Caraco Pharmaceutical: Underappreciated and Undervalued, Part 2

<< Part 1

The Financials

The Income Statement

Caraco’s (CPD) management has been conservative in making projections and has delivered beyond expectations.

In the 2006 annual report:

We believe that we will continue to achieve 25% to 30% revenue growth during Fiscal 2007 over Fiscal 2006.

• Net Sales for 2006: 82M
• Net Sales for 2007: 117M
• Increase in Sales: 42%

In the press release for 2007 annual reports:

Based on current trends and future realizations, we believe we will achieve a 30% growth in sales for fiscal year 2008, compared to fiscal year 2007.

• Net Sales for 2007: 117M
• Net Sales for 2008: 350M
• Increase in Sales: 200%

In the 2008 annual report:

Based on our own development pipeline and the current agreements we have with Sun Pharma along with other third party developers we believe we will achieve 25% growth in sales for Fiscal 2009, compared to Fiscal 2008.

• Sales for first 6 months of 2008: 76M
• Sales for first 6 months of 2009: 230M
• Increase in Sales: 202%

The company’s sales growth has been accelerating and future product pipeline is extremely strong. Between Sun Pharma and Caraco, there are 95 ANDAs awaiting approval. Caraco currently has 23 ANDAs awaiting approval.

The Balance Sheet

Caraco’s balance sheet has been free of long-term debt since 2003. The company currently has 33M in cash. Caraco has mentioned that it plans to use its strong balance sheet to make acquisitions. Given the tightening of the credit markets, there will be opportunities for Caraco to acquire companies that are struggling due to the credit crisis.

The company’s net book value is 161M. So you are buying the company for less than book value.

The Cash Flow Statement

For the 12 months trailing, Caraco had 40M in net profit. The CapEx for the past 12 months has been 18M, but in the last 6 months it has been 8M and 6M per quarter. Caraco is currently in the process of doubling its manufacturing capacity. So the CapEx are not normally expected expenditures. The CapEx for FY08 was 5M, FY07 was 6M, FY06 was 3.6M. So a FCF for the past 12 months is 22M (40M – 18M).

The company expects the expansion development to be completed at end of 2008. I expect the CapEx to get back to normal in 2009, expecting around 1-1.5M per quarter. If we apply the normal expected CapEx to the past 12 month’s CF from Operations (Caraco has negligible depreciation/amortization), we get a FCF of 34M (40M – 6M).

Valuation

I believe that currently Caraco sells at an extreme discount compared to its peers and valuations used in recent mergers and acquisitions.

Looking at valuations you don't need to look much further than Caraco's parent Sun Pharma. Sun Pharma recently offered to buy Taro Pharma (TAROF.PK), a generic pharma company, for .9x sales. If you apply a similar multiple to Caraco, you get a $10/share valuation. Also, Taro Pharma has substantial debt and is a turn-around opportunity for Sun Pharma. Caraco is in a much healthier position and has one of the best operations in the generic pharma sector.

	Caraco	Teva (TEVA)	Perrigo (PRGO)	Watson (WPI)	KV Pharma (KVA)
P/E Ratio	4	18.9	22.67	12.4	9.4
Price/Sales	.41	3.28	1.58	1.04	1.26
Price/CF (adjusted removes non-cash R&D expense)	6.6 (4.25 adjusted)	14.2	13.3	6.4	6.2

Caraco is attractive given the low P/E, Price/CF, and Price/Sales multiples. A Price/CF multiple of less than 6.6x for a company that is growing at 25%. The adjusted CF removes the non-cash R&D expense that the company had accounted for as part of the technology transfer agreement (Caraco transferred 544,000 shares to Sun Pharma for each ANDA that Sun Pharma transferred to Caraco). At adjusted Price/CF, you have the company selling at 40% discount to its peers.

In FY 08, the company had earnings of 35M. If you assume normalize CapEx of 5-6M, you get a company that is selling at 4.8x CF, and at 3.6x if you remove the cash. If you assume atleast an 8x of earnings, you are getting the company for half the price.

The generics industry is expected to grow in double-digits until 2011. The company has stated a 25% growth for current year. Let’s be conservative about the FY 2010 and 2011 growth rate and expect 15% growth. We assume that all sales increase have a 9% gross margin, and that 4% (of sales increase) hits the bottom line.

	FY 2008	FY 2009	FY 2010	FY 2011
Sales	350	437M	503M	578M
Net Income	35M	39M	41M	44M
CapEx	5M	22M	10M	11M
FCF	30M	17M	31M	33M
Cash	33M	50M	81M	114M
Sales Growth		25%	15%	15%
Gross Margin on additional sales		4%	4%	4%

The above projections use a fairly conservative growth of 15%. The company has been growing sales over 28% for the past 3 years, so 15% is a very conservative projection. I use the 25% growth estimate for FY2009, although the company is currently on a pace to grow much faster. Also, given the favorable conditions for the generic industry, I think the company can easily grow around 15% in 2010 and beyond.

For a terminal value, I expect the company to make a net income of 44M and growing in double-digits, I use a 12x of 44M. That gives a value of 529M and with 114M in cash, the company should be worth 643M. At the current price of 145M, it seems the market is throwing a pitch right in the middle of the plate.

Conclusion

With a large number of products in pipeline, a strong backing from a large pharma, zero debt, and solid balance sheet, Caraco is a fast growing company with large potential trading at an extremely cheap price. Caraco has the tools and the backing to compete larger firms on a large scale.

