Taro reported their quarterly results a few weeks back. If I had to write three to five pages on their earnings results, I might tell a few stories to take up the first four pages. There just is not that much new information in Taro’s reports or much excitement surrounding the quarterly ups and downs of a generic pharma company. For the excitement factor, L Brands would probably provide more view points to uncover…..
First, a few points of concern.
Revenue and Gross Margins:
Revenue declined approximately 14% y/y, but only 4% sequentially from the previous quarter (there is not a lot of seasonality in this business). However, revenue declined a similar amount from the Q2 2014 to Q2 2015 results, roughly 12%. The revenue declines are connected to competition entering highly profitable drug specialities. In these instances, I think Taro has become almost too profitable and attracts competition. Sandoz mentioned that they had left the market for one specific derm drug in 2013, but had re-entered that market in 2016 due to the increase in prices. In other words, there is a level of profitability where Taro attracts competition and it appears it might be right around 82% gross margins and 64% operating margins (i.e. really high). (Hopefully Sandoz does not want to enter the .com registry market)
Although I would much rather have 64% operating margins in perpetuity, the compressed margins do not impact the valuation of Taro substantially unless margins deteriorate significantly. For comparison, Akorn earns about 30% operating margins. If you apply those operating margins to roughly $900 in revenue (assuming continual revenue decline) for Taro, you get $270m operating earnings at a 10x multiple plus the 1.3B in cash, you have about a $105 stock price, give or take a few dollars. In that scenario, operating margins would have to get cut in half from here almost overnight and you still wouldn’t see much downside in the valuation. This also doesn’t factor in continued cash build between now and the future 50% downside in the operating margins. This is the back of the envelope margin of safety that we hope to find in an investment.
On the other hand, there were some “good things.” First and foremost, I think the endgame is playing out as expected. Sun Pharma is using Taro’s cash to buy out the remaining minority shareholders. However, given the ever-decreasing float, this effort has slowed somewhat. In the last buyback, Taro was able to buy about 1.8m shares over the course of 5 months in which 24m shares traded. In other words, Taro bought about 6.8% of the daily volume, which was about 242,000 shares per day. However, since the second round of $250m buyback started, the daily volume average has been roughly 160,000 shares, or a 33% decline in the volume. That being said, Taro has bought back 7.5% of the daily volume. In short, Sun does appear still committed to buying out the minority shareholders.
As a side note, there is no real difference to Sun whether it owns 70% or 90% of Taro. The only difference occurs when Sun reaches 100% ownership. Assuming this thought process is correct, Sun’s decision to move from 70% to even 71% (currently at 81.7% voting control) should indicate that they will continue to proceed to 100%, barring some unforeseen circumstance.
A few other points. Taro received approval for Acyclovir Ointment USP, 5%, but also indicated that their ANDA pipeline remained at 36 (instead of decreasing one upon the approval), so we can infer that Taro added another ANDA. The fact that this is a mystery or guessing game is only more indication that Sun does not want anything positively affecting short term price movements.
A quick note on the Acyclovir approval. The branded version is made by Valeant and comes in at a whopping $1,300, but there is only one other generic provider at this time, Mylan, who charges roughly $130 for the similar dosage size. In 2012, prior to Mylan’s introduction of the generic version in 2013, this drug did about $230m in annual sales. Given the pricing declines in the generic version, I imagine the market is probably between $40-$80m in annual sales with only one generic provider. This is a great example of Taro’s sweet spot. Taro will not drastically undercut Mylan at $130, but can still gain a significant market share at a slightly lower price point, all while still earning good gross margins. This is Taro’s sweet spot, two generic players at price points well below the branded version, but still operating in a rational market where profits are not competed away.
In summary, I think Taro is a great special situation. The business is a good one, providing real value to its end customers with little capital expenditure and highly cash generative. Additionally, we have a special catalyst in the form of Sun that will likely provide a premium to the current valuation in the next 12-24 months….