ACET: Underapprecaited And Mispriced

| About: Aceto Corporation (ACET)

Summary

ACET beat on bottom and top lines vs. our estimate.

Rich forward pipeline of products underscores value proposition.

Mispriced as a chemical entity but is mostly pharma and human health.

Aceto Corporation (NASDAQ:ACET)

Revenues ahead due to better PI and PC slightly offset by slower HH producing an 8.3% Y/Y increase. Higher international sales of APIs drove results. A pipeline of projects are expanding which we expect will drive continued growth in future quarters. Reiterate Buy rating with $30 price target.

52-Week Range

$18.03 - $32.20

Total Debt (million)

$117.4

Shares Outstanding

29.6 million

Total Debt/Equity

39.3%

Insider/Institutional

2.6% / 82.3%

ROE (TTM)

15.6%

Public Float

28.7 million

Book Value/Share

$10.25

Market Capitalization

$678 million

Dividend

$0.24

Daily Volume

177,908

Dividend Yield

1.08%

Click to enlarge

FYE JUN

2015A

2016E

2017E

EPS($)

ACTUAL

CURRENT

PREVIOUS

CURRENT

PREVIOUS

Q1 Sep

$0.23A

$0.37A

$0.37A

$0.39E

$0.39E

Q2 Dec

$0.28A

$0.36A

$0.36A

$0.39E

$0.31E

Q3 Mar

$0.34A

$0.42A

$0.41E

$0.47E

$0.50E

Q4 Jun

$0.48A

$0.44E

$0.43E

$0.50E

$0.52E

Year*

$1.33A

$1.60E

$1.57E

$1.75E

$1.72E

P/E Ratio

1 7.3 x

14.4x

13.1x

Change

9.9%

20.2%

9.4%

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FYE JUN

2015A

2016E

2017E

Revenue ($ mil.)

ACTUAL

CURRENT

PREVIOUS

CURRENT

PREVIOUS

Q1 Sep

$130.8A

$133.5A

$133.5A

$141. 5 E

$141.0E

Q2 Dec

$123.8A

$131.7A

$131.7A

$139.7E

$139.2E

Q3 Mar

$145.8A

$157.9A

$150.7E

$166.9E

$158.9E

Q4 Jun

$146.6A

$153.0E

$150.5E

$162.3E

$159.1E

Year

$547.0A

$576.1E

$566.3E

$610.4E

$598.1E

Change

+7.2%

+5.3%

+5.9%

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  • Numbers may not foot due to rounding.

HIGHLIGHTS

  • ACET posts revenues of $158 million, ahead of our forecast, due to improvements in Performance Chemicals (PC) and Pharmaceutical Ingredients (PI), partially offset by lower than expected growth in Human Health (HH) continuing Q2'16 trends.
  • Adjusted earnings of 42c surpass our 41c forecast. The impact of higher than expected revenues was tempered by a 90 bp decline in gross margin. SG&A costs rose less than revenues limiting the overall operating margin decline to 30 bps.
    • Gross margins were negatively impacted by product mix in HH and PC, while PI improved due to higher international sales.
    • Three products launched in Q3'16 and 9 currently approved and pending launch. Pipeline of 107 products including 49 ANDAs on file with FDA
    • Our FY'16 and FY'17 EPS estimates of $1.60 and $1.75 respectively and other valuation approaches imply a target of $30. We rate the shares BUY.

RISKS

  • Delays or denials of regulatory approvals for Aceto's products and/or supply disruptions could hinder the company's growth, profitability and share price.
  • Aceto operates in a highly competitive market, particularly for generic drugs, where pricing pressure and timing could impact margins and valuation.

Q3'16 EARNINGS SUMMARY

Total revenues rose 8.3% with the Human Health segment providing a 4.4% lift, Pharmaceutical Ingredients a 13.0% expansion and Performance Chemicals an 8.9% increase. Currency had a minimally negative impact in the quarter of approximately $800,000, in contrast to the material headwind that the company had experienced earlier in the year. Q3'16 adjusted EPS of $0.42 (which includes adding back tax adjusted amortization and interest rate swap expense) compares to $0.34 in the same quarter of the prior year, representing a 24% increase.

