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Taro Pharmaceutical Industries (TARO) is a generic drug manufacturer based out of Israel with its functional headquarters in the United States. An investment in TARO offers upside of 50% to 100% upon TARO trading near the multiples of its publicly traded peers and the inevitable buyout of the remaining public shares by Sun Pharmaceuticals (SUNP).

TARO manufactures over 200 different prescription and OTC products in facilities located in the US, Canada and Israel. Their main area of expertise and specialization is in dermatological creams, ointments and gels. This area of the generic pharmaceutical industry has characteristics that make it highly profitable for the companies in this niche.

Most dermatological prescriptions have relatively low demand and require more sophisticated production than normal generic drugs. This creates a large barrier to entry as it is quite expensive to build a manufacturing facility and gain FDA approvals for new generic drugs. This has led to an oligopolistic (2 to 4 competitors per drug) industry structure with high margins.

TARO is controlled by SUNP, a large Indian pharmaceutical company, which owns approximately two thirds of TARO's equity. SUNP's purchase of a majority of TARO was held up for a number of years as TARO's founding families fought SUNP over the price SUNP was paying for their shares. During this time period TARO did not issue audited financials and their stock was de-listed and began trading on the pink sheets. SUNP finally was able to resolve their ownership fight with original stakeholders in late 2010 with their ownership moving up to 66.3%. This led to TARO issuing year-end 2010 financials in late June 2011.

TARO's operating results have improved markedly since SUNP obtained operational control of the business. SUNP has a track record of running pharmaceutical operations at much lower costs than TARO. SUNP had accomplished this feat previously with Caraco, which was another US pharmaceutical company it partially acquired and managed. Caraco was finally acquired by SUNP after it resolved a manufacturing problem that undermined its initial success.

SUNP has acquired 13 pharmaceutical companies since 1997 and currently generates about $1.7 billion in annual revenue. Based on current figures, TARO is approximately one third the sales and EBITDA (earnings before interest taxes depreciation and amortization, a commonly measure of cash flow) of SUNP. While SUNP is now consolidating TARO's financials into their numbers and operating the business, it does not have access to the balance sheet and meaningful free cash flow generated by TARO.

SUNP announced the appointment of a new chairman, Israel Makov, in late May 2012. He previously led Teva Pharmaceuticals (TEVA) through its growth from a small generic drug manufacturer into one of the largest players in this sector. Mr. Makov grew TEVA through a combination of acquisitions and generic drug approvals. By my count TEVA acquired in excess of 20 other generic drug manufacturers during his tenure. Many of the deals were for private companies where it is difficult to obtain transaction multiples. For the public deals, TEVA paid EBITDA multiples from 6 times to 23 times. As can be seen in the table below, the median EBITDA multiple paid was 10.25 times (source: Bloomberg).

Click to enlarge.

Valuation Analysis

I have included two methods of valuing TARO shares based on current publicly traded company multiples and a merger and acquisition analysis.

The public comparables I used are Teva (TEVA), Mylan (MYL), Perrigo (PRGO) and Watson (WPI). These stocks trade at average and median EBITDA multiples of 11.3 and 9.8 times, respectively. Using the mid-point between the average and median multiples yields a price for TARO stock of $67 per share based on the latest twelve months financials ending with the March 2012 quarter. However, this understates TARO's current operating results since the first quarter of 2011 did not include the increase in revenues and cash flow from the price increases the Company was able to put through. Assuming the just finished June quarter had results similar to the three previous quarters brings LTM 6/30/2012 EBITDA to in excess of $280 million and results in a price of better than $73 per share and for the full-year 2012, I project EBITDA to be in excess of $284 million which results in a price of over $78 per share.

Using a comparable merger and acquisition analysis yields a significantly higher multiple of EBITDA. The transactions I used for comparison are Foguera, King Pharmaceuticals (KG), IVAX Pharmaceuticals (IVX), Andrx (ADRX), Bradley Pharmaceutical (BDY), Bentley Pharmaceuticals (BNT) and Eon Labs (ELAB). Average and median EBITDA multiples for these transactions are 17.8 and 16.1, respectively and yield share prices of $98 to $109.

Expected Scenario

I believe the improvement in the trading in TARO's stock price will be a two step function. Now that TARO's board has rejected SUNP's offer, the concern over a buy-out below where the stock is currently trading has dissipated. TARO's stock should begin to trade more in-line with its peer group. Using a 20% discount to the group's average would yield a multiple of about 8 times EBITDA or roughly $50 to $55 per share, which is nearly a 50% premium to current trading multiples. Should any analysts decide to follow the stock, that discount would probably shrink over time.

I also believe that at some point in the not too distant future, SUNP will want to be able to access the excess cash and cash flows at TARO. TARO is approximately a third of the overall business of SUNP and its results are being closely monitored by the 30 plus analysts that cover SUNP in the Indian equity markets. SUNP management spends quite a bit of time on their earnings calls answering questions on TARO. SUNP currently trades for 18.7 times EBITDA. Any transaction whereby SUNP acquires the rest of TARO's common stock for a lesser multiple is highly accretive to SUNP's shareholders. SUNP could choose to do this in a number of ways.

I believe the mostly likely way would be for SUNP to make a cash offer for the remaining TARO shares. At multiples between 10 and 15 times EBITDA that would work out to between $1.0 and $1.4 billion for the remaining shares. SUNP could fund most of this purchase with the combined cash from its and TARO's balance sheets at year end. Secondly, SUNP could choose to use TARO as a means to listing its shares in the United States through an exchange offer. This might make more sense than it had in the past due to the increased amount of business SUNP is now doing in the US. I would obviously prefer cash, but SUNP has a great track record and it would provide a way for US investors to gain easier access to a successful Indian company.

Source: After Rejecting Sun's Buyout Offer, Taro Is Now Ready To Shine