Teva a victim of Copaxone's success

Eli Tsipori

Teva's reliance on Copaxone made the company complacent, obese, and excessively self-confident.

One thing can be cited to the credit of Teva Pharmaceutical Industries Ltd. (NYSE: TEVA; TASE: TEVA) and its managers over the past decade: they took maximum advantage of Copaxone, Teva's original drug for the treatment of multiple sclerosis - the biggest success ever of any single product made by an Israeli company. Teva's success with Copaxone was so great that it became addicted to it and victimized by it. Teva's reliance on Copaxone also made the company complacent, obese, and excessively self-confident.

The operating profit on the drug totaled at least $3 billion annually in recent years - 80% of Teva's revenue from Copaxone and nearly two thirds of Teva's entire operating profit. Teva's aggregate operating profit from Copaxone since 2011 is $20 billion (NIS 70 billion). It is no secret that such profits are very typical for original drugs during the period of their patent protection. When the patent protection expires and generic drugs enter the picture, which is what happened with Copaxone last week, profit margins are likely to fall dramatically. Teva did excellent work by obtaining the longest possible patent protection period for the drug. It transferred most patients to a different dosage of the drug, which was also patent protected. Its competitors, however, among them Mylan N.V. (Nasdaq: MYL; TASE: MYL), also attacked this dosage. Risks have a habit of materializing, and Teva did not prepare properly for this risk.

Teva also did excellent work in extracting tax benefits from the state on the production of Copaxone in Israel - an exceptional 0% tax rate for 10 years. The benefit amounts to NIS 20 billion over 10 years - an unprecedented tax benefit for a single company. As an exporter, Teva would not have paid full tax in any case, and the tax benefit consists of the different between payment of full tax and the actual tax paid, but even assuming payment of less than 10% tax on profits from Copaxone, the annual saving for Teva is in the hundreds of millions of dollars.

The bottom line is that 21 years that have passed since the US Food and Drug Administration (FDA) approved Copaxone, and the drug's exclusivity period is now coming to an end. There can be no doubt that Teva has derived exceptional revenue, profit, and tax benefits from this drug, which constituted a major step forward for Teva. Unfortunately, it also contributed to Teva's current plight.

Teva is paying its Kare Schultz, its new CEO, a $20 million bonus for signing his contract, a sum that is arousing little criticism. The reason given for this bonus is that Schultz is a big name, and in order to persuade him to manage Teva in its current state from Israel, it is worthwhile and obligatory to pay this price. No one disputes Schultz's respectable record as president and CEO of Danish company Lundbeck, and no one disputes that Teva needs a CEO with experience in the international drug industry, but what has that got to do with a $20 million (NIS 70 million) signing bonus?

In the past, generous options packages and bonuses for executives were justified very simply and logically: if an executive enhances a company's value and the holdings of its shareholders, there is no reason why that executive should not benefit from it through the distribution of profit-dependent options, shares, and bonuses - giving him a stake in the company's success. If he succeeds, both he and the shareholders profit. But how can this fat signing bonus be justified? The executive is in effect regarded as successful before he succeeds, before he even gets to the company and holds his first meeting with its management team, and before he makes a single decision for Teva that will increase its value. He is getting $20 million before any of that happens.

No one expects Schultz to work for peanuts, but in addition to his signing bonus, his salary package also includes a fine base salary, handsome bonuses, and vested shares. Teva is really giving him an incentive to come. Why also give him a bonus before he sets foot in the company's offices?

More than anything else, this salary package highlights Teva's loss of identity (in its best years, Teva did not grant such excessive salaries to its executives), pressure, confusion, and failure.

Teva's managers and devotees often cite the company's "strong" cash flow as evidence of its ability to service its $40 billion debt. Within a year, Teva must repay three debts totaling $10.5 billion, and that is no trivial matter.

It is also worthwhile refuting this myth of a strong cash flow, especially in view of the events concerning Copaxone, which are likely to do some damage. Notice should also be taken of what happened to Teva's cash flow in its financial statements for the first half of 2017, even before the company suffered any damage from reduced Copaxone sales.

Teva's cash flow refers to the cash that the company produces from its drug business. This cash flow was impressive for many years, and constituted one of the company's strong points. At the same time, let there be no confusion in the matter. This is not cash received every quarter or every year; it is cash flow from current activity - in other words, before other cash transactions - investments and financing. In the first half of the year, this cash flow was minus $390 million. The company has a total of $600 million in cash - rather a small sum, given its challenges.

Over the years, Teva's stock of cash was never that large, which highlights how the company developed following its success with Copaxone: acquisition inflation, some paid for with shares and some with cash and bond issues (debt). Most of the acquisitions were not really successful, even before the grandiose acquisition of Actavis, which has confronted Teva with difficult questions about its ability to service its huge debts.

The negative cash flow is forcing Schultz to take several necessary actions: fewer investments and fewer expenses, meaning more and more cost-cutting. We can therefor expect another sale of assets and another wave of layoffs at Teva.

Teva attempted a hostile takeover of Mylan in April 2015, the same Mylan that will start marketing a generic version of Copaxone. In the course of this unsuccessful attempt, when Teva's share price was still sky-high, Mylan chairman Robert Coury sent a trenchant letter to then-Teva CEO Erez Vigodman. Coury, a harsh and arrogant man, set forth in his long letter his arguments against the merger in general, and against Teva and Vigodman in particular, stating, "As you well know, Teva faces the looming loss of significant revenue from the end of exclusivity for the Copaxone franchise, and has seen years of consistent and significant underperformance, even while enjoying the benefits of Copaxone. Further, Teva has faced a constantly changing and flip flopping strategy, rotating leadership, shareholder outrage and a flat to negative growth outlook… Teva's underperformance has been directly attributed to its 'dysfunctional' culture… 10 years of acquisitions and a flip-flopping strategy have left Teva with a smattering of assets in specialty, generics, biotech and consumer. You claim to want to 'redefine the generics industry,' but what faith can we have that you have any clear vision for the industry at all?

"During our meeting, we touched on Teva's many struggles throughout the last several years, including the approval of the first generic version of your flagship product Copaxone…; the persistent turnover and turmoil amongst the Teva leadership and Board and the resulting strategic confusion; Teva's consistent underperformance in comparison to the market and our industry; and your increasing need to find new sources of future growth… Erez, you told me in our meeting that Teva is different now and the challenges and cultural issues you have faced previously were now in the past. You assured me that Teva's new Board and management team had brought a new approach to the way it does business. Yet, this change was not evident in the way you approached your interest in Mylan. Through your leadership, you had the opportunity to set the right tone, and show the world that there is a new Teva. Instead, you chose to approach Mylan in a way that demonstrates that the old Teva is very much still alive, which only continues to beg questions about Teva's credibility."

Coury was more or less right. Both Teva and Mylan's shares have been hit hard, but Teva's share has fared far worse. Teva's current market cap is $15 billion, compared with Mylan's market cap of a little more than $20 billion. At that time, Teva offered to acquire Mylan at a $40 billion value. Today, both companies combined are not worth that much, but it appears that Mylan is far less confused (as Coury described it) than Teva.

Published by Globes [online], Israel Business News - www.globes-online.com - on October 10, 2017

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

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