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Hi-Tech Pharmacal (NASDAQ:HITK) is a $450 million market cap manufacturer of prescription and OTC drugs. The company came public in 1992. It was founded by Bernard Seltzer, and is now currently run by his sons, David Seltzer and the very colorful and entrepreneurial Reuben Seltzer. The two now fill the roles of CEO, Chairman of the Board, President, Vice Chairman and Director.

On the surface, Hi-Tech has many of the hallmarks of a very safe investment, including:

  • a strong cash balance with nearly $6 per share vs. $33.32 share price
  • an apparently low PE ratio of 11x (trailing 12 mos)
  • a presence in a stable, counter-cyclical industry
  • a high level of management ownership
  • over 50 different drug products currently in the portfolio

However, a closer look reveals that Hi-Tech Pharmacal is a company beset by significant near-term problems from all directions. A notable lack of sell-side analyst coverage has meant that the significance of these problems has not been widely disseminated or understood by investors. Only one major sell-side brokerage covers the stock (Bank of America), which reiterated an "underperform" rating when the stock was at $31.00, however the coverage has been infrequent.

As soon as next week (when earnings are announced before market open on Thursday), Hi-Tech shares are likely to begin a rapid descent of at least 20%-30% and could subsequently stabilize at a level that is as much as 50%-60% below the current share price of $33.32.

These problems facing Hi-Tech are all described in detail below and can be summarized as follows:

As a relatively under-followed and closely held stock, the current share price in no way reflects the massive problems that are about to become visible at the company as soon as next week when Hi-Tech releases earnings.

Oddly, some shareholders seem to hope that Hi-tech will eventually be acquired by a larger player in the space. However massive ongoing stock sales by management totaling nearly $5 million in the past 4 months alone make me believe that this is highly unlikely to be in the works. An in fact, given that Hi-Tech's assets consist simply of the right to sell existing generic drugs, there is very little rationale for any pharma company to pay any type of premium to acquire these rights when it could simply acquire them on its own at no premium.

At the risk of stating the obvious, the potential impact of the Medicaid fraud investigations on the future of Hi-tech as a company far outweighs the impact of a single quarter's results. However given that the earnings release will likely cause a significant drop in the share price in just a few days, I will address that first below, followed by an analysis of the implications of the fraud investigation.

Part I: Q3 earnings next week will be nothing short of catastrophic

Hi-Tech last released earnings on September 5. The stock had closed on the previous day at $36.54, but upon announcement of a triple fumble by the company, the stock plunged as much as 17% to as low as $30.20, closing down 10% at $32.77. The triple fumble was a 15% decline in revenue, a 40% decline in net income and a 5 point drop in net margin, even on the dramatically lower sales. Hi-Tech had previously traded as low $27.31.

Since that time, the share price has rebounded slightly to $33.32 even though all of the issues contributing to the earnings collapse have actually gotten much worse rather than better. In general, the stock appears to trade in line with other generic drug makers such as Teva (NYSE:TEVA) and Mylan (NASDAQ:MYL), such that when those stocks rebound, Hi-Tech does as well, even when Hi-Tech's fundamentals are deteriorating.

Hi-Tech is scheduled to announce its next quarterly earnings next week on Thursday, December 6, before the market opens. It does not require an exceptionally sophisticated analysis to determine that earnings will once again be dismal, for the 5th quarter in a row. Anticipation of this fact, along with uncertainty over the Medicaid fraud investigation may well explain the heavy selling of shares, which has gone on by management as recently as October, at prices within around 10% of the 52-week low for the stock.

Just because a company's earnings are in a steady and persistent downtrend is certainly no guarantee that the trend will continue going forward. Instead it is of much greater importance to try to understand the underlying reasons for the downtrend and how those issues will evolve going forward. However, in trying to gain insight into Hi-tech's upcoming earnings release a trend analysis is a simple and useful place to begin.

These numbers reveal several extremely negative trends, all of which paint a very clear picture of the direction in which Hi-Tech is headed.

