Healthcare: Warren Buffett's Surprising New Buy

Warren Buffett's quarterly stock picks are tracked closely because he's arguably the best investor of our time, and last week, a filing with the Securities and Exchange Commission revealed that his Berkshire Hathaway (BRK.A -1.05%) (BRK.B -0.83%) was a big buyer of Teva Pharmaceutical (TEVA -1.06%) in the fourth quarter of 2017. The decision to buy the generic drugmaker is surprising because Teva Pharmaceutical's business is struggling. However, there are some good reasons why this company may interest him.

In this episode of The Motley Fool's Industry Focus: Healthcare, analyst Kristine Harjes is joined by contributor Todd Campbell to explain Buffett's latest buy and discuss if individual investors should follow in his footsteps. Also, the two tackle Rite Aid's (RAD 12.50%) decision to merge with the privately held Albertsons to create a retail pharmacy and grocery giant.

A full transcript follows the video.

This video was recorded on Feb. 21, 2018.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Wednesday, February 21st. I'm your host, Kristine Harjes, and I'm joined as usual by healthcare contributor Todd Campbell via Skype. Todd, what's going on?

Todd Campbell: Happy Wednesday, Kristine!

Harjes: Happy Wednesday to you, too! Are you ready for our show today?

Campbell: I'll tell you, Kristine, I'm reeling from all the surprising news. Oftentimes we talked about things that are kind of expected or forecasted. But not this time. This last week has been, a couple of very surprising things today.

Harjes: Yeah, we had the news fairy come and deliver a couple of surprises. Eventually on the show, we'll be talking about one of Warren Buffett's recent buys that shocked us. But first, news in the retail pharmacy space. What's going on there?

Campbell: I think there's probably a lot of Rite Aid shareholders who are shaking their head right now, wondering what the heck just happened. Rite Aid, at one point a few years ago, was going to get purchased lock, stock and barrel for $9 a share, and now they're doing some crazy combination with the big grocer, Albertsons.

Harjes: Yeah, this was kind of crazy. I'm personally glad that I never was a Rite Aid shareholder, because this is a stock that has been on a wild ride. It's like nothing that they plan on doing actually happens as they planned it to.

Campbell: I know. And any of the investors who went out in 2015 thinking, I'll buy this for the arbitrage opportunity ahead of the Walgreens (WBA -0.06%) deal, which, if you thought that was going to close, is now looking at this going, what the heck is this stock even worth right now? You have Rite Aid at one point going to be sold for $9 a share, and then the FTC said, "No, we think that concentrates too much competitive power, so you're going to have to redo the deal." Eventually they scuttle the deal, right, Kristine, and then they come back with a new refreshed deal that's way smaller.

Harjes: This deal got revised so many times, but it ultimately led to Walgreens buying about 2,000 Rite Aid stores, which gave Right Aid some much-needed cash, it was a little over $4 billion worth of cash. Now, the most recent deal, yesterday the company announced that it would be merging with Albertsons. As you mentioned, Todd, that's the second largest grocer in the United States. They are a privately held company. There are some interesting options that are being presented to Rite Aid shareholders as far as what they'll get in this merger. They can either take, entirely, shares of the new company, or they can take shares and a little bit of cash in exchange for their Rite Aid holdings, or, of course, you can just sell your Rite Aid shares ahead of the closing of the deal, which should happen later this year.

Campbell: Right, and what makes this really confusing is that Albertsons isn't publicly traded yet. So, you're looking at it and trying to figure out what the deal value is, but you don't know what the value of that one share of Albertsons that you can get for each 10 shares of Rite Aid is. You know you're going to end up walking away with about 30% of the combined company, but you really don't know how to value that 30%. And I think that's one of the reasons that Rite Aid shares initially, pre-market, popped, and then they settled up only slightly, and I think they're down today, because people are looking at it and going, "I don't know if this deal is worth $2 a share, $3 a share, or $1 a share."

Harjes: Yeah, it's pretty crazy. Albertsons has a pretty interesting history as well, almost as interesting as Rite Aid's history. I believe at one point, they were public, and then they ended up being broken apart and they ended up being private. They tried to go public in 2015, but they backed out because the market was, I think this is actually a quote, "too jittery." Then, in 2017, they made a bid for Whole Foods, which would have made them go public again. I think our listeners all know how that ended, with Amazon (AMZN -0.16%) actually winning that bid for Whole Foods. But now, with this merger, the combined company would become a publicly traded entity.

