(Was Originally Published at Knowlegde@Wharton)
On 11 February, when Erez Vigodman stepped into the corner office at Teva Pharmaceutical Industries, he didn’t come as a stranger to the company. He has been on the board since 2009 and this exposure should hold him in good stead. Vigodman has been brought in not as a pharma man but as a turnaround specialist. His knowledge of the company is something he will need if he is to prescribe an effective new dosage for the global pharmaceutical major.
Moving someone from the board level to take executive charge doesn’t happen too often. In a way, it is an indicator of difficult days ahead. And Vigodman’s arrival is not the only sign of change. In a letter to shareholders, chairman Phillip Frost has undertaken to “review Teva’s governance including, among other things, the size and composition of the board”. Shareholders have been protesting that membership of the board is skewed towards Israelis. This has been a handicap for an international company, which is active in over 60 countries and numbers amongst the global top 10 in its sector.
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“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 after his appointment on January 9. He was chosen by a special search committee of his fellow directors and 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 which merged with ChemChina in 2011. This is why his fellow directors turned to him. “Erez has a deep understanding of the company and the industry in which it operates, ” says Frost.
Everyone agrees taking the top job at Teva is the 54-year-old Vigodman’s supreme professional challenge. But an essential precondition for getting things right is to identify what has gone wrong and that is a matter of fierce public debate.
An Iconic Company
The widespread degree of public involvement reflects Teva’s unique standing in the Israeli corporate firmament. It is not the largest company in the country, nor — even at its peak – was 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 them as a basic and permanent component of their investment portfolio. It is also the only major public company 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. It is not alone in its predicament but, because it has become an icon, it attracts far more notice .
Teva’s problems have been compounded by unstable leadership and poor governance. It has gone through four CEOs in the past seven years, with Levin leaving after an acrimonious row 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 to 12) and bringing in directors with more pharma experience. Some believe Landa’s ultimate target is Frost although the latter, ironically, is a genuine “pharma guy”.
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 thirties. The industry began to consolidate during the sixties and seventies, and Teva emerged as the largest and most dynamic firm in the sector – thanks primarily to Eli Hurvitz, who led it as CEO from 1976 to 2002 and as chairman from 2002 to 2010.
Hurvitz possessed a rare fusion of hands-on managerial ability and strategic vision, and personal charisma, modesty and commonsense. For Eyal Desheh, who has held senior positions at Teva since 1989 culminating in acting CEO in the period from Levin’s departure and Vigodman’s arrival, Hurvitz is the creator of today’s Teva. Asked if Teva could have developed in another country, Desheh shoots back: “If Eli Hurvitz had been born in another country, then yes.” Yet, in the 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, Hurvitz took Teva places. By the early eighties, Teva had become the dominant pharmaceutical company in Israel and Hurvitz began to plan its expansion overseas. This required Teva to use its expertise as a manufacturer 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.
Opportunity knocked on Teva’s door when the U.S. Congress passed the Hatch-Waxman Act in 1984. This created incentives for generic drug companies to challenge other companies’ patents, even before they expired. The legislators’ goal was to reduce the cost of drugs in the U.S. and Hurvitz positioned Teva to use Hatch-Waxman as its springboard to becoming a major player in the generics sector.
“Teva succeeded in its strategy, ” explains 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.”
Largest in the World
The strategy worked so well that today Teva is the largest generic drug company in the world. But this didn’t just happen; it was the realization of a conscious decision. 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.
The purchases of IVAX and Barr made Teva pre-eminent 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 merely became much bigger, but its own molecular composition also changed because of Copaxone – a big contributor to its sales and profits. Copaxone — effective in blocking the development of multiple sclerosis — had been developed by scientists at the Weizman Institute in the sixties, but almost 30 years of difficult work elapsed before the U.S. Food and Drug Administration authorized the use of the commercial version , in 1996.
Teva initially didn’t view it as a major plank in its business. The projections were for annual sales to peak at around US$250-300 million – profitable, but hardly a blockbuster drug. In the event, Copaxone conquered the market; it generates global sales of US$4 billion and accounts for over half the company’s annual profits.
This extraordinary development is the key to understanding Teva’s trajectory over the past 15 years – and the emergence of major problems over the last three. 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. That’s simplistic. The profits from Copaxone were used to fund the acquisitions, without which Teva would not have leapfrogged to leadership of the generics business. Cephalon was the only takeover that could provide a new drug to possibly replace Copaxone as a blockbuster. But, say critics, 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, ” says Tepper. “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
The share price peaked in mid-2010 (at over US$60). Then fears started surfacing about the company’s future profit streams. People realized that Copaxone’s patent would expire (at that time, it was expected to happen in 2015) and it 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 is being eroded. 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 turned: a period of several years in which an unusually high number of important drugs reach 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.
In another development, after losing to Teva in a long and hard-fought battle to acquire Ratiopharm, Pfizer had its revenge 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, they don’t think they have 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 expiry 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 dreaded disease, which 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 trod water, ” he says. Teva took an additional hit because a court ruled that the Copaxone patent would expire in 2014 instead of 2015.
Desheh feels the patent expiry 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 (or dismissal, as some like to put it).
Three Pillars of Strategy
The strategy has three main pillars. The first, explains Desheh, is to move from the stage of integrating new acquisitions into the group to the creation of ‘One Teva’ which will encompass all the units within a seamless group. Achieving this also requires that Teva stop making major acquisitions and focus its managerial energies into absorbing all those that have 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. These are neurology, particularly multiple sclerosis; women’s health; and ageing, with the diseases and syndromes related to it. How to address these areas is the theme of the third pillar: 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-three months, instead of weekly, or a product for people suffering from diseases affecting their breathing, which 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 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 usually happens.
Steven 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 concludes. “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.”