Teva's Generic Advantage

The Israeli pharma company is a leader in generic drugs. And a smart acquisition may extend its lead

From Standard & Poor's Equity Research

We at Standard & Poor's believe Teva Pharmaceutical (TEVA; recent price, $35) should remain one of the leaders of the generic drug sector, a position reinforced, in our view, by its Feb. 28 acquisition of IVAX Corp. Teva's R&D, now combined with that of IVAX, has provided the company with what we believe to be the broadest product line and most extensive generic pipeline in the U.S. and a leading generic pipeline elsewhere. Its manufacturing facilities in several countries, which increased via the IVAX acquisition, provide Teva with a broad array of production technologies and economies of scale.

Finally, we believe that its active pharmaceutical ingredient (API) business, which continues to expand, offers stability of supply and vertical integration efficiencies. This permits Teva to be one of the lowest-cost producers, a position we view as another competitive strength.

We're encouraged by the long-term prospects for the overall generic drug industry in the U.S., owing to an aging population, health care cost-containment efforts, the Medicare drug benefit that started in January, 2006, and an increasing number and variety of drugs, including several blockbusters, available in generic form. Teva's second-quarter 2006 revenues and earnings were encouraging to us, and we think prospects are bright for the long term.


  Teva was recently trading near the low end of historical p-e averages. We think this is partly because of what we see as EPS growth deceleration in 2007, mainly due to planned launch in that year of generic drugs with lower brand value than those slated for 2006. However, we see this priced into the stock. Based on our view of bright long-term prospects and earnings reacceleration in 2008, we think the stock is undervalued. We have a 5 STARS (strong buy) recommendation on the shares.

Israel-based Teva launched 30 new products in the U.S. in 2005 and, by year-end, was selling 250 generics representing approximately 680 dosage strengths and packaging sizes. In addition to the products marketed by Teva's existing operations, IVAX manufactured and marketed approximately 76 generic drugs in 181 dosage strengths.

In the 12 months ended June 30, 2006, the number of prescriptions in the U.S. filled by Teva products was 393 million, or 11% of the total U.S. pharmaceutical market, according to IMS Health data, making it by far the largest pharmaceutical company in terms of scripts. (Pfizer (PFE) is the largest in revenue.)

As of August 2, 2006, Teva had 148 abbreviated new drug applications (ANDAs) filed with the FDA, representing over $84 billion annually in brand value. Teva believes 46 ANDAs, with a brand value of over $35 billion, have first-to-file status, which permits an initial 180 days of marketing exclusivity.


  In Europe, as of February 28, 2006, excluding products acquired through the IVAX acquisition, Teva had 125 compounds representing 260 formulations, while 810 marketing authorization applications were pending approval, with over 280 additional compounds approved for development. We believe Teva's portfolio approach mitigates the company's risk profile compared to other drugmakers, including its peer group.

In our view, Teva's presence in the branded drug market, although limited, helps expand and further diversify its overall drug catalog, while also aiding gross margins. Copaxone for multiple sclerosis (MS), Teva's first proprietary drug, became the market leader in the U.S. in 2005's first quarter and remained so into the second quarter of 2006, according to IMS Health data. We think Biogen-Idec's (BIIB) Tysabri, once considered Copaxone's largest threat, will mainly be for those patients who benefit relatively little from MS drugs currently on the market. (An earlier version of this incorrectly characterized Tysabri's availability status.)

While Copaxone in-market sales grew by 26% in 2005, 29% in the first quarter of 2006, and 22% in the second quarter, we expect growth to decelerate going forward, due to growth off of an expanding base (in terms of both dollars and MS patients).

Once-daily Azilect, Teva's proprietary drug for Parkinson's disease, was launched in Israel in March, 2005, in Europe in the second quarter of 2005, and in the U.S. in June, 2006. Our earnings model assumes modest contributions from Azilect in 2006 and 2007, with more meaningful growth afterward.


  The global respiratory market exceeds $30 billion, and IVAX's products compete in the $16 billion-plus market for asthma and chronic obstructive pulmonary disease. Most of IVAX's products are sold in the EU, and we believe Teva has the marketing and distribution capability to increase its penetration in other parts of the world, including the U.S.

