In this article, we will explain why Taro Pharmaceutical (TARO) will likely be re-valued in the market. We believe the revaluation will happen both due to multiple expansion and earnings expansion, as TARO begins to use its huge cash hoard (estimated to be about $640m by end of June) in business development and inorganic growth opportunities. We believe TARO is a very attractive opportunity for value investors.
For those that are new to TARO, here is a brief background and some assorted relevant facts. TARO is 66% owned by the controlling majority shareholder, Sun Pharma. In the past, the majority shareholder has unsuccessfully tried to buy out TARO's minority shareholders, at prices that many believed were extremely inadequate. Israel has strong protections built in for minority shareholders. TARO has a number of active shareholders, including institutions like Iszo Capital, Raging Capital and a grassroots group of retail shareholders that calls itself "United Shareholders of Taro".
TARO currently trades at 5.21 times TTM EBITDA. Even if 50m of the TTM EBITDA of 380m was at risk due to pricing opportunities that may not sustain (Nystatin/Triamcinolone was 14% of TARO's fiscal year 2013 sales), TARO is still valued at <6 times EBITDA. No other product other than Nystatin/Triamcinolone in TARO's diversified basket of 180 products makes up for >10% sales. Below is the excerpt from its 20-F:
"Approximately $106.9 million relates to price adjustments on six prescription generic products, which represented 28.9% of consolidated net sales for the year ended March 31, 2013 and 16.0% in 2012, including Nystatin/Triamcinolone ("N/T"), which represents approximately 14.1% of consolidated net sales in 2013 and 5.7% in 2012. We were the exclusive supplier to the market of N/T during the year ended March 31, 2013. Subsequent to year end, analysis of market data indicates that competition has re-entered the market resulting in a decline in our sales of N/T. No other product represents more than 10.0% of consolidated net sales."
Here is an excerpt from March 6k filing which indicates many of the price increases for other products have sustained:
"Approximately $27.0 million of the increase resulted from price increases on seven dermatological topical products. These seven products represented 24.6% and 8.1% of consolidated net sales for the three month periods ended March 31, 2012 and 2011, respectively. None of these products individually represented net sales constituting over 10% of our sales on a consolidated basis for the three month periods ended March 31, 2012 and 2011. For the period ended March 31, 2012, pricing opportunities existed given these products were, and continue to be, cost effective to patients compared to a number of alternative treatment options available in the market.
The key words above are "continue to be", which implies price increases for these products have sustained until March 2013, the time of this filing.
Besides in this low competition and high technical barrier to entry business, one should not disregard future pricing opportunities in TARO's 180 products that may not be fully exploited yet or that may arise tomorrow, due to competitor FDA compliance issues or voluntary exit of competition for economic reasons.
Also, TARO in April launched its proprietary Topicort 0.25% spray, an exciting new product in the $100m corticosteroid spray market. TARO currently has 22 ANDA's awaiting FDA approval.
This year, Agila specialties, a generic pharma from India was acquired at 18.6 times EBITDA. There is no shortage of acquisitive companies in the dermatology drug industry. In our opinion, Valeant (VRX), Actavis (ACT), Perrigo (PRGO) will easily offer EV/EBITDA multiples in the range of 15-20 for an unique and an hard-to-replace asset like TARO. An acquisition with a specialty pharma like Valeant will easily fly by with no FTC issues. However to be conservative and to demonstrate the prevailing highly favorable reward/risk, below we will use Bloomberg's Median EV/EBIDTA multiple of 14 for M&A transactions in pharma industry.
|Enterprise Value/ LTM EBIDTA Multiple||14|
|Implied Enterprise Value||$5320|
|Implied Market Cap||$5932|
|Implied Value per Share||$133.3|
|Earnings Growth due to Acquisitions||?|
|Earnings Growth due to the Impact of EU-Israel Treaty||?|
|Earnings Growth in today's under-penetrated International Markets||?|
Estimated cash by end of June 2013.
All numbers shown are approximate.
Please note TARO's international sales (ex-USA, ex-Canada, ex-Israel) was at 1%. The above valuation does not factor in any potential upside of taro's sales in today's under-penetrated international markets(Europe, Australia, New Zealand, Russia, Japan, South America, South Africa, India and China), which we believe could offer another hidden upside to TARO's valuation.
