Changing the Prescription for Israel’s Teva

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When Erez Vigodman steps into the corner office at Teva Pharmaceutical Industries on February 11, he doesn’t come as a stranger to the company. He has been on the board since 2009 — experience that should hold him in good stead with leadership, employees and other stakeholders. Vigodman was brought in not as a pharmaceutical industry insider but as a turnaround specialist: His knowledge of the company is something experts say he will need if he is to chart an effective new strategy for the firm.

Vigodman’s arrival is not the only sign of change. In a letter to shareholders, chairman Phillip Frost detailed his plans to “review Teva’s governance including, among other things, the size and composition of the board.” Shareholders have been protesting that board membership is skewed towards Israelis. This has been a handicap for the international company, which is active in more than 60 countries and is among the global top 10 in its sector.

“I understand the challenges facing Teva, and I am confident that, together with the management team, we can address these challenges and deliver on our commitment to creating value for our shareholders by expanding Teva’s businesses and delivering long-term growth,” Vigodman said in a statement after his appointment on January 9. He replaces Jeremy Levin, who resigned in late October after a clash with the board.

Vigodman is regarded as Israel’s top manager and its foremost turnaround artist. He has overseen the recovery and subsequent expansion of two of the country’s major firms — Strauss Group in the food and beverages sector and Makhteshim Agan, a large agrochemical company that merged with ChemChina in 2011. “Erez has a deep understanding of the company and the industry in which it operates,” Frost noted in a statement.

During this expansion period, Teva not only became much bigger, but its own composition also changed because of Copaxone, a drug used to treat multiple sclerosis that became a big contributor to its sales and profits.

Most observers agree that taking the top job at Teva presents a significant professional challenge to the 54-year-old Vigodman. But an essential precondition for getting things right is to identify what has gone wrong at the pharma company, and that is a matter of fierce debate.

An Iconic Company

The widespread public interest in Vigodman’s appointment reflects Teva’s unique standing in the Israeli corporate environment. It is not the largest company in the country, nor is it the most profitable. But it is the only one in which large numbers of ordinary people — as well as, of course, every investment institution – hold shares over the long-term and regard those shares as a basic and permanent component of their investment portfolios. It is also the only major public company in Israel with an unbroken record of success stretching back over several decades.

But Teva has disappointed over the past few years and is now facing major challenges. The firm is not alone in its predicament but, because of its level of prominence, it attracts far more notice.

Teva’s problems have been compounded by unstable leadership and poor governance, critics say. It has gone through four CEOs in the past seven years, with Levin leaving following an argument with the board over how to implement his cost-cutting plan. In tandem with the search for a new CEO, one of Teva’s Israeli directors, Benny Landa, has led an internal campaign to overhaul Teva’s corporate governance structure by reducing the size of its board (from 16 members to 12) and bringing in directors with more pharmaceutical experience.

Generic but Unique

Teva’s roots go back to a company founded in Jerusalem in 1901, when the Ottoman Empire still ruled Palestine. But the future Israeli pharmaceutical industry was developed mainly by German-Jewish chemists and industrialists who arrived in Mandatory Palestine in the 1930s. The industry began to consolidate during the 1960s and 1970s, and Teva emerged as the largest and most dynamic firm in the sector, thanks primarily to Eli Hurvitz, who served as CEO from 1976 to 2002 and as chairman from 2002 to 2010.

Proponents describe Hurvitz as possessing a rare fusion of hands-on managerial ability and strategic vision, in addition to personal charisma, modesty and common sense. Eyal Desheh, who has held senior positions at Teva since 1989 culminating in a stint as acting CEO in the period between Levin’s departure and Vigodman’s arrival, says Hurvitz is the creator of today’s Teva. Asked if Teva could have developed in another country, Desheh replies: “If Eli Hurvitz had been born in another country, then yes.” Yet, as critics seek to place blame for Teva’s present crisis, there are fingers being pointed at Hurvitz, too: As chairman, he had a role to play in the management, particularly in giving direction.

