By David Moskowitz
It's not easy to do, but buying when there's blood in the streets is a way many have scored big on Wall Street. Take our recent call on Questcor Pharmaceuticals (QCOR) when the stock bottomed at ~$18 a share. The 50%-plus upside from that level (with perhaps more to go) didn't seem like a slam dunk at the time, but looking back, seeing beyond the immediate pain paid off in a relatively short period of time. Nothing was harsher than the global financial crisis in late 2008/early 2009, after which investors were able to make ~100% on their money by investing in the highest quality stocks in the world if they just had the discipline to buy when all others were panicking.
It all sounds good looking in the rear view, so today we are talking about a meltdown in real time that we believe can pay off with discipline and patience. The background for our thesis on Endo Pharmaceuticals (NASDAQ:ENDP) can be found in our prior article, and, notably, we were early and have been wrong on the stock by about 10% through Wednesday (likely to be >20% wrong at some point Thursday). Nevertheless, let's look at the stock with fresh eyes and think about how to make money using the "Trouble Is Opportunity" strategy.
ENDP Hits the Wall, CEO Leaving
Wednesday night, ENDP announced that it may not even make the low end of its recently updated 2012 earnings guidance (a range of $5.00-$5.10 per share), and that it no longer expects to achieve its just-established 2013 revenue and EPS guidance ranges of $3.0-$3.2 billion and $5.20-$5.40, respectively. New guidance for 2013 is expected to be communicated by the company in early January, likely at the JPMorgan Healthcare conference in San Francisco. The company also announced that David Holveck will retire as CEO and a member of the board in May, about a year and a half prior to his contract expiring.
While no guidance for next year leaves investors in the dark, and the stock will surely take a hit today, it's almost refreshing as the market clearly did not believe the prior guidance -- hence the stock trading at just ~5 times forward earnings (or about a 50% discount to the specialty pharmaceutical stock average). Several Wall St. analysts commented right after the news Wednesday night, taking credit for warning investors that guidance was too aggressive, and noting that the management change-up is a major positive. Key reasons that analysts did not like the story before were: 1) the company is set to lose its largest product (Lidoderm) to generic competition next year, 2) ENDP's next most important product (Opana ER) is not growing as expected and will face competition next year, and 3) company guidance did not appear to be capturing these and other risks. Looks bad, right? So the question is: What Now?
Looking Beyond the Trouble
The first word in evaluating ENDP as an investment is that the stock has been and will continue to be very "cheap," hence: 1) the market was already discounting a lot of the potential "trouble," and 2) lots of room remains for things to go wrong before significant long-term value is actually erased from ENDP's current share price. Let me repeat that analysts and investors knew that something like this could happen, as evidenced by ENDP's valuation. We stated in prior articles that ENDP, at just 5 times forward earnings guidance, was trading as if the market believed real EPS were going to be about half of what the company was anticipating. So with 2013 company guidance removed, the market is forced to set its own "guidance" for now, and price the stock accordingly.
To be conservative, we will suggest that ENDP management was wrong by one-third, hence instead of ~$5.00 per share in long-term earnings, let's say the company will only be able to earn $3.33 per share annually on a long-term basis. Using the specialty pharmaceutical peer group average of 10 times EPS, that means ENDP is worth $33 per share if one-third of earnings really goes away. Ironically, the specialty pharmaceutical analyst from BofA Merrill Lynch lowered his price target on ENDP from $38 to $33 on the news using a discounted cash flow (DCF) analysis on the business. So perhaps our rough estimate has some validity. Again, we believe our "one-third off" EPS guess is conservative, and, notably, the BofA Merrill analyst also states that his new DCF estimate and price target on ENDP may also be conservative.
So, in our opinion, based on our experience and backed by BofA Merrill's work, it makes sense to assume that the market will use a long-term EPS estimate of $3.33 until new information is obtained. Importantly, if the stock breaks to the mid-$20s today, that leaves over 30% upside on the table -- if the market truly believes the $3.33 EPS estimate. If the company comes out in early January with credible EPS expectations that are above the $3.33 figure, then the potential upside is even greater. We're not saying that the stock will instantly reward one who invests in ENDP's fallout today at a 30%-plus return, but we are saying that there is good downside protection if buying the stock in the mid-$20 range, and that there is also nice upside potential over the next couple of months, perhaps as early as January.
One thing is for sure: ENDP is more likely to "kitchen sink" new guidance when it is released, given its recent overpromise at its November analyst meeting. As a result, new guidance should have more credibility with investors. In other words, the market may be more willing to give the company a realistic P/E multiple on its EPS outlook, so now all we need is the company's new EPS guidance. For that we have to wait until January.
Seeing the Opportunity; Activism May Be Brewing
In addition to credible earnings guidance and a multiple of that to obtain a point estimate of ENDP's valuation, more corporate activity might be going on here with the CEO leaving 18 months sooner than expected. Our trader and investor contacts suggest that activism is brewing around the ENDP story, and several funds may be building positions in the stock in order to become more aggressive to "assist" the company in creating shareholder value. We believe that there is money that has been waiting on the sidelines to buy ENDP after the company announces more "realistic" guidance and perhaps brings new management in or pursues another strategy for shareholders to make money.
Support for the stock Thursday, after the shares have had a chance to fall, could come from new activist investors buying in, former investors who want to average down, short covering, and, of course, the company's own stock buyback program. In cases like ENDP's, where the stuff is hitting the fan, one can never gain perfect clarity on the way things will turn out. In this instance, we believe the market will assume the worst today with regard to future earnings guidance; opportunistic institutions will take advantage of others' pain and panic; and an activist mentality will begin to permeate the current shareholder base and perhaps attract new investors given the strong cash flow yield that ENDP can generate. From a company standpoint, ENDP's board now has six months to either find a rockstar CEO who can reposition the company to generate value, or pursue strategic alternatives such as selling the business for a premium. Both of those scenarios could be music to the ears of ENDP investors.
In the next day or so, the bad news for ENDP will be fully discounted into the stock, and that's when the story could get really interesting. We think the major fallout in ENDP Thursday will be short-lived, and that the shares could see a nice bounce, perhaps later Thursday, back to the upper $20s given the valuation and expected cash flow yield. To crystallize, reasons to get long ENDP on weakness include: 1) overhang of guidance being too high has been removed, 2) the stock is still cheap and new credible earnings guidance (expected in early January) is a catalyst, 3) the company buyback program and activist investor buying should get the stock off its bottom, and 4) a new CEO, potential for strategic alternatives, an attentive board, and activist investors is a good setup for value creation next year. Technicals suggest that $25.71 and $26.02 are points of major support, indicating that there are investors at that level willing to buy. Real longer-term value may take a little patience, and perhaps this will be one of those stories where some investors learn that bad news can signal a great time to buy.
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