  • Revenue has effectively stagnated over the past 5 quarters
  • Net income has steadily declined in every single quarter, plunging 40% last quarter alone. Relative to last year, net income is now down 57%.
  • In fact, EPS is now down by a slightly greater 58% due to the impact of additional dilution coming from additional share grants to management during this time, even as results have deteriorated massively.

Quarterly results

Jul 12

Apr 12

Jan 12

Oct 11

Jul 11

Total Revenue

$52.0

$61.3

$55.6

$56.9

$56.2

QoQ change

-15.1%

10.2%

-2.2%

1.2%

Gross Profit

$25.3

$31.8

$30.7

$33.4

$33.2

QoQ change

-20.5%

3.5%

-8.0%

0.5%

Net income

$6.0

$10.0

$10.8

$13.8

$13.8

QoQ change

-39.9%

-7.6%

-21.6%

0.1%

EPS

$0.44

$0.73

$0.79

$1.04

$1.05

QoQ change

-39.7%

-7.6%

-24.0%

-1.0%

All numbers in USD millions, except per share amounts

Gross Margin

48.7%

51.9%

55.3%

58.7%

59.1%

QoQ change

-3.3%

-3.3%

-3.5%

-0.4%

Net margin

11.5%

16.3%

19.4%

24.2%

24.5%

QoQ change

-4.8%

-3.1%

-4.8%

-0.3%

Again, of much greater relevance is the underlying reasons why earnings have plunged so dramatically and how the situation is likely to evolve going forward.

Hi-Tech derives fully 42% of its revenue from a single product, fluticasone. The price of fluticasone has been subject to continuing downward pressure due to competition from other generic manufacturers and the entrance to the market place of a 4th new competitor selling fluticasone in early 2012. In addition, as competitors steal sales, Hi-tech's overall sales of Fluticasone have declined, even as the margin shrinks dramatically.

In fact, while Hi-Tech's revenue is clearly heavily dependent on this single product, its net income is in fact vastly more dependent on fluticasone due to the fact that each of Hi-Tech's other product divisions are not even profitable. The profits from fluticasone are needed to offset the losses in the other divisions and therefore account for well in excess of 42% of Hi-Tech's profit. This can be seen from this disclosure included in the company's latest 10Q, which details profit and loss per division. It should be kept in mind that fluticasone is part of the "Hi-Tech" division.

Hi-Tech

HCP

ECR

Other

Total

2012

Net sales

$45.9

$3.0

$3.1

-

$52.0

Operating income

$14.8

($0.7)

($1.8)

($3.3)

$9.0

2011

Net sales

$49.0

$3.5

$3.7

-

$56.2

Operating income

$23.7

$0.3

($0.2)

($2.9)

$20.9

The table above reveals the following information.

  • Sales within the "Hi-Tech" division, (which consist mostly of fluticasone and dorzolamide), account for 88% of total sales - meaning that the results of any of the other divisions are really just a rounding error to the financial results of Hi-Tech the company.
  • Both sales and operating income fell substantially for each of the four divisions without exception, including the "Hi-Tech" division.
  • The "Hi-Tech" division is now the only profitable division of the four, with the other three divisions losing a combined $5.2 million in just the past quarter alone.
  • For the "Hi-Tech" division, operating income fell by 38%, while for the other three divisions, losses increased by 105%

Hi-Tech does not give earnings guidance, however it did disclose on its conference call that:

We anticipate growth across our leading health care products, OTC product lines, and sales from the re-launch of Nasal Ease, the homeopathic allergy reliever. Additionally, we will get a full year of sales from our newly acquired Sinus Buster products, which we purchased in March. These factors will contribute to a double-digit growth rate for this division.

But again, this "double digit growth" is coming from a division that only accounts for just 3%-5% of sales.

The numbers above help to illustrate the disproportionate overdependence of Hi-Tech's net income of fluticasone and dorzolamide. For the past quarter, Hi-Tech's total sales fell by just 7% however total net income fell by 40%.

When that happened, the stock quickly dropped by as much as 17%, but has bounced back slightly. Yet we have already been told that this exact same phenomenon is going to be repeated with fluticasone sales and margins, so further dramatic stock price declines should actually be entirely expected.

