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Purchase of Allergan and Sale of Teva

June 22, 2016 – Excerpt from Q2 2016 letter to IMA’s clients

To talk about our purchase of Allergan we have to talk about sale of Teva – as you’ll see, they are very interrelated.  Our buy thesis on Teva was simple: it’s a dominant generic pharmaceutical company, and a large portion of its profitability comes from a drug, Copaxon, whose patent expired, though Teva was able to replace lost revenue with a new formulation of the same drug.  We stress tested different replacement-rate assumptions and felt comfortable with the margin of safety in the stock.  This part of the thesis played out as expected.  

However, Teva’s management grew impatient and bought a generic pharmaceutical business from Allergan.  Teva paid a pretty penny – $40.5 billion for a business that generates about $6 billion of revenue and less than 2 billion of profits – a very expensive deal.  We thought the price, in excess of 20x earnings, was very high – especially considering that Teva will have to issue $7 billion of its undervalued shares that have a P/E of 10. But we are even more concerned about the $30-plus billion of borrowing Teva would have to take on to complete the transaction.  

Suddenly Teva went from being a high-quality company to a lower-quality one – and we put Teva stock on “double secret probation.”  In the second quarter, Teva’s competitors started to report weak pricing on generic drugs.  Normally this data point would not cause us to react, but combined with a lot of leverage it was a catalyst for us to sell Teva shares.  

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Vitaliy Katsenelson

I am the CEO at IMA, which is anything but your average investment firm. (Why? Get our company brochure here, or simply visit our website).

In a brief moment of senility, Forbes magazine called me “the new Benjamin Graham.”

I’ve written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. (I’m working on a third - you can read a chapter from it, titled “The 6 Commandments of Value Investing” here).

And if you prefer listening, audio versions of my articles are published weekly at investor.fm.

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