Endo International - Why Either A Short Or Long Position Is Too Risky For Me

| About: Endo International (ENDP)


Endo International acquires DAVA in a deal with a potential value of $600 million.

The deal seems fine and corresponds to the recently adjusted strategy.

CEO De Silva appears to copy Valeant's acquisition-based strategy combined with a lean business model.

His past ties to Valeant could make Endo a target itself, I shun the shares given the aggressive accounting and valuation.

Just a few weeks following the completion of its strategic review, Endo International PLC (NASDAQ:ENDP) announced that it has acquired privately held DAVA Pharmaceuticals, in what appears to be a very nice deal.

That being said, shares have seen a huge run over the past year driven by deal-activity under incoming CEO De Silva, while operational performance has been under pressure amidst loss of exclusivity and the continued GAAP losses.

That being said, I can easily envision De Silva selling the business, while I am not a fan of the operational performance of Endo, making both a short or long position too risky in my opinion.

The Deal Highlights

Endo International announced that it has reached a definitive agreement to acquire DAVA Pharmaceuticals. Endo will pay $575 million in cash for the privately held company with additional contingent payments of $25 million depending on the achievement of certain milestones.

DAVA specializes in marketed, pre-launch and pipeline generic drugs, and will provide a boost to Endos's commercialization and development platform.

Following regulatory approval the deal is set to close in the second half of this year.

Financial And Strategic Implications

For the year of 2013, DAVA reported revenues of $131 million, which values the deal at 4.6 times sales assuming earn-outs will be achieved.

The company posted adjusted EBITDA of $99 million for last year while reporting net earnings of $54 million. This values equity in the business at 6.1 times adjusted EBITDA and roughly 11 times GAAP earnings. For a pharmaceutical business, these appear to be very appealing multiples.

On top of the strategically focused generic portfolio including 13 on-market products, DAVA has a promising pipeline of therapeutic products. On top of the recent launch of generic Doxcycline and Cefdinir another 5 launches are anticipated in 2015, and another 20 products are expected to hit the market in the coming years. As such, the deal will already be accretive to 2014's adjusted earnings.

In the future DAVA stands to benefit from the leverage of Endo's extensive relationships with important suppliers and customers, as well as financial resources.

The deal fits within the company's strategy to pursue accretive and strategic external growth opportunities in which there is upside and potential for synergies. The acquisition of DAVA is a natural fit for Endo's generic business with further synergies anticipated thanks to increased focus and the lean business model.

Strategy Call Presentation

Earlier this month Endo updated the market with its strategic update after initiating a complete assessment of the business in March of this year.

Under the new strategic direction, Endo aspires to be a top tier specialty healthcare company. The focus will shift from integrated health solutions to maximizing the value of each of the core businesses. The company will furthermore focus on specialty areas, which carry higher margins and growth rates in order to maximize growth and cash flow potential.

In the near term, the focus will be on organic growth in the core business. The focus will furthermore focus on running operations more efficiently while sharpening the R&D focus in order to pursue near term opportunities. For HealthTronics the company is still considering the strategic alternatives. Accretive deals like the acquisition of DAVA are consistent with the strategy as well.

Updated Financial Guidance

At the strategic update, Endo furthermore gave a revised financial guidance for the year. The firm now sees revenues of $2.65 to $2.80 billion and adjusted gross margins of 64 to 66%. Diluted earnings per share are now seen between $4.10 and $4.40 per share based on roughly 116 million shares outstanding.

As recent as the first quarter earnings release, Endo was expecting annual revenues of just between $2.55 and $2.64 billion. Adjusted earnings were seen between $3.60 and $3.85 per share, while GAAP losses were seen between $1.10 and $1.35 per share.

The company aims to save $150 million in operating costs in 2013 compared to the year before at the back of the rationalization of operating costs spending and an increased focus on R&D spending. Overall, a 15% headcount reduction is targeted which should increase costs savings to a run rate of $325 million by 2014.

What About The Divergence Between Operational Performance And The Shares?

In May, Endo published its first quarter results. Revenues were down by 9.6% to $595 million. The fall in revenues was entirely the result of a 35% drop in branded pharmaceuticals sales, due to loss of exclusivity of LIDODERM, which posted an 82% drop in sales to $33.1 million. Modest device growth, solid growth in generics and the contribution from Paladin could not offset this revenue pressure.

The company posted a net loss of $437 million for the quarter, due to a current non-cash charge of $625 million to increase the product liability reserves.

Adjusting for this factor among others, adjusted earnings rose from $123 million to $134 million. However, a significant increase in the shareholder base resulted in a 16% drop in adjusted earnings per share, which fell to $0.92 per share.

Despite the falling current revenues and GAAP losses investors are very excited about Endo with shares having risen some 90% over the past year alone. Don't forget that while the company has access to $1.1 billion in cash, the company operates with a net debt position of about $2.4 billion.

So why are shares rising while the company is reporting falling revenues and has posted significant GAAP losses in recent history? The answer lies in the personnel changes, which have occurred at the company.

Rajiv De Silva Joins, The New CEO

Many investors are pleased to see Rajiv De Silva being the CEO of Endo International, after being the COO of Valeant Pharmaceuticals (VRX). Of course, Valeant is very well known for making a string of acquisitions, then cutting costs and thereby rapidly growing the business.

However many have questioned the accounting which focuses on non-GAAP measures and the build up in debt of the company. So far, shareholders have not been complaining, seeing their holdings roughly ten-fold in value over the time period of just a few years.

Given the strong past links, and the similarities in the new business model as Endo outlined in the recent strategic update, many have speculated that Endo could very well become a target for Valeant.

Investor Takeaway

Last year I checked out the prospects of Endo after it announced to acquire Canadian-based Paladin in a $1.6 billion deal. At the time both shares of Paladin and Endo jumped up significantly, with both shares combined seeing their value increase by about $2 billion on the back of anticipated annual synergies of $75 million.

I noted that growth was applauded as the positive effects of cost reduction would be largely made undone by a continued slide in drug sales. This was following increased competition and the loss of exclusivity from Lioderm pain patches. I also envisioned tax scrutiny from the inversion move to Ireland while neither of the companies was already located in the country. The valuation at premium valuation, the continued occurrence of ¨one-time¨ items, the aggressive non-GAAP accounting and huge momentum were red flags for me.

It seems to me that there is some divergence between the fundamentals based on conservative accounting and the enthusiasm for CEO De Silva, which has placed a premium on the shares. The employment of de Silva has turned Endo into a potential acquisition target itself, and if not investors are betting on a successful copy of Valeant's acquisition-driven strategy.

For the reasons mentioned above, I find shares too risky both for a long or a short position, but I will keep monitoring the situation closely.

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