The story on the generics giant Teva Pharmaceutical (Nasdaq:TEVA) really hasn't changed all that much over the past year. For investors who can just buy, ignore the volatility, and maintain a long-term perspective, the shares look too cheap. On the other hand, the generic drug business has clearly lost momentum, and it's uncertain if “bio-similar” and a more focused approach to drug development will deliver the promised returns for this company. Consequently, value investors have a lot to like here, but they have to accept that the Street is probably not going to share that enthusiasm for some time yet.

SEE: The Value Investor’s Handbook

Teva's First Quarter Numbers On Target, But Not Good

The best thing that can be said about Teva's first quarter results are that they were basically in line with Street expectations. While that's good for the near-term performance of the stock, long-term investors may be more troubled by the actual numbers and what they say about the business today.

Revenue fell 4% from the year-ago period, as both generics and branded drug revenue fell about 6%. Generics disappointed on big declines in the U.S. (down 27%) and disappointing performance in emerging markets, while branded drugs were stronger than expected on decent performance of Copaxone and Treanda. Teva's OTC business continues to grow nicely (up 26%), but it is a small business relative to the company's total revenue.

With the decline in volume, margins came under pressure as well. Gross margin declined about two points, while operating income dropped 21% on a nearly six-point decline in operating margin. Those numbers are ugly, but the operating income figure was slightly better than the average sell-side estimate.

SEE: Zooming In On Net Operating Income

A Lucrative Piece Of Generic Business Is In The Sights Of Competitors

Although Teva is like most major generic drug companies (Actavis (NYSE:ACT), Mylan (NYSE:MYL), Novartis' (NYSE:NVS) Sandoz) in that revenue is generated from a large number of products, it's nevertheless true that Teva generates a substantial amount of money from its generic version of AstraZeneca's (NYSE:AZN) Pulmicort Respules. Most estimates peg the contribution at around $500 million in annual sales and $0.30 per share in earnings, even with a sizable royalty going to AstraZeneca.

That business looks to be coming under pressure now too, though. With a successful court fight, it looks like Actavis, Apotex, and Sandoz will be on their way shortly with their own versions. This is likely to lead to significant price competition in the market and further pressure on Teva with respect to meeting or beating 2013 expectations, even though Teva management remains outwardly confident.

Is A More Focused Approach Appropriate For Such A Large Player?

Teva has outlined a strategy that sounds logical at first. Teva is going to continue focusing on the building up of its emerging markets business while also concentrating on high-value generics and specialty drug development in areas like CNS and respiratory.

Focus is a great thing, and zeroing in on biosimilars and other high-value generics should be good for pricing and margins. Likewise, focusing its proprietary drug development on fewer therapeutics areas should keep R&D in check while still giving the company the chance to develop blockbuster drugs.

I just wonder, though, if Teva can maintain that discipline in the face of what could be multiple years of Wall Street complaints about weak growth. Margins and free cash flow (FCF) generation are great, and it's good that Teva is sharing more cash with shareholders, but investors need only look at stocks like Pfizer (NYSE:PFE) and Merck (NYSE:MRK) to see that the Street still punishes drug companies that lack real growth momentum. My concern, then, is that management and/or the board of directors may get antsy down the road and do an ill-advised deal just to spike the apparent growth rate and appease the Street.

SEE: Free Cash Flow Yield: The Best Fundamental Indicator

The Bottom Line

As I said in the beginning, I do believe these shares are undervalued. If Teva can continue to grow its free cash flow rate at a low single-digit rate, these shares should be worth more than $40 today. Importantly, I expect very low revenue growth (as low, perhaps, as 1% a year over the long term), but better margins. It's important to note, though, that sell-side analyst expectations are all over the place with Teva, and that often points to stocks that will experience above-average volatility.

I think a smarter, more focused Teva is a better Teva, but I think the Street could well punish this stock for its weak growth. Likewise, if the development/approval/launch of biosimilars continues to progress at a slow pace, this whole sector could see pressure. If long-term value investors can block out the noise, though, and focus on Teva's qualities as a quality global drug company with good manufacturing and distribution leverage, the long-term rewards could be worth the short-term uncertainties.

At the time of writing, Stephen D. Simpson did not own shares of any of the companies mentioned in this article.