Teva Kicks The Can Down The Road

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Last week Teva’s (TEVA) shares rose nearly 3%, spurred by amendments to the company’s U.S. dollar and Japanese yen term loan and revolving credit facilities. The amendments will provide greater flexibility going forward:

Under the Tuesday announcement, Teva’s amended leverage ratio covenants in its credit agreements allow a maximum leverage ratio of five times through and including the end of 2018, declining gradually to 3.5 times by the end of 2020 …

Teva said that as of the end of June, the aggregate principal amount collectively outstanding under the U.S. dollar term loan facility was $5 billion and was $1.4 billion under the Japanese yen term loan facilities and, under the U.S. dollar revolving credit facility, the aggregate committed principal amount was $4.5 billion.

Greater flexibility is a good thing, but the question remains “What will Teva do with that greater flexibility?” Are bankers enabling the company or will management take the added breathing room to improve Teva’s operations?

Kicking The Can Down The Road?

The company’s current posture is a sharp departure from the unbridled expansion it engaged in with its $40 billion acquisition of Allergan’s (AGN) generics business in 2015. Teva expected both top line growth and cost synergies from the transaction:

Teva expects to enhance its financial profile significantly with highly diversified revenues and profits and to unlock substantial, achievable cost synergies by eliminating duplication and inefficiencies on a global scale and capturing economies of scale.

The world has changed since then. Healthcare costs are rising at multiples of the rate of inflation and governments are trying to rein them in. The FDA is accelerating approval of generic drugs, which has increased competition for Teva and other drug makers. Some of Teva’s largest customers have consolidated, giving them an outsized ability to negotiate lower drug prices. Such price erosion and declining volume hit its generics operations pretty hard. This could be a phenomenon germane only to Teva, but it should be watched closely in case it spreads to competitors.

Teva’s Q2 revenue was up 13% Y/Y, but its declining margins slightly offset the revenue increase. Gross margins declined from 57% in Q2 2016 to 50% this quarter; again, declining margins in generics hurt the company. EBITDA only increased 4% Y/Y, as EBITDA was 31%, down from 34% in the year earlier period. The company was able to reduce SG&A expense as a percentage of revenue, but all other costs – cost of goods sold and R&D – rose faster than revenue.

Are Teva’s Credit Metrics Improving?

Teva’s $35.1 billion debt load is 5.0x EBITDA – junk levels. The company recently sold its Paragard intrauterine copper contraceptive to CooperSurgical for $1.1 billion. It expects to sell more women’s health assets for about $1.38 billion. Asset sales could potentially spur the stock with giltzy headlines of debt pare downs. Teva also has to forgo future cash flow from divested properties. In my opinion, there is a risk in selling growth assets, while relying on slower growing properties to service the remaining debt. I would rather the company issue equity to pare debt. However, shareholders might balk over the dilution from new equity. Whether asset sales improve Teva’s credit metrics – which should be the point – remains to be seen.

What Happens After Copaxone Falls?

Revenue from Teva’s MS Specialty segment fell 10% Y/Y. This is problematic as the segment represents 18% of Teva’s total revenue. Copaxone, which treats multiple sclerosis, makes up the lion’s share of this segment’s sales. U.S. lawmakers have started a probe into the pricing of multiple sclerosis treatments. Apparently drug makers are matching price increases set by competitors in what is known as a “shadow pricing” scheme. It has caused the average annual cost of the therapy to rise from $16,000 in 2004 to more than $60,000 in 2015 – a 13% compound annual growth rate.

Lawmakers have sent letters to several drug makers inquiring about their pricing strategies, including Teva. With Copaxone under a microscope the company could be hard-pressed to raise prices for the drug. It might feel compelled to even cut prices to appease lawmakers.

Generic versions of Copaxone are on the way. Company’s like Mylan (MYL) and Dr. Reddy’s (RDY) have filed for approval of copycat versions of the drug. Generics could arrive as early as Q4 2017 or Q1 2018. A generic version could deeply reduce sales and EBITDA from Copaxone. The question remains, “What happens after Copaxone falls?” It could likely drive the company’s debt deeper into junk territory.

Conclusion

Amending debt covenants provides flexibility. Until Teva improves its credit metrics then amending debt covenants and engaging in asset sales could be the equivalent to “kicking the can down the road.” Headwinds in generics and MS Specialty could cause its credit quality to deteriorate. TEVA is a sell.

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