Taro Update

There is no sugar-coating Taro’s latest results.  They weren’t great.  Here are a few thoughts, some specific to Taro and some general.

The first mistake people make when fooling themselves (remembering of course, that you are the easiest person to fool) is not to admit a mistake.  If you have a 50-year investment horizon, the best way to earn great results over that 50 years is not to shoot for 20% per year, but to make sure you don’t “blow yourself up” with a few big mistakes.  I (and John) need to seriously consider whether Taro is/was a mistake.  

So far, I am not fully there yet, however, I want to keep a very open mind and not be deluded by my own bias.  

The results from the past 6 months compared to the previous 6 months have declined from significantly.

Last 6 Months Previous 6 Months
Revenue $416 $463
Operating Income $230 $285
Margin 55% 61%
Cash $1,452 $1,339

Although the revenues and margins have declined, the cash balance has actually grown despite spending roughly $295m in buybacks over the course of the past fiscal year (since March 2016).

This business isn’t on the ropes yet….

Second, one of the biggest reasons for the pricing and margin pressures, if you read between the lines, is the consolidation in buying power among the large wholesalers and pharmacies.

Sales in 2015 went 48% to three drug wholesalers (I am assuming this Cardinal Health, McKesson, and AmerisourceBergen).  When the final 20-F for 2016 (10-K for foreign issuers) comes out in the next few weeks, I think this number will be higher (and the pharmacies category will have consolidated also).

The problem with an industry where you are supplying so few end users is that they develop fairly strong negotiating power.  This situation is technically called an Oligopsony, where there can be many sellers, but there are only a few buyers.  The buyers in the pharma supply chain are beginning to exert this leverage.  Despite only a few companies offering a particular derm product, the few buyers use their leverage (Hey, Taro, who else are you going to sell that drug to?)

Given the dramatic decline in margins and pricing, I can admit that I did underestimate the impact that the consolidation on the buyer side would have on Taro.

A note on special situations: this is clearly a special situation investment opportunity.  The unique issue faced in special situations is the underlying business operations sometimes have less of an impact on your thesis than the nature of how the situation plays itself out.  In this case specifically, I believed Sun would slowly acquire Taro.  Over the course of 2016, this appeared to be firmly the case, even through the first month of 2017.  However, the buybacks have slowed dramatically since.  There are two explanations for this.  First, Sun has changed their minds about acquiring the rest of Taro.  Or second, Sun/Taro’s buybacks in the first quarter had such an impact on the share price, moving it up from 105 to 124 in the first quarter that Sun decided it was not worth buying little amounts of stock and having such a large impact on the stock.  

The rationale for this second explanation and Sun’s thinking would be as follows:

  1. We want to buy back as much stock as we can without affecting the share price and once we hit the 90% voting control, we will be forced to pay a roughly 20% premium to the share price for the remaining shares.  
  2. However, our small amount of share purchases is driving up the share price such that we will initially move the stock 20% and then have to pay a 20% premium on top of that.  
  3. In order to avoid paying what is effectively a 42% premium (the 20% on top of the 20%), we will merely slow/stop the buybacks and wait to launch a bid for the rest of the remaining equity.

This rationale sounds very self-serving to support my argument that Sun is still interested in acquiring the rest of Taro.  I recognize this and am highly skeptical of my thought process here.  

To summarize, the results of Taro’s operations have declined more rapidly than I was expecting, however, at this point, the downside appears to be somewhat well-protected by the business operations, cash balance, and potential Sun acquisition.  However, the upside from here appears to have declined given the pricing and margin pressures.  I am still monitoring the situation closely and will keep a “short leash” on the idea recognizing that I could be wrong.

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