The War on Drugs -- Inexpensive Generics, That Is (HITK)

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 |  About: Hi-Tech Pharmacal Co., Inc. (HITK)
by: Debra Fiakas

Hi-Tech Pharmacal Co., Inc. (NASDAQ:HITK) will release fiscal fourth quarter results on Wednesday , July 12, 2006 before the market open. A conference call is scheduled for the same day. We estimate EPS of $0.22 on $19.0 million in sales. The only other published estimate for the quarter of $0.11 EPS on $17.6 million in sales is substantially more conservative.

We expect sequentially lower sales as the April quarter is typically a seasonal low for the Company. However, we do not expect sales or earnings to be lower than the year-ago quarter when EPS were $0.21 on $17.6 million in sales.

The new, more aggressive tactics of Big Pharma to protect market share for their blockbuster drugs has the Street in a frazzled state as anticipated revenue streams for neither the generic drug developers nor Big Pharma appear to be reliable. In our view, the Street has over-reacted to the latest Big Pharma tactics. Furthermore, if the dramatic pullback in the price of HITK is in reaction to the Zoloft and Zicor news, we believe investors' concern may be off target.

We do not believe that the generic liquid and ointment therapies that are the focus of Hi-Tech's business model face the same threats from the owners of the branded versions by virtue of smaller market size. Hi-Tech has well established revenue streams such as the diabetic product line that are not directly related to the generic drug competition.

Hi-Tech's product line is composed of over a hundred generic and branded applications of otic, ophthalmic, oral and topical medications. At the current depressed price level for HITK, the market has discounted not only the potential in Flonase but all revenue streams. Indeed, our published estimates for 2006 and 2007 do not include any income from Flonase.

Thus the stock is now trading at 18.0 times earnings from the established product line - a compelling value in our view.

The pharmaceutical sector was roiled in recent weeks by the huffing and puffing of Merck (NYSE:MRK) over its cholesterol drug, Zocor. Zocor came off patent a couple of weeks ago and generic drug makers such as Teva Pharmaceuticals (NYSE:TEVA) have targeted the compound for generic versions. As the first generic applicant, Teva was expecting to have six months of market exclusivity with its generic version of Zocor. Status as first mover typically gives the generic drug maker some pricing strength as the market does not adjust immediately to the availability of generic alternatives to a branded drug. Merck has brandished a new weapon in the branded versus generic competition, by offering a substantial discount to UnitedHealth Group, Inc., a managed care organization.

Investors appear to be spooked by both Big Pharma's patent protection problems and generic drug companies' ability to compete effectively. We believe the uncertainty over future revenue streams for the generic developer will weigh on valuation metrics in the near-term. If the 'discount weapon' becomes widely adopted by Big Pharma, the fortunes of all generic drug developers could be adversely affected.

Our view is that each generic drug developer is uniquely positioned and merits individual attention. We believe there will be limitations to the extent to which Big Pharma will engage in such discounting of drugs coming off patent. We believe there will be a trade off between the reduction in revenue from discounts versus loss of market share to generics.

Some pharmaceutical companies may elect to record profits on lower unit sales rather than attempting to retain market share with discounted pricing that generates low or zero profit margin. A key consideration will likely be the market size since the benefits of aggressive discounting for the branded drug producer.

(We offer commentary on the recent erosion in valuation metrics in the generic drug sector in a new report on Hi-Tech Pharmacal dated July 3, 2006.)

Full disclosure: Author is long HITK

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