By segment, the Rising division benefitted from a $2.9 million increase in sales, contributing to the 4.4% increase in the Human Health segment. This rate was slower than in previous quarters with the deceleration attributable to price protection, product mix and chargebacks. Price protection detracted $1.5 million from sales related to one product and chargebacks, which compensate for lower than expected sales prices by wholesalers, had a negative $2 million impact. Performance Ingredients sales accelerated into double digits in the third quarter, Ingredients continuing to benefit from strong sales of active pharmaceutical ingredients (APIs) abroad, most notably in Germany and Singapore and sales of intermediates in Germany and France.

For Performance Chemicals, agriculture drove the improvement in this seasonally strong period for these products. Increase in sales of a widely used insecticide and growth in the potato sprout inhibitor were the key items. Agriculture increases were offset by a drop in sales of agricultural, dye, pigment and miscellaneous intermediates.

Human Health represented 37% of total corporate sales in Q3'16, falling slightly as a proportion of total sales from previous quarters. Pharmaceutical Ingredients has shown relative strength recently due to foreign API sales, and has grown to 29% of the total while Performance Chemicals rises to just over a third of the total. Corporate-wide margins declined in the quarter compared to Q3'15 due to mix shift among the segments and a decline in gross profit for Human Health and Performance Chemicals. Product mix negatively impacted overall gross margins reducing them 90 bps compared to the same quarter last year.

Two factors, in particular, had a material impact on Human Health profit margins causing a $3.5 million headwind: chargebacks and price protection. In the industry, chargebacks are requested by wholesalers who sell to pharmacy customers. The price that the wholesaler receives from the pharmacy is not initially fixed, and the wholesaler may not be able to obtain the expected price due in some cases to payor mix usually related to government customers. The contracts with the wholesalers provide an avenue to pursue chargebacks from Aceto under these circumstances. The impact from chargebacks was just under $2 million in the quarter. The effect from price protection was related to a single product where prices were increased in Q3'16. Under price protection, Aceto was obligated to pay wholesalers funds or in-kind shelf stock in return for raising the price. This factor negatively impacted gross margin by $1.5 million.

Below, we provide an update of Aceto's product pipeline and note that total projects vs. Q2'16 increased by two.

As compared to the prior quarter, seven products were launched vs. five in last quarter's update. Products in development increased by three to 46 and ANDAs approved pending launch increased to nine from six.

One of the tailwinds that Aceto is expected to benefit from is a recent push by the FDA to clear generic backlog and provide a response more quickly for products that merit action. Recently, the FDA began providing information relating to volumes of ANDAs in-process and those receiving action in what they call their Generic Drug Review Dashboard. This emerged from the Generic Drug User Fee Amendments of 2012 (GDUFA), which prompted the Office of Generic Drugs (OGD) to increase transparency and increase efforts to make generic drugs available to the public. For the first three months of calendar year 2016 (which matches Aceto's fiscal third quarter), FDA approvals and tentative approvals, complete responses and easily correctable deficiency and information requests (see below) totaled 2,115, a sharp increase from the same period in the prior year where the sum totaled 1,312. This represents a 61% expansion in volumes and suggests that the FDA continues to improve the timeliness of responses and we expect this will have a positive impact on Aceto's ANDA backlog.

With the FY'14 acquisition of PACK Pharmaceuticals, Aceto is now classified as a pharmaceutical company (69% of year to date FY'16 revenues are pharmaceutical related) and merits a higher multiple for this increased exposure to this higher margin and faster growing segment. Using FY'17 estimates, we apply a 17x EPS multiple, in-line with peers, to EPS of $1.75, an 11x multiple to EBITDA and apply an 11% discount rate to our DCF model, which together generate a one-year price target of $30. The stock trades at 12x FY'17 free cash flow and materially below our target price which is a discount to comparable companies. Thus, we rate the shares a BUY with a target of $30.