In his CEO days, however, Hurvitz took Teva places. By the early 1980s, Teva had become the dominant pharmaceutical company in Israel and Hurvitz began to plan its expansion overseas. Key to that strategy was Teva’s expertise as a maker of generics; generic drug companies need a very different skill-set from that of companies that develop new drugs, primarily the ability to manufacture high-quality products at low cost. Given the company’s background and the labor force available, this suited Teva perfectly, observers note.

Opportunity knocked on Teva’s door when the U.S. Congress passed the Hatch-Waxman Act in 1984. The legislation created incentives for generic drug companies to challenge other firms’ patents, even before they expired, with the goal of reducing the cost of drugs in the U.S. Hurvitz positioned Teva to use Hatch-Waxman as its springboard to becoming a major player in the generics sector.

“Teva succeeded in its strategy,” says Steven Tepper, an Israeli analyst who has been following Teva for many years. “It not only worked really hard at getting its production costs down, it also developed considerable expertise in the legal aspects of the generic drugs business — how to be the first to file for generic versions of patented drugs [the law awarded a period of exclusivity to the first generic version, during which time profit margins would be higher], and how to manage the testing and licensing process. Later, Teva became adept at acquiring other companies and integrating them into the group.”

The strategy worked so well that today, Teva is the largest generic drug company in the world. Achieving this designation was a conscious decision on the part of Teva’s leadership: It was achieved via a series of large acquisitions over a five-year period, beginning with IVAX, an American rival bought for US$7.4 billion in January 2006; Barr (also in the U.S.) for US$7.46 billion in December 2008; German company Ratiopharm in March 2010 for US$5 billion, and Cephalon in May 2011 for US$6.8 billion.

“If you look at the performance of the biggest pharmaceutical companies over the past 15 years, you will see that almost every one of them had a prolonged period … in which its share price fell or [remained stagnant].” –Eyal Desheh

The purchases of IVAX and Barr made Teva preeminent in the American generic market. Ratiopharm cemented its position in Europe. The Cephalon acquisition was motivated by the need to buy a company that not only had strong existing products but also a pipeline of promising future ones.

The Rise of Copaxone

During this expansion period, Teva not only became much bigger, but its own composition also changed because of Copaxone, a drug used to treat multiple sclerosis that became a big contributor to its sales and profits. Copaxone had been developed by scientists at the Weizmann Institute in the 1960s, but almost 30 years elapsed before the U.S. Food and Drug Administration authorized the use of the commercial version in 1996.

Teva initially didn’t view the drug as a major plank in its business. The projections were for annual sales to peak at around US$250 million to $300 million, making it a profitable drug, but hardly a blockbuster. But Copaxone conquered the market — it generates global sales of US$4 billion and accounts for more than half the company’s annual profits.

This development is the key to understanding Teva’s trajectory over the past 15 years, and the emergence of major problems over the last three, observers say. Because Teva’s management didn’t expect to have such a successful product, they didn’t plan for it. The criticism has been that Teva’s management did not invest the profits generated by Copaxone in an optimal manner and that it failed to prepare for the day that this profit stream would dry up. Others say that explanation is overly simplistic, noting that the profits from Copaxone were used to fund the acquisitions with which Teva leapfrogged to the leadership position in the generics business. Cephalon was the only takeover that could provide a new drug to possibly replace Copaxone as a blockbuster. But, critics point out, it was too little and too late.

The numbers show how Teva has fallen from grace. In 2005, Teva was a much smaller company, with revenues of some US$5 billion and net income of US$1 billion, Tepper notes. Its market value was around US$29 billion and its stock price was in the low-to-mid-forties range. By late 2013, its annual revenues — thanks both to the acquisitions and internal growth — had swollen to US$20 billion and its net income had kept pace at US$4.25 billion. Yet its market value was only around US$33 billion to US$34 billion. Its share price, on an adjusted basis, was around US$40.

Share Price Peaks

Teva’s share price peaked in mid-2010 (at about $64). Then fears started surfacing about the company’s future profit streams. Investors realized that Copaxone’s patent would expire (at that time, it was expected to happen in 2015) and the drug would be “generified” by other companies. The roles would be reversed: What Teva had done so often to other companies would be done to it.

