical trials. Another problem is tough times in the U.S. generic market, says equity research firm Sanford C. Bernstein. Investors' confidence had been rocked by forecasts that were a tad on the optimistic side, too.

Teva has had its adherents, and some of them aren't happy, it would seem. At a conference in Tel Aviv last Thursday, Sanford analyst Ronny Gal said he heard people say things like "Welcome to the club of silent sufferers" and, "Can we leave the bomb shelter now?" But he says he's interested because Teva is the most advanced generic company geographically: The U.S. generic market accounts for just 26% of its operations, compared with 49% for Mylan, the second largest U.S. generic company.

Gal anticipates the following growth drivers for Teva, one being generics in developing markets. Another is proprietary drugs, with 20 of these in the pipeline, that could start to boost sales between 2013 and 2015. Yet another area is biosimilars, and another is over-the-counter drugs in a joint venture with Procter & Gamble that Teva says could generate up to 20% of its sales.

Other growth drivers include generic versions of biological medications to be launched between 2013 and 2015m and respiratory drugs, where Teva has done well and where competition is limited.

Generic drug companies trade at low price-earning ratios typical for industries with declining growth prospects, Gal says. The U.S. generic market is close to saturation and the situation will only worsen; companies will need to run faster to stay in place, he says.

Looking at all the patented drugs in the United States with annual sales over $100 million, nearly all the challengeable ones have already been attacked, except for inhaled drugs, Gal says. These are relatively protected because of difficulties proving biological equivalence.

Another reason for generic companies' falling P/E ratios is competition from India. All 10 companies that entered the U.S. market a decade ago now have 30 to 40 products. After taking over the low end of the market - the less profitable drugs - they hold a 20% market share and are expanding into sophisticated areas like injected drugs.

And other companies have taken steps to expand geographically. Mylan, specializing in generic drugs with low competition, has bought companies in France, Germany and India, so it's now weighed down in debt.

Meanwhile, Paul Bisaro, CEO of Watson Pharmaceuticals, says he seeks a major acquisition of an innovative company. Investors, however, price such companies differently; innovative firms need to do more to prove themselves.

Gal estimates that North American generic sales will decrease to 17% of Teva's turnover in 2015, with generics in Europe and the international market rising from 44% to 47%. Meanwhile, the slice of Teva sales from Copaxone would drop from 19% in 2011 to 9% in 2015. He projects that the company's other branded activities like respiratory products, women's healthcare and Azilect for Parkinson's disease will rise from 11% to 27% of turnover.

Gal expects Teva to show earnings per share of $5.65 to $5.85 in 2012 and cash flow of $5 billion - one ninth its trading value. "The market doesn't believe Teva will maintain this level of cash flow surplus," says Gal. So he expects to see Teva shares trading at $45 to $55 in the short term and then hold steady for two years until investors are convinced the company can return to growth. The stock currently trades at around $44.

The main risk of investing in the stock, Gal says, is that Teva might lose Copaxone patent cases against four companies. But having attended some of the court hearings, Gal thinks Teva has an 80% chance of winning. He puts the chance of generic Copaxone hitting the market at 50% and thinks that in such a case the drug's price would drop 20% to 25%. Meanwhile, the generic would steal 50% of market share. The erosion of Copaxone sales in Europe would be slower.

Gal is confident that Momenta Pharmaceuticals and its partner, Novartis, aren't close to receiving U.S. Food and Drug Administration approval for their generic version of Copaxone. This is based on an agreement between the sides that Teva won't ask a court for a restraining order until FDA approval for marketing the generic is close.

Only the gorillas will survive

Gal believes Teva pays an 8% royalty on Copaxone sales to the Weizmann Institute of Science and that 60% of Copaxone revenues go to Teva's net income, accounting for 50% of the company's cash flow from operating activities.

Uri Hershkovitz, a partner and analyst at Sphera Global Healthcare Fund, says the most potential for pharmaceuticals lies in the BRIC countries: Brazil, Russia, India and China. But to fulfill this potential, companies need to invest and employ a new business model based on decentralized operations.

The companies that survive will be "gorillas" successful in all drug fields in developed and emerging markets, says Hershkovitz. He says branded generics are key in emerging markets; they require a generic company's production capacity and an innovative company's selling power.

Also required is a strong presence in vaccinations, because of the infectious diseases that ravage developing countries. The ability to produce and market non-prescription drugs also plays an important role in these markets, Hershkovitz adds.

The companies he thinks are prepared to target developing countries are Sanofi, Pfizer, Novartis, Merck & Co. and GlaxoSmithKline. Meanwhile, Roche maintains the model of a large company that develops original drugs. Hershkovitz thinks Roche will be forced to adopt the decentralized model within five or six years, after it has been stung by generic versions of its biological drugs.

Hershkovitz says Teva isn't the clear choice for an investor seeking companies that will cope with market transformation. Teva isn't well-positioned in developing-market fields like biotechnology, generics and OTC drugs, though it has a foot in each of these, he says.

"I can't say if Teva will be independent in another five or 10 years, or if it will be swallowed up by a company like Johnson & Johnson," says Hershkovitz. "It's important to everyone in Israel's pharmaceutical industry that Teva maintain its independence, but this depends on Teva revamping its systems and reading the map correctly."