Teva Bonds: 8.8% Yield To Maturity Understates Upside
By Left Brain Investment Research:
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As an asset class, high-yield bonds frighten some investors, especially with the media’s non-stop drumbeat of the coming recession. But with interest rates getting lower, and the idiosyncrasies the asset class offers, select high yield bonds can be more attractive than equities, especially for income-focused investors seeking significant price appreciation potential. This article describes why the price of Teva (TEVA) bonds declined (e.g. the opioid crisis, the latest Mallinckrodt (MNK) restructuring news and Copaxone margin pressure—thank you Twitter in Chief), why they have significant price appreciation potential (e.g. the “make whole” provision, free cash flow and the management), the risks (e.g. industry headwinds and Teva’s relative opioid liability) and finally our views on who might want to consider investing in these bonds.
If you don’t know, Teva Pharmaceutical Industries Ltd. is a global pharmaceutical company, which engages in development, production and marketing of drugs, generic drugs, over-the-counter (“OTC”) drugs, active ingredients for the pharmaceutical industry (“APIs”) and therapeutic products.
(table source: Teva’s Q2 investor presentation)
Why the Bond Price Declined:
For starters, here is a look at the historical price of Teva’s 2036 bonds.
(source: Finra Morningstar)
1. The Opioid Crisis: One of the reasons Teva’s bond price has declined is the opioid crisis. Nearly 400,000 Americans have died from opioid overdoses from 1999 to 2017, according to the Centers for Disease Control and Prevention. Currently ~2,000 lawsuits have been brought by municipalities and other plaintiffs accusing companies in the pharmaceutical supply chain, including Teva, of fueling the opioid epidemic.
About 1,500 complaints have been filed against Teva for its role in marketing and selling opioids, and most of those have been consolidated into a critical multi-district litigation set for a jury trial to begin in October. Teva has indicated that it is willing to settle in the opioid lawsuits if it receives a reasonable offer. The company’s legal exposure to these lawsuits is significant, as subsidiary Actavis Generics, acquired in 2016, controlled around a third of the opioid market.
Per the Q2 earnings presentation (linked earlier), Teva allocated $646 million in costs for legal settlements in the quarter ended June 2019, majorly related to opioid litigation. It should be noted that this amount primarily represents the current provision for the minimum potential for future liabilities and is likely to increase as more information becomes available. In August 2019, it emerged that three of the largest US drug distributors — McKesson (MCK), Cardinal Health (CAH) and AmerisourceBergen (ABC) offered up to $10 billion in order to settle lawsuits in 35 US states.
And while Teva’s total opioid liability cannot be known at this time, it is likely to be spread out over time so the company can continue to operate. Additionally, Johnson & Johnson recently lost its big opioid case in the state of Oklahoma, but the losses were less than expected (JNJ’s share price actually rose on the news), and it can be viewed as a small incremental positive for the industry.
2. Mallinckrodt Restructuring News: The recent news of a possible restructuring at Mallinckrodt (another pharmaceuticals company in the cross hairs of opioid litigation) caused a sympathy sell-off among similarly targeted businesses on Thursday (stocks and bonds), including Teva. According to a Bloomberg article, Mallinckrodt is mulling restructuring as a major opioid trial nears. However, Mallinckrodt's CEO downplayed the report calling it:
"unfortunate" since the company routinely hires advisors for a range of issues, although he added that it continues to look at all alternatives to move away from the opioid/generics business since it comprises only 10% of what the company does.
Nonetheless, shares of Teva (and others impacted by pending opioid litigation) sold off on Thursday in sympathy with Mallinckrodt.
3. Copaxone Generics Pressure: The Copaxone decline is another reason Teva bonds have sold off. Launched in 1996 by Teva as the company’s first major brand-name drug, Copaxone (used in the treatment of MS) had been the company’s blockbuster drug. For years, the drug was the company's cash cow, its highest selling and most profitable product. However, in 2015, it met with generic competition in the US, its main market, but Teva managed to transfer most patients from the 20mg dosage to 40mg, which partially diminished the impact of competition.
Teva’s challenges increased with the $40.5 billion purchase of Actavis Generics from Allergan (AGN) in 2016. The acquisition was initially well perceived by investors as the company’s stock rose to a record high market cap of $61 billion. The acquisition of Actavis Generics was aimed at turning the company into a generics giant whose profits would cover for the loss of exclusivity over Copaxone. Management estimated substantial synergies between the businesses and set lofty financial targets of $11.6 billion in EBITDA and $8.5 billion in free cash flow to be achieved by 2018.
