Taro Update

Taro reported their latest quarterly results on Tuesday evening.  Despite the sharp increase in stock price on Wednesday, John and I have both changed our minds on this company’s prospects and thus have decided to sell. The thesis rested on a reliable business with a potential for acquisition by the controlling shareholder.  The reliability of the business provided the downside support to the valuation and the potential acquisition represented the upside potential.

Over the past 6-9 months, the entire drug space, specifically the generics has come under increased pressure from a variety of sources.  After reviewing both drug companies and their wholesalers, it is clear that this pressure isn’t abating and may continue for quite some time.  The numbers for the generic drug segments were surprisingly bad. Some were worse than others (TEVA for example), but all basically reiterated that the generic drug business is worse than they expected, and likely to get worse rather than better in terms of pricing.

Basically:

  • Prices for generic drugs are falling
  • These price declines are because of two main reasons
    • FDA is promoting more competition and making it easier for drug makers to get new generics approved
    • Buyers of drugs are getting more powerful (wholesalers are gaining strength, pharmacies are forming group purchasing organizations to get stronger buyer power… all this is used to get lower prices from manufacturers)

So, the FDA under its new commissioner is very focused on promoting competition among generic drug companies in an effort to bring more drugs to market at more affordable prices. Last year was a record year for generic approvals (around 600), and this year has already equaled last year’s number through 9 months (fiscal calendar). In June alone, the FDA approved 88 new generic drugs. They are removing red tape, expediting the approval process, and so making it easier for generic companies to bring drugs to market. They actually posted a list of branded drugs that have gone off-patent that have no generic equivalent (basically inviting companies to bring a competitor to market). Here is a clip from the FDA commissioner last month outlining a few of these objectives: https://www.fda.gov/newsevents/speeches/ucm567323.htm

And on the demand side, wholesalers (companies that buy drugs from Taro and resell to pharmacies) are competing for business among the smaller independent pharmacies by offering lower prices, and then in turn are going back to drug makers like Taro and forcing them to offer lower prices.

Companies like Taro and others seem to be getting the short end of the stick, and don’t have many other options, since their main customers are much larger and stronger than they are.

All of this was generally known by me up front, but I think I misjudged the severity of these headwinds. It’s just worse than I thought.

So I think for me, I felt like I didn’t have a good handle on where the business was going over the coming years. Taro is still one of the best generic producers, they have a great balance sheet, and good management, so it’s not going to be a disaster, but I felt like the risk/reward just changed to the point that it was probably more prudent to sell.

————–

Here are a few scenarios I outlined for what next year could look like.  These numbers are based on the most recent 12 months.

Last 12 months:

  • $746m sales (down 25%)
  • Operating income $397m
  • Net income $329m

Last quarter:

  • Last quarter revenues down 26%
  • Operating margin 52% from 62%
  • Gross margin 73% from 77%  (18 months ago, gross margins were above 82%)

Let’s outline some scenarios. At best, they’ll have the same margins (73% gross) as they did last year, and likely have the same opex (because volumes aren’t declining, which is one good thing).

Scenario: Sales drop 30% from last year and GM is 73%, and $157m opex is same:

  • $522 sales
  • $224m operating income (43% margin)
  • 20% tax rate
  • $180m net income
  • 40m SO
  • $4.50 per share earnings

At 12 P/E,  it’s worth $54. If we add the $40 per share cash, we get $94.

Scenario B: Sales drop 15% from last year, and GM is 73%, and $157m opex is same:

  • $634m sales
  • $306m operating income (48% margin)
  • $245m net income
  • $6.15 per share
  • At 12 P/E that is $114 including cash

The top line declines are likely to be in that range somewhere, and likely to be closer to Scenario A. Also, there is further downside because gross margin is likely not to stay at 73% if sales decline that much.

So upside is almost entirely gone (with some significant change of control premium in the near future), and while downside isn’t disastrous, the risk/reward just is not there anymore.

 


Matt Brice is the portfolio manager of The Sova Group, LLC. Matt can be reached at matt@thesovagroup.com. 

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