Campbell: Right. The grocery market is actually a very tough business to be in, it's a very low-margin business. Because it's a low-margin business, a lot of the operators out there have decided that scale is key. So, when Albertsons went private, the people who took it private, the hedge funds and private equity funds, etc., they said, "Let's build up a lot of scale," so they went out and bought Safeway, for example. They went out and acquired a bunch of different stores over the course of the last few years to turn themselves into a really large player on the East Coast and West Coast, which is similar to where Rite Aid's geography is, it matches up. So, you could argue there's some synergies there. And even if you don't have Albertsons around your neighborhood, there are Star Markets and Shaw's and Vons and Safeways. So, you may be familiar with those brands instead. 

I don't know, I think this is a really interesting way for these private equity firms to start to realize the value, in by taking this public again, but, again, it creates so many different question marks for the Rite Aid shareholders. You look at it for the Rite Aid shareholders and say, just in January at the JPMorgan Conference, the management was unveiling this outline, this blueprint for a plan that involved taking the $4 billion or so in cash they were going to get from Walgreens, pay down debt, cut their interest expense from $400 million to $200 million per year, and reinvest in upgrading their stores and do all sorts of things that could make them leaner and meaner and potentially put them on a path to grow again. Then, fast forward now to February 21st, we just found out that they've decided, all those plans that we outlined, they don't really make sense after all, instead we're going to combine with Albertsons in this funky deal. And honestly ... I guess you could say, Kristine, that's their admission that trying to compete with CVS and Walgreens as a stand-alone small company would just be too big of a boulder to push up a hill.

Harjes: Yeah. I think a lot of Rite Aid bears were concerns that after selling so many stores to Walgreens, they wouldn't have the scale to be competitive. So, this deal does alleviate that pressure. Rite Aid will wind up with roughly the same number of stores as they had prior to the sale to Walgreens. That's because most of Albertsons pharmacies will be rebranded as Rite Aid. But they're still dwarfed by Walgreens and CVS, which have about 10,000 stores each. So, this is a story of a company that's facing a lot of competitive pressure. 

I also want to talk about the other side of the coin, which is that Albertsons is also facing some of these competitive pressures from the likes of Wal-Mart and from Amazon. And I think Amazon is the dark horse in this story, or the elephant in the room, if you will. We actually had an email come through the [email protected] account yesterday from a guy named Gabe from Connecticut. Hi, Gabe! Thanks for writing in! And he wanted some thoughts on the acquisition, and he specifically called out Amazon. He noted that Albertsons' move could be an effort to counteract Amazon and also enter the pharmacy space, because we know that Amazon is interested in the healthcare space in several different ways. And Gabe was wondering, is Albertsons a strong competitor to Whole Foods or Amazon?

Campbell: There's a reason that Albertsons wanted to get Whole Foods, and part of that reason was to block Amazon's entrance in being able to have a retail footprint. If you look at what Whole Foods had been doing, they'd been doing some pilot programs to create smaller format stores. I'm not going to say as small as a Rite Aid store, but, small format stores. Then, you look at what Amazon has also been up to over in Seattle with its Amazon Go, which is creating a small convenience store where you don't even have cashiers, you just walk in and pick up items and walk out the store, and it charges you automatically. I suppose you could make an argument that Albertsons is staying, maybe what we can do is leverage the pharmacy retail footprint of Rite Aid, put a lot of our private label foods and such in there, and we basically now have all of these new mini grocery stores throughout our area or geography as well. 

Same thing, you take a bunch of these Albertsons pharmacies, inside of their stores, they have about 1,000 of them. And you rebrand those as Rite Aids, and maybe you set your loyalty program up so that people who are already Rite Aid shoppers, but aren't maybe shopping at a Shaw's -- like, I have a Shaw's near me, and I don't currently shop there, but I am a member of the loyalty program on Rite Aid. So, maybe now, if they tie that in together, I might be more willing to go to Shaw's. 

And according to Albertsons' number crunchers, the people who go in and buy pharmacy items from them tend to buy about 2X as many groceries as someone who doesn't. So, they may be looking at it and saying, this is a great way for us to consolidate some additional market share, to expand within our particular geographies, and maybe to drive some additional sales within each of our stores which we can leverage against our fixed costs.

