Teva Pharmaceutical was downgraded to junk territory by Fitch on Monday, as analysts from the smallest of the three major US credit rating agencies broke from their peers in cutting the Israeli drugmaker out from the investment-grade credit universe.
Fitch cut its rating to double-B from triple-B minus and said it held a negative outlook on Teva, signalling further downgrades could be possible. The move affected roughly $35bn of debt.
“Teva is facing significant operational stress at a time when it needs to reduce debt,” said Patrick Finnegan, an analyst with Fitch. “Pricing pressure in Teva’s North American generics segment and erosion of sales of Copaxone will continue to weigh on free cash flow in the near term, requiring the company to continue to sell assets or find external capital resources to meet debt obligations.”
Teva’s stock initially fell by double-digits after the company gave a weak outlook following its Q3 earnings report. The Fitch downgrade could further punish TEVA. Below is my takeaway on the downgrade.
Teva Has Been Skating On Thin Ice For A While
Teva has been skating on thin ice for a while now. Its operations became challenged after its $40 billion acquisition of Allergan’s (AGN) generics business. It amassed tens of billions of debt to fund the deal. Since, the generics business has faced pricing pressure from large customers and has been hit by accelerated FDA approvals of new drugs. At Q2 2017 the company’s debt/run-rate EBITDA (Q2 EBITDA annualized) was already at 5.0x.
The company responded by selling assets. In September Teva sold its Paragard intrauterine copper contraceptive for over $1 billion. I intimated the sale was much ado about nothing:
After the Paragard sale, Teva will remain highly indebted and over 70% of its operations will face sizeable headwinds. The asset sale might be much ado about nothing.
Teva had to forgo the cash flow from Paragard and it still would remain highly-indebted. The Paragard deal was headline-grabbing news, but that was about it. In October Mylan (MYL) received approval to offer a generic version of Teva’s blockbuster Multiple Sclerosis drug Copaxone, which represents over 45% of Teva’s EBITDA. That likely set in motion the wheels of a ratings downgrade.
Earlier this month the company reported dismal Q3 earnings results. While revenue was up 16% Y/Y, EBITDA fell 16%. Teva’s EBITDA margin declined to 29% from 35% in the year earlier period on pricing pressure in generics. Teva also lowered Q4 earnings guidance due to more pricing pressure in generics and generic Copaxone entering the market earlier than expected. This likely sealed Teva’s fate. The company’s debt/run-rate EBITDA deteriorated to 5.3x. When lost sales from generic Copaxone kick in it will likely worsen.
Financial Impact Of A Downgrade
The downgrade might not have a large financial impact on Teva immediately. According to management, 80% of the company’s $35 billion debt load is fixed rate. The company believes the borrowing costs on $6 billion in terms loans could rise by about 25 basis points upon a notch downgrade:
But in the case there was a potential downgrade, it’s really just the $6 billion of term loans that would be impacted immediately. We have over 80% of our debt in fixed rates at this point. The term loans would be subject to a 25 basis point increase, upon a notch downgrade, in their interest rates.
Fitch actually downgraded Teva by two notches. Assuming the 25 basis points figure is correct, the downgrade could cause the company’s annual interest expense to rise by $15 million. This pales in comparison to Teva’s $1.6 billion in quarterly EBITDA. However, it could have an out-sized impact on any new debt issuance and hurt sentiment for the stock.
In my opinion, the main gatekeepers in the current market are auditors and rating agencies. TEVA hit a 52-week low of $10.85 last week just after earnings. I believe Fitch’s downgrade could hurt sentiment on the stock and force investors to focus less on what the “smart money” thinks and more on Teva’s deteriorating earnings fundamentals.
Will Generic Copaxone Render Teva Insolvent?
The combination of generic Copaxone, a loss of pricing power in generics and a $35 billion debt load could make Teva uninvestable. I would compare Teva to other serial acquirers like Valeant (VRX), Allergan, and Mallinckrodt (MNK).
These companies (including TEVA) trade at a mid-point of 7.7x run-rate EBITDA. Mallinckrodt is at the low-end of the range (5.7x) and is reeling from declining sales of its main product Acthar. Allergan is at the top-end of the range (11.1x) but I do not believe the potential impact of generic Restasis, its blockbuster dry eye drug, is fully priced in.
I also estimate that generic Copaxone could cut Teva’s EBITDA by about 34%, making it difficult to cover its $34 billion in net debt. Said another, generic Copaxone could cause Teva to become insolvent. Below I attempted to value Teva including the impact of generic Copaxone.
- Teva’s Q3 revenue and EBITDA were $4.6 billion and $1.6 billion, respectively. Assuming an 81% EBITDA margin for Copaxone, the drug would equate to about 49% of Teva’s total EBITDA. This is consistent with previous estimates that Copaxone was 45% – 50% of Teva’s total EBITDA.
- I previously estimated generic competition could cause Copaxone sales to decline by 70% in year one – 51% decline in price and 40% loss of market share. That would reduce Copaxone’s run-rate revenue to $296 million from $987 million at Q3 2017. Market chatter suggests Teva is already rushing to match Mylan’s 30% discounts on Copaxone.
- I assumed Copaxone maintained its 81% EBITDA (slightly optimistic), despite lower sales. This would equate to run-rate EBITDA for Copaxone of $240 million.
- Teva’s total EBITDA would then decline to about $1.1 billion, or a $4.3 billion run-rate.
At run-rate EBITDA of $4.3 billion and a median multiple of 7.7x, Teva’s enterprise value of $32.9 billion would be less than net debt of $34 billion. The previous chart illustrates this.
The Fitch downgrade will likely hurt sentiment for TEVA. Generic Copaxone could cause TEVA to retest its 52-week low, and even challenge its ability to remain solvent.
On Trump And The Global Economy
The second installment of Trump And The Global Economy Town Hall took place October 24th in Fort Greene. It Featured Professor Lance Brofman, Coconut Rob (Coconut Rob Smoothies), Wuyi Jacobs (AfroBeats Radio) and Ralph Baker, author of Shock Exchange: How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead.
The event was well-received by the community. We parsed through President Trump’s proposed tax plan and [i] how it was pure economic folly and [ii] high net worth individuals could potentially game the system by shifting income around. Apparently, Kansas Coach Bill Self did this when the state of Kansas cut taxes in the past. We discussed the pros and cons of technology on workers and the economy. How will the economy and country prosper under Trump’s leadership vis-a-vis Obama? What’s behind the verbal sparring with black athletes, ESPN’s Jemele Hill and North Korea’s Kim Jong Un?