Teva’s (TEVA) shares have been on a roller coaster ride over the past few days. The stock bounced over 10% Thursday after the company announced it would lay off about 25% of its workforce and suspend its dividend:
Teva Pharmaceutical Industries Ltd.’s new Chief Executive Officer Kare Schultz proved that when it comes to saving the struggling drugmaker, he’s ready to pull out all the stops.
Just six weeks into the job, he announced plans to slash 25 percent of the Israeli company’s 56,000-strong workforce, suspend dividends and forgo employee bonuses. The plans, which envision cutting costs by $3 billion in two years, surpassed even the most aggressive forecasts from analysts and sent shares surging the most on record in Tel Aviv.
Teva will now be a leaner organization; however, not much is really new. We have known for months the company needed to cut costs due to the approval of Mylan’s generic version of multiple sclerosis drug Copaxone. The cuts to employee bonuses and the suspension of the dividend are the right things to do. They will also increase cash flow. However, I believe the excitement is premature for the following reasons:
Teva Will Likely Have To Restructure $5B Debt Due Next Year
Teva still has $35 billion in debt that needs to be repaid. Its debt already exceeds 5x run-rate EBITDA. Fitch recently downgraded the company to junk status. Once generic Copaxone kicks in I expect the company’s credit metrics to deteriorate further. An even more pressing matter is that $5 billion of the company’s debt load is due next year, and $19 billion over the next three years.
Teva does not have the cash or the cash flow to make $5 billion in principal payments due in 2018. It currently has $680 million in cash on hand. Through the first nine months of 2017 it generated $1.7 billion in free cash flow, which equates to about $2.3 billion annually. However, the arrival of generic Copaxone will likely crimp its EBITDA and cash flow. Copaxone represents 45% – 50% of Teva’s total EBITDA.
Market chatter suggests Mylan (MYL) is already offering generic Copaxone at 25%-30% discounts to Copaxone, and Teva is matching those discounts in certain instances. I expect Teva’s cash flow to decline in Q4, and potentially next year despite CEO Kare Schultz’s cost-cutting efforts. According to Bloomberg the company is working with Evercore to review strategic options for its debt:
Teva Pharmaceutical Industries Ltd.’s new Chief Executive Officer Kare Schultz is working with advisory firm Evercore Inc. to review options for the beleaguered drugmaker’s outstanding debt, according to people familiar with the matter.
Executives from the Israeli company including Chief Financial Officer Mike McClellan have met with the main lenders in recent weeks to assess options including shrinking a revolving credit facility and extending the repayment period for some loans, the people said, asking not to be identified because the deliberations are private. Teva may also seek to reset some debt covenants and extend bond maturities, the people said.
Solving the company’s cascading principal payments might be easier said than done. At its current run-rate of $2.3 billion in annual free cash flow (this excludes the impact of generic Copaxone), Teva could generate about $7 billion in free cash flow over the next three years. That would imply it would need to restructure at least $12 billion of the $19 billion principal payments due over the next three years; this is the best case scenario. The worst case is that declining cash flows caused by generic Copaxone could make that number rise even higher.
I believe the next headline risk will be CEO Kare Schultz’s ability to restructure the $5 billion due in 2018. Debt holders will likely ask for their pound of flesh in the form of transaction fees and expenses related to time and efforts for such a large restructuring. This could further punish cash flow.
Teva Might Have To Re-Negotiate Debt Covenants
In October Teva amended covenants on certain tranches of its debt. I intimated the company was simply kicking the can down the road. The company’s amended leverage ratio covenants for certain tranches allow a maximum leverage of 5x through 2018, declining to 3.5x by 2020. The company has approximately $6 billion of its debt tied to covenants. I estimate that post-generic Copaxone, the company’s quarterly EBITDA could fall about 34% from $1.6 billion at Q3 2017 to a run-rate $1.1 billion. Its annual run-rate EBITDA would be around $4.3 billion; its debt/run-rate EBITDA could then exceed 8x.
Given the $5 billion in principal payments due next year it could be difficult for Teva to both make principal payments and repay $6 billion in loans tied to covenants. It might behoove the company to re-negotiate debt covenants now while before it is forced to. Such a re-negotiation would like involve the company paying additional fees, which on top of debt restructuring fees, could become onerous.
I believe Teva needs to raise equity to help shore up its balance sheet. Management would rather not dilute the stock. Headline risk of having to restructure $19 billion in debt due over the next three years and to re-negotiate debt covenants could pressure TEVA. Having to pay tens of millions in debt transaction fees while the company lays off 14,000 could tarnish Teva’s brand in the process. The stock remains a sell.