Harjes: I also found that last bit to be a really interesting point, when you're looking through the slide deck that the two companies presented in their announcement of this merger. I want to share some more numbers behind that. The average weekly spending of a prescription customer for Albertsons is 3.5X that of people that are non-Rx customers. And their average visits per week, 2.3X per week, as opposed to 0.8X for the non-prescription customers. That's huge. And that's clearly a huge value proposition. And I can see an argument for pushing into the pharmacy business in many more of their stores and getting Rite Aid's expertise there. You also mentioned their own labels, their private labels. I could see them combining scale, too, because Rite Aid also has its own labels to further drive these front of store sales or non-Rx sales.

Campbell: Right. And one the things that they've said is, we think if we get rid of a lot of the overlap in distribution warehousing, procurement, all of that supply chain stuff, we can save about $375 million EBITDA over the course of a few years per year in savings from the famous "synergies" that everybody talks about in mergers and acquisitions. One of the things that jumped out at me, Kristine, throughout that entire presentation, there was no mention of the word earnings. It was all EBITDA.

Harjes: Oh, interesting.

Campbell: And I think what that shows you, when you go back and look at the S-1 filing from 2015 for Albertsons, they're losing money. They're profitable on an EBITDA basis, but they had a net loss as of 2014. If you look at what their forecast for sales was, I think it was showing only 1.7% top line growth for Albertsons between 2016 and estimated 2018. That's certainly not barnburner growth. So, as a Rite-Aid investor, you're now looking at this and going, do I want to hold on and see what Albertsons shares come to market at? I guess you kind of have to. You're only going to get $0.18 a share in cash, plus one share. Or, what is it, you get 1.08 shares of Albertsons if you go the other route.

Harjes: If you give up 10 shares of Rite Aid.

Campbell: This is a tough one.

Harjes: Yeah, absolutely. And I think it also speaks to the difficulty of evaluating private companies. Even though we're getting more information about Albertsons now, it's just tough. It's hard to contextualize it, it's hard to figure out and peel back the layers of how this business functions, because they previously haven't had to share this information. I know Dylan Lewis, the host of the Tech show on Fridays, he talks about this all the time, about not investing in companies right after they IPO. I think he makes a lot of great points. 

I want to make another point in general about private companies, which is that it's so easy to forget that they are a factor here. I'm totally stepping on Vince's -- our Consumer Goods host -- toes here in talking about the grocery space, but I think we've already been doing that, so I'm just going to continue to step on those toes. That's a really low-margin business. When you're looking at the various grocery store chains, I don't know how much the people who are deeply analyzing that sector even remember to talk about the No. 2 biggest player here, which is Albertsons, because it's private. I know I make this mistake all the time where I'm looking at healthcare IT companies, and I forget that Epic Systems even exists. How can you forget about them? They're the top dog here. But it's so much easier to just think about Cerner, their biggest competitor, because Cerner is public. 

So, when you get news like this, where a private company all of the sudden really starts to matter to the public markets, it's always an eye-opener for me that it's important to consider these companies, and try to get as much information as you can about them, in order to really understand the broader landscape.

Campbell: Yeah. And I suppose that one take away from an investment standpoint, too, because we don't know a lot about Albertsons, it could be that investors generally are undervaluing its potential or what the potential worth might be to Rite Aid. It could be that it is worth more than $2. It wasn't that long ago that people were talking about Rite Aid getting sold for a much higher amount. Even after Walgreens did its restructuring, it was still talking about $6.50 a share all-in. So, it's hard to imagine that all of the sudden, Rite Aid is worth $2 a share right around where it's trading now. 

The other thing that we have to recognize, though, is that that market is moving and changing so quickly. We have CVS coming out and announcing they're attempting to buy Aetna. And if they do that, what does that do with all those now-Aetna customers, captive consumers being driven to the CVS stores? How does Rite-Aid combat against that? How does Rite-Aid combat against Walgreens, if Walgreens goes ahead and tries to acquire the rest of AmerisourceBergen and solidify its ability to drive down price and negotiating power that way? So, this is a very confusing deal, and it's definitely a surprising deal, as far as I'm concerned.

