Lannett (LCI) is a developer and manufacturer of off-patent pharmaceutical products. The company has grown the business at a very respectable pace over the past decade and a half.
While the historic growth trajectory looks great, the company has hit some serious roadblocks over the past year. The leverage incurred following the purchase of Urban Pharmaceutical in September of 2015, and the softer operating conditions (which in part can be blamed on increased price scrutiny) have heavily weighted on the shares.
The Core Business
Lannett has grown from a business with merely $12 million in sales in 2001, to $407 million in sales for the fiscal year of 2015, ending in September of last year. The company manufactured 13 products in 2015, tackling diseases like Glaucoma, Migraine, Hypertension and Congestive Heart Failure, among others. The company furthermore had 29 products under FDA review and another 47 products in development. These products are typically sold to large wholesale distributors like Amerisource Bergen, McKesson and Cardinal Health.
The company reported a 49% increase in sales for its fiscal year of 2015. While this looks very impressive, the quality of growth is disappointing as price increases were responsible for a 57% increase in sales, partially offset by volume declines. The company already indicated what it will not hike prices in 2016 amidst the public outcry, although generic medication prices are still very low compared to their branded counterparts. The very aggressive price hikes allowed the company to report net profits of $150 million last year, an increase by a factor of three compared to the year before.
The Purchase Of Urban Pharma
Lannett´s strong financial position changed overnight when the company announced the $1.23 billion acquisition of Urban Pharmaceuticals in September of 2015. This business has been acquired from Belgian-based UCB S.A. and would act as an extension of the generic specialty business of Lannett.
At the time of the purchase, Lannett believed that the deal would add 18 products to its portfolio, with pro-forma revenues seen at $800 million for the twelve months ending on June 2015. Given that Lannett reported $407 million in revenues for the twelve months ahead of June 2015, the purchase of Urban would contribute roughly $393 million in annual sales.
Given the reported $1.23 billion purchase price, this translates into a 3.1 times sales multiple. While Lannett believes that tax benefits could reduce the effective purchase price by $100 million, the final deal tag could increase as well following the inclusion of contingency payments into the contracts.
Lannett failed to specify how profitable the operations of Urban were. The company did say that it would expect 20-25% accretion to its 2017s adjusted earnings. A significant portion of the expected accretion was likely driven by the $40 million cost synergies which were expected each year in the three years following closure of the deal. There was actually some good news with regards to this subject. After the deal closed in November of 2015, Lannett indicated a month later that it expect to reduce costs by $40 million in year one of the deal.
That is the only real good news as an acceleration of cost savings was spurred by the disappointing operational performance of the acquired activities. Part of the disappointment stems from the fact that a big customer of Urban Pharma decided to source its drugs somewhere else. This move could hurt full year sales by $87 million, and adjusted EBITDA by $45 million. This news has been very painful for shareholders in Lannett as 22% of annual revenues just walked out of the door, just months after the $1.23 billion deal has been announced.
Troubles Continue In 2016
At the time of the acquisition of Urban Pharma, Lannett guided for pro-forma sales of $800 million. This revenue contribution was split pretty evenly between its own core and the acquired activities. The company furthermore communicated that pricing for its core operations would be flat into the fiscal year of 2016.
As the purchase of the acquisition of Urban Pharma closed during the second quarter of the fiscal year, comparables are relatively difficult to make. One thing is clear and that is that the purchase of Urban Pharma and the core operations are under pressure. Revenues for the first six months of the fiscal year of 2016 were up just 7% to $233 million, while actual gross profits were down. Note that this does include the contribution of Urban Pharma for a few months.
At the time of the second quarter earnings release, the company guided for full year sales of $585 to $595 million. This suggests that sales are seen at $352 to $362 million for the second half of the fiscal year, a period which includes the contribution of Urban Pharma. This suggests that the run-rate of the combination reports sales of roughly $700 million per year, much less than the $800 million communicated at the time of the purchase, back in September of 2015.
Things worsened even further in March as management admitted that the market has further softened. It cited FDA decision approvals, increased competition and a mild flue season as other negative factors. This softness resulted in another downwards adjustment to the guidance by the end of March. The company now sees full year sales of $555 to $565 million this fiscal year, suggesting revenues of $322 to $332 million in the final two quarters of the fiscal year. This suggests that the annual run rate of the business now comes in at roughly $650 million per year.
How Sustainable Is The Debt?
The company sees sales of roughly $560 million in the fiscal year of 2016. The projected adjusted gross profit margins of 61% result in gross profits of $342 million. After taking into account adjusted R&D costs of $49 million, and $60 million in adjusted SG&A costs, operating profits are seen at $233 million. Including an annualized $40 million in depreciation and amortization costs, adjusted EBITDA is seen at roughly $270 million.
After taking into account $53 million in interest costs and a 35% tax rate, adjusted earnings are seen at $115-$120 million per year. The good news is that excluding for restructuring and integration costs, adjusted earnings pretty closely mimic GAAP earnings a stock-based compensation expenses are fairly low.
The trouble is of course the debt load following the purchase of Urban Pharma. The company ended the second quarter of its fiscal year of 2016, corresponding to the end of the calendar year of 2015, with $190 million in cash and equivalents. Total debt stood at $1.06 billion, for a net debt load of roughly $870 million.
This debt load corresponds to roughly 3.2 times adjusted EBITDA, as calculated above. While the EBITDA number should increase going forwards, as the fiscal year of 2017 will include the contribution of Urban Pharma for an entire year, it is clear that both the core and acquired activities are seeing real pressure.
By now Lannett is a generic business which is facing real issues after the future looked very bright just a year ago. The financial leverage incurred and deteriorating operating conditions put real strain on the business, as aggressive price hikes could backfire.
The company´s 37 million outstanding shares have fallen to just $17, valuing equity at $630 million. Including the net debt load of $870 million, the business is valued at just $1.5 billion. This is slightly more than the $1.23 billion which the company paid for Urban Pharma.
The operational and financial stress has triggered a huge sell-off in the shares. Shares of the company peaked in their $70s in the spring of 2015. That valued the unleveraged business at roughly $2.5 billion at the time. This valuation has fallen to just $1.5 billion, even as the purchase of Urban Pharma should have resulted in pro-forma revenues to double!
By now the valuation is distressed and that is a direct consequence of the financial leverage and uncertain operating conditions and performance. Despite these headwinds, the company is still on track to report operating profits of roughly $115-$120 million, translating into an earnings multiple of merely 5-6 times.
This is a high risk and potentially highly beneficial situation. Lack of dividends and still decent adjusted earnings allow for a relative rapid deleverage of the balance sheet, as the company has liquidity at hand. The trouble is that the business is in poor shape, and that applies for both the core and the acquired businesses. Bankruptcy is a real risk if operating conditions deteriorate, yet shares have already lost 75% of their value over the past year.
The potential rewards are very large as the adjusted earnings still come in at roughly $3-4 per share. A stabilization of the performance, realization of synergies and relative strong pipeline could really trigger a potential valuable company in combination with that earnings power.
While I can see the potential upside case, I remain somewhat cautious for now, taking into account the elevated operational, financial and pricing risks. I furthermore remark that shares traded in their single digits as recent as 2013. This was followed by the huge momentum run on the back of increased interest in the field and exploding profits thanks to aggressive price hikes.
Given my aversion to potential large capital losses, I will only start buying into the shares when they fall towards the $10 mark, provided that operating conditions stabilize. Alternatively, long dated call options might provide an appealing risk-reward opportunity as well, certainly if volatility comes in after a potential stabilization period in the months ahead.
Disclosure: I/we 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.