Last week Bluemountain, an institutional shareholder of Taro Pharmaceuticals (TARO) proposed (see Bluemountain's letter) two nominees to Taro's Board. We were extremely delighted to see this. We welcome this new development and will wholeheartedly support the nominations of Mr. Ben-Ami Rosenfeld and Ms. Adi Bershadsky. We believe these 2 nominees from a shareholder will be truly accountable to independent shareholders and represent the best interests of all shareholders. This, we think, will bring in transparency and accountability to Taro's board towards all its shareholders esp. when the board is evaluating strategic options and important shareholder value maximizing proposals.
We liked the constructive and positive tone of this letter, despite the very challenging past 2 years where shareholders were buffeted by 2 squeeze-out offers (We will take the moral high ground and not comment further on those offers.). We were very delighted to see Bluemountain's obvious agenda to maximize shareholder value. In its letter to fellow Taro shareholders Bluemountain said:
"It is our belief that there exists a significant ongoing opportunity to create shareholder value at Taro through, among other best practices, refining of its business strategy, evaluating an optimal capital structure and the use of Taro's growing cash balance, implementing more robust capital markets and shareholder communications, and ensuring that all strategic options are considered on an arm's length basis."
We could not agree more that the above items are critically important in unlocking value and maximizing share price to the benefit of all Taro's shareholders. We will not rehash our prior article but will remind everyone that Taro operates in the limited competition dermatology/topical generic business. Taro has also accumulated significant cash ($613m by end of June) and has hardly any leverage which will allow it to grow significantly by way of acquisitions. We think the above proposed items is exactly the prescription needed to change this to the benefit of shareholders. And here is our thinking and analysis of Bluemountain's proposal point by point:
1. Refining of its Business Strategy and Evaluation of Optimal capital structure and use of Taro's cash balance.
Potential for Acquisitive Growth: Taro has a debt of only $29m and cash balance of $613m and growing. By taking on $500m in debt, Taro could easily make an acquisition of the size of $1 billion and increase its earnings and brand in the attractive dermatology specialty(Rx or Non-Rx/Aesthetic) sector. Sun Pharma, which owns 66% of Taro Pharma last year realized this opportunity for its shareholders when it acquired DUSA Pharma for $230m. Considering that Taro already has a long established brand amongst medical practitioners(physicians/dermatologists) and patients, we think it is a no-brainer for Taro to leverage its brand, its sales and marketing capabilities and make an acquisition in this space. Here are other recent acquisitions with similar rationale:Valeant's (VRX) acquisition of Obagi Medical products, and Allergan's (AGN) acquisition of SkinMedica both of which were operating in the specialty dermatology.
Potential Partnership or Sale of International Rights to its 180+ Strong Product Portfolio: Taro's 2012 international sales (ex-USA, ex-CAN, ex-Israel and ex-UK) was a meager 1%. Taro could partner with a global pharma by selling its 180+ products in international markets for sales royalties.
Alternatively, Taro could explore monetizing this asset by an outright sale of international rights to its entire product portfolio to a global pharma with international regulatory and marketing presence. The company could engage an independent investment bank to value and sell the rights of Taro's 180+ products in the various untapped rest of world markets to a strategic buyer. A product-by-product and country-by-country market research needs to be undertaken. These rights potentially could fetch significant value in the marketplace. We heard Taro Chairman Mr Dilip Shanghvi talk about this relatively untapped opportunity in the recently concluded Aug 9th Sun Pharma earnings conference call (40 minutes into the call) when asked by an analyst. We are somewhat surprised that Taro has not been moving fast on this front.
Galderma sells its Rx and OTC products in 70 countries and approximately 42% of its sales comes from Europe, Latin America and Asia Pacific. In recent years, Galderma has witnessed >20% year-over-year growth in the regions of Asia Pacfic and Latin America.
In the most recent quarter, Valeant, a dermatology specialty company, reported sales from emerging markets grew 26% year-over-year driven by continued strong growth in Poland, Russia, Brazil, Mexico, South East Asia and South Africa.
2. Implementing more robust capital markets and shareholder communications.
Our comments: While Taro is in compliance with all public listing requirements, Taro's Investor Relations (IR) practices pale in comparison to its peers Actavis (ACT) and Perrigo (PRGO). We have communicated this to the company by detailed benchmarking with its peers. We believe improving IR practices will have a positive impact on both market liquidity and valuation of Taro shares.
3. Ensuring that all strategic options are considered on an arm's length basis
Our comments: This will insure if there is another squeeze-out transaction proposal, the board will objectively evaluate the merits of such a transaction in the context of all potential alternate transactions available in the market to maximize all shareholders value.
Readers should be aware of the valuations in the recent M&A transactions in the niche generic pharma space. For example, Agila specialties, an Indian generic pharma that makes sterile injectables was acquired for 18.6 times its TTM EBITDA in Feb. 2013. It should be noted that Agila's revenue stream is not protected by patents and its products are open to further market competition. There is no reason not to believe Taro would be offered similar valuation multiples in a strategic sale.
Durability and Outlook for Taro's Earnings
Investors may recall Taro's board (including the independent directors that Bluemountain is trying to replace) relied on its management forecast all the way until 10/05/2012 recommending shareholders to vote in favor of squeeze-out offer. This seeking alpha article by another shareholder explains the large differences between the actuals and the forecast.
