Consider Teva While It's Down

 | Jun 25, 2013 | 9:00 AM EDT  | Comments
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While healthcare stocks have been both in and out of favor this year, depending on the market's view of cyclicals vs. defensives, Teva Pharmaceuticals (TEVA) has consistently been a laggard compared with both the market and its group. Teva is up just 2.5% year to date, compared with the S&P 500 up 10.3% and the pharma industry up 20%. Nevertheless, we have liked Teva and still do, since we believe that the company and its stock are both poorly understood by investors.

The core of the company is its generic drug business, and this is how it is primarily perceived. Historically, Teva has played the patent-challenge game better than anyone else, and it has used the profits generated from its first-to-file success and its proprietary drug business to fund the purchases of other generics makers.

Teva has also benefited from a proprietary business, mainly an injectable treatment for multiple sclerosis called Copaxone, which generates 40% of its current profits.

New competitive therapies for MS have come to market, including an oral one, and these competing drugs have raised concerns about Copaxone's prospects. These concerns are real but may be overblown, as both doctors and patients are generally slow to shift away from a successful and well-tolerated therapy for a chronic disease.

While we have little doubt that new patients for Copaxone will decrease, Teva's profit contribution from existing patients, though diminishing, will nevertheless have a long tail. Although Teva won an important patent trial last year, Copaxone is facing some renewed generic challenges on appeal. We don't have a good sense on how the appeal plays out, but in the event that Teva loses at the appeals level, the risk is that generics would reach the market in 2014 rather than 2015.  The company maintains that direct substitution labeling is not a certainty, but the market is skeptical.

Although the U.S. generic story may have peaked (exemplified by the patent expiration of Lipitor), Teva's generics business is still showing good growth in international markets, where it has made a number of acquisitions in recent years. Consolidations of the manufacturing and selling organizations of these targets are just now beginning to bear fruit as manufacturing and overhead costs improve.

CEO Jeremy Levin has been in place for 18 months now, and he is steering the company to pay closer attention to operations and expenses, as well as shifting the focus incrementally to more novel drugs. The heightened emphasis on new drug development, both organic and via acquisition, is reminiscent of his success with the "string of pearls" approach at Bristol-Myers Squibb (BMY). (As an example, the acquisition of Cephalon in 2011, though questionable at the time, has proven to be an excellent deal for Teva.) Investors should expect an accelerating news focus over the coming years from the drug-development side of the company.

Importantly, Levin is improving Teva's friendliness to shareholders. He is pushing Teva's board of directors to consider dividend increases more frequently, adding to the attractive 3.0% yield currently being paid. The company has hinted that 4% is a reasonable target.

Teva is changing its emphasis to more proprietary and likely higher-margin products, using its current strong foundation as the engine for change. This transition will take time to bear fruit, but investors seem to have given up on Teva as a stock; it trades at just 7.6x 2013 EPS estimates and 7.1x next year's. This compares with other generic or proprietary pharma companies in the 12x-to-14x range, some of which are also working transitions as their blockbusters go off-patent. So while the outlook is cloudy, the stock is simply way too cheap.

Therein lies some of the opportunity for the stock. While the stock has been a disappointing investment, the passing of time shortens the wait for Levin's strategy to gain traction.

In addition, the Teva story is timely, since it benefits from the attention to cost-effective healthcare and the aging population demographics, perhaps more so than others in its sector.

We believe that Teva would be more fairly valued above $60 a share. The upside/downside from here is compelling, and shareholders are getting paid to wait.

Adding Teva to your portfolio is a prescription for improving your long-term financial health.

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