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Summary

  • The Tysabri royalty rate increases from 12% to 18% starting May 1st. Also, Perrigo will get the full year effect of the Tysabri royalty. Perrigo's fiscal year ends in June.
  • EPS can reach $8.07 over the next 12 months if the Tysabri royalties are not sold.
  • If Perrigo returns to a more typical P/E multiple of 25, the share price can be $200.
  • If the Tysabri royalties are sold and the proceeds invested in M&A, Perrigo's share price can go much higher in the future.
  • The Tysabri royalty does not make up for share count dilution due to the Elan acquisition. The return on capital for the Tysabri royalty (5-7%) is lower than Perrigo's ROIC.

Introduction

Perrigo Company PLC (NYSE:PRGO) has a market cap of $18.6 billion with revenue in the latest quarter of $1 billion. Perrigo make store-brand medications, nutrition products such as infant formula and nutritional drinks for adults, OTC and generic prescription drugs, active pharmaceutical ingredients and also has a royalty on Tysabri. Perrigo is the largest OTC store-brand drug manufacturer and makes 47 billion tablets a year.

Perrigo's business model is to piggyback on the products made by larger pharmaceutical companies. For example, if Pfizer gets OTC approval for Lipitor, Perrigo will supply the store-brand version. Another example: when Perrigo saw that the Ensure adult nutritional drink made by Abbott Labs was doing well, Perrigo entered that market with a store-brand version.

In its latest 10-K, Perrigo says that its Consumer Healthcare segment markets over 2,700 store brand products to over 1,000 customers, the Nutritionals segment markets over 900 store brand products to nearly 150 customers, and the Rx Pharmaceuticals segment markets approximately 700 generic prescription products to approximately 300 customers.

Retailers are incentivized to sell store-brand because the retailer's profit margins on store-brand are far greater than those on the branded products.

Tysabri royalties

Perrigo acquired the Irish company Elan Pharmaceuticals last year to obtain a tax inversion. Apart from around $1.9 billion in cash and other assets, Elan came with a royalty stream on Tysabri. Tysabri is Biogen Idec's (NASDAQ:BIIB) blockbuster drug for multiple sclerosis. Royalty Pharma, an Irish company that specializes in buying royalties bid $8 billion for Elan, which implies that it valued the Tysabri royalty at about $6.1 billion.

My previous article on Perrigo, "Catalyst for Perrigo: Sale of Tysabri Royalties", describes Tysabri in more detail. That article said that by selling Tysabri royalties, Perrigo can improve its returns.

Perrigo states that historically its return on invested capital has been 13 - 17%. If Perrigo can sell the Tysabri royalty stream and invest it at a rate of return of 13 - 17%, it will greatly boost the earnings per share. For example, if the return is 15% and Tysabri royalties can be sold for $6 billion, that would be a profit of $900 million. This is more than twice what Perrigo can make by retaining the Tysabri royalties. The reason we see the big difference is that anyone can own the royalty (for instance Royalty Pharma has just 21 employees). But Perrigo's unrivaled store-brand network can give much better yields on capital.

This article will also look into the less desirable alternative: what happens if Perrigo doesn't sell the Tysabri royalties in the near future. The increase in the Tysabri royalty rate and the full year effect of the Tysabri royalty can give a strong boost to Perrigo's earnings per share over the next 12 months.

Tysabri royalty rate increase

The terms of the royalty agreement that Elan had with Biogen Idec say that the royalty rate increases from 12% to 18% starting May 1, 2014.

Quoting from Perrigo's latest 10-Q:

The Company is entitled to royalty payments from Biogen Idec Inc. ("Biogen") based on its Tysabri® revenues in all indications and geographies. Specifically, for the twelve-month period beginning May 1, 2013, a 12% royalty applies. Following the initial twelve-month period, annual sales up to $2.0 billion accrue an 18% royalty and incremental annual sales above $2.0 billion accrue a 25% royalty.

Calculating revenue increase due to Tysabri in FY 2015

Let us see how much more Perrigo can get from Tysabri over the next 12 months. Perrigo's fiscal year ends in June. Perrigo reported Tysabri royalty revenue of $53.4 million and $60.8 million for the three and nine months ended March 29, 2014. The reason the 9-month number is low is that the Elan acquisition closed in December 2013.

