Teva’s Choice: Rapid Earnings Growth or Investment in R&D

CEO Erez Vigodman gave a U.S. health-care conference a look at the mistakes the drugmaker made over the years and his view to the future.

Yoram Gabison
Yoram Gabison
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Teva Pharmaceuticals CEO Erez Vigodman, November 2014.
Teva Pharmaceuticals CEO Erez Vigodman, November 2014.Credit: Reuven Kopitchinski
Yoram Gabison
Yoram Gabison

What does Erez Vigodman, the CEO of Teva Pharmaceutical, prefer? A major acquisition of a synergistic company that will boost earnings per share to the delight of the capital markets? Or does he want to invest in developing products that might cut into earnings in the short run but create major value in the long term?

Appearing this month at the J.P. Morgan Annual Healthcare Conference, one of the pharmaceutical industry’s major showcases, Vigodman surveyed Teva’s achievements in his first year at the helm and shared a bit of the company’s strategy from now until 2019.

The questions from investors and analysts that Vigodman fielded focused on Teva’s short-term business-development plans, apparently due to the sense in the capital markets that the next boost in the company’s share price would require a substantial acquisition.

J.P. Morgan analyst Chris Schott, who moderated the discussion, asked Vigodman which financial criteria would guide Teva in weighing an acquisition.

He wanted to know whether earnings accretion was a threshold condition or whether the company was prepared to consider a transaction that would reduce earnings growth in the short run in favor of long-term growth.

Vigodman’s response reflected the dilemma he faces in an environment that expects Teva to get back into mergers and acquisitions big time and push its share price above the $56-to-$57 range, where it has been trading for the past three months. His answer also reflected his priorities and his own critique of Teva’s strategy over the past decade.

He hinted that he is not enamored with Wall Street’s obsession with M&A deals that are measured almost entirely by their contribution to short-term EPS increases. The more important gauge, he said, was return on investment or the internal rate of return, which is a better indicator of a company’s rate of growth.

The U.S. capital market generously rewards M&A deals that bring quick EPS growth. That means they need to bring short-term synergies through closing plants, canceling duplicate R&D and cutting staff. That usually requires the companies to have an overlapping geographic presence, a similar stable of products and big staff headquarters.

An good example of that type of M&A deal is Actavis’s $66 billion acquisition of Allergan. Considering that the acquiring company is valued at $64 billion, the risks are huge. Yet since the middle of November, Actavis’s share price has risen about 10%, thanks mainly to an estimated $1.8 billion a year in savings the company is promising.

Route to new products and markets

The problem is that transactions of this kind are frequently not engines for new growth and don’t offer any route for developing new products or markets.

From 2005 to 2011 Teva acquired four companies for $22 billion, but it is still not present in major emerging markets such as Brazil, India and China - and this is precisely the reason.

One indication of the limited value that the Teva acquisitions gave to shareholders is that from second-quarter 2005 to third-quarter 2014, EPS increased by 91 cents. Of that figure, 75% was attributable to sales of its multiple-sclerosis drug Copaxone, which was unrelated to the acquisitions.

In other words, $22 billion of acquisitions contributed just $200 million to quarterly earnings, a small return considering the cost of capital to Teva over the period.

A second option available to Vigodman is acquiring products in development or a generic-drug maker in a country where Teva isn’t present. Those kinds of deals don’t boost EPS because they don’t overlap with existing operations, but in the medium to long term, they could create major value for shareholders.

An example of this approach was the 2005 acquisition of the Massachusetts company TKT by Dublin-based Shire Pharmaceuticals Group for $1.6 billion in cash. The transaction didn’t generate a short-term increase in EPS; rather, it ended up cutting earnings.

TKT had annual sales of just $78 million at the time, along with operating losses and just one approved product. But three products in development that Shire acquired with TKT are now selling at a clip of $1.5 billion a year and enjoying double-digit growth.

When it acquired TKT, Shire was trading at a market cap of $5.7 billion, but the acquisition and others are the reason that it now trades at $42 billion.

In hindsight, if Teva had directed part of the cash it devoted to EPS accretion toward making an acquisition of the kind Shire made, it might have created greater shareholder value.

Vigodman hinted at what Teva would look like in 2019 based on the strategic plan that the company developed last year.

The company will be driven by consumer needs and operating in fields beyond those involving chemical intervention, meaning Teva won’t restrict itself to manufacturing and marketing drugs.

In the generic sector, Teva will focus on producing complex medications that pose high technological hurdles and would maintain the most efficient operations in the industry, he predicted.

In the field of proprietary - brand-name - and specialty drugs, the company will focus on the fields in which it has developed relative strengths and where it leads in local and global markets.

Supplying all a patient’s needs

With respect to the intersection of generics and proprietary and specialty drugs, where the bar is constantly rising, there is room that suits Teva, involving special combinations of drugs, medical instruments, technologies and services.

In other words, Teva will not necessarily seek to differentiate its operations by going after the next new proprietary drug but will instead become a supplier of all a customer’s needs, from medications to medical instruments and services in the therapeutic areas the company is now focused: respiratory diseases and central nervous system disorders.

Teva already runs a service center for patients receiving Copaxone in Kansas City, Missouri, where it employs a staff of 200. The center relies on the expertise Teva has developed in MS over the 19 years it has sold Copaxone to 84,000 patients.

The center provides services such as training for patients on giving themselves injections, a telephone hotline and help filing insurance claims.

Another example of this strategy is in respiratory medicine, where the company has innovated in technology through use of Teva formulations that have gone off patent. Teva’s DuoResp product for treating asthma and chronic obstructive pulmonary disease patients, for instance, is based on Teva’s original Spiromax inhaler and two generic active ingredients.

One might guess that Teva would like to emulate the success of Novo Nordisk, which has reaped handsome premiums by positioning itself as a leader in a specialty market. One of the leaders in the diabetes-medication market, Novo Nordisk is traded at a $116 billion market cap.

Its diabetes products generate 80% of sales and operating profit, and it controls 26% of the global market. But the company doesn’t make do just with producing insulin; instead, it addresses every aspect of a diabetes patient’s life, as well as those at risk of the disease.

Its efforts range from development of drugs and pen needles for self-administration to establishing the World Diabetes Foundation, which in turn obtained a commitment from the United Nations to commit to fight the disease.

Novo Nordisk has been investing more in R&D than Teva has, which enables the company to retain leadership in a huge and growing market like diabetes. Novo Nordisk spends 16.5% of revenue on R&D, twice the 8.1% at Teva.

Nonetheless, Teva has begun to develop similar capabilities in the field of brain sciences.

It has established a national network for excellence in brain sciences that includes annual support of $15 million as well as access to R&D facilities.

Teva is a founding partner in Bar-Ilan University’s medical school in Safed in northern Israel, where it dedicated a brain and genetic disease research center.

It is also a founding partner in a program that fosters cooperation between brain-science researchers in Israel and Germany.

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