Warren Buffett's famous for telling investors to be greedy when others are fearful, but buying Teva Pharmaceuticals Industries (TEVA -4.63%) last year seemed like searching for loose change in a burning building. Generic drug prices began collapsing just after the company borrowed heavily to become the world's largest generic drug producer, and that was just one disaster of many that forced the company to slash its dividend last year.
We know that Buffett loves a good turnaround story, and it looks like Berkshire Hathaway (BRK.A -1.32%)(BRK.B -1.63%) doubled down on its bet that Teva will be the next big one. The holding company shocked us a few months back by disclosing a sizable stake in the troubled drugmaker, and the latest round of filings shows that the stake doubled during the first quarter, to around $693 million at recent prices.
Should you follow America's favorite investor? To answer that, let's look at reasons to suspect this troubled company can turn itself around.
Copaxone near a bottom?
Generic competition for Teva's popular multiple sclerosis injection Copaxone tore a mighty chunk out of the company's top line, but there are reasons to suspect the worst is over. During the first quarter, generic competition pushed North American sales of Copaxone down 40%, to just $476 million. The abrupt drop isn't quite so terrifying when you consider Teva leaned on Copaxone for just 13% of its overall revenue stream in the first quarter, down from 19% in 2016.
Teva slashed Copaxone's net price to compete with entering generics, and the strategy appears to be working. The popular 40 mg dosage of Copaxone maintained an 85% share in the important U.S. segment. This is encouraging when you consider Teva has a lot more experience on the other side of these negotiations.
Still making money
An ongoing plan the company started last fall to reduce staff by 25% isn't doing wonders for Teva's public image, but it's helped keep its bottom line in positive territory. In fact, Teva raised its free cash flow outlook range by $400 million for the full year to between $3.0 billion and $3.2 billion.
You can define free cash flow as income from operations minus capital investments necessary to keep those operations humming along. Teva investors can think of FCF as cash available to pay down a colossal collection of long-term debts that formed a $29.5 billion eyesore on the company's balance sheet when it reported last.
At the end of March, the company was less than halfway into its massive 14,000 employee layoff, which could allow operating expenses to fall in tandem with generic drug prices until they finally hit a bottom. Investors will want to keep a close eye on margins in the quarters ahead, but it looks like they're staying positive.
What Buffett sees
The bottom may have dropped out of North American generic drug prices, but Teva's European generic drug operations recorded a 2% year-to-year gain in local currency. It seems generic drug prices are near a bottom in Europe, but operations in the region still are turning a strong profit. In fact, Teva's European segment reported a $377 million profit during the first quarter that was 40% higher than during the previous-year period.
Warren Buffett likes to buy companies with strong advantages over their competitors in industries likely to enjoy steadily rising demand. The number of Americans over the age of 80 is expected to double in the next decade, and this group spends around four times the national average on healthcare. Generic drugs are a big part of that spending, and Teva boasted of a 15% share of total U.S. generic prescription volumes. That's larger than any single competitor, and economies of scale could help the company remain profitable in this high-volume, low-margin industry.
An unstoppable demographic shift and economies of scale might not provide breathtaking growth -- or any growth, for that matter. At this stock's beaten-down price, though, investors could come out ahead if profits remain flat into perpetuity.
At the midpoint of its guidance range, Teva shares trade at just 6.9 times this year's expected free cash flow. In other words, for every dollar you put in right now, the company's going to generate around $0.15 cents this year, which will probably be used to pay down debt. If profits simply hold steady, within a few years, patient investors who bought the stock at recent prices could find themselves collecting a juicy dividend.
Of course, there still is a chance that generic drug prices will continue plummeting, and even the industry's largest player won't be able to turn a profit. That's a hard pill to swallow and a risk worth taking.