Teva's American Dream Boat is Sinking

Teva Pharmaceutical Industries Ltd. published its second quarter reports for 2018 on Thursday, painting a cautiously optimistic picture with profit that exceeded analyst expectations and an increased guideline for the year. In actuality, much of the company's profit margin was the result of a one-off income related to a patent infringement case, and though Teva did up its guidance, it is expected to see a decline in profitability in the second half of 2018, only partly to generic competition for its main cash cow Copaxone.

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Teva's generic sales in the U.S. and Canada were cut by a third between the first quarter of 2017 and the second quarter of 2018, with each quarter weaker than the last. The drop in revenues is due to three main reasons: downwards pressure on generic drug prices in the U.S., which cut sales mainly in the second half of 2017; limited launches of exclusive new generics; and a decrease in the sales of Teva's generic version of Concerta, used to treat ADHD. While the pricing pressure is affecting generic companies across the board, the other two have more to do with Teva's operations.

When Teva acquired Allergan's generic business Actavis in 2016 for $40.5 billion, the company banked on Actavis' significant generic pipeline and its high profitability in the generic drug segment. Teva's persisting weakness in this segment in the U.S., its weak launches and low profitability, all stress that Actavis' potential was overestimated.

Actavis' generic Concerta especially seemed highly profitable on paper, but when faced with serious competition, as of December 2016, its profits dropped. Every quarter, Teva publishes the sales ranking of its main generics in the U.S. Its Concerta topped the list every quarter, including quarters that saw Teva launch new exclusive generics—until Thursday's second quarter reports. For the first time since the Actavis deal was concluded, Teva's veteran generic for Cubicin, used to treat life threatening infections, generated more sales.

The lack of exclusive generic launches is also a major change compared to the first quarter of 2018. Teva launched ten generic versions in the first quarter of the year, but only one in the second. Furthermore, Teva's first quarter generic sales in the U.S. were buoyed by the high sales of its exclusive generic version for Viagra, but those sales took a hit in the second quarter due to increasing competition.

Teva expects to launch 10-15 generic drugs in the U.S. in the last five months of 2018 (so far the company launched one generic drug, in July). But their profitability will be greatly affected by the sales of the brand versions and by the existing market competition, as well as by Teva's ability to launch exclusive generics, which are more profitable by far. On the upside, Teva's generic sales in the U.S. are nearing rock bottom, and the downward pricing pressure in the market has eased compared to the second half of 2017, meaning there might be nowhere to go but up.

Teva reported an operating profit of $722 million for its North American segment for the three months ended June 30. This includes an "other income" of $100 million—derived almost exclusively from Teva's win in a patent infringement case in Canada, which saw the company receive $95 million in the second quarter and $99 million in the first quarter of 2018. Those sums are not counted as part of Teva's revenues—as they are considered a depreciation expense—but they significantly bolstered Teva's operating profit for North America, and in actuality account for almost all of Teva's increased guideline for the full year. As appeals in the case are still ongoing, this means Teva could still collect trial-related depreciation expenses—or incur expenditure—during the third quarter.

Until the end of the fiscal year 2017, Teva provided not just its total operating profit, but also the operating profit of individual segments. The company has ceased to do so as of the first quarter of 2018. Based on 2017 data and on second quarter revenues, the conservative estimation is that operating profit from Copaxone amounts to 70% of its sales; operating profit from Teva's brand drugs is 30% of their sales; and operating profit from drug distribution is equivalent to 5% of distribution sales. This means Teva's generic drug segment in North America generated an operating profit of only around $120 million, for a segment that used to account for a majority of Teva's operations—and is also the core of the Actavis business. Less conservative estimates regarding the profitability of the other segments could cut into those margins even more.

Teva's European segment fared better for the quarter, with an operating profit of $346 million but a higher estimated operating profit from generics. Copaxone sales are also falling in Europe, but more slowly than in the U.S. Teva reported a stable operating profit of $139 million for its international market segment.

Copaxone

Teva's total Copaxone revenues for the quarter were $626 million, down $19 million from the first quarter. By the end of June, Teva held an 85% market share for the 40 mg/ml version, with Mylan NV controlling almost all of the rest (a third U.S. player, Sandoz, has failed to secure significant sales yet). By the end of July, Teva's share was down to 83%.

However, the recent reports don't reflect the drastic price cut Mylan made in July—60% for large distributors and less for smaller clients. The decision is surprising due to a lack of a serious generic competitor, and estimates are that Mylan is looking to increase its market share quickly as well as wall Sandoz out. Mylan's discount led Teva to forecast a 35% drop in Copaxone sales in the second half of 2018—$830 million compared to the $1.27 billion it reported for the first two quarters, with the impact being felt more strongly in the U.S. market. The erosion to its profitability is expected to continue in 2019.

Teva's 2018 outlook

Teva's updated non-GAAP earnings per share for the year are $2.55-$2.8, meaning non-GAAP net income of $2.62 billion to $2.87 billion. During the first half of 2018 Teva's net income was $1.748 billion, meaning the company estimates a net income of $780 million to $1.12 billion for the second half of the year—a drop in profits that is only partially explained by Copaxone revenues, even when taking into account Teva's patent-related other income for the first two quarters. Optimistically, Teva's outlook is deliberately conservative. Pessimistically, despite the ongoing reorganization plan, Teva's profits are not expected to rise for the remainder of the year.

Three potential trump cards

Teva has three potential trump cards up its sleeve. It's only drug showing growing profits is recently launched brand name drug Austedo, used for treating a group of neurological movement disorders called dyskinesia. Its sales reached $44 million in the second quarter after growing $13 million-$14 million each quarter, and Teva estimates total revenues of $200 million for the full year and a continuous increase. Austedo could potentially generate annual revenues of over $500 million at its peak.

The second is migraine drug fremanezumab, which it hopes to launch following its Prescription Drug User Fee Act (PDUFA) action date, set for September 16. If Teva manages to get FDA approval by that date, it will be able to get insurance cover for the drug as of the beginning of 2019. However, the South Korean facility where the drug is manufactured, which belongs to Celltrion Inc., has repeatedly run into problems. On Tuesday, Celltrion announced that while the FDA completed its re-inspection of the manufacturing site, the FDA observed eight manufacturing violations, which Celltrion said it expects to repair very soon. Teva's approval may hinge on Celltrion's ability to restore FDA approval to the site on schedule.

If approved, Teva's sales are expected to be low in 2019, as it is a new domain that will take a while to gain the trust of consumers and service providers. However, the drug has a high sales potential for the next decade. The company will also face competition from Amgen Inc., whose Aimovig was approved in the U.S. in May, and from Eli Lilly and Company, who is expected to receive FDA approval for a migraine drug soon.

The third card is Teva's cost cutting plan, announced in December 2017, to deal with the company’s heavy debt load, which currently stands at almost $30 billion. By the second quarter of 2018, Teva managed to reduce its total base cost by $1.1 billion, mainly via significant layoffs. The company intends to reduce its total base cost by $3 billion by the end of 2019, also by asset divestment and portfolio streamlining, which will have an impact on the company's sales and bottom line. Those changes are expected to improve Teva's operating profit as of 2019, and especially as of 2020.

Teva's current price-earnings ratio reflect the market's optimism about CEO Kåre Schultz and his reorganization plan, but the company’s ability to get back on track depends on what is both its main market and its Achilles heel—North America.