By Jake King
A price target reduction from RBC Capital Markets took $1.06 (or 3.4%) out of Endo Health Solutions (ENDP) Thursday, noting risks to the company's pain product, Opana ER. Apparently, RBC's analyst was absent from class the day that Endo reduced expectations for Opana ER down to levels well beyond expectations, and perhaps below reality. In early January, the company provided 2013 financial guidance well below analyst estimates, and as part of the outlook, ENDP stated that Opana ER sales this year are expected to fall by 20% vs. 2012's sales of ~$300 million. That guidance was pretty dismal, but smart investors knew that the numbers, including those for Opana ER, were likely sandbagged in an effort to reposition expectations from aggressive to conservative.
For RBC, this bearish analyst made a nice call down to $25, when guidance took 2013 numbers down, but now the story has moved on. As stated above, Opana ER's impact has been significantly de-emphasized and de-risked by highly (perhaps overly) conservative guidance, and, even better, the pressure of a generic Opana ER launched in January appears to be losing its bite (more on this below). Given the many news reports that ENDP is for sale and is engaged in talks to be acquired, and that a purchase by either Warner Chilcott (WCRX) or Valeant Pharmaceuticals (VRX) would be highly accretive to the buyer, we believe the stock is trading on those prospects -- not whether there will be a few more or a few less pennies from the contribution of Opana ER to EPS.
Investors can take advantage of yesterday's price decline in ENDP, and we expect the shares to recover from the decline and more as buyout speculators step back in. ENDP remains cheap (trading at just 6.6x 2013 EPS estimates) and, most importantly, an acquisition of the company in the $40/share-plus range is easily justifiable. The question is not how well Opana ER performs, but how long ENDP will remain independent.
Generic Opana ER's impact muted, scrutiny of Opana ER contribution not significant enough to derail buyout talks. In early January, Impax Labs (IPXL) launched its generic version of an old Opana ER formulation. This "generic" is not freely substitutable by pharmacists; therefore, a doctor has to write exactly for the old formulation -- otherwise, ENDP's Opana ER will be dispensed. It must be emphasized that significant erosion usually seen for brand drugs by generic substitutes is due specifically to the ability of the pharmacy to switch the brand for the generic, and in the case of Opana ER and its generics, that simply cannot happen. Thus far (about three weeks into the generic launch) prescription share for the new generic is just ~5% vs. a typical freely substitutable generic, which would have 70%-80% share by now.
ENDP's branded Opana ER is abuse resistant, and in addition to the lack of substitutability of Impax's product, some doctors, pharmacies, and health insurers are reluctant to drive use of the generic due to concerns over abuse potential. We estimate that Opana ER contributes roughly $0.35 to ENDP's current earnings base, and that any potential buyers of the company are very much aware of the risks to this component of earnings and cash flow. As a result, we believe that any buyout discussions taking place between ENDP and potential suitors will not break down because Opana ER may contribute a nickel less in earnings. In fact, Opana ER could contribute more than expected, given the company's conservative guidance and the softer-than-expected impact thus far from the new generic Opana ER.
Generic Opana ER has potential to be removed from the market, and this is upside to expectations. The recent negative RBC report notes that hopes for the IPXL generic to be pulled from the market because of its abuse potential may not be realized. Therefore, there is downside in ENDP. We should point out that the stock is priced, earnings are modeled, and investor's expectations are set for this scenario. No one is counting on the generic getting pulled from the market. It is simply upside to the story. Regardless, there is definitely evidence that FDA has become more sensitive to the issue of opioid abuse and the need for tamper-resistant formulations (TRFs). Therefore, the chances for generic Opana ER (as well generic Oxycontin formulations) being removed from the market have increased (see here and here).
In May, the FDA is expected to respond to ENDP's Citizen's Petition, which requests to have the generic product removed from the market because it's not tamper resistant and has a higher chance for abuse. Should that occur, it would be a great day for ENDP's stock or a great day for the acquirer of ENDP (if a deal is made prior). Nevertheless, generic Opana ER being removed from the market is upside to current expectations, and is not priced into ENDP at current levels.
WCRX said during its earnings call it will use stock to finance a value creating deal. Potential suitor Warner Chilcott hosted its earnings call Friday morning, and management of this company noted the many challenges that WCRX will face this year. WCRX shares are down in pre-market trading in sympathy with these comments and financial guidance significantly below Wall Street expectations. We believe that the call made it clear that WCRX needs to do something strategic, and that management is contemplating an acquisition.
Importantly, when asked by an analyst about the prospects for doing a "larger deal" and whether or not WCRX would prefer to use stock or debt, Warner management said "never say never" and that despite the depressed state of WCRX 's stock, it would consider using both stock and debt to get a major acquisition done if necessary. We continue to believe that an ENDP acquisition makes sense, particularly given the opportunity for WCRX to boost earnings by as much as 60% in this kind of transaction, based on our estimates. This morning's WCRX earnings call supports that an ENDP/WCRX combination may be in the works. (Replay number for the WCRX earnings call is (800) 585-8367, passcode: 93786400.)
Disclosure: I am long ENDP.
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