Deteriorating Credit Metrics Make Teva A Sell

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Teva (TEVA) delivered a Q4 revenue and earnings beat. However, total revenue as off 16% Y/Y, which I found alarming. It could fall further as Mylan’s (MYL) generic Copaxone continues to kick in. TEVA is off over 7% since its earnings release. Below is my takeaway on the quarter.

Weak Guidance

Teva guided on 2018 revenue of $18.3 to $18.8 billion. The Q4 2017 run-rate was $21.8 billion. At the top of the range ($18.8 billion) 2018 revenue could decline by 14% vis-a-vis the Q4 run-rate.

The Q4 revenue decline was large and broad-based. Revenue from the core Generics business was off by 16% Y/Y. On a dollar basis revenue from U.S. Generics fell by $198 million. Large corporations have been wielding buying power to negotiate lower prices. The FDA has also accelerated approvals of generic versions of competing off-patent medicines. Double-digit declines in U.S. Generics revenue might not subside anytime soon.

MS Specialty comprises mainly of Copaxone, which has been hard-hit by Mylan’s generic version in the U.S. market. On a dollar basis revenue was off by $207 million, or 19% Y/Y. It was off 25% in the U.S. due to higher rebates and loss of market share. Meanwhile, Specialty revenue was off by $242 million or 18% Y/Y. The fall off was due to the divestiture of certain women’s health produces in Q4 2017.

Though management intimates a 14% decline in 2018 revenue vis-a-vis the current run-rate, it might behoove investors to wait on the sidelines until the revenue decline subsides. Copaxone revenue will continue to fall in 2018. Whether growth in Generics or Specialty revenue can offset this decline remains to be seen.

Declining Margins

Teva’s Q4 EBITDA of $1.5 billion equated to an EBITDA margin of 27%. That was down from 29% in Q3 and 32% in the year earlier period. As the company continues to lose the benefits of scale its margins could continue to suffer. The 2018 guidance suggests 2018 EBITDA could be in the range of $2.25 to $2.50 billion. The top end of the EBITDA range ($2.50 billion) and revenue range ($18.8 billion) implies margins of 14%, or about half that of Q4’s EBITDA margin.

The 81.6% operating profit margins on Copaxone are a blessing and a curse at the same time. Teva’s U.S. Copaxone market share fell from around 30% in Q3 2017 to 25% in Q4. Copaxone’s revenue and margins will likely fall further due to market share loss to generic Copaxone and further discounts from Teva to defend its share. The double impact of declining revenue and falling margins could be devastating given Copaxone’s ridiculously high margins.

The company can offset margin erosion with its announced restructuring efforts. Teva expects to lay off 25% of its workforce and generate $3 billion in cost savings. The global workforce reduction is expected to be completed by the end of the second quarter of 2018. The deterioration in Copaxone’s $3.2 billion run-rate operating profit versus an expected $3 billion cost-savings from lay offs will likely drive the narrative this year. I believe margin erosion is baked in, yet hitting that cost-savings number without losing operating efficiencies could be a stretch.

Deteriorating Credit Metrics

Though asset sales helped reduce debt they may not have improved the company’s credit metrics. Teva reduced its from long-term debt from $34.7 billion at Q3 2017 to $32.5 billion at year-end. However, the company’s debt/run-rate EBITDA deteriorated from 5.3x to 5.4x during that time frame. As the Copaxone franchise continues to decline, Teva’s credit metrics will likely slide even further.

S&P recently downgraded Teva’s debt two notches to “BB”, citing shortfalls in launching generic drugs and sooner than expected generic competition for Copaxone. The ratings action followed downgrades by Moody’s and Fitch. The company faces several billion in debt maturities in 2018 and 2019. Market chatter suggests the company plans to raise $5 billion in debt for general corporate purposes, investments and extensions of credit.

Its Q4 finance expense of $191 million equated to a weighted average interest expense of about 2.3%. Rates on new debt will likely rise given Teva’s junk rating. Rising rising and declining EBITDA portends less cash flow for Teva. If rates spike high enough it could make it difficult for the company to raise new debt and/or punish the stock.

Conclusion

Teva declining EBITDA margins and deteriorating credit metrics make TEVA a sell.

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