Teva's headquarters in Jerusalem
Teva's headquarters in Jerusalem. Photo by Bloomberg
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Ofer Vaknin
A worker at a Teva factory in Kfar Saba shows the Teva drug Copaxone Photo by Ofer Vaknin

Teva Pharmaceutical Industries has had a difficult year. Its success has always been a source of pride for Israelis and a font of gains for their investment and pension portfolios. Today however, like its industry, the company is at a crossroads.

How it overcomes the new challenges will shape the future of the Israeli company that became the undisputed world leader in its field.

Teva has become known as "the people's share" because everybody is invested in it through their pension and investment portfolios. The main criticism of the company in the markets is that, of late, Teva stock hasn't done well. It's lost 10% this year while the benchmark Standards & Poors pharma index gained 11%. From its peak in early 2010, Teva stock is down 35%.

Investors had been used to Teva stock reliably rising over the years. After seven years of lackluster returns, investors and analysts are beginning to ask questions.

Is the amazing success that the company enjoyed for nearly 40 years peaking? How badly did Teva hurt, if at all, from losing its long-time leader Eli Hurvitz, who passed away last November?

To be sure, Teva's results and forecasts for the next two years show no sign of trouble. Revenues in the first quarter of 2012 reached $5.1 billion, up 25% from the same quarter in 2011. Minus one-time expenses, Teva netted $1.3 billion in the first quarter, up almost 40% from the year before.
Its revenue forecast for 2012 is $20 billion, up 12% from 2011. It projects profits of $5 billion, up 8% from last year.

All are record figures. So? Why is the company's stock trading at a price-earnings ratio of just 7.5 times estimated earnings for 2012, after years in of a ratio of more than 20?

To these questions there is certainly more than one answer, but one thing is clear: Teva is in a process of change as the global pharma industry changes.

A scrappy giant is born

For years, Teva dominated the Israeli pharmaceutical market. Then it conquered the world, becoming the biggest generic drug provider on the globe. Its strengths lay in innovation, daring and financial creativity. Teva is a giant but it knows how to be scrappy and it knows when to push the so-called envelope. With Teva, envelopes moved.

This creativity marked the company's very beginning, when two small Israeli drug companies, Assia and Zori, merged in the 1960s. This merger, led by then Assia CEO Eli Hurvitz, laid the strategic foundations that served Teva well over the many years.

The merger immediately boosted sales, profits and market share. Hurvitz decided to pursue additional acquisitions.

Next he wanted to merge Assia-Zori with the well-established drug distribution company Teva, which was listed on the Tel Aviv Stock Exchange. But Gunter Friedlander, Teva's founder, objected.

Hurvitz went for a bold move: a hostile takeover, unknown in Israeli circles back then. He borrowed from the banks, persuaded some shareholders to sell him their stock, purchased more on the open market and presented his merger proposal to the company's remaining owners as a fait accompli. It took some years but the merger of Assia-Zori and Teva was sealed. That too was done creatively, as a reverse merger: the privately-owned buyer was swallowed into the publicly listed company that had been acquired.

A hostile takeover of a publicly owned company is a complex process packed with risk, and its successful execution spurred Hurvitz and Teva to base their future growth plans on acquisitions. The mergers continued in the 1980s with the Israeli companies Ikapharm and Abic.

Then, having steamed its way to the top of the Israeli market, Teva turned its focus to America.

Its first moves in the United States were to register its shares on the New York Stock Exchange, and to acquire the Lemmon Company, which it used as a marketing bridgehead. In 1991, armed with money from Wall Street, Teva embarked on an buying spree. Through the 1990s it bought eight different companies in the U.S. and Europe for a total of $1 billion.

The smaller acquisitions were usually carried out using cash, and larger deals, in the range of $200 million-$300 million, were done by stock swaps. Teva thus managed to avoid accruing massive debt that would have undermined its solid financial footing.

