Today's Buy Opportunity: Teva Pharmaceutical

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Yesterday's headline from The Wall Street Journal says it all, really. "Health Insurers Plan Hikes." You and I have both felt the effects of increases in the cost of health care, whether it's from higher copays for prescription drugs or higher prices for what we buy and use, as employers try to recoup some of the rising costs of insuring their employees. 

Today's 11 O'Clock Stock purchase, Teva Pharmaceutical (Nasdaq: TEVA  ) , the No. 1 generic-drug maker, takes advantage of governments', insurers', and employers' desire to rein in some of the rising costs of health care by offering cheaper alternatives to many prescription drugs. It also takes advantage of another opportunity, which I'll get to in a moment. 

Fast facts on Teva 

Market capitalization

$48.8 billion

Industry

Pharmaceuticals

Revenue (TTM)

$14.8 billion

Earnings (TTM)

$2.5 billion

Dividend yield

1.4%

No. of generic drugs, end of 2009

>400 in U.S., with >200 awaiting approval

>150 in EU, with >240 awaiting approval

 Source: Capital IQ, a division of Standard & Poor's, and company filing. TTM = trailing 12 months.

With the large number of generic drugs it sells in the U.S., Teva filled some 599 million prescriptions last year, roughly 22% of the generic prescriptions written. I expect that number and market share to grow as Teva continues to acquire smaller players -- it wrapped up Barr Pharmaceuticals last year -- and as more big-selling drugs come off patent.

A double opportunity
Here is the second opportunity I mentioned. The big pharma companies are facing what's been dubbed a "patent cliff" over the next several years, as some of their biggest brand-name drugs lose patent exclusivity, allowing generic versions to be sold. Take a look at this list:

Company

Drug -- 2009 Revenue

Patent Cliff Date

Eli Lilly (NYSE: LLY  )

Gemzar -- $1.4 billion

Zyprexa -- $4.9 billion

Cymbalta -- $3.1 billion

Nov. 2010

Oct. 2011

2013

Pfizer (NYSE: PFE  )

Lipitor -- $11.4 billion

Xalatan -- $1.7 billion

Viagra -- $1.9 billion

2010

2011

2012

Merck (NYSE: MRK  )

Cozaar / Hyzaar -- $3.6 billion

Singulair -- $4.7 billion

2010

2012

Source: Company press releases and 10-Ks.

That's nearly $33 billion in revenue facing generic competition over the next few years, from this list alone. While that's a big problem for the pharmaceutical companies, it represents a great opportunity for Teva, which we're taking advantage of here. In fact, Teva has already launched generic versions of Merck's Cozaar and Hyzaar.

Investors in Lilly or Pfizer or the others facing the patent cliff have to worry about their companies' replacing the revenue lost when generic competition ramps up. An investor in Teva, however, is playing the other side of that coin.

One way Teva runs up that ramp is to challenge the validity of patents covering specific branded drugs at the same time as it files a generic-drug application with the Food and Drug Administration. If it is the first to file that application, then it gets a 180-day window of being the only generic supplier, which allows it to charge prices just slightly lower than the branded price.

In other words, if it wins the patent challenge and its application is approved, it can achieve essentially the same margins as the branded drug has. An FDA study has shown that the first generic-drug competitor averages about 94% of full-branded price. When two generics are on the market, they average about 52% of the branded price. It's not until the fifth generic hits the market that the average price drops below 33%.

Concerns
As with almost any investment, all is not rosy. Teva also has branded drugs, primarily Copaxone, the biggest seller for treating multiple sclerosis. This will lose patent exclusivity beginning in the spring of 2014. The Sandoz division of Novartis (NYSE: NVS  ) and Momenta Pharmaceuticals (Nasdaq: MNTA  ) have filed their own generic version with the FDA and are fighting in court with Teva over the patents protecting Copaxone.

As Teva expands its branded-drug business, which contributed about 28% to revenue in 2009, this kind of problem will persist. If the company swings strongly toward becoming a branded-drug maker, I'll have to reconsider the investment.

Further, everybody recognizes the importance of generic drugs. Sandoz is the No. 2 generic-drug company and big pharma is moving into the field as well. Teva had to beat Pfizer off with a stick in obtaining German generic-drug company Ratiopharm. So far, it's managed to retain and even grow its No. 1 spot. Right now, I believe that it has the resources to keep it, but if market share begins to slip, I'll also have to reconsider.

Final thoughts
The investment thesis boils down to investing in the No. 1 generic-drug company in the world at a time when many big-selling branded drugs are beginning to come off patent and when many seek to reduce their health-care costs. That combination should lead to growing sales and market share for Teva. While it won't be a barn-burning investment, it should provide a solid performance to anyone's portfolio over the next several years.

Previous recommendations:

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The Motley Fool will wait at least 24 hours after this publication before buying shares of Teva. To see an FAQ on "11 O'Clock Stock," click here.

Fool analyst Jim Mueller does not own shares of any company mentioned. He works with the Stock Advisor investing newsletter service. Pfizer is a Motley Fool Inside Value choice. Momenta is a Rule Breakers selection. Novartis is a Global Gains recommendation. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 09, 2010, at 11:25 AM, tekennedy wrote:

    Although I am a fan of the industry I haven't made any investments due to difficulty in valuing the companies. The way I view it revenues and profits for generic companies are always coming "off patent" as they will always be earning significant profits from their 180 day exclusivity periods. The unreliable yet somewhat consistant nature of these one time gains has made assigning a fair value to a generics company difficult. What measure do you use to determine the value of a company within the space?

  • Report this Comment On September 10, 2010, at 10:19 AM, TMFTortoise wrote:

    Hi tekennedy,

    Good question. Actually, due to the very difficulty you mention, I believe it is impossible to reliably model what revenue or profit will be in the future from which to generate a fair value. The timing of when drugs come off patent is pretty well known, but the timing of winning a Paragraph IV challenge in court and then getting the 180-day exclusivity is really unknown. Thus judging revenue and margins from those and blending with all the other drug revenue, well, make a mistake of six months and your whole model is off. Significantly.

    For that reason and others, I prefer to let the market tell me what growth is expected by today's price. In this, I'm following the footsteps of Michael Mauboussin of Legg Mason and his great book "Expectations Investing."

    Using last night's close of $54.23 and TTM FCF of $3.113 billion and a discount rate of 12%, the expected growth that justifies that price is 10% for 5 years, 5% for 5 years, and 2.5% terminal. If you penalize the company $1.7 billion for acquisitions (treating it as capex as the company regularly acquires others; that's the average for the last 6 years), but then credit them back the $442 million 6-year average of after tax in-process R&D such acquisitions cause Teva to expense, that gives $1.855 billion TTM adjusted FCF. Plugging that into the simple DCF calculator results in expected growth of 19.6% for 5 years, 9.8% for 5 years, and 2.5% terminal to match last night's closing price.

    *Unadjusted* FCF has an average 5-year compounded growth rate of 21.3%, though a lower 15.9% 3-year compounded average growth rate.

    By this lens, at least, and assuming that it can match that 21% rate going forward, then Teva is either undervalued or roughly fairly valued. Take your pick, but be ware of that assumption.

    Either way, this simple model assumes a 12% average rate of return. Add in a modest dividend and the investment probably won't do too badly. However, please do your own further research and do not rely upon what I've written to convince you one way or the other.

    Hope that gives you an idea of how I was thinking about this from a valuation perspective.

    Thanks for reading and your question.

    Cheers,

    Jim

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