$700 Million Gift Will Not Stop Teva’s Slide

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Teva CEO Kare Schultz
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Teva (TEVA) has been reeling since Mylan (MYL) received approval for a generic version of its blockbuster multiple sclerosis drug Copaxone. The company got some good news recently. Allergan (AGN) will pay Teva $700 million to settle a dispute related to the acquisition of Allergan’s generics business:

Wednesday, the former deal partners inked an agreement to settle a dispute over the amount of working capital that changed hands when Teva took over Allergan’s generics unit last year. Allergan will fork over $700 million, and Teva says it’ll use that money to repay some of the debt it incurred with that disastrous $40.5 billion buy.

M&A deals usually require the seller to transfer a property with a certain level of working capital. An adjustment is performed months after the deal closes; if the working capital is lighter than expected an additional payment is due to the buyer. The payment is less than the over $1 billion Teva was seeking, yet still a pleasant surprise for the highly-indebted drug maker.

Why It Matters

Allergan had $5.4 billion of cash and securities at the end of Q3. The $700 million payment would be less than 15% of its current liquidity. However, Teva needs this capital badly amid its shrinking earnings. The company reported Q3 revenue of $5.6 billion and EBITDA of $1.6 billion. Revenue was up 1% Y/Y, while EBITDA fell 16%. Teva has been losing pricing power in its core generics business, seeing prices fall in North America by double-digits. As large customers continue to wield leverage over generic drug companies, this decline in prices is not expected to abate any time soon. In turn, Teva’s EBITDA margins fell from 34% in Q3 2016 to 29% last quarter. This is important given the company’s $34 billion debt load which is now at over 5x run-rate EBITDA.

Teva’s ability to service its debt will likely drive the narrative going forward. Fitch downgraded the company to junk status a few months ago and Moody’s followed suit last week. These downgrades came despite the fact the loss of exclusivity for Copaxone has not fully impacted the company. Copaxone has EBITDA margins around 80% and I estimate it represents from 45% to 50% of Teva’s total EBITDA. Discounts on Copaxone to meet new competition combined with a loss of market share to Mylan’s generic version could punish Teva’s EBITDA and hurt its credit metrics.

Management expects to wring out up to $3 billion in operating costs; however those cost savings are expected to be phased in over two years. I expect the EBITDA hit from generic Copaxone to begin to materialize in Q4 2017 and start cascading over the first two quarters of 2018. The $700 million payment and cost cuts will help, but they likely will not keep the rating agencies from downgrading the company again. The company faces several billion in debt maturities in 2018 and 2019. If Teva’s credit metrics deteriorate too badly it might be forced to seek an equity raise or raise new debt at extremely onerous terms.

Conclusion

Teva’s credit metrics will likely deteriorate once generic Copaxone fully kicks in at the end of Q1 2018. TEVA remains a sell.

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