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Sunday, December 19, 2010

Teva Pharmaceutical Industries -- Fear and Misunderstanding Means Opportunity

TEVA Phamaceutical Industries Limited (symbol TEVA) is the world’s largest manufacturer of generic drugs. It also produces Copaxone, one of the most important drugs for the treatment of Multiple Sclerosis as well as some other less important proprietary drugs. It has been growing quickly and steadily both through wise acquisitions and internally generated progress. So you would think that it should have a nicely rising stock. After all, no matter what happens with healthcare, generic drugs will be getting ever larger shares of the market. TEVA stock, however, has not had a good year. In December of 2009, TEVA ranged between 53.26 and 56.88 and one year later, the stock has spent the first half of December trading between 50.62 and 53.88. So what is happening here?

The answer to the likely cause of TEVA’s trading pattern reveals an opportunity for profit. Mostly, the pattern stems from misunderstanding and baseless fears. First, let’s look at the misunderstanding. To understand this, one needs some additional background. In early 2010, TEVA stock continued its long term trend of rising steadily and it hit $64 in April. At that point, an extraneous change started to push the stock down. Specifically what happened is that Israel was moved from the status of a developing country to that of a developed country. TEVA, after all, is based in Israel, but no one would suspect that the change of status of the country should affect the share price for the stock. In truth, however, the effect was large. While Israel was a developing country, its companies were purchased by the various funds that own stock in such markets. TEVA seems to have accounted for a large portion of the Israeli stocks held by such funds, and among developing countries, the Israeli economy comprised a large share of the total. As a result, when Israel got reclassified as a developed country, the emerging market funds had to sell TEVA along with their other Israeli holdings. While it is true that other funds that cover developed markets had to buy into the Israeli market, the amount so purchased was much smaller (Israel is only a tiny part of the world’s developed markets). So there was a lot of selling of TEVA that started to drive the price down in May and June. Indeed, the low for June was 50.63, more than $13 off the high. As investors saw the price start to decline, many (who had nice profits on the stock) ran to take those profits. The price declined even though not many investors in the stock understood the reason why it had happened. That was the misunderstanding.
Next we come to the baseless fears. Here the big issue is Copaxone and whether or not someone else will be able to produce a generic version or a competing drug. Many investors fear that the loss of Copaxone would hurt TEVA severely. The true issue, however, is not how the loss of Copaxone would affect TEVA; rather, it is whether or not TEVA will lose Copaxone, and on that front there is much too much gloom and doom in the market. Copaxone is not manufactured by a simple process. I will not go into the entire story as to how the drug gets produced, but suffice to say that production is extremely complex and difficult. Right now it seems more likely than not that any company wanting to manufacture generic Copaxone when the patents expire will have to first conduct trials of some sort to prove that it can manufacture the product in effective and safe form. This will add enormously to the cost and time of manufacture and it should give TEVA many more years of exclusivity. Beyond this, TEVA is likely to be out with its new oral drug before the patents expire on the basic version of Copaxone, so it will have a further advantage.
The truth is that those who fear for TEVA’s future with Copaxone are also misunderstanding the essential nature of the company. TEVA remains a generic drug manufacturer and should be evaluated as such. Those who import the modality used in evaluating big pharma like Merck, Pfizer or Abbott are looking at the stock in the wrong way. As a generic drug company, TEVA has no equal. It has a major presence in both North America and Europe. It has made some savvy acquisitions (the latest large one being Ratiopharm, a major player in Germany and the rest of Europe). Even for those who want to transform TEVA into a regular large drug company, it must be noted that TEVA has a pipeline of proprietary drugs in development.
And then there is the other side of the fight to retain Copaxone exclusivity, namely that Teva is uniquely positioned to best succeed in the relaxed regulations in many countries which for the first time allow for biosimilars to be approved for biotech drugs (the equivalent of generics for pharmaceuticals). Teva has the financial strength, know-how and manufacturing expertise and efficiencies to succeed in obtaining such approvals in the medium term, according to many analysts. This is a huge potential upside for Teva which is barely, if at all, reflected in EPS estimates for 2012 and beyond. As is, the PE on the 2011 consensus is 9.8 which is very inexpensive for a 16% grower.

In short, TEVA is now at a very attractive price as a result of the market misunderstanding the true nature of the company and what has affected the share price in the past. Buying TEVA at the Friday close of 51.93 can also be combined with options to improve the return. For example, were one to buy the stock and write the March 55 calls, would and annualized result in a return to call of about 32%.

Disclosure: I am a long time investor in TEVA and am currently long the stock. I also write and/or buy both calls and puts on the stock. I have no plans to change my holdings in the near future.

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