Why Warren Buffett's Berkshire Hathaway loves loathed Israeli drug stock Teva

  • On Wednesday, Warren Buffett's Berkshire Hathaway disclosed a $358 million stake in Israeli generic drug company Teva Pharmaceutical Industries.
  • Teva is among the most heavily shorted stocks in the market. It has tons of debt, recently began a major restructuring, including mass layoffs, and faces expiring drug patents.
  • But it could be a classic value stock that fits Buffett's investment discipline.

After news hit Wednesday that Warren Buffett's Berkshire Hathaway had made a $358 million investment in Israel-based drug company Teva Pharmaceutical Industries, a skepticism lingered even as shares of the heavily shorted stock soared.

What does Berkshire Hathaway see in an out-of-favor drug stock that has languished — Teva shares have declined by roughly half in the past year — that the rest of Wall Street doesn't?

Maybe nothing special. And the size of the bet — at $358 million — is within the discretionary stock selling mandates of Buffett's hedge fund lieutenants, Ted Weschler and Todd Combs. But the bet is consistent with Buffett's long history of value investing, albeit with a twist.

Buffett has been associated with a few drug stocks. He is a longtime holder of Johnson & Johnson, though he has cut that stake significantly in recent years. He once held GlaxoSmithKline, and that was first purchased before he brought on the hedge fund managers, but was eliminated as a stock holding in 2014. And interestingly, the only ADR that Berkshire currently holds in its stock portfolio is an overseas drug stock, France-based Sanofi. It isn't a big stake — about half the size of the Teva buy, and it also has been reduced over time — but has been in the Berkshire stock portfolio for years.

Since the drug industry has not traditionally been a big focus for Berkshire, it suggests the investment is led by Combs, 47, and 55-year-old Weschler, the younger generation of stock pickers to which the 87-year-old Buffett has been giving more power over Berkshire's giant portfolio of stock bets, said Lawrence Cunningham, author of Berkshire Beyond Buffett: The Enduring Value of Values.

Warren Buffett, chairman and CEO of Berkshire Hathaway
David A. Grogan | CNBC
Warren Buffett, chairman and CEO of Berkshire Hathaway

But that doesn't mean the surprising stock buy doesn't fit into the classic value investing discipline that attracted Buffett to his stock-picking heir apparents in the first place.

"It's not classical Buffett, given the industry, so it's likely the younger investors,'' Cunningham said. "But it's classic Berkshire in being what some would call contrarian, though I would call it opportunistic. They invest capital in great businesses at a reasonable price, when others are negative enough to create those conditions."

Or in the famous Buffett words: When others are fearful, be greedy.

Most investors are fearful about Teva right now. It is among the top 25 most-shorted stocks by total share count, though that represents only 6.5 percent of its public float. Shares have already declined by more than two-thirds since 2015, and in the most recent weekly period, the short interest did decline by close to 7 percent. But even the perennially cheerful ranks of Wall Street analysts are less than thrilled about Teva's future, even after its massive share price decline — nine rate Teva shares a buy, but eight analysts call it a hold. On Wall Street it's not typical to see as many holds as buy recommendations, since holds are often interpreted as a "soft sell."

CNBC's Jim Cramer said on Thursday the move is interesting, given Buffett's new health-care alliance with Amazon and J.P. Morgan, but as far as a stock buy, he was shocked: "It is amazing that Warren Buffett goes for what I largely regard as the worst of the worst."

Israeli employees of Teva, the world's biggest manufacturer of generic drugs, hold placard during a protest in the centre of Jerusalem on December 17, 2017, against plans by the pharmaceutical giant to shed employees
MENAHEM KAHANA | AFP | Getty Images
Israeli employees of Teva, the world's biggest manufacturer of generic drugs, hold placard during a protest in the centre of Jerusalem on December 17, 2017, against plans by the pharmaceutical giant to shed employees

The company is also a lightning rod for criticism in its home country of Israel, where it is a major employer and faced recent protests after mass layoffs.

The bet is over whether heavily leveraged Teva can use cost-cutting to reduce its debt in the short term, while rebuilding a shaky product portfolio over time. Teva's CEO has already claimed progress in restructuring, though he cautioned that 2018 will be a challenging year.

The near-term problem is that Teva has $23 billion in debt, Sanford C. Bernstein analyst Ronnie Gal said in an interview. The company has been restructuring to cut costs because revenue is declining. Teva also faces expiring patents and generic competition on its multiple-sclerosis drug copaxone, which has had sales of $3.8 billion annually but is expected to drop to $1.8 billion this year, Deutsche Bank bond analyst Miles Highsmith said.

Having cut more than a quarter of its research-and-development programs and dropping a number of generic drugs from its product portfolio, Teva is betting on the cost cuts to help it reduce debt and reestablish the value of its stock.

A classic value play, or trap?

"It's a classic value situation,'' Gal said, who rates the stock a hold. "If you think they can make $3.5 billion to $4 billion a year in free cash flow to pay down debt, you buy the stock. If you think it's $2.5 billion to $3 billion, you sell the stock. If interest rates go up, they're in trouble because they have to refinance at higher rates. If rates stay low, they will be able to take down the debt."

Free cash flow in 2017 was $2.7 billion, according to Teva's financial statements. The company said last week that 2018 free cash flow will be $2.6 billion to $2.8 billion.

The company last week projected an earnings drop for this year, citing weak conditions in the U.S. generic drug market. This made already-skeptical analysts knock the shares anew.

"The $3 billion in cost cuts through 2019 are a necessary and effective address to near-term patent cliffs," RBC Capital analyst Randall Stanicky said in a note to clients. "But they do not solve Teva's growth problem, and we still think the bull case is overestimating medium-term growth given the multiyear period of lack of business-development support."

Buffett is betting on management's ability to steer the ship until it pays down debt, but will that be enough? Analysts like Stanicky prefer alternatives, including Mylan. He has made mistakes, but Buffett didn't get where he is without seeing things that others don't, at least much of the time.

By Tim Mullaney, special to CNBC.com

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