Teva: A Favored Pharma

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From Standard & Poor's Equity Research

Looking Ahead

We expect a deceleration in Teva's U.S. generic sales growth rate in 2007. The company has been benefiting this year from the exclusive launch of generic Lotrel for hypertension ($1.3 billion in annual brand sales), which occurred earlier than anticipated, and from the generic Oxycontin pain reliever, particularly as several rivals exited the market. While Teva might shortly benefit from the exclusive launch of generic Protonix for acid reflux ($2.5 billion), our model currently excludes this drug. Despite these "blockbuster" and other generic launches, we expect the aggregate 2007 brand value to still be below 2006's, when Teva benefited from 180-day exclusive launches of generic versions of Zocor anti-cholesterol ($4.4 billion), Zoloft antidepressant ($3.1 billion), Wellbutrin XL antidepressant ($1 billion), and Pravachol anti-cholesterol ($1.5 billion); the launches of several other drugs; and the February, 2006 acquisition of IVAX.

For 2008, we expect Teva to have 180 days of marketing exclusivity on some drugs, particularly generic Fosamax for osteoporosis ($1.9 million), generic Lamictal ($1.9 billion) anti-psychotic, and generic Wellbutrin XL ($900 million) for depression. All told, we believe that the aggregate brand value of generic drugs launched in the U.S. in 2008 will be above that of 2007's rollouts. Factors that may impact future launches include patent-protection litigation by branded drugmakers and the timing of FDA approvals.

Teva views price erosion as stable in its U.S. generic base business, with erosion rates comparable to those in the most recent quarters at just below 10% on an annualized basis. We expect price erosion to continue at this level for the next few years.

Our model assumes that Teva will begin to sell biogenerics in Western Europe in 2008 and that the number of biogenerics it will offer in the region will increase over time. While Teva sells hGH (human growth hormone) as a branded product in the U.S., pursuant to an agreement with Savient Pharmaceuticals (SVNT), we do not see it selling additional biopharmaceutical products as generics in the U.S. until 2010, by which time we expect a regulatory pathway for biogenerics to be in place.

On the branded pharmaceutical front, we see Teva benefiting from continued strong sales of Copaxone, Azilect, and respiratory products. In North America, Copaxone is currently marketed by Teva and distributed by Sanofi-Aventis (SNY). Teva indicates that it will assume full responsibility for the distribution of Copaxone in the U.S. and Canada commencing April 1, 2008, and will then record the full in-market sales of Copaxone, net of a royalty payment to Sanofi-Aventis of 25% of the in-market sales for two years. We assume only a modest profit contribution from the planned U.S. and Canadian rights buyback of Copaxone, due to Teva's full assumption of certain marketing expenses that Sanofi-Aventis shared.

For 2008, we see Teva's revenues growing in the mid-teens in Western Europe (including Hungary) and in its international segment (comprising the CEE, Latin America, and Asia), as the company introduces new generic and specialty drugs and continues to penetrate these regions.

We expect the company's gross margin to decline, albeit gradually, as the impact of intensifying competition in the generics market is mostly offset as Teva benefits from its vertical integration, improving economies of scale, the continued rise of specialty drugs in the sales mix, and assuming the launch of biogenerics in Western Europe. We also believe that Teva will gain the full value of the $200 million in cost savings it expects from the integration of IVAX, as well as the absence of costs undertaken to realize these synergies, in 2008. All told, we think the benefits will compensate for most of the price erosion we see on generic drugs without 180-day market exclusivity and for price controls outside the U.S.

We see a modest rise in research and development spending as a percent of revenues, due to Teva's increasing focus on specialty and biogeneric drugs, while the selling, general, and administrative expenses cost ratio should decline on well-controlled general and administrative expenses and on revenue leverage. All told, our 2007 operating earnings estimate is $2.30 per ADR, matching 2006's $2.30, and we look for $2.70 in 2008.

Our earnings model does not assume future acquisitions. However, we think that Teva has the financial flexibility to make additional acquisitions with cash and short-term investments of $2.7 billion and $936 million in operating cash flow in 2007's first half.

We remain encouraged about the long-term prospects for the overall generic drug industry, owing to aging populations in the U.S. and worldwide, health-care cost-containment efforts, the Medicare drug benefit in the U.S., and an increasing number and variety of drugs available in generic form. Frost & Sullivan, a market research firm, sees more than $100 billion worth of blockbuster drugs going off patent between 2006 and 2013. We believe the total value of drugs going off patent is significantly higher, reflecting the many nonblockbuster drugs that are also slated to go off patent during this time period.

Valuation

The stock recently traded at 16 times our 2008 EPS estimate of $2.70 a share. Our projected three-year EPS growth rate of 16% for Teva starting in 2008 is above the 14% estimated peer average growth rate and we think Teva's size and diversity permit more stable and better-assured earnings growth than peers. For these reasons, we believe Teva's P/E-to-growth ratio deserves to be higher than its peers' 1.1 times. By setting its 2008 PEG ratio to an above-peer-average 1.2 times, we derive a 2008 P/E of about 19 times and, hence, our 12-month target price of $51.

Our discounted-cash-flow model derives an intrinsic value of about $51 per ADR.

Corporate Governance

We view positively that the board is comprised of 15 directors; the current chief executive is not a board member; a large majority of directors, 11 (73%), are independent, according to Nasdaq regulations; the board meets frequently; and that insiders do not sit on the audit and compensation committees. We view negatively that there is no disclosure of a policy that the board reviews its own performance regularly, and that there is no governance committee.

Investment Risks

Risks to our recommendation and target price include FDA and foreign agency approval risk and the timing of the approvals, competitive and foreign regulatory pricing risk, and currency exchange rate risk. The company also has legal risks, most of which involve patent litigation, with Teva challenging the patents of the brand name owner or the brand name owner challenging Teva's right to make a generic equivalent of the brand name drug in question. Teva has significant operations in Israel, which may be adversely affected by terrorism or major hostilities.

Seligman is an equity analyst following managed health care and other health-care companies for Standard & Poor's Equity Research Services.