Meanwhile, more immediate threats to Copaxone were emerging, including orally administered substitutes. Furthermore, the generics market — still the bedrock of Teva’s activity — began to change. The 180-day monopoly status for the first generic version of a drug to be approved was beginning to erode. In Europe, the drug market saw pressure on prices as part of the continent’s economic crisis, and new competition began to emerge in the generic sector from Asian manufacturers. In the U.S., the generic drug cycle has shifted dramatically: A period of several years in which an unusually high number of important drugs reached the end of their patented period has been followed by several years in which the number of branded drugs losing their patents has or will decline sharply.

“If you wanted to take Teva apart, the sum of the parts might be perceived as higher than the current market value for the complete business.” –Steven Tepper

In another development, after losing to Teva in a long and hard-fought battle to acquire Ratiopharm, Pfizer achieved a revenge of sorts when, in June 2013, it won an even longer and harder-fought court case
over patent infringement by Teva. The settlement will cost the latter a hefty US$1.6 billion.

Inside the company, however, leadership doesn’t think it has been lax in management. Desheh says that the share price fall is quite natural in the pharma industry. It is a phenomenon known as the “patent cliff” — companies that own blockbuster drugs enjoy outsize profits from them but develop a skewed profit structure, with one or two products generating a large proportion of total profits. As the expiration date for the patents on these drugs approaches, analysts and investors adjust their expectations for the company’s future profits accordingly, and the share price “goes over the cliff.”

Teva, in Desheh’s view, is simply another victim of this phenomena, which often strikes drug companies precisely when they are at their peak. “If you look at the performance of the biggest pharmaceutical companies over the past 15 years, you will see that almost every one of them had a prolonged period — of as much as five to seven years — in which its share price fell or [remained stagnant],” he notes. Teva took an additional hit because a court ruled that the Copaxone patent would expire in 2014 instead of 2015.

Desheh says the patent expiration has already been factored into the price and not much downside is left. In fact, the appointment of Vigodman has been well-received by the market, pushing the price up toward US$45 and the market cap to over US$37 billion. In the meantime, the company has been developing other sources of revenue. The new strategy formulated by Levin is being implemented, despite the acrimony surrounding his resignation.

Three Pillars of Strategy

The strategy developed by Levin has three main pillars. The first, Desheh states, is to move from the stage of integrating new acquisitions into the company to the creation of “One Teva,” which will encompass all of the units within a seamless group. Achieving this also requires that Teva stop making major acquisitions and focus its managerial energies into absorbing those that have already been bought. This process involves eliminating duplication and therefore requires fairly significant layoffs, which Teva announced during 2013.

The second pillar is to focus on a few specific areas in which Teva has developed or acquired expertise, including neurology, particularly multiple sclerosis; women’s health, and aging and the diseases and syndromes related to it. How to address these areas is the theme of the third pillar, Desheh notes: To develop and market the new therapeutic entities (NTEs).

The focus on NTEs is itself a major strategic decision. These are not new drugs, which are based on new molecular structures and hence require years of development and testing, with all the risks involved. Instead, an NTE typically takes an existing chemical compound and creates a revamped, improved or more efficient way of manufacturing it or delivering it to the patient. For example, a drug for schizophrenia that can be delivered by an injection once every two or three months instead of weekly, or a product for people suffering from diseases affecting their breathing can be taken once a day instead of every hour.

In addition to the NTEs, Teva is developing its own new drugs, which are also targeted at its selected areas of operation. “During 2014, Teva will start selling six new specialty products — meaning those with new molecules,” says Desheh. “In addition, 10 other specialty products will begin the process of regulatory approval.”

The combination of new drugs and NTEs — some of which will reach the market by 2016 — is meant to fill the gap left by Copaxone going off patent in 2014. Desheh also points out that the demise of Copaxone is not a foregone conclusion because the drug’s complex structure makes it difficult to produce. Generic versions may not get to the market as quickly or as effectively as they have with other drugs.

Tepper echoes this point, noting that the market has now virtually written off Copaxone in its valuation of Teva, which may prove overly hasty. More generally, and in contrast to many of his local peers, Tepper is cautiously positive about Teva’s new strategy. “Given time, it should work,” he says. “But if they are in a hurry, other options could be tried. If you wanted to take Teva apart, the sum of the parts might be perceived as higher than the current market value for the complete business.”

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