Teva: Healthy business, sick share

Teva Photo: Reuters

Every change in Teva's business is amplified in its share price.

The share price of Teva Pharmaceutical Industries Ltd. (NYSE: TEVA; TASE: TEVA) has behaved this year like a small speculative share. It plunges 20% on a day with a poor report, rises 18% in one day when the company announces layoffs and streamlining, and swings of 3-4% a day (usually downward) have become routine. That sounds like a lot - losing 20% in one day is a pretty big loss, and the pattern is even more prominent when we look at the share price's behavior in the longer term - falling 50% in six months and 70% in the past two years. With all the investors' pain and sorrow, however, the share price's behavior is really not such a big deal.

The share's plunge does not directly reflect the state of the company's business. Teva's business is not worth only half of what it was worth six months ago. The share price may have dropped 50% during this period, but the business itself is worth about 20% of its value six months ago. The conclusion is therefore that Teva's share price is amplifying the state of the company's business: business goes down 20%, and the share price falls 50%. This state of affairs highlights the great risk in the company's share (and also the opportunity), its great volatility, the probability that its upswings and downswings will continue, and the simple fact that a 20% fall in the share price, and even a 50% fall, is not as bad as it sounds (again, excuse me, investors).

Why did the share go down 50% when the value of the company's activity went down "only" 20%? Just over six months ago, Teva's market cap was $36 billion, and the share has since fallen by 50% (accompanied by and following poor results), pushing the company's market cap down to $18 billion, after having been as low as $12 billion. This is a loss of market value, but not in the value of its business activity. The company's value in the stock market (the number of shares multiplied by the share price) is not necessarily the value of the company's activity (the two are usually different). While this distinction is sometimes ignored, it explains a good deal of extreme behavior by share prices, including Teva's share price. Teva's market cap six months ago was $36 billion, but the company had a net debt of over $40 billion. This debt is not related to Teva's business, and its business is not related to the company's capital and debt structure, or that of its balance sheet. When you want to derive the value of a business from the market cap, you exclude items not related to business activity, and at Teva, this is mostly the debt. This means that Teva's business was worth $76 billion, and when you subtract a $40 billion debt, you get exactly the $36 billion market cap (a year ago).

Another (perhaps simpler) way of looking at this is to define the market cap as the value of the business plus the company's debt (if the company has cash, its market cap is the value of its business minus the cash). Once we have understood that the value of Teva's business activity a year ago was $76 billion, we can calculate its current value. The company's current market cap is $18 billion and its debt is still around $40 billion, which means that its business activity is worth $58 billion. This means that the value of its business fell from $76 billion to $58 billion. That is not so bad. A 23% fall is not the end of the world.

Is this the bottom? Probably not

Once we realize that the value of Teva's business is around $58 billion (all of these numbers are approximations), we realize that if Teva CEO Kare Schultz does not succeed in righting the company, it has a long way to fall. Investors tend to look at the company's record and think to themselves, 'The share fell 50%. It has reached bottom, the company is worth only $18 billion. Maybe that's the floor?' That might be right, but keep in mind that the significance of the market cap is limited. The company has a huge debt, which indirectly indicates that its business activity still has a high value, so investors should be thinking, 'The company's business is worth $58 billion; is that a reasonable valuation? At a valuation of $40 billion, which is 30% less than the current value, the share price will be zero.' This is the downside; there is also an upside. This debt, which is actually responsible for the share's wild behavior, and is also responsible for Teva's financial and cash flow plight (the debt resulted from the acquisition of Allergan's generics division), is a double-edged sword. While every minor decline in business activity puts the share price into a tailspin, the effect of every upturn in business activity, however small, is likely to be several times greater.

For example, assume that the value of Teva's business increases by $1 billion, or 1.6% of $58 billion. What happens to the share price? The market cap will increase by $1 billion, which is 5.5% of $18 billion. Every change in the valuation of the business affects the share price by almost four times as much (for better or worse).

Regardless of which way the business is going, keep in mind that the share price amplifies what is happening several times over, and that is probably the reason that Teva's share price will continue to be volatile - it will still rise and fall steeply in a single day.

Are the layoffs essential? If the value of Teva's business is impressive, why make layoffs? Teva's business is worth $58 billion, and the company is still making a profit, of course, so why is it making such major cutbacks? The layoffs at Teva are essential to keep the company profitable, competitive, and efficient. The purpose for which Teva was founded was to create profits for the shareholders, not the workers. Therefore, with all their pain, the laid off workers have no real cause for complaint against the managers.

"Wait a minute," you will says, "The factory in Jerusalem (the tablets factory) makes a profit, so why get rid of it, together with its workers?" There is no problem with the profit, at least for now. It is important to keep in mind that Teva is a profitable company. The problem is with its cash flow. When a company is loaded down with debt, it has no breathing room, and is liable to be unable to service its debt, because it may not be able to generate enough cash to cover its debt payments. Even if Teva's management sees that it has no problem in the short term, it has to prepare for the medium and long term. When it has a $40 billion debt facing it, this is hard work, and Teva must make its cash flow as good as possible in the future.

This can be done by laying off workers and savings in cash flow. Teva is simply going on an extreme diet in order to make sure that its future cash flow will enable it to repay its debt.

At the same time, incidentally, Teva is trying to reschedule its debt payments, and this is probably the really important news for its shareholders. A renewed debt arrangement will restore calm to the company.

Published by Globes [online], Israel Business News - www.globes-online.com - on December 21, 2017

© Copyright of Globes Publisher Itonut (1983) Ltd. 2017

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Teva Photo: Reuters
Teva Photo: Reuters
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