RTCrawford’s Weblog

Teva is a stock that seems to defy gravity. To defy gravity, it is not necessary to rise (levitate and hover). Instead, it is sufficient to do nothing more miraculous than not fall when gravity would suggest falling is appropriate behavior. I mention this not because I have a short position in the stock. In fact, I am long. Instead, I mention it because, normally, companies that buy other companies decline in stock value, while the acquired firm is bought at a premium and rises.

Why?

If the efficient market theorists are correct and the true value of each company is fairly priced, the two companies that were fairly valued separately should achieve the same total when combined. For Teva, which recently announced its intention to acquire Barr Pharmaceuticals (BRL) in a friendly takeover, the stock has held steady while BRL has jumped nicely (“nicely” because I own BRL, as well).

The only explanation for this gravity defying event is that Teva is undervalued — which, as a value investor, was my conclusion when originally buying the stock on November 5th of last year at $43.96 per share. The stock is currently selling for $46.01 — roughly a 4 percent increase, after deducting brokerage fees. Since I tend to buy stocks selling at a 50 percent discount to intrinsic value, the the stock should still be undervalued by roughly 46% — a little less after factoring in brokerage fees.

[Note: WordPress seems to be having problems this evening. Many of the charts and graphs appear distorted as thumbnails but seem to work fine if the viewer clicks them for an enlarged view. This, however may represent a problem with my computer, alone. Nevertheless, if the reader has difficulty with any chart, just click on the image for a better and more legible version.]

First, let us consider the intrinsic value by discounted cash flow analysis, starting with the core data.

The core data is presented first, followed by the median of the five-year and seven-year median growth rates.

Since the company’s intrinsic value is the net present value of projected future cash flows, we will take the free cash flow rate and project it out over the next decade, followed by an assumed 5% growth rate in the second decade.

Summing these future projections, we will discount them back to present at 15% and use current shareholders equity (see above) as the continuing value. This renders the following results:

This suggests the company is worth $360.5 billion, or a per-share value of $445.40. The only problem with this is that it uses a 60% growth rate for free cash flows — a rate that is unsustainable.

At this point, it would be beneficial to try and identify a reasonable growth rate. To do this, we can conduct sensitivity analysis for the discounted cash flows.

The investment thesis behind the stock rest largely on its role as a manufacturer of generic pharmaceuticals. With health-care costs growing at rates significantly greater than wage inflation, institutional payors (i.e., insurance) strongly favor generic medications over the namebrand versions. In some cases, that preference is evidenced by lower deductibles for the generics, and, in other cases, it shows up in the requirement that the patient first fail on the generic before the payor will cover the name-brand version. Today’s 47 million seniors (in the United States) will grow to something over 80 million in the year 2030, as the boomer generation begins retiring as soon as the year 2010. Europe has its own boomer generation, to say nothing of China’s. Consequently, if believing that the company can grow at 18%, the company is undervalued. Since 70% of health-care costs are generated in the last five years of life, a sustainable 20 percent growth rate over the next decade seems abundantly reasonable. If believing that the company can sustain growth over the next decade at 30% (less than half the growth rate evidenced during the prior decade), the stock is undervalued by something approaching 43%.

Which produces a compounded annual growth rate in various timeframes up to 5 1/2 years of:

If expecting that it will take the market three years to realize the company’s intrinsic value (at the 30% growth rate), the return on investment would be 20.86%.

The company, however, has announced its intention to purchase BRL. Since most companies seeking to grow based on acquisitions generate inadequate returns to justify expansion, it is appropriate to consider whether cash return on invested capital exceeds the weighted average cost of capital.

In this case, Teva fails the test until realizing that just 0.08% of the weighted average cost of capital is attributable to outright debt — the rest follows from equity capital. Given this, we should compare the company’s earnings power value to its replication value.

In most years over the past decade, replication value exceeds earnings power value, suggesting that growth is not in the best interest of the stockholder. Cash return on invested capital, however, is diminished by working capital deployed toward growth in any given year. So, let’s take a look at the company’s capital expenditures.

It appears that, with the exception of the most recent year, cash from operations has grown due to capital expenditures invested toward growth. With the exception of the most recent two years, capital expenditures for, both, growth and maintenance have supported the declared level of depreciation (a surrogate for maintenance capital expenditures). In other words, the company has, indeed, been profitably growing to the benefit of the stockholders, but the recent shortfall in depreciation coverage suggests the need to monitor this metric is in the future. At this point, however, expenditures toward growth seem perfectly reasonable given the expected expansion of market demand (i.e., the boomer generation entering retirement). In fact, the purchase of Barr pharmaceuticals (an American generic manufacturer, which provides diversification into the European market) represents a nice opportunity for Teva — a firm headquartered out of Israel and benefiting from the recent decline in the dollar.

Next, we turn to the financial ratios to identify the fiscal health of the company.