On the quarterly conference call it was explicitly noted that:

We expect to see continued declines on our top selling Fluticasone product as a result of the additional competitor which came on the market in January

Other products which were acquired in 2011 and launched since that time have helped to slightly offset some of the dramatic declines in the two lead products, however their slow rate of market adoption and their tiny size relative to fluticasone and dorzolamide have kept their contribution to the overall bottom line negligible.

However the launch of an undisclosed "mystery product" has now been delayed from December 2012 until February 2013 at the earliest, meaning that any revenue bump we might see from the "mystery product" will likely not be felt until late 2013 at the earliest.

The importance of the product / revenue mix simply cannot be overstated.

Even if we assume just a 5%-10% drop in fluticasone revenues (which is likely conservative), we can expect to see EPS drop to just $0.30-$0.35, once again a 30% drop in just one quarter.

The continued drop in sales of dorzolamide will further exacerbate this, but to a lesser extent that fluticasone.

From a valuation standpoint, this "new normal" of EPS becomes extremely critical.

In looking at historical 12 month EPS, Hi-Tech appears to trade on a PE of roughly 11x, which would be expected for a company in the highly commoditized business of selling generic pharmaceuticals.

However in the same way that PE is misleading for high growth companies (where we must use a PE-growth metric), PE is also misleading for companies such as Hi-tech, who are in steady decline.

The historical 12 months PE calculation includes the following EPS numbers.

Jul 12

Apr 12

Jan 12

Oct 11

TTM Total

EPS

$0.44

$0.73

$0.79

$1.04

$3.00

Decline %

-39.7%

-7.6%

-24.0%

-1.0%

So Hi-Tech has earned $3.00 per share over the past 12 months, resulting in a PE vs. the current price of 11x. However even if we normalize that PE ratio going forward at $0.44, as was reported last quarter, the resulting PE over four quarters jumps to almost 20x earnings, implying that at these prices investors would require some type of substantial growth going forward, rather than steady decline.

And in reality, with both revenue and net income from fluticasone and dorzolamide in steady decline, if we normalize at a more realistic $0.30 per share (which we will almost certainly see next Thursday), the PE ratio jumps to nearly 30x earnings, which is clearly downright absurd for any commodity generic drug maker.

As this materializes, then a medium-term correction in the share price of at least 50%-60% should become entirely expected. And in the very near term (immediately following the earnings report), a share price drop of 20%-30% should be in no way surprising.

Based on sustainable quarterly EPS of $0.30-$0.40, Hi-Tech would be expected to trade somewhere around $12.00-$16.00.

Hi-Tech has made a number of substantial (and very expensive) efforts to diversify into other product areas, including into higher margin branded (non-generic) pharmaceuticals. As highlighted by management, the expected bright spots include Tussicaps, Nasal Ease, Sinus Buster, Dexpak and Bupap which should in fact show some revenue growth. However, as we can see from the table above, each of the other product divisions remains entirely unprofitable and the overwhelming dominance of fluticasone in their product mix ensures us that no amount of success (even massive success) from any other product will offset the steady decline in revenues and profits from fluticasone.

Part II: Medicaid (and possibly Medicare) fraud investigations have the potential to take the stock to single digits, a decline of more than 60%

In 2010, Hi-Tech and a subsidiary were named in a Massachusetts "whistle-blower" civil action alongside a number of other drug companies including Abbott Labs (NYSE:ABT), Mylan Inc , Teva Pharmaceuticals and Watson (WPI). As shown, the civil action states that the defendants "knowingly provided false information" in order to received inflated reimbursement from Medicaid and seeks triple damages along with additional civil penalties. Hi-Tech drug products identified as being submitted with false information totaled $46 million for 11 different products. In a revised complaint, Hi-Tech notes that its subsidiary was no longer named, only Hi-Tech itself.

Now, in June 2012, the Texas Attorney General initiated a separate civil action requiring Hi-Tech to preserve and produce all documents across 50 categories in connection to its Medicaid fraud investigation regarding price submissions for drugs to Medicaid.

