Teva Pharmaceuticals (TEVA): How Safe is the High Dividend Yield?

Certain large pharmaceutical companies have proven to be excellent high-yield dividend growth stocks.

 

However, due to the cyclical nature of the business, high R&D costs, and various regulatory risks, pharma can also be a very challenging industry in which to invest.

 

Let’s take a look at Teva Pharmaceuticals, one of the highest-yielding big pharma stocks available today, to see whether its recent challenges (and plunging share price) make it a possible opportunity for our Conservative Retirees dividend portfolio or a classic value trap to be avoided.

 

Business Overview

Founded in 1901 in Petach Tivka, Israel, Teva Pharmaceuticals is the world’s largest maker of generic pharmaceuticals. In fact, it currently sells 1,800 drugs in over 80 countries around the world and plans to almost double that number in the coming year.

 

However, it also has a large patented drug business specializing in central nervous system, oncology, respiratory, and women’s health drugs. Finally, the company operates as a third party distributor for other pharmaceutical companies’ products.

 

Business Segment	% Of Revenue	% Of Segment Profit
Specialty Drugs	39%	58%
Generic Drugs	55%	41%
Third Party Distribution	6%	1%
Total	100%	100%

Source: Teva Pharmaceuticals 20-F

 

As you can see, the majority of Teva’s sales are derived from its generic business; however, the majority of profits are from higher margin, patented drug sales. The company is working to decrease its dependency on patented drugs with its $40.5 billion acquisition of Actavis Generics, a subsidiary of Allergan (AGN).

 

This acquisition is expected to boost Teva’s generic sales to nearly 60% of revenue, thanks to its planned launch of 1,500 generic drugs worldwide in 2017. Unfortunately, Teva’s timing was very poor because generic drug prices peaked at the time of its acquisition and have since declined across the entire industry.

 

Business Analysis

It’s not hard to see why Wall Street has been rather bearish on Teva shares over the past year. The company has struggled with weak top line sales growth in the past few years, while earnings, margins, and returns on shareholder capital have fallen off a cliff.

 

 

However, in fairness to the company, its Actavis Generic acquisition has helped to restore the company to revenue growth, and most of the earnings and margin declines are due to $4.9 billion in one-time charges the company the company included in 2016 including:

 

• Restructuring costs of $699 million

• Legal settlements (from lost patent cases) of $899 million
• $900 million goodwill write-down on Mexican Generic drug maker Rimsa, which it bought for $2.3 billion in 2015.
• $1.3 billion impairment, mainly from having to write down losses from Venezuelan operations (the economic crisis in that country makes it impossible to extract cash Teva has earned).

 

In addition, Teva’s 2016 R&D spending rose 38% and combined with its numerous special charges, resulted in a large earnings decline. Adjusting for these charges Teva’s net income came in at $5.2 billion, or $5.14 per share.

 

While this adjusted EPS was still down 5.2% compared to 2015, that was due mainly to the 100 million in shares that Teva used as part of the Actavis acquisition because adjusted net income on an absolute basis actually increased 10.6%.

 

Meanwhile, free cash flow has continued to grow nicely over the years and hit an all-time high in 2016.

 

In addition, thanks to the large number of drugs the company is planning on launching in 2017, management is confident that it can achieve much better results this year.

 

Metric	2017 Growth Guidance
Revenue	10.3%
Adjusted EPS	1.1%
Free Cash Flow	51.1%

Source: Management Guidance, 20-F, Morningstar

 

So if Teva is expected to achieve such impressive growth, especially when it comes to sales and FCF, why are shares down more than 30% in the past year? The answer is that Teva’s results are likely to take a hit, at least in the next year or two, from two major factors.

 

First, in order to acquire Actavis Generic, the company had to increase its share count by 11%. That explains why 2017’s Adjusted EPS and FCF per share guidance is a less-than-impressive 1.1%, and -8.2%, respectively.

 

The other major reason for Wall Street’s pessimism is the fact that so much of the company’s sales and profits are highly concentrated in its patented Multiple Sclerosis drug Copaxone.

 

This single drug accounted for 19% and 34% of the company’s sales and profits, respectively, in 2016. Up until now, Copaxone sales have continued to hold up against generic competition because it only had to contend with a single rival, thanks to its patent on the 20 mg/ml formulation of the drug, which expired in 2015.

 

However, 84% of the company’s U.S. Copaxone business is from its 40 mg/ml variant that enjoys patent protection through 2030.

 

Or rather it did, until a recent court ruling that four of its five patents on U.S. Copaxone were invalid. This means that Teva’s largest cash cow is likely to face major generic competition from rival drug makers such as Biogen (BIIB), Novartis (NVS), and Genzyme, who could launch one to two generic versions in the U.S. as early as 2017.

 

Management expects that could result in 2017 sales and adjusted EPS declining by as much as $1.3 billion and $0.95 per share, respectively. The reason for the big hit to EPS is because management expects to have to continue spending heavily to maintain its U.S. Copaxone market share.