Harjes: Yeah, I completely agree. Changing gears now, our next segment features the oracle of Omaha, Mr. Warren Buffett himself. Let's preface our discussion that we're about to have with a little bit of explanation of how we get our information about what Warren Buffett is up to stock-wise. When we talk about what Buffett bought in the most recent quarter, what we're specifically saying is, we know from a filing called a 13-F that Berkshire Hathaway, the company that he runs, bought shares of the given stock.

Campbell: Right. They have to file those every quarter. Big investors have to file it every quarter. In this case, we're not talking about Warren Buffett's personal portfolio. We're talking about Berkshire Hathaway, the company that he and Charlie Munger run, and what that portfolio happens to own in it. I think that portfolio manages about $180 billion in equities, so it's definitely one worth paying attention to. So, yeah, we have that information, and we get that on a quarterly basis, and it just came out -- and it's in a rear, so we're talking about what was bought at the end of December 31st, so, the fourth quarter, in this case, of 2017.

Harjes: Right, So, with all of those caveats in mind, we wanted to highlight something that we thought was a really shocking buy -- quite frankly, I was surprised to see this -- which is a very large position in Teva Pharmaceutical. I should walk that back a little bit. For them, it's not a very large position. It was a $358 million stake, which to you and me, Todd, that's pretty large.

Campbell: And after appreciation, since the news came out, it's closer to a $400 million stake. He bought 18.9 million shares in Teva Pharmaceutical. And that launched him into the company's ninth largest shareholder. So, instantaneously, in one quarter, Warren Buffet surprises everybody, becomes the ninth largest shareholder of Teva Pharmaceutical.

Harjes: Right. The reason this is kind of surprising is, Teva is in a bit of a rough patch. The stock lost about half of its value in 2017. For context about what the business does, they're the largest maker of generic drugs. They also have a few brand name drugs, specifically Copaxone is its top-selling drug, it's for multiple sclerosis. It has been facing generic competition, and it's still generating multiple billions of dollars per year. But its revenue is dropping pretty sharply. 

On top of that, Teva is also saddled with a ton of debt due to an acquisition of Allergan's generic unit, which was Actavis. This was back in the year 2016. That was a $33 billion cash acquisition, plus, also, $100 million in shares, which made it the world's largest drug maker, right at a time where generic drugs are facing very steep competition that puts a lot of pressure on the pricing of these drugs.

Campbell: Right. We hinted at the consolidation in the prior segment when we were talking about what's going on with some of these pharmacy retailers. The same thing is happening with insurers consolidating together, drug distributors trying to consolidate their buying power, pharmacy benefit managers consolidating their buying power. And as a result of all that buying power getting consolidated, companies like Teva, which has about 13% market share in generic drugs, are having a harder time demanding better pricing. And as a result, their profit margins are sliding. 

So, you have them making this huge purchase of Actavis, saddling themselves with a lot of debt even at a time where the profit margins on the generic drugs that they're producing are shrinking. And then you throw on top of that the fact that last fall, the first 40mg versions, the long-lasting version, of Copaxone, got approved. That was launched by Mylan in October of 2017. So, in the fourth quarter, you had a situation where $4 billion or 20% of Teva Pharmaceutical's revenue has now been called into question. How much of this is going to end up moving or migrating to Mylan and others? And how much is Teva going to have to issue in rebates to continue to maintain its market share, thereby putting even more pressure on its bottom line?

Harjes: Yeah. So, it's no secret that Teva is struggling, and it's reflected in their stock price. The company is down almost 60% from their highs reached in mid-2015. But Warren Buffett loves a bargain. This is clearly a value play here.

Campbell: Yeah. I suppose when you start looking at it that way, Kristine, it's not as surprising once you start thinking about it. He loves companies that have a moat, he loves buying companies that are cheap to their book value, and he really doesn't care that much about dividends, so the fact that Teva got rid of its dividends last year doesn't really matter to him. What probably did matter to him is that in November, Teva actually started trading below its book value of $13.50 per share.

Harjes: Yeah, absolutely. You mentioned that he loves companies that have a competitive moat. Do you think that Teva does?

Campbell: To some degree, it does. It's obviously the biggest maker of generic drugs. And I think you look at that and say, by the nature of the beast -- what does he like to buy? What does Buffett like to buy? He likes to buy big companies like ExxonMobil. He's taken stakes in that one when it's gotten beaten up. He's taken stakes in big banks when they got beaten up. He likes to find these big players within those markets and then be able to go and grab them on sale at discount prices. 