Obviously it is important to note that there is nothing unique about the legal environment in Massachusetts, or Texas, nor is there anything unique about Hi-Tech's specific business practices in those states. So it seems quite safe to assume that the issues being raised in Massachusetts and Texas should be equally applicable to all 50 states and to the federal Medicare program as well.

In other words, Massachusetts, and Texas, should likely be viewed not as the only states taking action against Hi-Tech, but instead are just the first states taking action against Hi-Tech.

As a point of reference, Forest Pharmaceuticals, a subsidiary of Forest Labs (NYSE:FRX) paid over $313 million when it settled a similar whistle-blower suit under the False Claims act. And earlier this year, generic drug maker Actavis settled for $118 million for inflating drug prices for reimbursement. The point is simply that when the dollar amounts are large and triple damages become involved, the potential settlements can be enormous.

For those who are not familiar with the situation, Medicare/Medicaid fraud by drug companies (both large and small) has been downright rampant for years. The government seems to be unable to muster the resources to properly monitor and enforce the program on its own, and for a long time, submitting inflated prices to Medicare and especially Medicaid was very easy and seemed to carry no consequences. In an effort to combat this widespread abuse of the system, the Federal and State Governments have implemented a massive incentive for "whistle-blowers" to come forward with information regarding fraudulent practices by drug companies. The results for government prosecutors (and for whistle-blowers) have been nothing short of spectacular.

Under the "False Claims Act", the whistle-blower can typically receive 15%-25% of the amount that the government recovers from a fraud case against a drug maker, and the recent settlements have been in the hundreds of millions of dollars, creating a massive incentive for future whistle-blowers to come forward as well. And as would be expected, a wide variety of law firms have now sprung into action to specialize in handling these whistle-blower cases. Whistle-blowers have now received an estimated $3-4 billion in recovery money from False Claims Act lawsuits.

Not surprisingly, both the number and sizes of the whistle-blower cases are increasing sharply each year. In their 2012 Mid-Year False Claims Act Update, law firm Gibson Dunn states that,

Since January 2009, we have noted a nearly 50% increase in the number of new whistleblower matters filed with the Department of Justice (DOJ), along with FCA recoveries exceeding $11 billion. More than 760 new FCA matters were initiated in 2011, and 2012 is (not surprisingly) on pace to be the largest recovery year of all time.

During the first half of 2012, several other state lawmakers introduced bills to enact or expand false claims laws, which bills remain in various stages of the legislative process.

Gibson Dunn predicts a tremendous increase in state false claims activity as state attorneys general and private plaintiffs begin to take full advantage of these laws.

The incidents in Massachusetts, and Texas, do not appear to be isolated problems for Hi-Tech. In fact, just over the past two fiscal years, Hi-tech has had a series of run-ins with the FDA, and Medicare/Medicaid through the Federal government and several individual states. Even though some of these problems appear to ultimately have been resolved from a legal standpoint, the financial consequences ran into the tens of millions for Hi-tech due to forced discontinuation of products.

In just the past two fiscal years, Hi-Tech has had the following regulatory and legal conflicts which are still outstanding:

It is odd that despite this long history of expensive legal and regulatory problems Hi-Tech disclosed on its last conference call:

In August, the current quarter, we introduced Paregoric USP to the market. The product is unapproved; however, the FDA is aware that this being marketed for use in drug shortage and it is being reimbursed by Medicare and Medicaid. We are currently the only company marketing this product and believe it will be a good contributor to this year's generic business.

Because Paregoric contributes only a tiny percentage of generic sales, the risk of continuing to be the "only company this product" without FDA approval seems to arguably outweigh the small amount of revenue it will generate relative to the repercussions that this activity could have in the near term.