It should be noted that the current ratio is below the normal threshold for established firms, but is well within the normal range for this operations-intensive firm. The days-survival metric or “interval measure” is a healthy 3+ years. This goes a long way toward explaining the debt structure of the company.

The rest may be explained by increasing profit margins in comparison to asset turnover, as contributors to the company’s return on assets.

Even in 2007, which was a down year by other metrics, return on invested capital came in at 9.78%– exceeding Benjamin Graham’s minimum threshold of 6% handsomely.

With a healthy cash conversion posture.

A statistically significant growth in owners earnings:

A new and demonstrably higher range for book value:

Leading to steady growth in shareholders equity:

As year-over-year changes in cash remain above the zeo line:

These result even translate into earnings per share, despite that measure’s use of non-Cash items:

Even if concerned with stock volatility in comparison to the broader market (something not typically considered by value investors), Teva’s performance has been impressively above the securities market line for stocks trading at this low level of volatility (i.e., a beta significantly below 1.0, at 0.67).

The dividend payout ratio appears reliable, even as the dividend drain on the company’s excess capital declined from 2006 to 2007.

Revenues are growing at a rate significantly greater than cost of goods sold, with gross profits in 2007 exceeding COGS.

Research and development has increased with profits, while sales, general, and administrative expenses appear positioned to support growth.

Taxes paid increased in 2007, but this was to be expected given the company’s growth in prior years versus the relatively stable level of taxes paid.

Earnings per share and diluted earnings per share are one and the same– providing a sense of the favorable equity capital structure.

Net income, under cash from operations, strengthened in 2007, as the “other” category ceased to provide a drag on the results.

While the company did not undertake M&A in 2007, acquisitions have contributed to growth in the past, as this cash from investments chart indicates. The proposed Barr purchase is not, therefore, out of character.

Cash from financing declined in 2007 and represented a marginal drag on the company’s results.

Free cash flows, however, remained strong, even if representing a marginal decline from 2006.

Next, let’s look at the balance sheet, starting with current assets.

While the growth in current assets is impressive, it is important to note that Accounts Receivable grew at above trend starting in 2006 — which is, arguably, when the current economic concerns first appeared in the corporate world. That was when many companies began increasing their cash positions, in anticipation of the decline we are witnessing today. That increase in accounts receivable, however, accompanied a commensurate increase in inventories, as the company began realizing the benefits of their earlier investments in growth.

With total assets, I tend to discount (mentally ignore) the influence of “intangibles.” Therefore, the jump in total current assets becomes significantly less impressive from 2005 to 2006. Instead, it is important to recognize the increase in plant, property, and equipment in 2006, in addition to the previously noted increases in current assets in both 2006 and 2007. In fact, the growth in total current assets from 2006 to 2007 is largely attributable to increases in total current assets and plant, property, and equipment, rather than intangibles.

Next, we turn to current liabilities.

Current liabilities increased significantly from 2005 to 2006 and from 2006 to 2007. This was attributable to a dramatic rise in short-term debt and “other” short-term liabilities in the most recent year. While we will put this into perspective with a subsequent chart, this graph provides prospective for the company’s level of debt, identified earlier when considering the financial ratios. This does represent a doubling of both categories, which largely offsets the significant decline in accounts payable.

The company did, however, make significant reductions in long-term debt, while holding “other” long-term liabilities steady. In general, it is preferable to see the reverse — preferring long-term debt over short-term debt.

Previously, I indicated that we would put the company’s debt posture into appropriate perspective, and we do that with the next chart.

Please note that, while total liabilities grew from 2006 to 2007 (and more prominently from 2005 to 2006), this pales in comparison to total stockholders equity — especially, from 2006 to 2007. In other words, the stock represents the best of both worlds, in that it appears to be significantly undervalued (based on our earlier discounted cash flow analysis) while evidencing traits common to “growth” stocks, as well.

Lastly, let’s considered the issue of fair value for the stock. As indicated at the start of this analysis, discounted cash flow analysis at the extreme growth rate of just over 60% indicates an intrinsic value of more than $400. If that growth rate is reduced by half (30%), cash flow analysis indicates an intrinsic value of $81.22. This is significantly greater than the company’s book value of $19.38. The difference between the two is nothing more than the expected growth rate in the future. This is why we performed the sensitivity analysis (above).

If, however, we apply the 30% growth rate, given the expected retirement and aging of the boomer generation and increased health-care needs associated with them, then we can compare the current stock price with its estimated intrinsic value over the past 10 years.

If reducing that growth rate to 20%, fair value declines to marginally above the current price.

Please note that, in both of the prior charts, the expected growth rates declined by 10% in stepwise fashion at two points over the next decade. This renders an even more conservative estimate of intrinsic value than accomplished in our earlier discounted cash flow analysis.

Nevertheless, even if assuming a 20% growth rate, the stock is not only undervalued, it is an attractive purchase based on the growth investment philosophy of Phil Fisher (the father of growth investing).

And this is why Teva’s stock price has not declined with the announcement of the Barr purchase.