Endo International (NASDAQ: ENDP) is a hybrid generic and branded drug company with a roughly 60/40 revenue split between generic and branded pharmaceuticals. Both businesses have various challenges but in the current negative environment for many pharmaceutical companies, ENDP's stock had a recent bottom at only 3-times cash flow. The stock has already recovered a bit prior to today's earnings release but the company was still only valued at 4-times cash flow prior to the release.
Another factor in the very inexpensive valuation for the company is what I might call "the Valeant effect" as many acquisition oriented pharmaceutical companies that were using acquisitions as a growth driver were also assumed to be using the same flawed strategies as Valeant such as overpaying for acquisitions with relatively low cost debt and then attempting to implement unsustainable price increases for newly acquired drugs.
Endo's most recent acquisition in 2015 was actually of a very well run generic pharmaceutical company which was Par Pharmaceuticals. Par had a long successful history as a very well managed generic drug company and such management strengths were a great addition to Endo's existing generic drug business which was originally named Qualitest Pharmaceuticals. While Endo has used debt for acquisitions, I still believe the company has been disciplined in terms of prices paid for acquired companies and that is also shown by its manageable leverage ratio of debt being six-times current cash flow (versus Valeant where debt is over 15-times cash flow, which I guess was missed by both Bill Ackman and the Sequoia Fund!).
Endo's strong cash flows of close to $5 per share annually should also enable rapid deleveraging of the debt which is currently on the balance sheet. My financial model projects that by 2020, the total debt should be less than three-times cash flow and such rapid deleveraging would also result in annual earnings gains of around ten percent just from lower interest expense each year. Given the stock's currently very inexpensive valuation, a future valuation increase to just six-times cash flow would result in a roughly 50 percent gain in the company's stock price.
New Growth drivers in both the Branded Pharmaceutical and Generic drugs businesses
Endo currently has two relatively new branded drugs on a growth curve which are Xiaflex for various excess collagen related conditions and Belbuca which is a novel pain medication with less risk of unprescribed abuse due to its delivery mechanism which is through a "buccal" film (a strip placed inside a cheek within the mouth).
The primary indications for Xiaflex are in Dupuyten's Contracture and Peyronie's Disease where there are essentially no alternative therapies other than surgical approaches which rarely have effective outcomes. There is a bit of a learning curve in marketing to physicians for both indications but Xiaflex is already on-track to generate $200 million of revenues this year and has the potential to grow by 15 to 20 percent per year over the next three to five years.
Belbuca is currently in its initial marketing stages with very low revenue generation expected in 2016 but it is projected to produce annual revenues of between $200 and $300 million within three to five years. Belbuca marketing also benefits from Endo's established franchise in pain management medications which include four other branded and well-established pain management medications. Pain management is a somewhat controversial market segment currently due to opioid abuse concerns but the reality is that roughly 100 million U.S. residents do have some level of chronic pain for which valid prescriptions would be appropriate. Novel formulations such as Belbuca help mitigate concerns about possible unauthorized diversion of an opioid compound which should create a very attractive growth profile for the medication.
Endo's generic business also has a stable base of revenues diversified across three main market segments which are primarily pain management, injectables, and alternative dosages. While generic drugs are a very competitive business where existing compounds are usually subject to ongoing price reductions, Endo mitigates such pressures with an active development program of newly offered generic drugs through an active 505(b)2 program and traditional ANDA applications where between 20 and 30 new compounds are being developed each year. This year will also result in two "blockbuster" generic compounds being approved for sale by Endo which are the generic equivalents for Seroquel and Xetia which are both generating over $1 billion in annual sales.
Business Risks and other Factors to consider
The growth oriented activities for Endo described above are both attractive business and earnings growth drivers but also required activities given the overall characteristics of both branded and generic pharmaceuticals. Branded pharmaceuticals are continually subject to new therapies being developed in the same market segment which can result in both pricing pressure and market share losses. Generic drugs are also continually subject to pricing pressures due to additional entrants into each generic therapeutic area and also from large groups of concentrated drug purchasers. Such purchasers are known as "consortiums" and four very large consortiums currently control around 90 percent of total generic drug purchases each year.
Part of the reason for Endo's very inexpensive valuation currently is that consortium contracts usually renew at the start of each year but the integration process with the new Par Pharmaceutical purchase in 2015 resulted in some market share losses when various Par and Qualitest drugs were not included in consortium purchase contracts at the start of 2016. Endo's generics business has now stabilized, however, and should be positioned for regaining market share going forward.
Another factor within Endo's overall operations is that a now discontinued woman's health business was acquired in 2012 which had a "mesh" product used for various gynecological procedures. Such mesh products, which were also sold by many other medical device companies as well, were subsequently implicated in causing both chronic pain and other complications across many patients who received the mesh implants. Endo has established a $1.6 billion reserve fund, which has already been expensed to earnings, that it feels should be adequate to pay for any claims connected to the mesh products sold by its former subsidiaries. Endo also currently expects that all claims should be settled and paid by the end of 2017 and so the matter should be behind them at that point. The cash flow projections already mentioned earlier in this article are also after any cash payments involving the mesh claims.
Current Business Trends
Endo's current results are effectively characterized as a "rebuilding year" given the early in the year disruptions in its generic drug segment and also a patent expiration for one of its primary branded drugs. As I mentioned at the start of this article, I also think that a lot of acquisition oriented pharmaceutical companies have been affected by perceptions that such companies had a lot in common with the very badly flawed strategies and financial irresponsibility of Valeant and suffered similar stock price decreases.
Endo's Q2 results released today show that their business has stabilized, however, and earnings were actually above expectations due to an unexpected revenue increase due to stronger restocking orders right before the end of the quarter. Endo's forward guidance for the rest of 2016 is somewhat conservative, however, and assumes that Q3 may have revenues slightly below previous expectations in case that the late in the quarter orders in Q2 may have pulled forward some demand that would have otherwise been seen in Q3. Overall guidance for the year has remained the same, however, and is forecasting non-GAAP earnings per share of at least $4.50 (for an $18 stock!).
Endo's financial statements are actually pretty complicated and that may result in some amount of additional discount for its shares as there are very large goodwill amortization charges (roughly $850 million per year) that depress GAAP earnings per share results. The amortization charges are included in Cost of Goods Sold and so that depresses Gross Margins as well which is somewhat misleading relative to other comparable companies. I view the very large goodwill amortization charges as actually a positive, however, given how much they add to Endo's cash flows each year relative to their reported GAAP earnings.
Such strong cash flows are the reason why Endo can deleverage very quickly over the next three to four years. My financial model projects operating cash flow each year to be between $1.2 billion and $1.5 billion per year between 2017 and 2020 relative to what is currently $8.2 billion of debt. Capital Spending each year is relatively low at around $150 million and so that should result in between $1 billion and $1.2 billion each year to be allocated to debt repayments once the mesh litigation payments are completed in 2017. With such large debt repayments forecast for 2018 through 2020, I'm projecting that total debt by the end of 2020 to be less than $4 billion, which would also be less than three-times cash flow.
Although Endo has a somewhat complicated business with both branded and generic drug operations and also a complicated set of financial statements with very large goodwill amortization charges each year, I believe that overall cash flows should be both very large and relatively stable. The company is currently valued at only four-times cash flow but I believe that an appropriate cash flow multiple should be at least six-times cash flow given what I believe is the company's visible path to rapidly repay debt. Additional earnings gains will also occur from the debt paydown as there will then also be lower interest expense each year.
Disclosure: I am/we are long ENDP.
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