Going out of trouble – or running directly into it?

Teva is a multibillion pharmaceutical company, originally Israeli, now international, but Israel still feels close to. Two years ago the value of the company was estimated at $65 Billion.  It looks now like ancient times as its current value is estimated at $19 billion.

Teva is a sad story from which we all should learn. It reflects the problematic behavior of top executives, their megalomania coupled with personal fears and how they are dragged into gambling on the life of their employees.

The big problem of Teva started with a very big success with clear expiration time. The patent on a specific original drug that has contributed substantial profits was going to expire. This means profitability goes sharply down and this situation is quite frightening to people used to high bonuses.  Another threat to the executives was the possibility of a hostile takeover.  The “remedy” was to become bigger, with less excess cash, by purchasing more and more companies.

Teva operates mainly in the generic drugs pharmaceutical business, taking advantage of the expiration of patents of other drugs. To do well such a company needs to be truly agile, starting with coming up first with good replacements to drugs that just lost their patent, which gives them six months of exclusivity with the exception of the original drug producer. The second field of potential advantage is being truly good in managing the supply chain, ensuring no shortages while not holding too much surpluses.

Due to fierce competition the generic drugs business has to live with low profitability relative to the potential “easy profits” coming from few successful original drugs. This requires very high volume of sales backed up by smooth flow of products.  The need for excellent management of both R&D of new generic drugs and supply chain is as an ongoing burden on management in a field where clients have very low loyalty and reduced price is the key parameter.  It is a real must for such a company to keep highly competent middle-level managers in order to ensure stable financial performance.

The situation in the sad story of Teva was that the pressure of the time bomb and the threat of a takeover caused hysteria among top executives. Failing to come up with worthy new original drugs meant coming back to operate just in the generics market.  This is where the company, much smaller at that time, excelled in the past:  being truly great performer in the generics business.

Somehow Teva management believed that to stay successful enough after the expiration of the one key original drug was to buy a large competitor and become the largest producer of generic drugs in the world. Being the biggest still means just one-digit percent of the world generic drugs business.

This pressure to buy companies, showing momentum, becoming the biggest in the world and be relatively immune against takeovers has led to a series of very bad decisions. One of them was to acquire a Mexican company for only $2.5 billion just to realize that the company is empty and its real worth is zero.  Then Teva executives and board of directors decided to acquire Allergan, a large competitor in the generics manufacturing for $40 Billion.  After the purchase of Allergan Teva became the biggest with 8% of the generic drug market. Financing that deal created a debt of about $35 Billion.

This was a kind of a gamble that top executives should never take!

The simple meaning was basing the future of Teva on the HOPE that the market would behave as Teva wanted it to behave.

What actually happened in the market that disrupted Teva position is ironic. One of the reasons to become the largest supplier of generic drugs is to be able to dictate higher price.  However, many buyers of drugs in the US have collaborated to create bigger organizations that would buy the drugs for reduced price.  Here is an insight to digest: the idea that a big player is able to force the rules on the whole business area is open to both sides!

There are two common objectives for a company to buy a competitor, on top of upgrading the image of the executives and making the possibility of a hostile takeover remote:

1. Gaining a stronger position in the market to dictate better price.
2. Being able to reduce cost by cutting redundant jobs.

However there are also several possible negative branches:

1. Merging the operations of two different organizations calls for problems both companies have not faced so far, like a clash between two different cultures, managerial policies, middle-level management practices, language barrier and general reduced morale of employees because of too many unknowns.
   1. Note the possible negative impact on the performance of the accumulative supply chain.
2. Very high increase in the burden on several key executives and managers whose area of responsibility, including the number of subordinates, increased. Such increase might overload the capacities and capabilities of these individual managers. In other words, management attention constraints might emerge and cause a certain level of chaos.
3. Making CASH the constraint of such an organization. We in TOC can understand the ramifications, which are not obvious to non-TOC managers. A previous post by Ravi Gilani and I on cash constraints has appeared on this blog. The emergence of the new constraint can happen in two different ways.
   1. The company drains its own free-cash and line-of-credit to partially finance the deal.
   2. The company finances the deal by taking a big loan, hopefully to be returned from its own future profits. If the company would face difficulty to return the debt its very existence will be in jeopardy.

Not paying attention to deal with the above potential negative consequences and deciding unanimously to take such a clear big risk caused the collapse of once great and successful company. We, in TOC, should learn the emotional causes for such behavior and think how we could prevent such reckless behavior when we have the chance.