Thesis

We remind investors that our favorable view on Aceto is based on several factors which we list below:

  • Company has tremendous growth opportunity in the rapidly expanding pharmaceutical and active pharmaceutical ingredient space. Based on information provided by IMS Health, a well-recognized healthcare services information company, total pharmaceutical spend is anticipated to grow at a 4-7 percent rate over the next five years, which is well in excess of the anticipated developed economy growth rate of 2-3 percent.
  • Aceto's shift towards human health and pharmaceutical ingredients merits a higher multiple given greater margin opportunity, higher anticipated growth and higher peer valuations. We believe Aceto is undervalued.
  • Company brings a high degree of international exposure in its diversified portfolio, with over 25% of revenues attributable to Europe and Asia-Pacific.
  • Changes from Generic Drug User Fee Amendments of 2012 (GDUFA) have prompted the Office of Generic Drugs (OGD) to add additional personnel to the roster in an attempt to clear backlog. We anticipate that this change could potentially reduce the duration of the FDA approval process from almost four years to two years, significantly accelerating the launch of products that have been filed with the agency.
  • Aceto is a strong free cash flow generator, and is expected to produce a free cash flow yield of almost 4% in 2016 rising to over 8% in 2017, as working capital balances grow in line with sales.
  • Aceto provides a dividend of approximately 1%.

Q3'16 DETAILS

  • Third quarter sales increased 8.3% to $158 million vs. Q3'15, and rose sequentially on seasonal strength by 20%. Revenues compared favorably to our estimates of $151 million due to the lack of a currency headwind and as lower than expected growth rates in Human Health were offset by improvements in Performance Chemicals and Pharmaceutical Ingredients. As in previous quarters, slower sales in nutritionals were offset by improvements in agricultural sales and strength abroad.
  • Gross margins contracted slightly due to several factors. Q3'16 gross margin of 24.2% contracted 90 basis points compared to Q3'15. Price protection, increased levels of chargebacks and product mix conspired against the company to reduce margins. These factors were partially offset by strong international sales and increased revenues from intermediates in the Pharmaceutical Ingredients category.
  • SG&A expenses (including R&D) decreased by 70 basis points but rose slightly in dollar terms versus Q3'15. Aceto incurred $1.16 million in expense related to an acquisition that it did not pursue due to price competition and structural issues with the target. These expenses were almost completely offset by a reversal of contingent consideration for two prior acquisitions, with the reversal related to estimates regarding ultimate payouts. R&D spending increased to $2.3 million from $2.1 million due to milestone based project expenditures. Excluding R&D, SG&A expenses were up by $430,000 but declined as a percentage of revenues on effective cost control and fixed cost leverage.
  • Earnings were 42c in the quarter which was a penny higher than we forecasted. We note that operating earnings were slightly behind our estimates ($16.5 million vs. $17.2 million) and the beat was achieved due to a lower tax rate. Sales in foreign jurisdictions are subject to a lower tax rate than sales in the United States, bringing the rate down to 32.9% from our forecast of 37.0%.
  • Three new products launched in the quarter. In January, Aceto launched Zolmitriptan used for the treatment of migraines in adults. In March, the company launched lithium carbonate extended-release tablets which are used in treating manic depression and metronidazole tablets which are used in treating a variety of bacterial infections. As of May 2016, the pipeline continues to be strong with the number of pipeline projects up two to 107 as compared to Q2'16 with 7 products launched this fiscal year and four new additions to the portfolio.
  • Of the 107 products in the pipeline, 49 are abbreviated new drug applications (ANDAs) that are on file with the FDA and represent end market sales of $6.2 billion. 29 of the 49 ANDAs have been on file with the FDA for more than 24 months. We anticipate that the GDUFA tax in 2012 will continue to accelerate the approval rate due to increased staffing at the agency. This change could potentially reduce the duration of the FDA approval process, accelerating the response regarding products that have been filed with the agency.
  • In November 2015, the company issued $144 million in convertible debt, including a $19 million over-allotment. The funds were used to pay down $82 million in bank loans, with the remainder available for business and product acquisitions. Trailing 4Q net debt to EBITDA is approximately 0.75x. Cash and investments are $57 million and total debt was $116 million. We believe the overall financial strength of the firm and cash flow generation will continue to support the servicing of these borrowings and the payment of the dividend for the foreseeable future.
  • Guidance and Estimates: Aceto maintained its FY'16 sales guidance of a low mid-single digit increase due to a reduction in revenue in Performance Chemicals stemming from the devaluation of the Chinese currency and increased competition in the generic market. Adjusted net income growth is expected to increase in the low double-digit range. In the prior quarter, the company reduced GAAP net income guidance due to the impact of costs related to the convertible bond issuance. As in previous years, management believes that performance will be back-half loaded. Based on trends for the first three quarters of FY'16, we anticipate Aceto will be able to surpass its guidance with an almost 6% sales increase year to date and an adjusted earnings increase in the high 30% range.
  • Aceto targeted its R&D budget guidance to the low end of its previous range at approximately $8 million in FY'16, which compares to $5.9 million in 2015. R&D will support new product development with development partners and should also foreshadow new product launches in future years. Year to date, R&D spend has been $6.3 million.
  • Our forecast increases to $1.60 for FY'16 due to the better than expected results in Q3'16, and we continue to anticipate that the majority of earnings occur in H2'16. We are forecasting 5.3% revenue growth for FY'16 up from the previous 3.5% rate. Growth will predominantly come from high single-digit increases in the Human Health and Pharmaceutical Ingredients with low single-digit increases in Performance Chemicals. Gross margins are expected to continue to improve for the year, despite the issues previously mentioned in the Human Health segment. SG&A, after adjusting for one-time items, will decline slightly vs. FY'15 levels as a percent of sales. R&D expenses will rise as Aceto and its partners take on new projects and is anticipated to rise to $8 million. Operating margins should maintain and improve on their position in the low double-digits for the full year, increasing on a rolling quarter to quarter basis.
  • Cash levels are expected to rebound in FY'17 due to continued free cash flow generation. Wholesalers have been consolidating in recent years and with increased negotiating strength, they have increased their payables terms. Consolidation in the industry has led to slower payables from these parties and an increase in DSOs; however, based on our research, we believe that the terms have settled in recent quarters, and we should see working capital increase only in line with revenue growth going forward.
  • Consistent Dividend of $0.24 per annum. Aceto generates sufficient free cash flow to pay a dividend of 6c per quarter, which represents an annualized yield of approximately 1.0%.