This implies that Tysabri's global revenue was $445 million for Q1 2014 ($53.4 million / 0.12 = $445 million). The royalty rate for April 2014 would be 12% and for May and June it would be 18% . If we assume Tysabri sales of $445 million for Q4 and also assume it is evenly distributed throughout the quarter, we get an estimate another $71 million in Tysabri royalty revenue for Q4. That adds up to a total of $131.8 million in Tysabri royalty revenue for FY 2014.

Assume that Tysabri's sales for the next 12 months grows by $100 million to $1.88 billion (conservative assumption because Tysabri is growing much faster - its 2013 sales were $1.526 billion).

Multiplying this by 18% gives $338.4 million for FY 2015. That is an increase of $207 million over FY 2014's Tysabri royalty revenue.

Calculating EPS increase due to Tysabri

The nice thing about the Tysabri royalty for Perrigo is that it is taxed at 1%. Therefore, the profit increase would be 99% of $207 million which is $205 million. Perrigo currently has 134 million shares outstanding.

Perrigo has forecast $6.15 - $6.30 in EPS for the FY 2014 ending June 30. This is based on a weighted average of 116 million shares. Perrigo's weighted average is lower because it acquired Elan in December 2013. The mid-point EPS of $6.23 implies net income of $723 million.

Estimating Perrigo's upside

There should be a further earnings increase due to the normal growth from Perrigo's base business. Let us assume that the rest of Perrigo gives an earnings increase of 15% (which is conservative based on historical growth rates). The ex-Tysabri net income for the last 12 months should be around $593 million ($723 million - $130 million).

The total net income for the next 12 months would be:

$723 million + $205 million + ( 15% of $593 million ) = $1017 million

That is an EPS of 1015 / 134 = $7.59

One more thing about the tax rate. Perrigo is using an average tax rate of 22% for the last 12 months since Elan closed in December. But it has forecast a tax rate of 17% for next year due to the tax inversion. If we factor in the 5 percentage point tax savings, the EPS would be $8.07 ($7.59 * 0.83 / 0.78).

Perrigo closed last week at $138.95. Thus, Perrigo has a forward P/E ratio of 17.2 (138.95 / 8.07). That is really low for a non-cyclical company with a 5-year CAGR of 22% for its cash flow. The P/E for 22% growth should be at least 20 - 25.

Perrigo's CEO, Joseph Papa, said in the most recent earnings call that we can expect 5 - 10% organic revenue growth per year and double that in operating income. He has also indicated another 5-10% revenue growth per year from acquisitions.

Perrigo's revenue has grown at a CAGR of 15% since 2008 while its operating margin has expanded every year - from 14% in 2008 to 24% in 2014. Perrigo's operating margin was just 9% before Joe Papa took over in 2006. Half the revenue growth has been organic and the other half has come through acquisitions.

If we multiply our EPS estimate by a P/E of 25 , we get $202. That is an increase of 45% in stock price.

Indeed, Perrigo was trading at a P/E of 25 times FY 2014 EPS estimates before it got knocked down due to the Q3 EPS miss. It will be interesting to see what happens when Perrigo releases its 2015 forecast in August.

My own preference

I would like to see the Tysabri royalty sold and the proceeds used for acquisitions. This is because Perrigo's store-brand retailer network is its durable competitive advantage. Perrigo is a Buffett-type company except for the Tysabri royalties. Holding on to the Tysabri royalty is sub-optimal and the opportunity cost is too great. Perrigo's returns can be increased by selling the royalties and exploiting its store-brand distribution network. In my first article on Perrigo, "Allergan can buy Perrigo to avoid Valeant", I had this quote from Joe Papa in Perrigo's latest earnings call transcript

The basic premise of what we're seeking to do, Jami, is simply saying we've got a great distribution channel with the large retailers, how do I get one more item on the truck that's at Perrigo today going to the large retailer that will be important to the retailer. Well, you may think that is a diversification. I simply would say to you that we believe that strategy allows us just to get -- be more important for our large retailers. And I think that is the overriding, what we believe, unique, sustainable, competitive position Perrigo has, is that we've got these relationships and distribution channel with the retailers. And therefore, by adding additional adjacencies, it allows us to have a longer-term stronger business with each of the retailers.

