Teva's Rocky Road

By Stephen D. Simpson, CFA | April 26, 2011 AAA

It's usually a great idea to buy proven long-term winners when the Street goes momentarily sour on a company's ability to stay in the game for the long-term. Companies as different and varied as Coca-Cola (NYSE:KO), McDonalds (NYSE:MCD) and Stryker (NYSE:SYK) have rewarded contrarian thinking, and it is an established investment philosophy.

The question now is whether Teva Pharmaceuticals (Nasdaq:TEVA) is just such a play. Not only has the company had to deal with recent FDA violations in its facilities, but there is now widespread concern about the company's ability to maintain its lucrative multiple sclerosis franchise. What's more, there is another potential risk on the horizon - the end of a major run of patent expirations that have fueled generic growth across the industry. (For more, see 6 Drug Companies With Expiring Patents In 2011.)

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Trouble in a Lucrative Franchise
Biogen Idec (Nasdaq:BIIB) recently released favorable trial results on its oral multiple sclerosis drug candidate BG-12. This drug showed more than double the rate of two-year relapse reduction (49%) of Teva's drug and a similar reduction in disease progression (38%). Like Teva's laquinimod, BG-12 is an oral drug, and also like Teva Biogen has an established MS business in place (selling drugs like Avonex and co-marketing Tysabri with Elan (NYSE:ELN).

This is another setback that Teva clearly did not need. Novartis's (NYSENVS) oral MS drug Gilenya had already established better efficacy than laquinimod, but there were some convenience and safety advantages that Teva's drug that would have maintained it as a viable drug in its own right. Now with potentially two more effective drugs on the market, Teva's chances of maintaining market share look lower.

Now for the other side of the story. First, there is still the chance that BG-12 will have side-effects or other issues that limit its popularity or tolerability. There is also a chance that additional data on laquinimod will show better results. Last and not least, there is the nature of the disease to consider. MS is a nasty disease, but it is also somewhat strange in that patients do not always respond to medications in predictable ways - what works well for one patient may not work much for another. It is possible, then, that laquinimod may find a role for patients who do not respond to these other oral medications. (For more, see Measuring The Medicine Makers.)

Of course, there is also the future of the existing MS business to consider. Copaxone goes off patent in 2014, and investors are clearly worried about that fall off in sales, to say nothing of the risk that the introduction of BG-12 could hurt sales as soon as 2013. That said, it does not automatically follow that there will be a generic available immediately - some drugs are simply harder to clone and Teva could hang on to more sales than bears currently believe.

The Hard Landing at the Bottom of the Cliff
Oddly enough, it may be a less talked-about issue that proves harder for Teva to deal with in a few years' time. The generic drug industry has really made hay from an unusual concentration of patent expirations that started a couple of years ago and continues out through 2012/2013. After that point, though, there are relatively few major drugs all going off patent at once.

That could mean more restrained revenue growth opportunities for a company like Teva, and perhaps some vulnerability to lower-cost competition from India and China. Worse still, it is not immediately clear how Teva could respond - further M&A may be difficult as there are not a lot of prime targets left, and investors may not be all that happy to see Teva go deeper into branded drug development. (For more, see Profit From Teva's Travails.)

The Bottom Line
While a truly dire worst-case scenario could see more than a quarter of Teva's free cash flow at risk in just a few years, it is more probable that the company will escape with a "lost" half-decade of virtually no growth. From that point on, Teva should be able to get back to business and enjoy a relatively steady growth rate predicated on the usual drivers - a great product development operation, increasing pharmaceutical usage throughout the world, and so on.

If the lost half-decade comes, Teva's stock is presently a borderline buy. For investors who believe that the company will do better with its MS franchise and/or navigate the tougher post-2013 patent expiration situation without much trouble, the stock has probably been beaten down too far and would be a good candidate to buy. (For more, see Pharmaceutical Phenoms: America's Best-Selling Medicines.)

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