Endo Health Solutions - The Market Is Exaggerating On The Paladin Deal

| About: Endo International (ENDP)

Shares of Endo Health Solutions (NASDAQ:ENDP) saw a massive spike upwards on Tuesday following the news to acquire Paladin.

While the deal looks nice, the massive move upwards in Endo Health's own shares is a massive exaggeration compared to expected synergies. These synergies are itself of a "questionable" nature given the high tax synergy component within the synergy estimates.

I remain on the sidelines.

The Deal

Endo Health Solutions announced that it has reached a definitive agreement under which it will acquire Paladin Labs.

Endo will pay CAD $77 per share for Paladin, valuing the Canadian specialty pharmaceutical company at $1.6 billion, based on yesterday's closing prices. Based on the offer, Endo is offering a 20% premium for Paladin.

Shareholders in the Canadian firm stand to receive CAD $1.16 per share in cash and 1.6331 shares of Endo for every share they own. Upon closing of the deal, shareholders in Paladin will own 22.5% of the new Endo.

The deal accelerates Endo Health's goal in creating a specialty healthcare company, creating a platform for future growth. Paladin's franchise, the near-term pipeline and emerging market business are strong growth drivers going forwards.

CEO Rajiv De Silva commented on the rationale behind the deal, "The acquisition of Paladin Labs accelerates Endo's transformation from an integrated health solutions company to a top tier global specialty healthcare leader. Together with our sharpened focus, lean operating model and improved execution within our core businesses, strategic acquisitions will continue to play a key role in maximizing our growth potential and cash flow generation to drive future value for Endo shareholders."

Paladin Labs has over 60 marketed drugs, and partnerships with leading pharmaceutical companies. Following the deal, Endo Health expects annual tax and cost synergies of at least $75 million per annum.

Note that Paladin Labs generated annual revenues of CAD $210.2 million for 2012 on which the firm reported earnings of CAD $59.9 million. Note that the company operates with CAD $254.5 million in cash and equivalents and merely CAD $42.0 million in debt, for a net cash position of CAD $212.5 million.

The deal is subject to normal closing conditions, including regulatory approval in the US, Canada and South Africa. The deal is furthermore subject to shareholder approval from shareholders in both firms, although 34% of Paladin's shareholders have already voted in favor of the deal.

The deal is expected to close in 2014.


Endo Health Solutions furthermore announced its third quarter results on Tuesday as well. The company ended the third quarter with $594.1 million in cash and equivalents. The company operates with $2.64 billion in total debt, for a net debt position of around $2.04 billion.

Revenues for the first nine months of the year came in at $2.19 billion, down 2% on the year before. The company reported GAAP earnings of $90.6 million compared to a $24.1 million loss last year. Adjusted earnings rose by 9% to $450.3 million.

Full year sales are seen around $2.75 billion. GAAP earnings are seen between $0.95 and $1.10 per share, with adjusted earnings seen between $4.60 and $4.75 per share.

Factoring in steep gains of 29%, with shares exchanging hands at $56 per share, the market values Endo Health at $6.4 billion.

This values equity in the firm at 2.3 times annual revenues, 12 times non-GAAP earnings and roughly 55 times non-GAAP earnings.

The company does not pay a dividend at the moment.

Some Historical Perspective

Long term holders in Endo Health Solutions have seen moderate returns. For most of the past decade shares have traded in a $15-$40 trading range. This announced deal has pushed shares to fresh all time highs as shares traded as high as $58 per share on an intraday basis.

Between 2009 and 2012, Endo Health has more than doubled its annual revenues to $3.03 billion. After reporting modest earnings in recent years, the company reported a net loss of $740 million on the back of $1.2 billion in various charges last year.

Investment Thesis

Investors in Endo Health are super enthusiastic about the deal. Shares rose by some $12 per share, boosting the value of Endo Health itself by a cool $1.4 billion in total.

Shares of Paladin rose by 50%, far surpassing the $77 offer price with shares trading around $96 per share on the Toronto exchange. This move has boosted the value by roughly $600 million.

As such investors are wildly enthusiastic about a deal, boosting the combined market value of both firms involved by some $2 billion, on the back of estimated synergies of $75 million. This seems a bit of an exaggeration to me.

On a pro-forma basis revenues of $3 billion are within reach. Note that Endo is on track to report GAAP earnings of $115 million this year, and non-GAAP earnings of little over $500 million. Add to that $55 million in earnings from Paladin and expected synergies of $75 million per annum, and earnings could come in around $250 million on a GAAP basis.

Now add to that the fact that cost reductions next year could total $325 million per annum, up from an estimated $129 million this year. These positive effects will be made largely undone by the continued slide in drug sales following increased competition and intensified competition. Endo's Lioderm pain patch lost exclusivity while the Opana painkiller is facing increased competition.

Let's be generous and say GAAP earnings of $350 million are attainable going forward. The market capitalization of the new Endo will be around $8 billion as the company operates with some $2 billion in debt. While the lower tax rate could be a competitive advantage going forwards, as the company aims to pay Irish statutory tax rates of 12.5%, the company might face some scrutiny given that neither Endo or Paladin is based in Ireland.

As such I think the market is overreacting a great deal. The $2 billion jump in the combined market capitalization is equivalent to 26 times expected synergies. This is as many of the synergies are based on "dodgy" tax benefits. The valuation at 23 times GAAP earnings seems a bit rich on a pro-forma basis, given the continued troubles of Endo's business, which are not solved by just this deal.

Therefore I remain extremely cautious. I applaud for shareholders in Paladin, but remain on the sidelines with regards to Endo Health given the almost irrational jump on Tuesday.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.