Why is an earnings expansion likely?
In June, SUN agreed to a $550m settlement in the patent infringement case with Pfizer (PFE) and all of that cash has to be disbursed by the end of the year. This will significantly reduce SUN's non-taro cash position and SUN's ability to acquire companies. Although SUN can report 66% of TARO's cash on its balance sheet, SUN still does not have access to any of it.
So, why could a cash reduction in TARO's majority shareholder be a serendipitous event for TARO's minority shareholders?
Following are the reasons we believe that the above event is good for minority shareholders of TARO:
1. First, it reduces the likelihood of SUN coming up with another offer for TARO's minority. SUN historically has used cash(not debt or stock) to make acquisitions. While SUN can still use TARO's own cash to buy out TARO's minority, it simply would not be enough.
2. Second, since SUN no longer has the cash wherewithal to make acquisitions (Sun was in acquisition mode buying URL pharma, DUSA in the last year alone), and since TARO is cash rich, it will likely have to use TARO as a vehicle to make acquisitions.
3. Third, TARO in its most recent filing has stated it will not use cash to pay dividends, which we believe is desirable as dividend pay-out is a tax event.
Below is an excerpt from the 20-F:
"Dividend Policy: We have never paid cash dividends and we do not anticipate paying any cash dividends in the foreseeable future. We currently intend to retain our earnings to finance the development of our business, but such policy may change depending upon, among other things, our earnings, financial condition and capital requirements."
Sunshine is the best disinfectant: Shedding the spotlight on cash, leverage and acquisitive growth in the dermatology drug industry. Why it behooves TARO to grow earnings by making acquisitions?
TARO, compared to its peers and its own working capital needs has a disproportionately high amount of cash and disproportionately low ($28m) amount of debt. It behooves TARO to look at its peers to grow inorganically and opportunistically increase its dominance in this niche generic industry which over the last 3 years has witnessed a great degree of consolidation.
Leverage and Acquisitive Growth in the Dermatology drug industry
|Number of acquisitions in last 3 years||8||5||4||25||0|
Source: Yahoo Finance on 06/23/2013
Here is an incomplete listing of acquisitions by major competitors in the last 3 years alone.
- Perrigo: Paddock lab ($543m), Rosemont ($283m), Sergeants ($285m), Cobrek ($45m), Velcera ($160m), PBM holdings ($808m), Orion ($48m)
- Mylan (MYL): Agila ($1.6b), Unichem ($30m), SMS Pharma ($33m), Bioniche ($550m).
- Actavis: Ascent Pharmahealth Ltd, Warner Chilcott, Watson, Uteron Pharma SA
- Valeant: Listing of acquisitions
- Taro: None
It is our view that by using its estimated $640m cash (estimated by end of June) and taking on $500m debt, TARO easily has the capacity to expand its earnings by a further 100m-150m and yet command a leverage ratio of less than 1, well below its market peers. Depending on the pricing of the acquisitions and the expected synergy savings, we believe this would provide further upside to TARO's shareholders.
Please note ordinarily, for such an undervalued stock, a stock buy-back would be the most compelling way to maximize value to shareholders. However, in this situation stock buy-back is somewhat grey: for every 3 shares bought back, 2 goes to majority and 1 goes to minority, thus increasing the majority shareholder's economic stake relative to minority.
Why is a multiple expansion likely?
Once TARO's Board starts using the cash to make meaningful acquisitions, the overhang of another squeeze out offer will fade away. As market's perception of the Board changes, a multiple expansion will likely follow thus narrowing the prevailing deep valuation discount to its peers. Perrigo is valued at 15 times EBITDA compared to TARO's 5.21 times. We think the market currently perceives that the cash is idle, purportedly for financing a future buy out of minority interest. Thus, TARO's use of cash to make meaningful acquisitions will unequivocally reassure the market, once and for all, that the board will truly maximize ALL shareholder's value.
So in the light of the protonix settlement and the imminent cash outflow from Sun, TARO's shares will likely be revalued when TARO starts to deploy its disproportionately high cash and low debt to make meaningful synergistic acquisition(s). Notwithstanding past conduct, this gives an excellent opportunity for TARO's board to embrace ALL of its shareholders.