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6 Reasons Buffett Bought Into Teva Pharmaceutical, as Told by a Teva Shareholder

Sean Williams, The Motley Fool

The past couple of years have been rough on Teva Pharmaceutical Industries (NYSE: TEVA) and its shareholders. The largest maker of generic drugs and developer of a handful of brand-name medicines lost practically half of its value in 2017, and it tumbled by well over 80% from its all-time highs in less than three years.

Teva has a laundry list of problems

The list of reason why Teva ran into a brick wall last year is a mile long. Fundamentally, the wheels fell off the bus. The company cut its sales and profit guidance on a handful of occasions, slashed its dividend by 75% in the summer, and then eliminated it completely a few months later in order to conserve more of its cash.

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It also has struggled for multiple quarters with generic-drug pricing. Aside from grossly overpaying for Actavis, and in the process becoming the world's largest generic-drug producer, pricing power on generics has eroded, pressuring Teva's core business.

Making matters worse, the company agreed to settle on bribery charges in three countries where it had allegedly bribed physicians to prescribe its medicines in late December 2016, forcing it to replace some of its top executives after its CEO and CFO stepped down last year.

As the coup de grace, the company's top-selling branded drug, Copaxone, an injectable treatment for multiple sclerosis, began facing generic competition late in the year. Teva exhausted a multitude of legal recourses to keep these generics off the market, but now has around $4 billion in annual sales exposed to generic competition priced at a clear discount to Copaxone.

That was Teva's 2017, in a nutshell.

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Buffett surprises Wall Street by buying into Teva

However, this past week brought something of a shock to Wall Street. As disclosed in 13F filings with the Securities and Exchange Commission, buy-and-hold stock mogul Warren Buffett purchased a $358 million stake in Teva Pharmaceutical during the fourth quarter (about 18.8 million shares, or 1.8% of Teva's outstanding shares), making it the only new position for the Oracle of Omaha. As a shareholder of Teva, this move caught me by surprise.

What's truly notable about the purchase is that Buffett doesn't have a lot of exposure to healthcare. His investment team sold down Berkshire Hathaway's (NYSE: BRK-A)(NYSE: BRK-B) stakes in Johnson & Johnson and Sanofi somewhat recently, while continuing to maintain a healthy position in dialysis giant DaVita. Aside from these positions, it's a sector that Buffett otherwise treads lightly or avoids altogether. 

Six reasons Buffett's purchase makes sense

Though Teva does have a lot of kinks to work through, I believe there are six reasons behind Buffett's acquisition. We've heard numerous theses up to this point of why he bought into Teva from those on the outside looking in, but here's a take from a Teva shareholder -- me.

1. Healthcare is mostly inelastic

To begin with, Buffett prefers businesses that can essentially run themselves and have clear competitive advantages. The "advantage" of the healthcare industry, and a company like Teva Pharmaceutical that provides generic and brand-name prescription medicines, is consumers don't have control over when they get sick or what ailment they have. Illness doesn't care about inflation, recessions, or politics. It means there's always steady to growing demand for prescription medicines, which checks off an important box on Buffett's investment wish list.

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2. The generic-drug trend is Buffett's friend

Buffett and his team are probably betting on a long-term bull market in generic drugs. Even though pricing has been a bit weaker in recent quarters, and Teva has cautioned it could remain that way for a few more quarters, the overall trend in the industry is a push toward higher generic-drug usage. As brand-name drugs move higher in price, consumers, insurers, and physicians will likely push for broader generic-drug use.

According to QuintilesIMS Institute for Healthcare Informatics, generic drugs are expected to total 91% to 92% of all prescriptions written by the turn of the decade, up from 88% in 2015. Between limited exclusivity for brand-name therapies and price inflation, volume alone can make Teva a long-term winner -- and I believe Buffett knows it. 

Let's not also forget that longevity has increased in nearly all countries around the world. As access to medical care improves, the market for prescription medicines as both treatment and maintenance therapies should rapidly grow.

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3. Little pipeline oversight is needed with Teva

Possibly the biggest deterrent for Buffett when it comes to drug companies is that he just doesn't have the time or patience to read through copious amounts of clinical trial data. That's why pharmaceutical stalwarts like Merck and Pfizer aren't currently part of Berkshire Hathaway's portfolio. With Teva, that's not as big of a concern.

You see, generic drugs made up 57% of total sales for Teva in 2017, and Copaxone, which is now facing generic competition, was the only major unknown within the company's branded portfolio. There's nothing specific in the product portfolio or pipeline that's going to require Buffett to sit on the edge of his seat and wait for clinical trial data. That isn't to say he and his investment team at Berkshire won't be reviewing Teva's pipeline a few times a year, so much as that he won't have to read each and every clinical update. That's another checkmark for Buffett.

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4. Teva's management is making tough choices

Even though Buffett has said that he doesn't focus on the management teams of the businesses he invests in, he probably appreciates the no-nonsense leadership of new CEO Kare Schultz and Teva's steadfastness in making tough decisions to pay down its debt.

Teva has already eliminated its dividend, saving more than $1 billion annually in the process, and it announced in December that it would be shedding around 14,000 jobs, or a quarter of its workforce. These layoffs, along with numerous asset sales where these employees had worked, should lop $3 billion off expenses by the end of 2019. On a percentage basis, we're talking about an almost 16% reduction in total expenditures for one of the world's biggest drugmakers. 

It also jettisoned all aspects of its women's health operations for more than expected (over $2 billion), which is a big reason why debt levels fell $2.2 billion in the fourth quarter to $32.5 billion. A few more noncore asset sales may still be on the docket to help lower debt levels even more.

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5. The company is healthfully cash flow positive

Despite all of its woes last year, Teva remains healthfully cash flow positive, generating $3.5 billion from operations in 2017. Excluding net capital expenditures, it generated $2.7 billion in free cash flow. In other words, the dire straits that Teva was deemed to be in by Wall Street may have been overstated, and Buffett probably realizes this.

Even with the expected erosion of Copaxone sales in 2018 -- Copaxone is Teva's highest-margin product -- we're still looking at an estimated $2.6 billion to $2.8 billion in free cash flow, according to the company's outlook. That's more than enough capital to continue paying down debt and advancing its world-leading generic drug portfolio. 

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6. Buffett loves a good turnaround story

Last but not least, let's not overlook the fact that Buffett has historically loved a good turnaround story from time to time.

For example, back in 2011, Berkshire Hathaway invested $5 billion in the struggling Bank of America (NYSE: BAC), which was a far cry from the usual set-it-and-forget-it business he usually buys. However, Bank of America did have a lot going for it, including a well-known brand, a lot of customers, and huge market share in the United States. When Buffett exercised his Bank of America warrants in 2017, his bet netted about $12 billion in profit when all was said and done. 

While Teva is unlikely to make Buffett anywhere near that amount, he likely sees a company with strong generic market share that's complemented by high-margin brand-name products. He probably also believes that generic pricing power will return given the aforementioned demand growth expected from generics over the long run.

All things considered, Teva checks off a lot of the boxes that Buffett would look for in an investment.

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Sean Williams owns shares of Bank of America and Teva Pharmaceutical Industries. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and Johnson & Johnson. The Motley Fool has a disclosure policy.