By Jake King
Reuters reported on Wednesday afternoon that, according to industry sources, Endo Health Solutions (ENDP) is in talks with potential buyers of the business. Our "Trouble is Opportunity" article, published in December (see article here), discussed that many times when a quality company runs into major issues, but has become over-discounted by the market, a chance to make good money can arise. Shares of ENDP were already rising since their December lows, and with the boost from the Reuters report, investors buying in mid-December when it looked like the world was ending for the company have made a 27% return. Part of our thesis was that ENDP would either get a new CEO or be sold, both good news and a chance for a major recovery in the stock from its depressed valuation. To us, the recent news should not be that big of a surprise, and an offer from one of the companies mentioned in the Reuters article, Valeant Pharmaceuticals (VRX) or Warner Chilcott (WCRX), seems plausible.
Other companies could also enter the bidding process like Abbot Labs' (ABT) recent pharma spin out AbbVie (ABBV) or potentially, Covidien's (COV) Pharmaceutical division, Mallinkcrodt, which is planned to be spun out later this year. Both of these drug companies need a new element to their story to facilitate growth and attract investors. Regardless of the near-term scenario, value is likely to be created from here, with ENDP shares still ultra-cheap in the low-30s. As a result, we believe there is a lot more room for the stock to run, particularly in the event that a take-out is announced. We agree with analyst estimates, which call for acquisition values averaging in the $40+ range, and with the shares trading at just 7.1 times 2013 EPS estimates, a potential buyout of ENDP is not fully factored into the stock.
Consolidation is a core Specialty Pharma strategy, Valeant could move quickly. Given the acquisitive nature of large specialty pharmaceutical companies, it seems only a matter of time before ENDP gets broken up or acquired buy another company. Companies like VRX, WCRX, ENDP itself, and others have driven growth through major acquisition strategies, a tactic widely appreciated by specialty pharmaceutical investors. VRX's CEO has notably stated that the company is in the early innings of its acquisition strategy and that future sales for Valeant could reach the $10-$20B range, as the company looks to further consolidate the industry. Interestingly, VRX has also said that "speed is one of our real strategic advantages" in pursuing acquisitions (see video here), suggesting that ENDP shareholders may not have to wait long to monetize their investment. In early January, we wrote that we wouldn't be surprised to see an executive from Valeant step up to the ENDP helm, or that Valeant might simply consolidate Endo as it has done successfully with so many other specialty pharmaceuticals in the last few years. That remains our thesis.
From an internal perspective, we know that ENDP's top executives and Board are working hard to please shareholders. CEO Dave Holveck announced that he would leave the company before his employment agreement officially ended, likely a response to external pressure for change. While Wednesday's chatter on an ENDP acquisition has yet to be confirmed, it seems all parties at ENDP, major shareholders, the Board, and management, are aligned in terms of repositioning the business or selling the company outright to maximize shareholder value as soon as possible.
Warner Chilcott and Valeant are logical suitors for ENDP. The Reuters report cited both WCRX and VRX as companies that are in talks with ENDP about a potential business combination. We believe there are four key reasons why these two companies make the most sense for buying the company.
- Both suitors have acquisition-driven strategies and the timing couldn't be better for serial asset-seekers to swoop in on an undervalued drug manufacturer.
- VRX and WCRX are both foreign entities, Irish and Canadian respectively, therefore the tax implications for buying ENDP are very favorable. A buyout could create instant earnings and cash flow upside to current estimates. Valeant has proven this strategy quite effective in "creating value" simply through a better tax structure.
- On top of the better tax rates, either VRX or WCRX could enjoy significant operating synergies by cutting ENDP's SG&A and R&D costs. The leverage from expense savings as well as better tax rates (above) suggest that an acquisition of ENDP by either VRX or WCRX could be substantially accretive to earnings for either party.
- Endo's American Medical Systems (business) was originally purchased by the company for $2.9B, and because both VRX and WCRX are pure pharma companies, these potential suitors could sell the AMS business for cash. This non-core divestiture could help either of these two companies pay for the ENDP acquisition.
Sum-Of-The-Parts valuations justify higher prices, but still may underestimate the consolidation opportunity. Several Wall Street analysts are publishing or re-publishing their sum-of-the-parts analyses on ENDP Thursday morning, with firms like UBS, Cantor Fitzgerald, Buckingham Research, and even Gabelli & Company offering valuations for the company in the $35 to $47 range per share. Importantly, these valuations are based on EBITDA multiple averages for similar businesses, and we remind investors that ENDP is more valuable to a VRX or WCRX because their lower tax rates enable outsized cash flow from acquisitions of U.S.-based businesses. Hence these valuation estimates are likely conservative. Even today's downgrade by Oppenheimer pegs ENDP at $32 a share, suggesting that downside in the stock is limited, and it may be worth staying the course to see if an actual bid materializes. Overall, we think the ENDP acquisition activity is real and that pain relief for shareholders is on the way. We continue to like ENDP and believe the shares can trade up to the mid-$30s while investors await the next, or perhaps the final, chapter in the story.
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