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>>> Taro Pharmaceuticals : A Beautiful Ugly Duckling


Jan. 28, 2014



http://seekingalpha.com/article/1972951-taro-a-beautiful-ugly-duckling?source=yahoo



Taro Pharmaceutical Industries (TARO), a maker of generic drugs, has all the hallmarks of a beautifully underfollowed gem: a boring business, a horrible website, coverage by a single analyst, few Seeking Alpha followers, a blizzard of irrelevant SEC filings hiding the useful documents, and zero self-promotion. Want flashy presentations telling you in a few pithy slides exactly how the business functions? Don't expect it from Taro. Nevertheless, despite appreciating dramatically since the prescient articles found here and here by Retail Investor, Taro has a wonderful business with good long-term growth prospects. For serious investors who believe that making money is more important than having conversation-starters available for cocktail parties, Taro is a reasonable and conservative investment with a present value of about $125.

Generics: a good business

At first glance, the generic drug business seems to be designed to be profitless. By definition, the exclusivity rights that make for blockbuster sales in the new drug business are absent in the generics business. The whole purpose of patent protection is to capture profits for inventors of valuable technologies and then, after a period of time has elapsed, disseminate the necessary information for other players to enter the business at lower cost to society. Governments are explicit in their desire to use generic drug manufacturing as a means of reducing healthcare costs. The generics business appears to be the worst business of all: a wretched commodity business where profits have to be skimmed at fractions of a cent per unit sales.

In reality, for well-run manufacturers like Taro, the generics business is intensely profitable with margins that many businesses would envy. Generic drugs are not a monolithic entity; they range from true commodity-type, mass-market pills like aspirin or acetaminophen to specialized formulations for niche markets with high barriers to entry and oligopoly pricing. Although Taro offers some products in the former category such as warfarin (an anti-clotting medication) or carbamazepine and derivatives (used for seizure control and trigeminal neuralgia), the bulk of Taro's product line is specialty dermatology products including steroid ointments and creams. The biggest seller is a combination of steroid and antifungal medication. A full listing of Taro's products can be found here.

The reason that the topical drugs favored by Taro have high margins is that FDA rules on bioequivalence create barriers to entry. According to a presentation prepared by the FDA, topical agents frequently have low blood plasma concentrations that render measurement of bioequivalence difficult. Consequently, manufacturers and the FDA rely on clinical endpoints to determine therapeutic equivalence. Frequently, these trials require hundreds of patients, sometimes even more than required for initial drug approval. While multiple competitors might be willing to perform such large trials for a drug with a potentially large market, only a few are willing to perform such expensive trials for drugs with relatively small markets. For niche drugs, the FDA's requirements inherently create oligopoly pricing and, hence, profitability for manufacturers like Taro.

A recent paper from the National Bureau of Economic Research addressed the development of the competitive landscape after loss of exclusivity for 6 drugs (Cozaar, Ambien CR, Plavix, Augmentin XR, Lipitor, and Lexapro). In general, drugs with huge numbers of annual prescriptions attracted significant competition with 12-15 companies in play. Augmentin XR, with prescriptions numbering merely in the thousands per month, attracted only 2 companies into the business. Review of the data from the NBER shows that while drug prices invariably fall after the loss of exclusivity, they by no means plunge toward the cost of manufacture (see Figure 1 of the NBER paper, page 32).

Taro: a growth company

Quantitative metrics for Taro's business are excellent. Prior to a recent share buyback, the company boasted a positive working capital of $869 million. The balance sheet is not inflated with the usual goodwill and intangible assets that obfuscate the reports of companies that have squandered shareholder money. Total liabilities are $250 million, of which $17 million is long-term debt and $216 million are routine payables. As expected for a company with this sort of financial strength, the Kamakura default probabilities are very low, comparable to Walmart's. The company has a 1.04% cumulative default probability over the next 10 years.

One of the most appealing aspects of Taro's business is the very long runway for continued growth. Taro is a large company (market capitalization of ~$5 billion) but small compared to other major generic manufacturers. Moreover, the number of drugs in Taro's stable is quite small: approximately 145 formulations covering roughly 41 different drugs. To say the least, this is a tiny fraction of the 1055 drugs approved for prescription use in the US. Every year approximately 60-100 new drugs come off patent according to data published by the FDA dating back to 1938. A trend in the past decade has been for new blockbuster drugs to be focused at orphan diseases. Due to the low numbers of prescriptions, this creates a long-term pipeline of minimally competitive drugs for niche generic makers to exploit. For rare diseases, the generic pipeline will be refreshed by highly profitable products. Taro reports that it has 19 drugs in the pipeline awaiting FDA approval, amounting to a potential increase of 13% in Taro's product line over the next 1-2 years.

Topline growth has been solid. Since 2008, revenues have grown from $327 million to an estimated $717 million for the fiscal year ending March 31st, for a compound annual growth rate of 14%. In the same period, earnings per share have grown from $0.76 to an estimated $6.92.



Note: The company changed its fiscal year to end on March 31 in 2012; revenues for FY 2012 reflect the first quarter only.

In the post-recession years, the growth has come from a combination of improving revenue and aggressive control over SG&A and input costs, with gross margins rising from 57% to 74% in the most recent quarter. Growth has not come at the price of cuts to research and development, which grew from $34 million to $54 million. These are the features of well-run business: more investment in future growth and progressively decreasing friction over time.

Taro has controlled SG&A while increasing its investment in future products.