In light of the above, we were scouring for opportunity to see if their views on Taro's business outlook or future earnings has changed. We got that opportunity when an analyst asked this below question in the Aug 9th Sun Pharma earnings conference call.
Analyst: Do you look at Taro as an annuity business or do you think it is a growing business ?
Mr. Dilip Shanghvi: Laughs! Generic business is so much linked with competition and market dynamics, that to take a long term view on a business you really don't know what is happening in the competition scenario is a challenge. There is not a single product in Taro's basket which has any kind of patent protection. Generic competitor can come to market based on when they get FDA approval. It is difficult to predict the competitive dynamics.
We have been thinking about this very issue for close to 2 years. While a majority of Taro's products are generics, they have limited competition. And there are fundamental reasons why there is limited competition. They are well-documented in this March 2013 paper by none other than the regulatory authority, FDA's office of generic drugs. Below we have reproduced content verbatim from slide 20 of the referenced presentation.
Fundamental Reasons for Limited Generic Competition in the Dermatology/Topical space:
• Most topical dermatological drugs have < $50 million in yearly sales before generic competition
• High cost of equivalence studies
- Need one per dosage form/strength (few waivers for lower strength)
• Complexity of semi-solid formulations.
The above reasons along with this below quoted text from Feb 2012 press release from Iszo capital, which explains the regulatory and market happenings in the last 3 years, convincingly explains why Taro's earnings has increased in recent years and why it will largely sustain.
"So what explains some of the improved performance by Taro and is this sustainable?
Because of problems with contamination and poor quality control, particularly with IV formulations, the FDA has greatly increased its scrutiny of all manufacturers of drugs. This has broadly affected the generic drug industry and greatly increased the cost to manufacture and comply with more stringent regulations. Due to this increased scrutiny and cost, many generic drug companies have decreased the number of marketed products to focus on their most profitable drugs. This is affecting most, if not all, players in the generic drug space and is likely to continue for the foreseeable future. Our research shows that on a few products, Taro has seen greater pricing power due to the withdrawal of competition.
Given that Taro is also very well diversified and has only 1 product that constitutes greater than 10% of sales or sales greater than $67m/year (Nystatin/Triamcinalone was 14.1% of sales and recently saw the entry of competition), 20 ANDA's and 1 NDA awaiting FDA approval, exciting recent launches including Topicort Spray 0.25% and a consistent R&D investment of approximately $50m/year, we are quite happy to own a small part of this business and the risks that come with it. We think it is significantly undervalued trading at only 6 times TTM EBITDA. With the 2 nominees from Bluemountain, and the above shareholder proposals, we think there is a significant opportunity to increase earnings and unlock value.
A Message to Taro Shareholders: Take Action or Get Off the Pot !
Please complete the proxy voting by 09/12/2013. The proxy vote link we have received thus far don't have the 2 Bluemountain's nominees but we are expecting soon that it would contain them.
We strongly encourage you to support the nominees of a minority shareholder as external directors. They are: Mr. Ben-Ami Rosenfeld and Ms. Adi Bershadsky. We believe they will take up or accelerate the above important shareholder proposals. Both the candidates are also highly qualified and diverse in their professional experience. We also would like to remind fellow shareholders that the incumbent directors, Ms. Ilana Avidov Mor and Mr. Dan Biran, voted for the $39.5 offer (the offer valued Taro at <5 times TTM EBITDA) less than a year ago and were recommending minority shareholders to vote in favor of it. Taro's share price closed at $65.79 on 08/05. We will stop at that and let shareholders be the judge.
We also quote this below text from the above Bluemountain's press release which explains the votes required for the external directors to be elected to serve in the board.
In plain English, this means that in order for each candidate to be elected or re-elected as an External Director, it is not enough that he or she receives a majority of the votes in his or her favor, but also requires that the candidate, either (I) receives the support (i.e., the votes) of a majority among the minority shareholders participating in the vote; OR (ii) that the total votes cast against such candidate are less than 2 percent of the total voting rights in the Company.
Thus, if a majority of the minority shareholders who actually vote, and represent more than 2% of the voting rights of the Company, VOTE IN FAVOR of the candidates nominated by BlueMountain (i.e., in favor of Mr. Ben-Ami Rosenfeld and Ms. Adi Bershadsky), AND SIMULTANEOUSLY VOTE AGAINST the re-election of Mr. Dan Biran and Ms. Ilana Avidov Mor, the re-election of the current External Directors who are endorsed by Taro's Board of Directors will be blocked.
Finally, we ask all constituents: management, board and major shareholders to work together constructively and truly focus on making Taro great. Taro has all the ingredients to grow significantly in the coming years:
- Accumulated cash of $613m
- Almost zero leverage with a debt of $29m
- Backed by a business with stable cash flow
- Longstanding Brand name amongst practitioners and patients
- An opportunity to make an acquisition in the specialty sector
- A relatively untapped sales opportunity in the rest of world markets for its portfolio of 180+ products.
We believe Taro is at an inflection point and if stewarded in the interests of all its stakeholders, is poised for significant growth in the coming years.