Through acquisitions, by the 1990s Teva had become the biggest pharmaceuticals company in the U.S. by sales and market share.

Its skill at integrating new operations, its ability to better the companies it acquired and the careful financial management by Eli Hurvitz and Teva's long-serving CFO Dan Suesskind drove the company’s growth, helping it reach its goal of doubling sales and profits every four years.

Teva's acquisitions policy brought healthy returns. The company's leaders were patient, swooping in when other companies ran into trouble or when their owners had tired of managing them. Its knack at buying companies and rapidly creating added value remained one of its most strategic assets.

The string of acquisitions also continued after 2000, with ever-bigger deals. Sicor was bought in 2003 for $3.4 billion; Ivax Corporation was purchased in 2005 for $7.4 billion; Barr Pharmaceuticals was acquired for $7.5 billion in 2008; the German company Ratiopharm was bought for $5 billion in 2010, and Cephalon was acquired for $6.8 billion in 2011. It also bought smaller companies, mainly in Europe and the U.S.

In the last 10 years Teva has spent $30 billion on acquisitions. But its present market cap is just $37 billion. Teva seems to be having more difficulty in creating added value from its acquisitions.

Not all of its acquisitions were applauded by investors. Ratiopharm and Cephalon were bought in haste, for too much, say critics.

"Teva's purchase of Ratiopharm had problematic timing. [It was completed] a moment before the financial crisis in Europe," says Ori Hershkovitz, partner and analyst at Sphera Global Healthcare Fund, which specializes in pharmaceutical and biotechnology investments. "Cephalon doesn't have enough products in its development pipeline. The products it does have that benefit from patent protection will lose it within two years. There's a risk that within six or seven years not a thing will remain from this acquisition."

Cephalon brings new skills to the table

Analysts criticize Teva's failure to forge into original drug development earlier. Buying Cephalon buys it drugs under development, a new direction for Teva. Sources near Teva say Cephalon brings value that the public has yet to see.

"People think that receiving approval from the U.S. Food and Drug Administration to market a brand drug is a black and white matter," says an insider. "But it entails negotiation and touches upon all sorts of gray areas. Teva isn’t good at that yet because it hasn't developed many brand drugs. Cephalon does have this capability."

Indeed, Teva hasn't developed many brand drugs, but it gained a world leading position in generic medicines.

Teva's expertise in generics began in the 1970s. It utilized a loophole in Israeli and international patent law, which gave it license it to develop knockoffs of original, patent-protected medicines.

This opportunity presented itself when some foreign pharmas acceded to Arab boycott demands after the 1973 Yom Kippur War. Teva proceeded to strike down the patents of boycotting pharmaceutical companies in court one after another and received approval to manufacture and market copycat versions of their drugs.

But Teva didn't stop there. After every such legal victory it would contact the drugs' original manufacturers and offer a partnership in producing the brand drug, or at least its active ingredients – for marketing outside Israel.

Developing generic versions of brand drugs improved Teva's skills at chemistry and manufacturing medicines for the word market required it to meet stricter quality standards. It also developed legal skill as it challenged patents of trademarked drugs.

Generics were all the rage in the 1980s and 1990s as governments, mainly the U.S., sought to slash spending on health care. Government policy was tweaked to help generic drugmakers like Teva get their off-brand versions to market as soon as possible.

To promote generics, the U.S. enacted Paragraph 4 under: the first company that gets FDA approval for a generic drug can get exclusive sales rights for six months.

In that time, the company can sell its copycat drug for a good price, while capturing market share from the brand drug. (After the 6-month window, other generic companies can enter the fray and the generic drug's price typically falls.)

The siren-song of the 6-month window of exclusivity encouraged generics to challenge patents: if it worked, the company could start marketing immediately.
Teva accumulated much expertise in developing generic knockoffs and challenging patents. In the late 1990s, having conquered the U.S. generics market, Teva turned its attention to Europe.

Parlez vous generics?