Meanwhile, Teva has clinical trials under way for an oral MS treatment and drugs in pre-clinical trials that treat Lupus, ALS, Alzheimer's disease, and cancer. (The company plans to discuss its innovative R&D with investors and analysts on September 26, 2006.) While we see the sales of branded pharmaceuticals, bolstered by intensified sales efforts behind respiratory products, growing faster than generic pharmaceuticals, we expect the branded business to remain a small proportion of Teva's overall business.

In our view, Teva's position as one of the largest suppliers of active pharmaceutical ingredients provides it with the competitive advantage of being vertically integrated. The company is less dependent on outside sources than most, if not all, of its generic drugmaker peers, which helps keeps cost of production low. As of December 31, 2005, Teva had in excess of 220 products in its API portfolio. The acquisition of IVAX added another 30 products. Looking ahead, we expect Teva to launch 20 to 30 new APIs per year.


  Most API sales are internal, and we see no change going forward. We view external sales as enabling Teva to realize better production economies of scale, thereby lowering its internal API costs, while API prices charged to third parties also positively impact the gross margin. What's more, we think Teva's ability to sell externally provides it with opportunities to enter into joint ventures and/or possibly share first-to-market, 180-day marketing exclusivity periods garnered by other generic drugmakers.

We see 2006 revenues increasing 60%, to over $8.5 billion, mainly reflecting the acquisition of IVAX and sale of generic equivalents of several blockbuster drugs slated to lose patent in 2006. Generic version blockbusters that Teva launched with 180 days of marketing exclusivity as of August 6, 2006, include generic Pravachol anti-cholesterol ($1.4 billion in annual brand sales), generic Zocor anti-cholesterol ($4.4 billion), and generic Zoloft anti-depressant ($3.1 billion).

Teva has projected that approximately 25 generic products will be launched in 2006, representing up to $17 billion in branded value in the U.S. It looks for 70 to 80 products to be launched in 2007 to 2008, representing up to $35 billion in branded value in the U.S. On the branded pharmaceutical front, we see the company benefiting from strongly growing Copaxone sales, the recent U.S. launch of Azilect, and Teva's ability to bolster sales of IVAX's respiratory products.


  Teva believes the IVAX integration will result in $100 million in cost-savings synergies by the end of 2006, and $200 million by the end of 2007, and should be derived partly from plant closings, product rationalization, and supply-chain efficiencies. Our 2006 operating earnings estimate is $2.25 per American Depositary Receipt.

For 2007, we see earnings per ADR of $2.30, on flat-to-down U.S. generic sales, the launch of generic drugs with a lower aggregate brand value than those rolled out in 2006, and intense price competition on drugs launched in 2006 that had 180 days of exclusivity. We see increased sales of IVAX's respiratory products as a partial offset. We also see strong growth in Western Europe, Eastern Europe, and Latin America.

We anticipate earnings growth accelerating again in 2008 on the planned launch of generics with higher brand value than those expected to debut in 2007, IVAX integration synergies realized during 2007, expectations for strongly rising sales of respiratory products, and, possibly, additional launches and continued penetration of biopharmaceuticals in Western Europe.

Our earnings model does not assume future acquisitions, which we think will be required for Teva to attain its goal of $17 billion in revenue in 2011. But with debt to total capital at 36% as of June 30, 2006, we believe Teva has the financial wherewithal to make more acquisitions.


  The stock recently traded at 15.7 times our 2006 EPS estimate of $2.25 per ADR. Our projected five-year EPS growth rate for Teva of 17%, starting in 2006, is above the 15% estimated peer average, 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 the peer average of 1.1 times, calculated after excluding outliers. By setting its 2006 PEG ratio to an above-peer-average 1.15 times, we derive a 2006 p-e of about 19.6 times and, hence, a 12-month target price of $45.

Combining our p-e and p-e-to-growth valuations, as well as our discounted cash-flow-derived intrinsic value of $45 per ADR, we set our 12-month target price of $45. Based on this price, we see potential total return of about 30% from recent levels.

We view positively that the board is comprised of 14 directors; the current CEO is not a board member; a large majority of directors, 10 (71%), 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's no disclosure of a policy that the board reviews its own performance regularly; and there's no governance committee.

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. In addition, the company 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. Lastly, Teva has significant operations in Israel, which may be adversely affected by terrorism or major hostilities.

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