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Although many well-known medical device franchises can trace their roots back to Big Pharma, most of those companies jettisoned their device companies in a wave of divestitures in the 1980's and 90's. More recently, Abbott Labs (ABT) has decided to separate its drug and device businesses, while pressure mounts for Medtronic (MDT) to ponder splitting its slow-growth and high-growth businesses.

So of course Endo Pharmaceuticals (ENDP), once a specialist in pain and urology drugs, decides to buy some slow-growth device businesses and build itself into a triple-threat of drugs, devices, and generics. While the company did take on quite a lot of debt to restructure itself, time may prove that diversification was the right move.

A Respectable Fourth Quarter Report

All in all, Endo Pharmaceuticals delivered a solid fourth quarter result. Overall sales rose 57% as acquisitions added a lot to growth numbers. The core branded drug business grew 16% (on 12% growth in Lipoderm and 31% growth in Opana), while the generics business more than doubled (up 21% on a pro forma basis). The device and services unit chipped in $194 million in revenue (almost 25%) on single-digit underlying growth.

Although Endo has significantly altered its business mix, the margins haven't changed all that much. Gross margin dropped about three points, while operating income rose 45% and operating margin retreated less than two points.

The Drug Business Under Fire On Two Fronts

Right now Endo has its hands full with the branded drug business. The company has been battling Watson Pharmaceuticals (WPI) over its patents to Lipoderm (almost 30% of sales), but the court case is only part of the fight - Watson may yet have to conduct clinical trials before getting FDA approval and the outlook is quite uncertain. While generic competition for Lipoderm is almost certainly a "when-not-if" matter, the timing and magnitude of competition are very much up in the air.

The other issue in drugs relates to supply problems tied to the shutdown of a Novartis (NVS) plant that produced Opana ER and Voltaren gel for the company. While the company is moving around its production to compensate, the shutdown has created short term supply shortages and lower revenue and profit guidance.

Managing The Declines, But Still Searching For Growth

Endo Pharmaceuticals has done a relatively good job of trying to manage the threats to its branded business. In addition to the aforementioned Lipoderm litigation, Endo has moved to a tamper-resistant version of Opana ER that should extend that franchise for another ten years or so. At the same time, the company's acquisition of Qualitest offers more growth potential in the generics space than many seem to acknowledge.

That said, growth looks poised to reverse in a few years barring a major development. The HealthTronics and AMS acquisitions offer an arguable amount of synergy with the drug businesses and no real growth. Yes, AMS is a good play on the aging of America, but that seems more likely to play out in many years of mid-to-high single-digit growth as opposed to double-digit growth.

Moreover, Johnson & Johnson (JNJ), Boston Scientific (BSX), and Bard (BCR) have been moving fairly aggressively to position themselves for this same opportunity. Said differently, Endo took on quite a lot of debt to pay for the privilege of competing against these three large device companies, and all three have identified urology as an area of focus and future growth. Barring large increases in R&D, which has not exactly been a long-term specialty, it may be hard for Endo to keep up.

The future of growth in the drug business is also cloudy. The Opana franchise looks sound, but Pfizer (PFE) is working hard to build up its pain franchise and privately-held Perdue is likewise a huge player. Endo does have a few products in its pipeline (including a painkiller and some cancer compounds), but nothing that looks like a blockbuster today.

The Bottom Line

With the overlapping businesses, it wouldn't be out of the realm of possibility for J&J to buy Endo Pharmaceuticals lock, stock, & barrel, but I wouldn't count on that as an Endo investor. On the flip side, the diverse business mix probably means that this is a less attractive target for other potential suitors like Pfizer or Bard.

The consistency of the device business will help offset the volatility of the drug business, but won't necessarily provide a huge boost to growth. That said, Endo is small enough that a successful partnership in a single drug could move the needle.

Investment orthodoxy says that debt has to be subtracted out of a discounted cash flow valuation, and that's the problem with Endo. On the basis of its cash flow, the stock is arguably worth close to $60, but the debt chops that down to the mid-$30's in short order. With the company will to spend so much for so little (in terms of growth), investors should probably approach this stock with caution for now.

Source: Endo Pharmaceuticals Playing An Unconventional Hand