As we saw earlier in the article at a 15% ROIC, if we get $6 billion by selling the Tysabri royalty, we get $900 million in profit. This is far higher than the $320 million in Tysabri revenue we used in our EPS calculation above. That is an incremental $580 million which is an incremental $4.32 EPS. Multiplying that by a P/E of 25 gives $108 per share. Perrigo will get a huge increase in stock price if it can do that.

Right now Perrigo is getting penalized for the dilution in share count due to the stock used for the Elan acquisition. The Tysabri royalty does not make up for the dilution because the return on capital for the Tysabri royalty (5-7%) is lower than Perrigo's own ROIC.

Return of JNJ brands

Some of Johnson and Johnson's (NYSE:JNJ) cough/cold/flu medications had been recalled due to manufacturing defects. They have recently returned. In the Q3 earnings call, Joe Papa says that the return of JNJ's cough/cold/flu medications should get anniversaried in a couple of quarters. Perrigo estimates that it will keep 50% of the market share it gained during JNJ's absence. Perrigo often cites a 5-year University of Chicago study that says 91% of the people who try store-brand stick with store-brand, and that 72% of doctors and pharmacists themselves use store-brand. The more educated the consumer, the likelier they are to use store-brand. Perrigo doesn't see anything so far that indicates retaining less than half the marketshare gains.

Perrigo grew revenue at a CAGR of 16% from 2005-2013 steadily. For most of that period, JNJ's brands were present. But they did not have much of an effect on Perrigo's ability to grow.

Perrigo has been expanding into other areas over the years. The issue of JNJ's brands returning is overblown. Cough/cold/flu medications form 27% of Perrigo's revenue.

Areas of recent expansion

Perrigo's strategy is to add more items to the trucks that go out from its distribution center to the retailers. This strategy yields great profit margins, evident in the steadily increasing operating margin year after year. There hasn't been a year without margin improvement ever since Joe Papa took over as CEO. He has taken Perrigo's operating margin from 9% in 2006 to 24% in the latest quarter in a steady march. I made a table of Perrigo's acquisitions over the last few years to show how it has been expanding into other areas.

AcquisitionDatePrice (in millions)Product
FeraJune 2013$110Ophthalmic sterile ointment and solution products
VelceraApril 2013$156Pet health products
RosemontFeb 2013$283Specialty and generic prescription pharmaceutical company focused on oral liquid formulations.
CobrekDec 2012$42Generic pharmaceutical foam dosage form product
Sergeant's Pet Care ProductsOct 2012$285Animal health
CanAm CareJan 2012$39Diabetes care
Paddock LaboratoriesJuly 2011$546Generic Rx pharmaceuticals
PBM HoldingsApril 2010$839Infant formulas, pediatric nutritionals and baby foods
Orion LaboratoriesMarch 2010$48OTC store brand pharmaceuticals
Unico HoldingsNov 2008$51Pediatric electrolytes, enemas and feminine hygiene

A useful thing to note while looking at the table above is that Perrigo's Rx pharmaceutical division has by far the highest operating margin - it is 45% whereas Perrigo's overall margin is 24%. This is because this category consists of topical drug forms - these are harder to manufacture and therefore have less competition. Perrigo's 10-K describes the Rx segment as "predominantly 'extended topical' and 'specialty' as it encompasses a broad array of topical dosage forms such as creams, ointments, lotions, gels, shampoos, foams, ophthalmics, suppositories, sprays, liquids, suspensions, solutions and powders."

Recent selloff

Perrigo was hit during the biotech selloff earlier in the year. The stock price fell from a high of $168 in March to around $143 before the Q3 earnings release. Perrigo missed Q3 earnings due to a weak flu season and a weak flea/tick season. Perrigo fell to $126 after the earnings release in May and has since rebounded to around $138.

This selloff provides a great opportunity.

Conclusion

Perrigo's stock price got knocked down due to one-time factors. The weak flu season and weak flea/tick season made Perrigo miss EPS estimates in the latest quarter.

If Perrigo doesn't sell the Tysabri royalty, the full year effect of the Tysabri royalty coupled with the royalty rate increase should give a big boost to Perrigo. If Perrigo trades at a more typical P/E multiple, its stock price can see a $200 share price.

If Perrigo sells the Tysabri royalty and uses the money for M&A as it has hinted it would, the upside is much greater. Perrigo can even sell the royalty in pieces - for example it could sell off 1-2% at a time.

Source: Perrigo Can Reach $200 If It Keeps Tysabri Royalties, Lot More If It Sells Them