Teva CEO Kare Schultz

Teva (TEVA) has been reeling since Mylan's (MYL) generic Copaxone was approved Q4 2017. Having one's most-profitable drug go generic is never a good thing. Teva has also been hampered by the $40 billion acquisition of Allergan's (AGN) generics business. The company's credit metrics have been in a steady state of decline. It could potentially wilt under its $32 billion debt load, yet the stock is up over 80% since reporting disappointing Q3 earnings in November. 

Bershire Hathaway (BRK-B), (BRK-A) even took a position in the Teva, which really assuaged Teva bulls. Below I explain what Berkshire could see in Teva.

Teva Will Survive

Despite being up 80% since its Q3 2017 earnings report Teva is still down by over 43% Y/Y. It is the largest generics drug maker in the world and the last time I checked branded drugs were still going generic and consumers were still buying them. This phenomenon will not change any time soon. Secondly, the company's credit metrics have continued to decline. Its debt/run-rate EBITDA was 5.0x in Q2 2017, 5.3x in Q3 2017 and 5.4x in the most recent quarter. This occurred despite paring debt from $35 billion in Q2 2017 to $32 billion in Q4 - albeit aided by asset sales.

The rating agencies have reacted rather negatively to Teva's deteriorating credit metrics. Fitch downgraded the company's debt two notches to junk status in November. Moody's downgraded Teva to junk in January and S&P followed suit earlier this month. However, despite having a high debt/EBITDA ratio the company's reputation and status as the largest generic drug manufacturer means that banks will likely be willing to let Teva restructure its debt. According to Bloomberg, the company is working with Evercore to review strategic options for its debt. That includes potentially shrinking its revolving credit facility and extending the payment period for some term loans.

Teva generates $1.5 billion in quarterly EBITDA. Management could spin a story that expected savings from cost cuts ($3 billion) and plant closings could buffet further EBITDA declines. By delaying debt maturities the company could kick the can down the road for years. This could give traders ample time to speculate on the stock and voice wild predictions on how high TEVA could go. Valeant's (VRX) debt/run-rate EBITDA is hovering around 7x. The company has been paring debt via asset sales. VRX hit a 52-week low in the first half of 2017 shortly after lead investor, Bill Ackman of Pershing Square (PSHZF), abandoned the stock. VRX has more than doubled off its 52-week low due to asset sales, a reduction in deferred tax liabilities and bets on its survival. Berkshire could be betting on a similar melt up for Teva.

Berkshire Likely Believes Bondholders Are Mullets

Despite Teva's high debt/EBITDA ratio its interest coverage is strong. That is where the disconnect comes in. In Q4 the company paid finance expense of $191 million. This equates to an implied weighted average interest rate of about 2.4% - this is paltry. Teva's Q4 EBITDA of $1.5 billion generated interest coverage of 7.8x - this is extremely robust. 

I am not sure if its relationship with Israel or out-sized leverage with bankers helped garner such low costs. The question remains, "Will it continue?" If it does continue it could portend that banks are providing mullet money or dumb money. That has to be what Berkshire is betting on. Why else would it invest in Teva at this juncture?

Berkshire should probably think again. The yield to maturity on Teva's bonds are as high as 6.6% for bonds maturing in February 2036. The yield was around 5.04% a year ago. The company has $7.5 billion in debt maturing through 2019. It will likely have to refinance the lion's share of those maturities. If $7.5 billion in new debt is brought on at 6.6% or higher then the company's borrowing costs could increase by over 400 basis points.

For every $1 billion in new money raised the company's interest expense could rise by $40 million (assumes a 400 basis point increase). Rising interest expense would cut into Teva's cash flow at a time when the company is trying to preserve its cash flow. Layoffs and dividend cuts could be partially negated by rising interest expense.

Teva's Credit Metrics Could Deteriorate Further

Teva's Q4 EBITDA of $1.5 billion was off 8% Q/Q and 29% Y/Y. What is not debatable is that EBITDA will likely fall much further. The generics business is experiencing price erosion, particularly in North America. That is expected to continue. Secondly, the company will not feel the full impact of generic Copaxone until Q1 or Q2 of this year. Q4 Copaxone revenue was off 19% Y/Y. I previously estimated generic competition could cause Copaxone sales to decline by 70% in year one - 51% decline in price and 40% loss of market share. That means it Copaxone revenue could fall another 50% - 60% before the impact is fully felt.

Copaxone has EBITDA margins in the 80% range and represents 45% - 50% of Teva's total EBITDA. I anticipate Teva's EBITDA declines will outweigh the benefits of cost cuts - at least over the next few quarters. Its debt/EBITDA will also likely deteriorate further. Rising interest expense and declining EBITDA will likely cause its interest coverage to deteriorate further. The rating agencies are aware that Teva's EBITDA could fall from here. This could beget more ratings downgrades which could beget investors demanding higher interest rates on new debt.