Part III: History of the Seltzer family fiefdom with Hi-Tech

Hi-Tech was founded in 1982 by Bernard Seltzer. When the company decided to go public in 1992, Bernard Seltzer appointed his two sons, David and Reuben, as board members, who then later evolved into management figures as well. The two brothers now simultaneously fill all the roles of CEO, Chairman of the Board, President, "Vice Chairman" and director of Hi-Tech. After serving for a stint as an associate at Hi-tech itself, a third brother, Steven Seltzer, has been responsible for "business development" for their other company, Marco Hi-Tech, in which Hi-Tech owns a 17% stake.

In years past, Reuben Seltzer was not particularly involved in Hi-Tech Pharmacal. Instead, he seemed to be focused on replicating the Hi-Tech model by taking a big stake in a small venture and then taking it public via reverse merger. Notably, Reuben Seltzer even chose to copy the naming convention used by his father, and named his new ventures Marco Hi-Tech and Neuro Hi-Tech.

Although not even an employee of Hi-Tech Pharmacal, Reuben Seltzer did act as a "consultant on special projects" to the company, in order to broker millions of dollars worth of investment by Hi-Tech Pharmacal into his own companies. As shown below, each of these ended up losing substantial amounts (up to 99%) of the principal. In exchange for these "consulting services", Reuben Seltzer was paid six figure consulting fees by his brother at Hi-Tech Pharmacal. Hi-Tech also picked up the tab for his automobile allowance and health insurance.

Reuben's Seltzer's first attempt was with Marco Hi-Tech, which was to specialize in "neutraceutical" healthcare products such as green tea from China. Here Reuben Seltzer assumed the role of CEO and President. Hi-Tech Pharmacal ended up investing in Marco Hi-tech, buying a 23.3% stake in the company as a "joint venture" despite the unrelated nature of the business. Hi-Tech then signed a guarantee of up to $1.5 million in debts for Marco Hi-Tech. At the time, Reuben Seltzer owned an identical 23.3% stake.

Hi-Tech's stake in "Marco Hi-Tech" has now declined to just 17% and over the years Hi-Tech has never realized any material income from the "joint venture". In 2011, this investment resulted in a loss for Hi-Tech Pharmacal of $174,000 and by 2012, the carrying value of the entire investment was down to just $213,000.

Marco Hi-Tech's only notable publicity seems to stem from an incident where it was sued by Pfizer in the U.S. District Court of New York. According to the lawsuit, Reuben Seltzer's Marco Hi-Tech actually forged a "letter of certification" from the Jewish Orthodox Union, the leading U.S. kosher-approval group, in order to state that its products were Kosher.

According to the lawsuit, Orthodox Union letterhead was used to make it seem Marco's grape-seed extract had received the group's stamp of approval, and was then sold to Pfizer. Pfizer ultimately reassured consumers that none of Marco's products ever made it into any Pfizer products, which were being sold as Kosher.

Marco Hi-Tech was ultimately combined into a reverse merger which completed a public offering as a newly formed "Neuro Hi-Tech", whose business was unrelated to both Marco Hi-Tech and to Hi-Tech Pharmacal. Reuben Seltzer was CEO and director. The company raised over $4 million in a private placement, but went bust within 2 years and now trades on the pink sheets as NHPI.PK for just $0.0003. As expected, Hi-Tech Pharmacal again invested in the going-public private placement. Hi-Tech still owns its stake in Neuro Hi-Tech, however the stake is now worth just $15,000 down from its peak of over $7.8 million.

For Reuben's most recent (and third) venture, EMET, Hi-Tech has already invested over $7 million, but this time Hi-Tech has oddly expensed it as R&D even despite explicitly describing this activity as "developing a generic product outside of its area of expertise". Hi-Tech continues to invest more each year in the EMET venture, despite originally stepping up for a large 50% stake.

Until 2009, Reuben Seltzer was not a direct employee of Hi-Tech at all, but instead was a simply a consultant on "new business development," where he was paid six-figure consulting fees to broker the deals into his own companies. However, following the implosion of Neuro Hi-Tech, in 2010 Hi-Tech formally hired Reuben to fill the somewhat ambiguous role of "Vice Chairman" at Hi-Tech. Since 2009, he has already received nearly $5 million in direct compensation, and has personally sold over $6.3 million in stock which he had been awarded in options. $11.3 million certainly seems like a very attractive payday for three years of serving as "Vice Chairman" of his brother's company.

