A company's costs structure can indicate how it adapts to changing market conditions. There is a correlation between its flexibility and ability to adjust its costs to market conditions, and the company's risk from a downturn. This flexibility is expressed as the ratio between fixed and variable expenses: the lower the ratio between fixed expenses (which do not depend on a company's business) and variable expenses (which depend on a company's business), the greater the flexibility, and vice versa - the greater the fixed expenses, the harder it is for a company to adapt to new conditions, and the effect on the bottom line will be much greater.
In other words, the effect on the bottom line from a downturn in business is a function on the makeup of a company's expenses (the fixed costs/variable costs ratio). An example of this ratio (albeit not exact) is the current condition of Teva Pharmaceutical Industries Ltd. (NYSE: TEVA; TASE: TEVA).
20 years ago, Teva, the world's largest generics drug company, developed a proprietary drug, which turned out to be a bonanza: Copaxone for the treatment of multiple sclerosis. Copaxone sales set new records every year, but the party is apparently about to end. From May 2014, Teva will likely face competition from generic Copaxone as well from the expected launch in the coming years of improved brand drugs by competitors. This follows the launch a few months ago of oral multiple sclerosis drug Tecfidera, made by Biogen Idec Inc. (Nasdaq: BIIB), Teva's longstanding rival and the first company with a multiple sclerosis drug.
Generic Copaxone and oral multiple sclerosis drugs are the two things scaring Teva's analysts and investors and undermining the share, which has had underperformed in recent years. They fear a substantial loss of Copaxone's market share along with a drop in prices, which will affect the bottom line. The analysts and investors are busy trying to estimate the effect on Teva's net profits. The obvious figure is the amount of Copaxone sales - over 20% of Teva's total sales ($1.05 billion out of $5.1 billion revenue in the third quarter of 2013), but its contribution to Teva's profits are uncertain.
There are various estimates - 50%, 60%, 70% - but it is impossible to know Copaxone's share of Teva's profits, partly because Teva discloses only partial information, and because it is impossible to really know which expenses can be saved when business is down. The theoretical assumption is that fixed costs cannot be cut; after all, they are fixed in all business scenarios. For example, Copaxone's production manager will probably continue functioning even if activity slumps, which suggests that there can be no savings on his salary costs, but if the manager takes on other products, it will be possible to save some of his costs.
It may not be possible to reduce fixed costs in the short term, but recovery/ restructuring plans, which include reductions in fixed costs, can be implemented in the long term. For the purpose of discussion, we'll stick with the theory that fixed costs cannot be reduced, but that savings are possible in variable costs. In practice, however, it is hard to estimate the composition of Teva's cost in general, and of Copaxone in particular. That said, there is enough information to realize how critical the product is for Teva's operations, and how hard it will be to fill the vacuum.
The terror of brand drugs
We will begin with the top line: Copaxone sales totaled $1.05 billion in the third quarter, and Teva's management said that the gross profit margin was 89.5%, which translates into a gross profit of $942 million (out of a total gross profit of $2.9 billion). The conversion into gross profit is straightforward: the product cost is $1 and Teva sells $10; a situation that reflects the product's strength, but also the great risk that generic companies entering the market will be able to slash the price, and Teva is aware of this. After all, it is the terror of brand drugs, but now the shoe is on the other foot. Copaxone's gross profit margin (84.6%) exceeds the margin of generic products (40.3%), which means that while the drug contributes 20% of Teva's revenue, its contribution to profits is much higher.
Teva's Copaxone report lists operating expenses: R&D costs amount to 1.2% of revenue, or $13 million; and sales and marketing costs amount to 11.8% of revenue, or $124 million. Teva does not disclose administrative and general costs, apparently for the simple reason that they cannot be directly attributable: are headquarters costs, such as the CEO, rent, and other items included in this expense, linked to Copaxone? To some extent, yes, but the proportion is uncertain.
Teva's administrative and general costs amount to 5.9% of revenue, and if we apply Copaxone's share of revenue, these costs total $62 million of the drug's share. Therefore, Copaxone's operating profit is $742 million, out of Teva's total operating profit of $1.33 billion; i.e. Copaxone accounts for 56% of the total operating profit. This is not the whole story: Copaxone's profits benefit from tax breaks compared with Teva's other products, which when translated into net profits, shows that Copaxone accounts for over 60% of the company's net profit.
This is a heavy 'burden', and explains the weakness in Teva's share, but does not yet explain how much the bottom line will be affected. Lower Copaxone income depends on lower costs, but it unclear which of them will disappear and which will not. In theory, were Copaxone to disappear altogether, the question is which of the abovementioned expenses can be eliminated in full. Even if we assume that R&D and sales and marketing expenses are eliminated in full, the extent of the savings in administrative and general expenses is uncertain.
In other words, the blow from Copaxone could be greater because Teva's management, in anticipation of the drop in Copaxone sales, embarked in the past year on a restructuring plan, which is due to save $2 billion when completed in 2017. If this works, it could be the cure for Copaxone.
Published by Globes [online], Israel business news - www.globes-online.com - on November 17, 2013
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