Teva And Mylan Show Some Value Remains In Generics

By Stephen D. Simpson, CFA | August 04, 2011 AAA

Generic drug company stocks have been all over the map this year, with companies like Teva (Nasdaq:TEVA) struggling, companies like Watson (NYSE:WPI), and the likes of Mylan (NYSE:MYL) and Impax (Nasdaq:IPXL) falling somewhere in between. While the sector is still broadly benefiting from popular branded drugs going off patent, pressures from large buyers like AmerisourceBergen (NYSE:ABC) and Cardinal Health (NYSE:CAH) and declining patient-doctor visits are making for a more challenging operating environment.

TUTORIAL: The Industry Handbook: Biotechnology

Mylan - Good Here, Not So Good Over There
Mylan reported 15% revenue growth (10% in constant currency), with North American sales rising over 27%. Asia-Pacific sales also grew by 17%, but Europe was flat as reported and down double-digits on a constant currency basis due in part to government-mandated price cuts in many European markets.

Profitability was solid as well, as gross margin improved three points and GAAP operating income jumped 44%. (The biotechnology sector is very exciting and can be very rewarding for investors. For more, see The Ups And Downs Of Biotechnology.)

Teva - Flip It
Teva reported similar top-line growth of nearly 11%, but had a much different make-up. North American revenue fell 15% on a 40% drop in U.S. generic sales - a drop fueled in part by a dearth of major launches making for a very unsatisfying comp. On the flip side, European sales were up 82% as Teva doesn't seem to be getting hit to the same degree by pricing challenges in European markets.

Profitability was not nearly so strong, however. Gross margin fell by more than three points (due at least in part to a product mix shift, as well as some amortization), while reported operating income fell close to 45% and non-GAAP operating income dropped about 9.2% on higher SG&A expenses. (For related reading, see Understanding The Income Statement.)

Big Unknowns For the Future
The generic space is going to be getting more interesting soon and "interesting" is almost never good for shareholders. For starters, while there are still a few major drugs due to go off patent in the next couple of years, the tide is receding and generic companies are going to find relatively few whales to hunt. Now, moving into biosimilars could change this outlook, but there are still a lot of uncertainties there and potential competitors like Momenta (Nasdaq:MNTA), Hospira (NYSE:HSP), and Protalix (AMEX:PLX).

The bigger threat could be the intended merger between Express Scripts (Nasdaq:ESRX) and Medco (NYSE:MHS). AmerisourceBergen, Cardinal Health, and McKesson (NYSE:MCK) are hard enough to deal with as they push generic makers for better pricing. With a combined ESRX-MHS, though, there will be a new major buyer and one that will have some real muscle when it comes to negotiating drug prices.

This new world may push Mylan to consider more deals - either a merger of near-equals like Watson, the acquisition of a smaller name like Impax or Hi-Tech Pharmacal (Nasdaq:HITK), or maybe one of the biosimilar plays. At the same time, maybe Mylan takes a page from Teva and considers entering the branded drug market with select acquisitions. For its part, Teva continues to be a busy buyer, soon to be adding Cephalon and Japan's Taiyo to the fold. (For related reading, see A Primer On The Biotech Sector.)

The Bottom Line
I have been skeptical on Teva for a while and the year-to-date downward chopping in the stock price seemed to back that up. At this point, though, it is worth wondering how much more downside is left. True, the company's MS franchise is facing some uncertainties (and makes up nearly a quarter of sales), but this is still a cash-generating leader in its industry. Now may not be a bad time to think about buying these shares.

At the same time, while Mylan shares have been stronger than Teva, they too look modestly underpriced. Mylan should be in good shape to weather the challenges in the generics industry - either by selling to a large drug company that lacks exposure to generics (say, Johnson & Johnson (NYSE:JNJ)), or by being an acquirer and consolidator. Neither of these stocks are so cheap as to be can't-miss prospects, but investors tired of the turbulence in tech and industrial, and resource names may find some value and relative stability here. (For related reading, see Pharmaceutical Sector: Does The FDA Help Or Harm?)

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