So, I think you can argue that while Teva faces an awful lot of competitors in the generic drug marketplace, I think it does have a little bit of a moat. And I think the other thing that you have to consider is, when you think about what the demographics look like heading forward. There's this huge tailwind because of this aging global population demanding more and more drugs. That's going to provide this natural support for Teva Pharmaceutical. Then, when you consider that, all of that, right, Kristine, alongside the fact that it's not like Teva is losing money, they're still going to turn a profit of over $2 a share this year, so it's not like this company is losing money. So, buying a company that still has earnings at cheaper than book value, maybe that's not as crazy or surprising as it seems.

Harjes: Yeah, it was one of those headlines that really surprised me, and then when I started digging into it and thinking about companies that Warren Buffett has been interested in the past and his general philosophy, I can kind of see it. It's actually not that surprising when you look at the details. 

I think you made some great points, Todd, about the long-term demographic trends. If you project all the way out to 2020, it's estimated that generics will be about 91-92% of all prescriptions. That's up from 88% in 2015. So, even if the short-term and even the medium-term don't quite look great for the generics business, Warren Buffett is a long-term buy-and-hold investor. It's very much in line with what we believe here at The Motley Fool. 

I'll also point out another thing that I bet Warren Buffett probably likes about this stock, which is that healthcare in general is inelastic, meaning that in great economies or terrible economies, as the cycles come and go, people still have consistent demand for this type of product. You can't choose when you get sick. You're always going to need drugs that you're going to need. On the other hand of that, Berkshire doesn't actually own much healthcare. They've been trimming their stakes in Sanofi and Johnson & Johnson, although they do maintain a position in DaVita, which is a dialysis company. So, I'm on the fence about whether that's a really good reason to say Buffett would like this, because it's healthcare and it's inelastic, because traditionally, he hasn't been a huge healthcare guy.

Campbell: Yeah, he's kind of shied away from that market, hasn't he?

Harjes: Yeah.

Campbell: I think it's probably because of the uncertainty of drug approvals, etc. You never know who's going to outmaneuver you. He may also like the fact, Kristine, that after cutting its dividend, the company has a big restructuring plan that's starting to get really ramped up over the next year and a half that should be able to cut $3 billion in expenses per year once it's fully done. They expect that to happen in 2019. So, there's operating leverage there. 

Like you said, he's long-term focused, so he may be looking at it and saying, listen, you're going to end up with operating leverage because of all the cost cuts. And yeah, Copaxone is going to lose some amount of its sales, maybe it drops from $3 billion to $2 billion to $1.5 billion, who knows. But if it stabilizes, and you have all that operating leverage, over time, this could actually become a much more profitable company than it was in the peak of 2014 or 2015.

Harjes: Yeah. Ultimately, when I look at this and I try to justify why Teva might be a good stock based on the things that Warren Buffett might see in it, the conclusion that I ultimately come to is that, why wouldn't I just buy Berkshire? What do you think, Todd?

Campbell: Right. Why wouldn't I buy Berkshire, or why wouldn't I just go out and buy the SPDR that covers the healthcare industry? Why wouldn't I do that? I tend to focus more on companies that have more certainty to their growth, rather than uncertainty to where the bottom will be found. But he has such deep pockets. This represents such a tiny fraction of his portfolio. I suppose if you're looking at it as an individual investor, should I also buy this too, well, yeah, if you want to put 0.3% of your money in it. Why not take that risk, I suppose?

Harjes: Yeah, absolutely. I guess it's probably time to make the general disclaimer about 13-Fs, which is that they don't really come with a lot of information about what is on the inside of these billionaires' heads. So, we don't know exactly why. We're speculating here based on what we know about Warren Buffett. It's never wise to just follow billionaires into these stocks, particularly because it's so rearview-looking, because it was over the past quarter. No one is to say whether or not, right this second, Warren Buffett still thinks that Teva is a buy.

Campbell: Right. And it could very well be that he liked it at $13.50 when it was trading at book value, but now at $20 he thinks it's fairly valued and has no interest in adding more shares. We won't know until the next 13-F report.

Harjes: For sure. Todd, we're about to wrap up for the day. Thank you so much for being here, as always. People on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!