VALUATION

Aceto Corporation is trading at just over 14x our 2016 adjusted EPS estimate of $1.60 and 13x our 2017 EPS estimate of $1.75. As a multiple of 2016 estimated revenues, ACET trades at 1.3x and on an EV/EBITDA basis, 9.3x. We calculate a target price by blending our multiple of EBITDA, Price to Earnings and DCF valuations, summarized in the table below.

Since last year, multiples in the industry have declined, and we have reduced our peer average target group accordingly. Using 2017 estimates, we use a 11.0x EBITDA, a 17.0x price to earnings multiple, and an 11% discount rate to determine our target price of $30. Our previous price target was determined using an 11.0x EBITDA multiple, 24.0x P/E multiple and an 11% discount rate and generated a target of $34. Based on our update, we believe these multiples are justified given Aceto's high potential growth rate, low capital intensity and strong free cash flow metrics. Our target price of $30 offers 47% upside from current levels.

Aceto Corp.

2017 EPS/EBITDA

Valuation Calculation

Method

Multiple of EBITDA

P/E Multiple

DCF

Multiple/Discount Rate

11.0x

17.0x

11%

Target Price

$29.73

$29.73

$30.62

Blended Target Price

$30.03

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We reiterate the favorable industry dynamics, attractive valuation, strong free cash flow generation, and attractive portfolio of assets which we believe will be launched at an accelerating rate supporting our BUY rating of Aceto Corporation.

The calculations above suggests Aceto shares are undervalued based on our 2016 EPS estimate of $1.60 and any PE multiple of 15x or higher.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ACET over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.