He has sold 295,000 shares since his employment began, but has received additional options on 220,000 new shares during that time. Most recently, in October 2012 he sold an additional $1 million in stock, however he has already be awarded options on 100,000 new shares ($3.4 million worth of stock) in 2012 alone. He continues in his role as "Vice Chairman" today.

Part IV: "Ownership recycling" - Insiders have already sold over $56 million in stock, but management has simply given itself options on additional Hi-Tech shares to maintain ownership during this time.

The Form 4 filings by David Seltzer, Reuben Seltzer and Hi-Tech Pharmacal tell the story in a concise 1 page way for each party involved.

As shown in the links above, David Seltzer has sold 561,250 shares of Hi-Tech to realize proceeds of just over $15 million. During this time he has never purchased a single share, however he has awarded himself options on precisely 500,000 shares, effectively maintaining his ownership despite the $15 million cash-out.

Meanwhile Reuben Seltzer has sold 477,001 shares of Hi-Tech, bringing him $13 million in proceeds. During this time he has also never purchase a single share of Hi-Tech stock, but instead has been awarded 315,000 shares via options, again helping to maintain his ownership stake in Hi-Tech despite his 8 figure monetization. (Note, the only stock purchase Reuben Seltzer has ever reported on Form 4 was for $100,000 of Neuro Hi-Tech, the pink sheet traded company in which Hi-Tech invested and which now trades at $0.0003).

Also as shown in the links above, additional members of management and the board have also been heavy sellers, including Jack Van Hulst (director), William Peters (NASDAQ:CFO), Kamel Egbaria (Chief Scientific Officer), Gary April (President, HCP division), and Martin Goldwyn (director).

Together these insiders have also sold nearly $3 million stock just this year alone, while never having purchased a single share at any time.

All told, despite having only 12 million shares outstanding, Hi-Tech has awarded insiders over 400,000 shares worth of new options in 2012 alone, despite the 40% plunge in net income and stagnating sales which have been witnessed.

Conclusion:

Hi-Tech Pharmacal had a very profitable one-hit wonder with fluticasone for several years, allowing it to record revenue as well as profits, and propelling the stock into the $40-$50 range. However the "new normal" for Hi-Tech is one in which it must rely on its broader portfolio of lesser selling drugs to generate sales and profits. Hi-Tech will undoubtedly generate meaningful sales, and eventually some level of profit, from these other drug products and in the future the company may once again achieve a decent level of profitability. In addition, over time new product launches may help to begin an eventual growing of revenue once fluticasone finally bottoms out and stabilizes.

In the meantime, Hi-Tech is likely to see a period of several years where quarterly EPS in only in the $0.25-$0.50 range, which only justifies a share price in the $10-$18 range, at least 30%-60% below the current levels even if there is no fallout from the Medicaid fraud investigations that are now ongoing or from the FDA's latest Form 483 issued to Hi-Tech.

The consequences of the outstanding FDA issues, whistle blower lawsuits and Medicaid fraud investigations remain to be seen. However at the current price of $33.32 the share price is clearly not factoring in the reasonable risk of tens or hundreds of millions in payouts by Hi-Tech or of the risk to revenue that Hi-Tech products could be excluded from Medicare / Medicaid in the near future. If these events do materialize in any meaningful way, then the real downside in Hi-Tech stock becomes difficult to gauge, but certainly a share price in the single digits would suddenly not become at all unreasonable.

The stock is under-followed by research analysts and tends to trade along with the fortunes of larger, unrelated generic drug makers. As a result, it will almost certainly take some sort of catalyst before Hi-Tech begins its rapid descent.

The most likely catalyst for this sharp drop will be when earnings are released on Thursday, December 6, before the market opens and I expect to see the share price drop by at least 20-30% at that time.

The author can be reached at comments@pearsoninvestment.com

Source: Hi-Tech Pharmacal Set To Drop By 60% On Earnings And Fraud Investigations