Berkshire Likely Believes Bondholders Are Mullets
Despite Teva’s high debt/EBITDA ratio its interest coverage is strong. That is where the disconnect comes in. In Q4 the company paid finance expense of $191 million. This equates to an implied weighted average interest rate of about 2.4% – this is paltry. Teva’s Q4 EBITDA of $1.5 billion generated interest coverage of 7.8x – this is extremely robust.
I am not sure if its relationship with Israel or out-sized leverage with bankers helped garner such low costs. The question remains, “Will it continue?” If it does continue it could portend that banks are providing mullet money or dumb money. That has to be what Berkshire is betting on. Why else would it invest in Teva at this juncture?
Berkshire should probably think again. The yield to maturity on Teva’s bonds are as high as 6.6% for bonds maturing in February 2036. The yield was around 5.04% a year ago. The company has $7.5 billion in debt maturing through 2019. It will likely have to refinance the lion’s share of those maturities. If $7.5 billion in new debt is brought on at 6.6% or higher then the company’s borrowing costs could increase by over 400 basis points.
For every $1 billion in new money raised the company’s interest expense could rise by $40 million (assumes a 400 basis point increase). Rising interest expense would cut into Teva’s cash flow at a time when the company is trying to preserve its cash flow. Layoffs and dividend cuts could be partially negated by rising interest expense.
Teva’s Credit Metrics Could Deteriorate Further
Teva’s Q4 EBITDA of $1.5 billion was off 8% Q/Q and 29% Y/Y. What is not debatable is that EBITDA will likely fall much further. The generics business is experiencing price erosion, particularly in North America. That is expected to continue. Secondly, the company will not feel the full impact of generic Copaxone until Q1 or Q2 of this year. Q4 Copaxone revenue was off 19% Y/Y. 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 means it Copaxone revenue could fall another 50% – 60% before the impact is fully felt.
Copaxone has EBITDA margins in the 80% range and represents 45% – 50% of Teva’s total EBITDA. I anticipate Teva’s EBITDA declines will outweigh the benefits of cost cuts – at least over the next few quarters. Its debt/EBITDA will also likely deteriorate further. Rising interest expense and declining EBITDA will likely cause its interest coverage to deteriorate further. The rating agencies are aware that Teva’s EBITDA could fall from here. This could beget more ratings downgrades which could beget investors demanding higher interest rates on new debt.
Conclusion
Rising bond yields imply bondholders are starting to price Teva’s bonds closer to market rates. Rising interest expense and declining EBITDA could beget more ratings downgrades and higher interest rates. I do not believe this is priced into the shares. TEVA remains a sell.