 

So does that mean that Teva’s best days are behind it and dividend growth investors should stay away? Not necessarily.

 

While Teva is certainly facing strong growth headwinds right now, management is working hard to decrease the company’s dependence on specialty drugs, and Copaxone in particular.

 

For example, Teva expects to be able to reduce its operating expenses (via economies of scale and merger synergies) by $1.3 billion in 2017. This should allow Teva to continue its impressive track record of steadily rising profitability from its generics business.

 

 

In addition, the completion of the Actavis Generic acquisition (finalized in August of 2016) will boost 2017’s sales and profit share of generics to 58% and 49%, respectively.

 

This is good news because Teva’s competitive advantage is in generic drugs, thanks to its integrated manufacturing process. Specifically, this allows Teva to be the lowest cost producer and make highly complex and difficult to recreate generic drugs, such as biosimilars and respiratory inhalers. In other words, Teva’s increased generics business should help to both grow and stabilize future cash flow.

 

In addition, the company is working hard to pay down the $25.8 billion in debt it needed to acquire Actavis Generic.

 

 

This is very important because a high debt load can strangle a company’s ability to secure and grow its dividend, as well as limit its ability to grow via acquisitions.

 

Meanwhile, the company’s specialty drug segment’s development pipeline remains large and diversified, with over 80 drugs currently in trials that management believes have the potential to generate over $30 billion in annual sales.

 

 

In other words, Teva’s development pipeline has the potential to eventually more than double the company’s sales and boost free cash flow even more via cost cutting and higher margins. However, several major obstacles stand in the way.

 

Key Risks

While Teva is certainly making moves to diversify and strengthen its core generic business, at the same time there are numerous risks to consider before adding the stock to one’s diversified dividend portfolio.

 

First, remember that the generic drug industry is ferociously competitive and has essentially no moat – even for dominant players like Teva. That’s because, despite massive industry consolidation in recent years, the barriers to entry remain very low. In addition, low cost producers from developing nations such as China and India continue to enter the market and challenge Teva’s cost structure.

 

Meanwhile, the most promising part of the generic drug business, biosimilars, will likely remain a challenge going forward. That’s because biological drugs, while both highly effective and far higher margin than inorganic drugs, are much more challenging to make and get to market.

 

Unlike inorganic, chemical generic drugs, which can simply be replicated based on the public, formerly patented formula, biologic drugs need to be created in far more expensive and complex processes. What’s more, they also need to go through their own drug trials to gain regulatory approval, which is something inorganic drugs don’t face.

 

So while the complex manufacturing and regulatory processes of biosimilars earn them a high margin and provide a potential growth driver for Teva, at the same time the company will have to increase R&D spending in order to capitalize on this opportunity.

 

This brings us to the second major risk, one faced by all pharmaceutical companies: failure to achieve regulatory approval.

 

Specifically, the potential failure of a major drug to get through the FDA’s rigorous 3 stage trial process, such as occurred with Teva’s promising oral MS drug Laquinimod in 2011. Drug trial failures, which frequently happen to all drug makers, make long-term growth projections challenging and can make for highly volatile share prices.

 

There are also legal and regulatory risks to consider. For example, this year’s patent case loss struck a major potential blow to Teva’s Copaxone business going forward. Meanwhile, as we saw with the massive legal liability bill in 2016, lost legal challenges can result in very high earnings volatility.

 

In fact, 2016’s $900 million in legal losses isn’t anywhere close to how bad things can get. For example, in 2015 Teva had to pay a $1.2 billion fine for anticompetitive practices over its generic answer to Narcolepsy drug Provigil.

 

Worse still, in 2013 a court declared that Teva needed to pay Wyeth (now owned by Pfizer) $2.15 billion over patent violations on its generic gastroesophageal reflux disease drug Protonix. That lawsuit was launched all the way back in 2007, and Teva just settled with Pfizer for $1.6 billion after a very expensive nine-year court battle.

 

And then there is the ever-present regulatory risk, specifically around healthcare spending policies in all of Teva’s major markets. After all, high drug prices are an easy target for populist politicians to go after “heartless and greedy corporate profits.”

 

If U.S. Medicare and Medicaid policy is altered to allow the US government to negotiate bulk drug purchases, then all pharmaceutical margins could be reduced.

 

Next is the risk of ill-advised acquisitions, which are very common in the pharmaceutical industry. That’s due to the large and rising cost of getting a drug through the FDA’s human trials (around $2.6 billion per drug).

 

 

With only one in 5,000 drug candidates making it through all three stages of trials, pharmaceutical companies naturally prefer to acquire rivals with promising drugs already on the market or in stage three trials. However, this aspect of the pharma business model creates the risk of overpaying for acquisitions, resulting in large write-downs, as occurred last year.

