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At Teva, Bigger Isn't Better: Why Acquisitions Are Ruining a Once Great Company

When Teva (TEVA) beat Valeant (VRX) to acquire Cephalon for $6.8 billion ($81.50/share ) recently, it was easy to get excited about Big Pharma's new kid on the block. Teva vowed to grow its revenues through acquisitions to $31 billion by 2015, making the fast-moving Israeli company that type that gets mentioned in the same breath as Pfizer (PFE), Sanofi (SNY) or AstraZeneca (AZN). Teva has grown speedily in the last few years. Since 2008 it has acquired Barr, Taisho in Japan, Ratiopharm in Europe, Corporacion Infarmasa in Peru and now Cephalon.

Unfortunately, bigger is not turning out to be better for Teva. As the company -- which has a lower profile than many of the big U.S. companies because it specializes in generic drugs -- has approached Big Pharma size, it has also taken on Big Pharma's problems: Its operating costs are growing faster than it revenues and show some signs of eroding its net income.

In short, the theory that once a drug company reaches a certain size there are built-in inefficiencies, or "diseconomies of scale," that no amount of cost-cutting can get rid of, is holding true for Teva. This chart shows the company's net income as a percentage of sales. (Note that the timeline runs from right to left -- that's the way Teva presents them in the extremely useful Excel spreadsheets it provides with its quarterly earnings statements.)

Profits are affected by many variables, of course, and declining profitability is not always management's fault. Having said that, Teva is having trouble maintaining a 20 percent-plus profit level when once it bounced around happily near the 30 percent level.

This next chart suggests why that might be. The blue line shows how many dollars of revenue Teva gets for every dollar it spends on sales and administrative costs. Back in 2007, before all those acquisitions, Teva got a handsome $5 or more for every dollar it spent running the company. Today it gets less than $4 -- roughly the same as all the other large drug companies. As Teva's revenues are going up, the declining blue line shows that sales/admin costs are going up even faster:

Because Teva is a generics company that does very little marketing, its largest expense is the cost of manufacturing its pills. The pink line shows how much gross profit (revenues minus manufacturing costs) Teva earns after every dollar spent on sales and admin. In other words, it asks whether the decline in Teva's efficiency is due to an increase in its sales/admin expenses or the cost of manufacturing. You can see that the gross profit yield has remained steady over time, suggesting that the cost of manufacturing is declining in comparison to Teva's admin costs.

It is not surprising that Teva's stock has declined recently, it always does when companies spend cash buying others:

But Teva's earnings-per-share has gone up as it adds the profits of other companies to its own. Increased EPS usually drives stock upward. So here is another signal that that the once nimble Teva is becoming just like every other company in the drug business: A slow-moving mammoth.


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