The game in Europe was different. There is no centralized drugs market. Every country has its own rules.

But European governments have also been looking for ways to trim health spending. Teva copied its American strategy and bought companies in Italy, Spain, Turkey, Hungary, Ireland and more.

While it was snapping up companies, Teva was able to grow and stretch, utilizing its accumulated competitive advantages.

But looking forward, the generics market seems to be heading for change. By 2015, most of the blockbuster drugs on the market will lose patent protection.

That will hit brand drugmakers first, but the generics will hurt too and the biggest is Teva. Its bottom line could take a huge hit as it falls down the so-called "patent cliff" (when a drug's patent expires and its sales figures drop precipitously). Teva needs alternative sources of income.

This is a key reason why its share price is low despite its rosy forecasts.

Teva has also been expanding to new territories like Japan, Eastern Europe, China and India – though in the last two it's just starting. But again, like in Europe, every country has its rules. Expanding globally will be much more complicated than expanding in the U.S. market, and Teva needs to move fast to compensate for dwindling income in Europe and U.S. as the patent cliff nears.

Biter bit: Generic competition for Copaxone?

Teva's succeeded in generics thanks to strategy, skilled management, and organized and methodical work. The success of Copaxone, its brand drug for multiple sclerosis, was luck.

About 15 years ago, when Teva received approval to market Copaxone, sales forecasts were for $500 million a year at most.

But these were conservative estimates, based on the assumption that Copaxone would compete with other drugs. Also, Copaxone costs a fortune to make, and it's a daly injection, not exactly easy to market.

This year Copaxone sales are expected to reach $3.8 billion, on which the company should net about $2 billion, about 40% of its profit.

Copaxone was Teva's first real foray into brand drugs. Its success brought cash for Teva's massive acquisitions. But what will happen when the "blockbuster curse" takes effect - Copaxone loses patent protection?

Copaxone's patent expires either in 2014 or 2015. Making a generic knockoff won't be easy because Copaxone is a complex molecule, and patients using it for years may not want to switch. There's no telling how Copaxone sales will diminish if generic competition arises, says Amir Argaman, an analyst at Oppenheimer Israel.
To refresh its patents Teva has been developing newer versions of the drug. It's also working on oral MS drugs.

The longer Teva manages to fend off decline of Copaxone's sales, the more it numbs the impact of the impending hit from losing of patent rights. It also gives the company more time to develop new growth drivers.

The future is in biotechnology

In short, Teva probably needs to develop more original drugs, replicating its success with Copaxone.

Jeremy Levin's appointment to replace Shlomo Yanai as CEO indicates that is what the company thinks too. Levin, a top figure from pharma giants Bristol Myers Squibbs and Novartis, is considered an expert in brand drugs.

The latest wrinkle in brand drugs is "biotechnological" ones, rather than synthetic chemical drugs.

Teva would prefer to get into biotechnologicals the same way it came to dominate generics: by developing generic knockoffs. But it is incredibly difficult to imitate biological processes.

Regulators have yet to solve the problem of how to approve a copycat drug if they can't be sure it does exactly the same thing as the brand version. Generic companies will likely also be required to conduct clinical trials of biosimilar drugs, which will increase the cost of developing.

Developing a chemically synthesized generic costs roughly $10 million. Developing a biosimilar drug is expected to cost up to $150 million.

Teva is a giant. It has dozens of manufacturing plants around the world and tens of thousands of employees. It turns over about $20 billion a year, 20 times its revenues just 15 years ago. Teva still aims to double its sales every four to five years.

Teva’s executives saw the problems and took precautions. Acquisitions reduced dependence on the American market, where growth has slowed. The focus is shifting from generics to developing pioneering, name-brand drugs that ought to reduce the company's dependence on Copaxone. The company has been expanding around the globe. Teva is also cooperating with the international consumer products giant Proctor & Gamble on over-the-counter medications. How much growth these measures can produce for the gigantic company will be tested by time.