Up until now was brief learning on how a big organization chooses to go into trouble. Let’s now try to analyze what are the pitfalls when the company tries to get out of the trouble.

The common paradigm is: An organization in financial trouble needs to decrease its size.  This means either selling parts of the business or employing a massive “efficiency program”, meaning mainly cutting jobs, closing some facilities and moving them to cheaper locations. The common focus is on reducing costs not on increasing sales!

For Teva the potential alternative of selling the same company that purchasing it caused the trouble is UNTHINKABLE. Suppose that the former owners of Allegan are ready to pay $15 Billion to purchase their company back, in spite of the tougher market in generic drugs.  For the management of Teva the humility of the situation is unbearable.  Teva still needs to pay the $35 Billion in full.  But, they need to pay it anyway, even if Allergan does not produce enough profit to be worth more than $15 Billion.  Was such an alternative considered???

So, the solution that looks acceptable is being more efficient and this would, hopefully, bring enough cash to cover the loan, which is required in order to keep Teva alive.

The key assumption is that right now there are many places of inefficiency in Teva operations. By inefficiency I mean that there are costs that can be cut without reduction in revenues.  There might be cases where some functions could be closed because the costs are higher than the revenue they generate.  I assume these are minor cases.

It is relatively easy to calculate the cost saving of cutting 14,000 jobs (the number quoted in the media). It is not easy to fairly estimate the true impact on revenues.  However, the numbers that leaked out about the current efforts of Teva to stay alive are all about costs saved; nothing about revenues.

Think about it, when you evaluate an investment then estimating the generated increase in revenues is a must. But, when you decide to cut jobs then your assumption is that revenues would be kept at their current level.  When cutting jobs is done due to a significant decrease in the demand then the utopia is that it is possible to save cost just in the right amount required to serve the shrinking demand.  It is a flawed assumption in itself, but the case of Teva is different and it makes the assumption irrelevant.  The world consumption of generic drugs is probably not going down, certainly not by much.  The pressure to reduce price is what truly goes up.  So, Teva faces about the same demand for quantity, but its revenues go down.  If Teva ends up with less available capacity, due to massive job cutting, then revenues would go down much further.  What is the net of saved costs and reduced revenues?  Would this generate enough cash for returning the loans?

We in TOC are fully aware to the insight:

Operational excellence definitely requires excess capacity

The amount of excess capacity required to preserve the agility for gaining competitive advantage cannot be easily determined. In TOC we get signals, through buffer management, whether the current situation is about right or not.  I doubt whether any other methodology is better than that.

Cutting jobs reduces excess capacity, allow new bottlenecks to emerge and reduces the responsiveness to the market. The common act of moving the production from an expensive location to a cheaper location takes considerable time and expenses, especially in the pharmaceutical area.  But the real long term question is whether the cheaper plant can produce all the required quantity, including the quantity produced by the closed plant, while adhering to the agility standards of the supply chain.  If the answer is ‘NO’ or it might require substantial unplanned investment in additional capacity then the risk for future business is considerable.

Another devastating aspect is the ability to maintain the required high standards of middle-level management looking for the flow of goods throughout the supply chain.  Cutting jobs means losing substantial amount of middle-level management expertise.  How would the remaining middle-level managers be motivated to excel in what they do?  Are they going to try harder because of their gratitude for not losing their jobs?  Or they will learn from that experience to look actively elsewhere because they have lost trust in Teva management?

Instead of cutting x% of the manpower, organizations could offer all the employees a temporary cut in salaries in order to avoid the act, and promise that once the bottom-line reaches a certain point an automatic restoration of the previous salary would be done. There are negative branches to such an act, but in most cases they can be handled.  The upside is that the capacities and capabilities are kept intact and can be used to gain a competitive edge.

Throughput Economics provides superior tools to assess the bottom-line impact of moves like purchasing a competitor, or cutting high number of jobs. The distinction TOC is doing between Throughput (T) and Operating-Expenses (OE) helps to clarify what to consider in evaluating the net impact.

Eventually any company in crisis needs to improve its sales.  In the generics market it means managing the supply chain in a superior way to any other competitor.  This would allow creating real advantage in the market, by providing perfect availability everywhere in the chain, while holding lower inventories than the competitors.   This could open the door to improved VMI agreements and even opening the scope for Teva to take, in certain chosen locations, responsibility for the whole drug inventory for hospitals and other medical-care organizations, maybe even to some pharmacy networks.  This could be a viable vision for Teva and TOC has the tools to achieve it.