Look carefully, and there are signs that the generic drug industry’s long stock-market nightmare is ending. A poorly timed deal spree left the big players with too much debt as drug prices got hit, causing many stocks to fall by half or more.
Prices declined faster than usual because of consolidation among U.S. drug buyers and Trump administration policies that encouraged new generic drug applications, which creates more competition. Through August, the Food and Drug Administration had approved 719 applications in the current fiscal year, which ends in September. The agency approved 763 and 651 applications last year and in 2016, respectively.
That hit to pricing power came right as the largest manufacturers made expensive acquisitions. All of which resulted in too much debt and accelerated the fall in share prices. A Department of Justice investigation into price fixing throughout the industry added to the misery.
Even after a recent rally, shares of Teva Pharmaceutical Industries (TEVA) are down by nearly 70% from the 2015 high, while Mylan has dipped about 50% since then. But management teams have responded appropriately to the trouble. Measures included shutting down unprofitable drug production in the U.S. and using free cash flow to pay down debt.
Those measures have set the industry up for a rebound. For starters, three of the five largest U.S. generic drug companies will reduce their leverage to less than three times earnings before interest, taxes, depreciation and amortization by the end of next year, according to Randall Stanicky at RBC Capital Markets. That is important for investors; consider that Teva trades at less than 8 times forward earnings. Include debt however, and its valuation of 10 times earnings before interest, taxes depreciation and amortization looks more expensive.
While those moves have resulted in lowered short-term profitability, they have made it easier to generate growth in the future. As Mr. Stanicky, who correctly anticipated the sector’s downturn back in 2016, put it, “the result of the decline in earnings we have seen over the last couple of years is ultimately going to be a positive.”
And while generic approvals could set another record this fiscal year, the rate of growth has slowed from recent years. And applications, a leading indicator of future approvals, are actually behind last year’s pace.
Investors shouldn’t expect an immediate stock surge; for one thing, the price-fixing investigation is still open. And the sector likely needs more time to reduce debt before cash can be used for more productive uses, like stock buybacks or new deals.
But this time, patience should pay off: years of ugliness have helped create a much prettier picture.
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