Alpharma Drops on Shrinking Margins

Alpharma (NYSE: ALO) reported its earnings for Q3 2007 after the close on Oct. 29, and investors were underwhelmed. The company announced earnings of US$0.34 per share, an increase of 9% from the same period last year and US$0.09 over expectations. Initially the response was positive and shares rose over 7% on Oct. 30^th. However, the gains have disappeared as shares fell 2.2% on Oct. 31, returning to their pre-release level US$20.62. The reason behind the disappointment? Shrinking margins.

On top the numbers looked good. For the nine months ending Sep. 30, revenues were US$523 million, up from US$484 million last year. The three major divisions of the company – Pharmaceuticals, Active Pharmaceutical Ingredients (API), and Animal Health – all showed revenue growth. Unfortunately not all of those revenues flowed to the bottom line:

There were two primary reasons for the margin erosion: increased R&D expenses and increased production costs. R&D spending more than doubled to US$ 56 million or roughly 10% of revenues. This reflected spending on clinical trials related to abuse-deterrent opioid product development. This includes phase 3 trials of its analgesic compound ALO-01, for which a mid 2008 application for FDA marketing approval is expected. Also included was a US$2 million licensing payment to Tris Pharma related to the development of a sustained release liquid drug delivery platform. The company’s Kadian (sustained release morphine sulfate) appears to have solid acceptance in the chronic pain treatment arena, and these R&D investments have the potential to build on that success.

The problem area is production costs. With cost of goods rising faster than revenues, the company needs to bring costs under control if it hopes to boost margins. One key approach being taken by Alpharma is to increase its production capacity in China. In April the company acquired Shenzhou Tongde Pharmaceutical Co. Ltd, a primary supplier to Alpharma’s animal health division. This was followed by the June acquisition of Yantai JinHai Pharmaceutical Co. Ltd. The acquisitions totaled US$6.9 million.

In July the company inked an alliance with Zhejiang Hisun Pharmaceutical Co. [SHA: 600267], a primary supplier of the antibiotic Vancomycin to Alpharma’s API division. Under the agreement the company reports it has invested nearly US$7 million in expanding manufacturing capacity at Hisun’s plant in Taizhou, Zhejiang Province. With the cost of API production in China estimated at 1/3 that of Western plants, these China moves should help to control costs over time. However, margin pressures on API producers are likely to persist.

“In our Animal Health and API businesses, we are targeting strategic investments in China that we believe over time will improve our supply chain and establish a presence in this important global market,” said Alpharma President and Chief Executive Officer Dean Mitchell. “We are also building the core competencies in our organization that will enable us to be an active future participant in the growing Asian region.”

While Alpharma’s latest earnings release was clearly a mixed bag, the company is making some moves to try to set things right. In addition to its R&D and China investments, the company recently licensed the Flector analgesic patch from Swiss drug maker IBSA. The company has also licensed topical ketoprofen from IDEA AG. Flector and topical ketoprofen should augment the company’s pain management portfolio, but the company will need to control costs as it ramps up its sales effort for the new product.

Management currently estimates 2007 earnings at US$0.90 to $1.00. Analyst consensus is currently US$0.95. With current earnings at US$0.92 the risk of a Q4 earnings disappointment is high. Investors will be watching closely over the next few months to see continued growth in its current product lines, revenue enhancement from new products, and continued progress on cost reduction. Should margins remain under pressure, however, the share price is unlikely to see a lift.

Disclosure: none