(source: Teva’s Q2 investor presentation)
While the intention of turning Teva into a generics giant to make up for the profits of its fading blockbuster drug (Copaxone) may have been correct, the acquisition of Actavis Generics happened at the worst possible time for the company. Accelerated approval of generic drugs under the Trump administration resulted in the generics market being flooded by a record number of new drugs, wreaking havoc in generic drug pricing. However, it is worth noting that despite a challenging industry environment and losing exclusivity on its most profitable drug, the company has still been able to generate ~$3 billion in FCF every year.
Despite the Sell-Off, The Bonds Have Upside:
Free Cash Flow: Despite very challenging market conditions, Teva has been able to generate ~$3 billion in free cash flows annually and has repaid $7 billion in debt (the debt increased significantly in 2016 from the acquisition of Actavis Generics).
(source: Left Brain, FactSet)
Further, management is committed to using free cash flow to pay down debt in the coming quarters and years.
(source: Teva’s Q2 investor presentation)
Management: Kåre Schultz became Teva’s President and CEO in November 2017, and has put the company on a trajectory for improvement. For perspective, Schultz inherited a company whose share price had fallen by ~84% since the all-time high of August 2015 with declining profitability and an accumulated debt burden of ~33 billion. In December 2017, Schultz announced a comprehensive restructuring plan intended to significantly reduce the company’s cost base, unify and simplify the organization and improve business performance, profitability, cash flow generation and productivity.
We believe the systematic manner the company has executed its operational restructuring plan is commendable. The divestment of unprofitable manufacturing plants, accompanied by the laying off of over 10,000 employees, were painful, but necessary steps for the company to recover. Suspension of cash dividends and capital allocation focused on debt reduction are also tough decisions but a necessity for a company that is heavily levered. And the company’s ability to pay down $7 billion in debt between 2016 and 2018 under distressed conditions is commendable.
“Make Whole” Provision: One of the attractive qualities of this particular bond is the “make whole” provision. As you can see in this bond’s historical pricing chart (presented earlier in this report), it previously traded at a large premium to par. We believe it can trade at a large premium to par again in the future before it matures.
A make-whole provision is “a call provision attached to a bond, whereby the borrower must make a payment to the lender in an amount equal to the net present value of the coupon payments that the lender will forgo if the borrower pays the bonds off early.”
And here is a link to this particular bond’s prospectus. The relevant information is as follows:
“The notes will be redeemable at a redemption price equal to the greater of (1) 100% of the principal amount of the notes to be redeemed or (2) the sum of the present values of the Remaining Scheduled Payments discounted on a semi-annual basis, at a rate equal to the sum of the Treasury Rate and 20 basis points with respect to the 5.550% Senior Notes due 2016 and 30 basis points with respect to the 6.150% Senior Notes due 2036.”
This is basically the reason the bonds traded so much above par in the past (because the coupon rate is so much higher than the market rate), and it is the reason the bond can trade well above par again in the future (because interest rates are low and going lower, and Teva’s business is on an improvement trajectory thereby creating a lot of potential price appreciation).
Of course, there are risks to investing in this bond (it offers a high yield for a reason). Specifically, the market is scared and has created selling pressure. For example, the opioid crisis (as we discussed earlier) is a big risk. More specifically, market dynamics have deteriorated further with the threat of a massive opioid-litigation liability looming over the entire industry. Secondly, S&P Global Ratings assigned a negative outlook to the pharmaceutical industry, with ratings downgrades expected to outnumber upgrades in 2019. S&P Global Ratings said increasing M&A activity, intensifying pricing pressures and regulatory scrutiny in the US, along with the opioid crisis are key drivers of rating pressure in the pharmaceutical sector.
In our view, these risks are real but likely overdone considering the improving business cash flows and debt position for Teva. Further, because Teva has a large generics business, it won’t be in the first line of fire regarding opioid litigation. Specifically, the brand names were putting forth the most marketing efforts and selling pressure as compared to generics. Further still, the fact that the bonds are ahead of the equity in the capital structure is attractive, especially considering the company is focused on paying down debt and thereby decreasing the risks for bondholders. Overall, negative publicity and the trial-by-media in the opioid litigation has cast a dark cloud over the entire industry, and this is often a better time to be a buyer (buy when there is blood in the streets according to contrarian investor Baron Rothschild).
If you’re looking for the safest yield in the world, Teva bonds are absolutely not for you. But if you like to opportunistically add high yield at a discounted price, then you may want to consider these bonds (assuming you have an ironclad stomach to hang on so long as the thesis remains intact). Despite the risks Teva currently faces, we believe the business is improving, and the 2036 bonds are worth considering within the context of a prudently-diversified, goal-oriented, high-return portfolio. Not only does the company likely have the financial wherewithal to support its debt, but the make whole provision combined with current low interest rates create the potential for the 2036 bonds to again trade at a significant premium to par thereby making the upside greater than the current 8.8% yield to maturity may suggest.
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