FY

Cost of Goods

R&D

SG&A



2008

140

33.7

97



2009

147

33.3

100



2010

159

36.4

30.9



2011

176

30.9

94



2012

46

9.8

23



2013

176

46.5

86



2014E

185

54.2

86


When I see a company that has such an attractive profile, I worry that the books are not what they seem. However, I'm reassured that the balance sheet has been steadily growing year after year and that no money shuffle is taking place to disguise poor operations. As further evidence of a strong business, the company recently concluded a tender offer for $200 million, executed at $97.50 and amounting to 4.4% of the outstanding shares. Share buybacks are hard to fake.

Risks

Despite the favorable aspects of the business, there are nontrivial risks in Taro's business. The barriers to entry in its drug portfolio are high, but there is no intrinsic reason that a competitor could not step in at any time. Such is the nature of the generic drug business. A competitor in the generics business such as Teva (TEVA) or Mylan (MYL) could step in; or a hybrid brand/generics manufacturer such as Novartis (NVS) could expand its generic business; or other manufacturers could angle for a piece of the business. The only real limitations that block competitors are the fragmented markets for generics and the need for cGMP manufacturing facilities. Thus far, these two inconveniences have protected Taro's turf, but there is no guarantee in the future.

I'm always concerned when the voting power is tightly controlled by executives. In Taro's case:


Dilip Shanghvi and members of his immediate family (two of whom are directors of our board of directors) currently control, through their beneficial ownership of 65.9% of our outstanding ordinary shares and 100% of our founders' shares through Sun, 77.3% of the voting power in our Company. Dilip Shanghvi, along with entities controlled by him and members of his family, control 63.7% of Sun Pharma. Sun would be able to control shareholder votes requiring a majority of the votes.

Such concentrated control amplifies the conflicts of interest between management and minority shareholders. Extra scrutiny is required of such companies; in this case, the track record of Mr. Shangvi in creating value for shareholders year after year speaks for itself. In the future, however, on matters that come down to a shareholder vote, it is not clear that corporate actions will be aligned with minority shareholders rather than the personal interests of Mr. Shangvi and his family.

Another risk in Taro's business is the large size of the top 3 customers, who control 20.8%, 14%, and 12.2% of revenues respectively. Taro does not disclose the identities of those customers. Review of these customers' contributions to Taro's revenues over the past 4 years illustrates the degree to which variation in these large accounts poses a very real threat of decreased revenue to the company. The fractional contribution of these three customers has been trending higher over the past several years.

Looming in the background, there are a number of lawsuits initiated by Utah and Louisiana alleging that Taro and other generic manufacturers conspired to raise generic drug prices. These lawsuits are gradually moving through the courts and will probably be decided in the next 2-3 years. Based on the small contingencies taken by Taro relating to this litigation, the company estimates that they will have a near-negligible impact on the company. According to the most recent annual report:


Taro is a defendant in two actions brought against various pharmaceutical manufacturers in the States of Utah and Louisiana. The actions relate to drug price reporting by these manufacturers. In addition, Taro has received an investigative demand that also relates to drug price reporting from a third State. In May 2008, the State of Utah filed a lawsuit against the Company and a number of other pharmaceutical manufacturers and in November 2010, the State of Louisiana filed a lawsuit in state court against the Company and a number of other pharmaceutical manufacturers. Generally speaking, the lawsuits allege that the defendants caused the State to overpay pharmacies under the State Medicaid Program by reporting inflated published prices. The Utah trial court dismissed the case with prejudice in February 2010. However, in March 2010, the plaintiff appealed the decision and the Utah Supreme Court issued its decision in June 2012. The ruling generally affirmed that the complaint by the plaintiff is inadequate and the State was given leave by the court to re-plead its case, which it did. A motion to dismiss filed by the defendants in this case is currently pending before the court. In the Louisiana action, the parties are currently in the discovery phase of the litigation. Taro has responded to the investigative demand from the third state. During the year ended March 31, 2013, the Company recorded a provision of $30 million as management's best estimate of potential litigation and related costs to these AWP-related matters.

Although the litigation could theoretically result in large judgments, it is unlikely to fundamentally change the weak competition in Taro's business because the noncompetitive pricing is a direct side-effect of the FDA's regulations rather than a true conspiracy among drug manufacturers. The litigation appears to be a sideshow rather than truly jeopardizing the business. Additional minor litigation is reported by the company, but in my judgment none of it presents a serious threat to shareholder value.

Due to the presence of a large portion of Taro's manufacturing facilities in Israel, the company also faces significant geopolitical risk. A war in the Middle East or terrorist events could easily disrupt Taro's business.

The trade

I'm reluctant to highlight a company when it is trading near its all-time high. Nevertheless, there are several factors favoring entrance at the current time. Taro has an extremely small beta of 0.13. A wealth of academic research in finance suggests that investments in low-beta stocks tend to outperform a higher-beta portfolio over time. Aside from the risks mentioned above, there are no major negative catalysts in the near future. It may be possible to take advantage of the turmoil in the capital markets right now to buy the company in a moment of relative weakness due to market risk, but overall I do not see any company-specific risks that will allow investors to buy shares at a discount in the near future. Assuming a 6% annual growth rate in revenues (based on Taro's pipeline), 5% growth in SG&A and cost of goods, 15% annualized growth in R&D, 8% discounting rate, and future P/E of 15, I estimate that Taro has an intrinsic net present value of about $125 per share.

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