At current earnings, you are getting a high double-digit growth company, with a strong backing from a large pharma company, with over 20% of market cap in cash, and no debt for about 3x of current earnings (adjusted for cash).

Further Reading:

• Story on Sun Pharma’s acquisition strategies and future acquisitions
• Another analysis of Caraco:
• Investor Presentations
• Story of Dilip Sanghvi (Buffettesque CEO):

Disclosure: Long CPD

Comments

[Punter Patel:]

This will get acquired by SUNP eventually and SUNP has no interest in creating value in Caraco as it is not in its interest when time comes to acquire the remaining shares. Appreciate your detailed analysis though.

Aug 05 03:20 AM

[PlanMaestro:]

Very interesting idea. Why don't you comment on the FDA raid and its impact?

Aug 12 01:58 PM

[Pakiya:]

If SUNP decides to buyout Caraco, it will have to pay a premium to the current price. Caraco makes 20-25M in cash each year. At current market cap of 150M, you have a company with net cash of about 50M and making 20-25M per year. If SUNP wants to buy CPD, they will likely pay in double-digits.

It is not clear that SUNP will buyout Caraco. They are interested in expanding in US and have mentioned interest in doing another acquisition. Also, Caraco taking on debt is a sign that CPD might become another acquisition vehicle for SUNP.

Either way, CPD sells for much higher in 12-18 months.

Aug 13 12:28 AM

[Pakiya:]

there isn't much to say about the FDA raid. the company can't manufacture any drugs until it fixes the FDA issues. i think it will be 12-18 months before these issues are fixed.

SUNP has plenty of experience in FDA compliance. SUNP bought Able Labs when it had FDA issues and now the Able Labs plant is in FDA compliance and manufacturing drugs.

When SUNP invested in Caraco, CPD had FDA issues. SUNP got the issues fixed and CPD ended up w/ over 350M in sales.

The current trend with FDA compliance is that FDA has become very strict with the compliance issues. If you look at what is happening in the pharma industry, you got big pharma companies and small generic companies getting FDA compliance warnings. So part of the problem CPD faces is that FDA is more stricter than before. Although, CPD has the management team to fix these issues. Also, Sun Pharma's management team is very patient and looks at the long-term picture. They will get these near term issues fixed.

CPD recently signed a manufacturing and distribution deal with another Sun Pharma sister company. CPD will get access to ANDAs from this subsidiary which CPD will file with FDA for approval. These drugs will be something CPD will manufacture and distribute. CPD has 40%+ margins on drugs it manufactures, so the growth potential is strong. Also, Sun Pharma wouldn't consider doing this deal if it thought CPD couldn't get its FDA compliance issues fixed.

CPD recently signed a deal with Forest Lab to distribute generic versions of Forest Lab's drugs. Forest will manufacture them and CPD will distribute them. This should be in a 7-10% margin range, this should create adding cash and growth for CPD.

Any you look at it, at current prices you are getting the company for basically for book value (50M in cash and 60M in PP&E). Add the ability to make 20-25M each year and potential to grow in double-digits, there is no reason that company shouldn't be selling in mid-teens once the FDA issues are fixed.

Aug 13 12:37 AM

[CBrown:]

In addition to all of the analysis thank you for such a thorough & informative read.

Aug 13 02:20 AM

[PlanMaestro:]

One thing we could analyze on the FDA raid is the margin of safety if these issues are not solved.

- Will the licensing cash flow will be enough to keep breakeven while the manufacturing issues are solved?
- I read also about the job cuts. What will be the impact?

Sorry about so many questions, if you have a public email we can go through this together.

Aug 13 09:41 AM

[Pakiya:]

the margin of safety is the assets the company owns. CPD has about 50M in cash, 60M in PP&E, and owns over IP for over 25 generic products. at the current market cap of 150M you are getting 110M in hard assets. With the 25 drugs, about 18 are pending approval. I think the other 7 created revenue of roughly 50M a year. CPD has 40%+ margin on manufactured drugs, so it is safe to conclude that you can easily get 1x of sales on the 7 drugs. as for the 18 pending, there is atleast 1 where CPD has a potential for 180 day exclusivity on a branded drug. I think the branded drug had over 1B in sales. So you can put whatever valuation you want on just that 1 drug and I think you got a huge margin of safety.

CPD has said the licensing cash flow will allow it to cover its operating expenses. I can easily see that happening. Even after the FDA raid, CPD has taken over distribution for multiple drugs for Sun Pharma. Also CPD signed the distribution deal for generic versions of Forest Labs. Recently Sun Pharma got a shared 180-day exclusivity for a branded drug that had over 2.3B in sales. If CPD gets the distribution deal for the generic, CPD will be cash flow positive even while resolving the FDA issues. (There are some legal issues around when Sun Pharma might start manufacturing this generic version, but CPD has a very good chance of distributing the drug).

The job cuts should get the operating costs in line with the revenue generated with distribution. Basically the company is running on a slimmed version until it gets the FDA issues resolved. Once the FDA issues are resolved, CPD will hire the employees. CPD is located in a part of Michigan where there isn't much economic activity. So CPD doesn't have to compete for its employees. The biggest pharma company in Detroit area is Pfizer, and they were laying off people last year. So job cuts are a non-issue.

you can email me at pakiyafunds [at] gmail.

Aug 13 03:42 PM

[Marc Courtenay:]

The generic drug sector is very promising. This article and its thoroughness is very helpful. Thank you Pakiya

Aug 14 01:55 PM