The clock has been ticking on Teva (TEVA) ever since Mylan’s generic Copaxone was approved last month. Copaxone represents over 45% of the company’s EBITDA and Teva needs to rapidly grow revenue or cut costs to compensate for the loss. New CEO Kare Schultz chose the latter, announcing layoffs of up to 25% of its local workforce in Israel:
Israeli drug manufacturing giant Teva Pharmaceutical Industries is reportedly expected to fire up to 1,700 workers in the coming months as part of a streamlining plan aimed at countering poor financial results.
The plan could see up to 25 percent slashed from the 6,860-member local workforce, and an overall cutback of 20% from its total global employee numbers of around 57,000, the economic daily Calcalist reported Thursday. Most of the international firings are expected to be in the US rather than in the company’s European sites, the report said.
The company is sending letters to employees summoning them to hearings about the layoffs. The letters are expected to continue for weeks.
How Much Costs Can Schultz Wring Out Of The Business?
The arrival of generic Copaxone sent TEVA down 20%, yet bulls stayed the course. They were adamant that declines in revenue and EBITDA from more competition was priced into the stock. Then Q3 results were announced. Teva’s revenue grew 1% Y/Y, yet EBITDA of $1.6 billion was still off 16%. Gross margin slid from 50% in Q3 2016 to 47%; EBITDA margin fell from 35% in Q3 2016 to 29% in the most recent quarter.
The erosion in margins all occurred before generic competition impacted Copaxone. It begged the question, “How much would Teva get punished after generic Copanxe finally kicked in?” It also indicated that something was fundamentally wrong with other parts of the business. Generics (59% of revenue) is the company’s largest operating segment. It is experiencing pricing pressure and delays in launching new products. In the near term Teva needs to wring costs out of the business.
The following chart outlines Teva’s Q3 revenue and EBITDA for Copaxone and other segments:
Total Q3 revenue and EBITDA were $5.6 billion and $1.6 billion, respectively. That implies operating costs were around $4.0 billion. It also implies that about $3.8 billion of the company’s operating costs were borne by segments other than Copaxone. Since Copaxone’s EBITDA margins were so high (81%) there might not be much costs to cut once its revenue declines.
I estimate Copaxone’s revenue and EBITDA could fall by 70% after generic Copaxone arrives. The reduction in EBITDA would about $559 million ($799 million less $240 million) or a run-rate of $2.2 billion. That’s the amount of costs Teva would have to wring out of the business to remain EBITDA neutral. That equates to about 14% of total operating costs and 15% of operating costs related to the Generics segment.
Is Teva Sacrificing Employees For Shareholders?
Teva’s decision to lay off 1,700 employees could potentially buoy the stock in near term. TEVA bulls might actually believe that cost savings from mass layoffs might offset the diminution in margins or the loss of Copaxone. I doubt head cuts alone will offset a potential $559 million quarterly decline in EBITDA.
After the company’s abysmal Q3 results all signs appear to point to the need for an equity raise. Fitch recently downgraded Teva’s debt to junk status, and I believe (see the above chart) generic Copaxone could render the company insolvent:
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 way, generic Copaxone could cause the company to become insolvent … 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 its net debt of $34 billion.
A potential insolvency of $1 billion would not be cured by laying off 1,700 people. On the Q3 earnings call an analyst asked management about the need for an equity raise:
Liav Abraham – Citigroup: And then can you talk a little bit about your credit rating? Just given some of the operating cash flow trends, is investment grade – you didn’t allude to that in your remarks, Sol. Is investment grade still a priority for the company? How do you plan on – if so, how do you plan on maintaining that over the next 12 months? And would you consider some kind of equity raise or hybrid structure as a means of paying down debt in order to maintain investment grade rating?
Management intimated it had important decisions to make – including a potential equity raise – in order to protect its credit rating. Protecting its investment grade rating is a moot point after the Fitch downgrade. Secondly, Teva never discloses how it expects to save from headcount reductions or their impact on its solvency or credit rating.
TEVA trades at just shy of $13.85 – just 24% off its 52-week low. I believe an equity raise could crush the stock. It could be highly-dilutive to issue new shares at such a low price. It could hurt sentiment as some bulls believe the bottom is already in. I believe signs lead to an equity raise to shore up the balance sheet and help repair Teva’s credit rating. By announcing mass layoffs instead of seeking an equity raise management might be sacrificing employees at the expense of shareholders.
Headcount reductions are a start but they likely do not fully address the potential impact of generic Copaxone . TEVA remains a sell.
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?