 

Then there’s the currency risk that comes with being a multinational corporation and operating all over the globe. For example, in 2017 Teva expects the strong dollar to reduce its sales growth rate by one-fourth.

 

And finally, while this isn’t a risk per say, be aware that, because Teva is an Israeli company, 15% of the dividend is withheld as foreign taxes. While there are ways for U.S. investors to offset or even entirely negate foreign dividend tax withholdings, the process can be very complicated.

 

Teva Pharmaceutical’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Teva Pharmaceutical’s Dividend Safety Score of 38 indicates that the company’s dividend could be at risk of being cut in the future.

 

At first glance, it might not be obvious why the company’s dividend carries above average risk. After all, Teva has a low free cash flow payout ratio near 20%, seemingly healthy revenue growth (double-digit sales growth the last three quarters), solid free cash flow generation (a steady rise over the past decade, including 2016), and perceived stability based on the stock’s relatively low beta (0.64) and performance during the financial crisis (sales and cash flow increased each year).

 

Despite these positives, Teva’s balance sheet and dwindling cash on hand are concerning. You can see that Teva’s debt load ballooned following its $40 billion acquisition of Allergan’s genetics business, which closed in 2016.

 

 

Teva had nearly $36 billion in debt at the end of 2016 and hopes to pay down $5 billion in debt this year. The company expects to continue generating healthy free cash flow, but there is still plenty of uncertainty around Copaxone and the generic competition it could face (which would reduce sales and profits).

 

 

All things considered, the company could probably continue paying dividends, but it is certainly in more of a gray area today. Management was supportive of the dividend on the company’s fourth-quarter earnings call (see quotes below), but you can’t always put much blind faith in a company’s statements:

 

“And if I can just say a word about dividends, there are no plans to do any changes with respect to dividends. And I’ll just leave it at that, I think…

 

And regarding dividends, our board is approving dividends every quarter, and that’s the policy…

 

And as we said throughout this call so far, we’ll need more clarity. We don’t know if there will be a generic competition to Copaxone when and what would be the order of magnitude. So we do have the tools ready and we’ll implement it as necessary. But as you heard before, there are no changes currently. Sol, do you want to add anything on the dividend question?”

 

“In terms of dividend, just to reiterate the fact that there are no plans to change anything.” – Sol Barer, Chairman of the Board

 

Teva’s board evaluates paying the dividend on a quarterly basis, and it’s hard to predict what could happen from here with rising generic competition for Copaxone and pricing pressure facing the generic drug industry as a whole. Teva’s dividend could eventually find itself on shaky ground.

 

Teva Pharmaceutical’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Teva Pharmaceutical’s Dividend Growth Score is 10, indicating the investors probably can’t expect much income growth going forward.

 

In fact, Teva’ dividend has been frozen for the last two years, marking a major slowdown compared to the company’s 13.7% annualized payout growth over the past decade.

 

 

While Teva’s free cash flow payout ratio is low enough to allow for strong dividend growth right now, management is focused on strengthening the company’s balance sheet by paying down the debt that resulted from its most recent acquisitions.

 

For the next year or two, especially as the uncertainty around Copaxone sales hits its peak, investors seem unlikely to get any dividend increases due to anemic organic growth in the specialty drugs segment.

 

Valuation

Teva’s stock has tumbled by more than 30% over the past year and now trades at a forward P/E ratio of just 6.4, which is a significant discount compared to the S&P 500’s multiple of 17.5 and marks a steep decline since 2015:

 

 

Teva’s 4.2% dividend yield is also more than double its historical norm and greater than 92% of its rivals.

 

The stock’s relatively low multiple and high yield suggest that investors are worried about the company’s future growth prospects.

 

If Teva’s Copaxone revenue holds up better than expected and its generic drug pipeline delivers, the stock could be a strong performer well over the coming years.

 

However, given the murkiness of these drivers, the company’s very high debt load, its concentration in Copaxone (which faces growing competition), and the continued pricing pressure on generic drugs, conservative income investors are best off avoiding Teva.

Concluding Thoughts on Teva Pharmaceutical

Teva Pharmaceutical faces a number of short to medium-term growth risks, which are only amplified by the high debt load the company took on to finance its ill-timed acquisition of Actavis Generics.

 

While management has maintained the dividend for now, the company’s credit rating is very close to reaching junk status, placing extra pressure on Teva to direct as much cash flow as possible to restoring its balance sheet.

 

Divesting its oncology and women’s health business units will free up some cash, but Teva’s more than $1.2 billion in annual dividend payments could eventually be targeted to provide greater breathing room.

 

Teva’s valuation looks cheap at first glance, but the stock’s low multiple reflects the numerous challenges facing the business. I prefer to avoid most areas of healthcare given the industry’s complexity and high regulatory risk, and Teva’s financially-strained, fairly concentrated business is no exception.

 

Conservative investors living off dividends in retirement are likely better off investing elsewhere.