After a $35 Billion Catalyst, Where Do Generic Manufacturers Stand?

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Generic producers received a nice tailwind this year from $35 billion worth of brand-name drugs losing IP protection. However, there won't be nearly as many exclusivity losses going into 2013 that the major generic producers can count on. I therefore recommend looking at how the multiples compare to peers and historical levels, the pipeline, and the possibility of accretive takeover activity. Below, I review three generic manufactures with these variables in mind.

Why You Should Buy Teva (NYSE: TEVA)

Over the year to date, the world's largest producer of generic drugs has materially underperformed its peers, losing 6.4% in value versus a gain of 30.2% for Mylan (NASDAQ: MYL) and a gain of 50% for Watson Pharmaceutical (NYSE: ACT). But it now trades at only 15.9x past earnings (industry average: 19.4x) and 1.5x book value (industry average: 4.7x). In light of this discount and remarkable underperformance, value investors should take the advice to "buy low and sell high."

There are several reasons to be optimistic that investors will get the chance to sell high. First, the company's new CEO, Jeremy Levin, seems fairly committed to taking over businesses. In his tenure at Bristol Myers, Levin orchestrated a "string of pearls" strategy, wherein the pharmaceutical company would take over relevant businesses and create value through synergies. I do not doubt that he will be capable of achieving the same, and probably better, success at Teva, which has the largest patient population to extend drugs out to.

Slowing growth and the nearing exclusivity loss to multiple sclerosis treatment Copaxone, which contributes one-fifth to the top-line, have investors worried. In terms of a takeover strategy at Teva, Levin will thus likely be focusing on reducing dependency on a limited number of products and diversifying through increasing branded generics in emerging markets. The recent JV agreement with South Korea's Handok Pharmaceuticals for greater distribution represents a step in the right direction. In particular, it will target its core CNS and respiratory markets.

The company's billionaire Chairman & CEO Phillip Frost spoke specifically about the idea of takeovers, arguing that the days of multi-billion dollar buyouts are over and that the main inorganic growth curve ahead will come from this opportunity:

"There is the opportunity for product acquisitions, for small company acquisitions, for technology acquisitions, and to bring in new people who themselves are capable of creating the new products."

It also has strong potential through the existing pipeline. 10 to 15 new therapeutic entities, or NTEs (formulations, uses, or administration methods of existing therapeutics), are planned for next year, and, if a pending multiple sclerosis drug is combined with Copaxone, the result could be a game changer. 15 drugs are already in their late-stages, so I believe we will see further improvement from recent patterns. Free cash flow trends have already been on a bit of a recovery since late 2012 after falling in mid-2011. Over the TTM ending 3Q12, $3.3 billion in FCF was generated, a strong yield of 9.3%. With 40 drugs losing patent protection this year, $35 billion worth of "open potential" has been added to the generic market.

Mylan vs. Watson

Mylan and Watson are both at around their all-time highs and trade at a respective 10.1x and 11x forward earnings, a notable premium to Teva's 7.4x. Is this worth a preferential investment in the first two? Analysts are highly bullish on both. 10 of 14 reporting analysts rate Mylan a "buy" or better, and 15 of 18 feel the same way about Mylan. While Watson generates a 6.8% return on invested capital (ROIC), Mylan generates 9.4%, which is closer but still meaningfully short of the 13.1% industry average.

Mylan and Watson are both forecasted around the same EPS growth rate of 11.1% over the next five years. Assuming expectations are met, Mylan and Watson's stock prices will be worth $49.50 (for 15.4% average annual returns) and $151.32 (for 13.4% average annual returns) at a 13x multiple by 2016. This is despite adding in around 100 bps greater annual EPS growth to Watson.

So what does Mylan have going for it? First, several of the downside catalysts have been removed: Moody's and S&P both upgraded the credit rating, with the latter increasing it from BB+ to BBB-. The board approval for a $500 million share repurchase program also communicates to the market that the share price is still advantageous despite a bull run. Lastly, management's expressed interest in buyouts (possible those well over $4 billion) to expand the geographical footprint and broaden the product line makes sense. Thus, I strongly encourage preferentially buying a stake in Mylan alongside a more value-based stake in Teva.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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